Please ensure Javascript is enabled for purposes of website accessibility

How Cabot Oil & Gas Is Tackling This Overwhelming Challenge

By Arjun Sreekumar - Jul 10, 2014 at 2:43PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Over time, Cabot Oil & Gas’ investments in new takeaway capacity should help reduce currently wide Marcellus basis differentials and improve its returns.

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 (CTRA 1.29%) 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.

Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Coterra Energy Inc. Stock Quote
Coterra Energy Inc.
CTRA
$28.18 (1.29%) $0.36

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
379%
 
S&P 500 Returns
123%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/09/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.