The oversupply that accompanied OPEC's decision to flood the markets in 2015 wreaked havoc on oil and gas producers, driving down prices for crude oil and natural gas. This year, we can expect more low prices and oversupply thanks to Russia and OPEC. In the midst of this uncertainty, one company, Cabot Oil and Gas (CTRA 1.76%), has consistently cut operating costs, posted an operating profit margin of 40% in 2019, and sells its natural gas for much more than the commodity's trading price, thanks to some clever moves by management. But the company may not be able to sustain this impressive track record forever.
Source: Getty Images.
A quick pivot from oil to gas
OPEC's 2015 actions made leaving the oil game a likely no-brainer for Cabot's management. Houston-based Cabot has been steadily decreasing production of oil since then. Here's Cabot's production mix since 2015:
Source: Company SEC filings.
With production way up and prices way down once again, investors should rejoice in management's decision. Right now, oil's trading at $20 per barrel, far below any U.S. company's costs to produce that oil, making Cabot's 2018 decision to abandon oil and focus only on natural gas even wiser.
The company divested most of its oil-producing assets in 2018 and into 2019, leaving only its Dimock field in Northeast Pennsylvania to produce all its natural gas. According to the company's annual earnings statement, at 2019's end the Dimock field still had 8.1 trillion cubic feet of natural gas in proved developed reserves waiting to be extracted.
Even though natural gas currently trades at around $1.65 per million British thermal units, or MMBtu, the company is able to sell it for $2.45 per MMBtu thanks to hedging instruments and customer contracts. It did all this while producing at a cost of $0.06 per MMBtu, making production costs from direct operations a scant $77 million last year.
By going all-in on natural gas, Cabot incurred a relatively modest $1.19 billion in operating expenses in 2019, down 15% from 2018 -- and just short of the target percentage management cited in earnings calls throughout 2019. But what did the company cut in order to keep costs so low?
Hedging its bets
First off, Cabot has not recorded an impairment charge on its assets since 2017. Like every other company, Cabot records the values of its assets on its balance sheet at fair market value -- basically, what the assets can sell for on the open market. In the case of natural gas-producing wells, the value of those assets is based upon the price of natural gas at the time it is being recorded.
On Dec. 31, 2019, natural gas closed at $2.24 per MMBtu. Cabot has hedging instruments ensuring that 42.8 billion cubic feet of its production stays above the price of $2.27 per MMBtu. The company also has contracts with customers that lock in the sale price, and desired volume, of its production.
Cabot has steadily taken advantage of these contracts and hedging instruments to keep its wells valued similarly for the past two years. The latest valuation of its wells is based on a price per MMBtu of $2.35, much higher than what natural gas actually trades for now. Cabot has customer contracts for production that last until 2024, according to the company's last 10-K, meaning the prices Cabot gets from those customers won't fluctuate much over the next year.
In its latest earnings announcement, Cabot management warned that after 2020, the whole of its production is not hedged against price fluctuations that we are seeing in the natural gas commodities market. When these hedges expire, Cabot will be forced to receive a much lower price for natural gas -- currently $1.92 per MMBtu.
Falling (and rising) costs elsewhere
One factor that helped keepCabot's costs low in 2019 was the elimination of costs associated with brokered natural gas. Sometimes natural gas wells don't produce enough to meet what Cabot has promised to deliver to its customers. In that case, the company has to purchase natural gas from external sources until it can boost production and pick up the slac.
In 2018, Cabot did this to the tune of $184 million in costs, for which it realized $209 million of revenue. While a 13.8% profit margin may not sound too shabby to you and me, the company realizes an effective profit margin of 97.5% from producing its own gas. Stepping up production to fulfill its contracts without needing to buy outside gas -- and eliminating this cost -- helped to boost Cabot's earnings.
The company also cut exploration costs to just $20 million in 2019, from $94.3 million in 2018. Given its huge existing reserves, the company chose not to explore for new wells in 2019, instead using $783.3 million to build facilities for existing wells.
However, Cabot may not be lucky enough to enjoy a similar reduction in costs for the transportation and gathering of its product. At $574 million, this operating expense represented more than 48% of its operating expenses, and it rose 16% from 2018's $497 million. Higher wages and input costs have driven this operating expense reliably upward for the past three years, with no end in sight.
Why these costs could make a comeback
Cabot's use of hedging instruments and customer contracts to stabilize natural gas prices is certainly impressive. These maneuvers are going to help it maintain a low operating expense environment and stabilize revenue for 2020. But investors far prefer to see companies promising growth in both revenue and cash flow.
If Cabot were interested in growth, we would see a higher number for exploration expenses than we do now. And if natural gas prices remain subdued into 2021, after Cabot's hedging instruments have expired, the company may have to write down the value of its wells, leading to those dreaded impairment charges.
When Cabot runs out of time on its hedging instruments at the end of this year, and when customer contracts start coming up for renewal, the costs it's been cutting are likely to return. Investors may want to wait on an investment in Cabot until the 2020 10-K is released and management provides an insight into its future hedging strategies.
