One of the biggest issues for operators in Pennsylvania's Marcellus shale has been infrastructure limitations. Basically, pipelines, processing plants, and other infrastructure have failed to keep up with the rapid growth in the play's production, which has surged from less than 2 billion cubic feet per day (bcfd) in 2009 to more than 14 bcfd currently.
This has not only led many producers to hold off on bringing new wells online, but it has also caused regional prices to trade at a sharp discount to the NYMEX benchmark price. Indeed, during certain periods over the past year, gas at Marcellus trading hubs sold at a more than $2 per Mcf discount to the NYMEX benchmark.
While this price differential fell to under $1 per Mcf for most Marcellus producers in the first quarter, it remains a major concern for investors, especially for Cabot Oil & Gas (COG +0.00%) shareholders. Let's take a closer look at how the company is tackling this huge challenge and why its basis differentials should compress significantly over the next few years.
Cabot's big challenge
Despite Cabot's exceptionally strong production growth prospects and industry-leading cost structure, its inability to receive a higher price for its gas production has weighed on its share price performance this year. The company's shares are down about 10% this year, even though gas prices are significantly higher than they were a year ago.
In the first quarter, Cabot's average realized gas price came in at $3.74 per Mcf. While that's an 8.4% year-over-year improvement, it's still about $0.60 to $0.65 per Mcf lower than the NYMEX benchmark price. Second-quarter differentials are unlikely to be any better, since the gap widened to $0.75 to $0.80 per Mcf in April as certain winter contracts rolled off.
While Cabot can still earn an extremely strong rate of return at this price, its returns would increase dramatically if it could reduce basis differentials and receive a price closer in line with the NYMEX benchmark price. At a wellhead gas price of $3 per Mcf, Cabot earns a BTAX IRR (before tax internal rate of return) of 102%. But at a gas price of $4 per Mcf, its BTAX IRR more than doubles to 206%.
How Cabot is tackling the issue
The way to reduce differentials is by increasing takeaway capacity and diversifying one's marketing options. To that end, two major projects should provide a massive boost to Cabot's takeaway capacity and increase its exposure to more favorable gas indices. The first of these projects is the Constitution pipeline, a 124-mile line that will run from the Marcellus to Schoharie County, New York.
The line will be 75% owned by Williams Partners (NYSE: WPZ) and 25% owned by Cabot. It is expected to come online in late 2015 or early 2016 and will ship some 500 million cubic feet of Cabot's gas production daily to premium markets. For perspective, that represents more than 40% of the company's first-quarter Marcellus gas production of 1,209 million cubic feet per day.
The second major project that will boost Cabot's takeaway capacity is Williams Partners' Atlantic Sunrise project, which will greatly expand capacity on the partnership's existing Transco system -- a key pipeline system in the Marcellus. Cabot has already secured 850 million cubic feet a day of capacity on the project, which is expected to be completed by 2017.
As you can see, these two projects alone could ship all of Cabot's current Marcellus gas production. In addition, the company also has significant existing takeaway capacity on Kinder Morgan's Tennessee Gas Pipeline 300 Line and the Millennium Gas Pipeline. The combination of these options should result in a significant compression of basis differentials after 2015 and especially after 2017.
Investor takeaway
Cabot's forward-thinking investments in pipeline infrastructure should substantially improve its takeaway capacity and provide a more diverse array of gas marketing options over the next few years, helping drive down basis differentials and improving its returns. Given this expected improvement in differentials and the company's exceptional prospects for production growth -- 28%-41% this year and 20%-30% next year -- I think shares could currently be undervalued at 22 times forward earnings.
