America's abundance of natural gas thanks to shale is a game-changer for the country. Not only is the fuel much cleaner than coal, but it's cheap, too. That combination is fueling strong demand both in the U.S. and abroad.
However, just because demand for gas is strong doesn't necessarily mean natural gas stocks will make huge profits profits. The only real chance companies have at making a mint on gas is to be an ultra-low cost producer. Those that can achieve cost leadership have a major competitive advantage over rivals, making them the best natural gas stocks in the group.
The low cost leaders
Having an ultra-low cost structure is important for two reasons. First, producers with low costs can actually make some money when commodity prices are down, as these producers have a bit more wiggle room. The other reason low costs are important is because these companies have the potential to earn really outsized returns when prices improve, as they'll have the widest margins.
The current natural gas cost leaders are noted on the slide below from a recent investor presentation by EQT Corp (NYSE:EQT).
That slide points out the cost structures for natural gas companies based on the three-year average finding and development costs as well as the average operating expenses per MCF of production.
Finding and development costs, or F&D costs, are the costs incurred when a company purchases, researches, and develops properties to increase its commodity reserves. Basically, this is what it costs an energy company to turn acreage into assets. The top five F&D cost leaders, CONSOL Energy (NYSE:CNX), Antero Resources (NYSE:AR), Cabot Oil & Gas, EQT Corp, and Range Resources (NYSE:RRC), all share one thing in common: All five have major Marcellus Shale operations, which isn't a surprise, as the Marcellus is the most economical natural gas play in the U.S.
The other important cost, and the one where EQT in particular shines, is per unit operating expenses. This is what it costs each company to produce 1,000 cubic feet equivalent, or Mcfe, of natural gas. The top five here are slightly different: EQT Corp leads and is followed by Rice Energy (NYSE: RICE), Chesapeake Energy (OTC:CHKA.Q), Southwestern Energy (NYSE:SWN), and Cabot Oil & Gas. While all five have key positions in the Marcellus, Chesapeake and Southwestern are in this group because of their sheer scale -- the pair are among the top five largest gas producers in the country.
Of all the companies mentioned, EQT Corp and Cabot Oil & Gas really shine above the rest. The pair have a very powerful competitive advantage as both are in the top five in terms of F&D costs as well as per unit operating expenses. These industry-leading cost structures put both in a position to stay profitable in a low natural gas price environment as well as enjoy really robust profits when conditions improve.
Low costs = robust returns
Having the lowest costs enable a commodity producer to continue to grow when many of its peers can no longer make money. We see this on the following slide from Cabot Oil & Gas.
As that slide points out, Cabot Oil & Gas can still make an economic return on new natural gas wells even if natural gas prices plummeted to $1.79 per Mcf. That's nearly $0.50 lower than its nearest competitor, and more than a dollar less than others. That's a huge competitive advantage in a low price environment, as it means Cabot Oil & Gas can keep drilling well after others need to stop. Further, these low costs mean it can really supercharge its returns when conditions improve. That's a lot of upside potential considering the company can already earn an internal rate of return of 50% at a $2/mcf gas price.
The best natural gas stocks are those with the lowest costs. The top two in that department are EQT Corp and Cabot Oil and Gas, as both are in the top five for lowest F&D costs and operating cost per unit. That competitive advantage will enable both to drill economic wells at lower natural gas prices then their competitors.