According to a new report from the Energy Information Administration on Tuesday, natural gas production from the Marcellus shale -- one of the largest shale gas plays in the country -- continues to grow faster than anticipated.
The booming Marcellus
The EIA report finds that current production from the play has soared to 12 billion cubic feet per day, which represents a whopping sixfold increase over the play's daily production in 2009. Though the Marcellus formation spans several states, Pennsylvania and West Virginia are leading most of the growth in output.
In fact, production from the Marcellus currently outpaces production from any natural gas-producing country in the world, except Russia. And what's more is that production is growing despite a decline in the number of rigs operating in the Marcellus, as energy producers continue to become more efficient in their operations.
Now, you may be wondering: With oil drilling currently much more profitable than gas drilling, why are companies continuing to drill in the Marcellus?
Solid returns despite low gas prices
It really boils down to the play's exceptional economics, which are, by most measures, the best of any shale gas play in the country, as well as its relatively high content of natural gas liquids, which offer better returns than plain old dry gas.
Even at a gas price of $3.50 per MMBtu, Marcellus "dry gas" wells generate an average internal rate of return, or IRR, of 12%, while "wet" gas wells in the play generate an IRR of around 30% because of the higher proportion of gas liquids they contain, according to a report by Standard & Poor's.
That's why companies such as Cabot Oil & Gas (NYSE:COG), Chesapeake Energy (NYSE:CHK), and Range Resources (NYSE:RRC) continue to charge ahead with their drilling programs in the play. As some of the lowest-cost producers of natural gas in the Marcellus, these companies can generate solid returns even as producers in other parts of the country are forced to curtail gas drilling.
In the second quarter, Chesapeake grew its Marcellus dry gas production by 58% year over year and wet gas production by 56%, despite drastically reducing the number of rigs it has operating in the play. Similarly, Cabot's solid operational performance in the Marcellus helped it grow total production in the second quarter by 52% year over year, while Range delivered a commendable 27% year-over-year growth in production volumes.
1 stock to consider
While all three of these companies are intriguing investment opportunities, I'm currently most interested in Cabot. Not only has it aggressively grown both reserves and production in the Marcellus, but its Marcellus wells also generate some of the best returns out there because of the company's phenomenally low development costs. Even with the 10%-15% discount for Marcellus natural gas during the second quarter, Cabot's typical Marcellus well provided a staggering 120% return.
However, some investors may be concerned about the company's valuation, which looks stretched by some measures. Cabot currently trades at roughly 17.8 times trailing cash flow, which makes it look expensive compared with peers Ultra Petroleum (NASDAQ:UPL) and Southwestern Energy (NYSE:SWN), which trade at 5.8 and 7.6 times cash flow, respectively.
But those companies' growth prospects are much lower than Cabot's. Compared to Range Resources, which has similar growth prospects and trades at 18.8 times cash flow, Cabot doesn't look all that expensive. While I'm still hesitant to buy the stock at its current price, more risk-averse investors may want to dig deeper to see whether the company could be a good fit for their portfolio and risk appetite.
Fool contributor Arjun Sreekumar owns shares of Chesapeake Energy and Ultra Petroleum. The Motley Fool recommends Range Resources and Ultra Petroleum, owns shares of Ultra Petroleum, and has options on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.