With oil and fuel prices on the rise and worldwide demand starting to heat up again, I think it's time we looked at some of the exploration and production (E&P) companies in the energy sector. One in particular, Cabot Oil & Gas (COG) looks particularly interesting at current levels. It bears noting that, although crude oil and gasoline prices have been rising at a steady pace recently, natural gas prices have not been keeping up. As a result, those companies with heavy exposure to this resource have struggled.
Oil and natural gas E&P companies have always been at the mercy of price trends in the underlying commodities they develop. This is especially true of the mid-tier energy producers, given their lower capital base in this highly capital-intensive industry. Cabot falls squarely into this category. With nearly 90% of its revenue coming from natural gas related products, COG is highly susceptible to swings in the commodity price. So then, what's to like about this mid-tier player in a beaten up industry? Well, read on.
We've all heard the comparisons - the U.S. is the Saudi Arabia of natural gas - and it appears as if we're now finally ready to begin capitalizing on our abundance of this valuable resource. Natural gas production in the U.S. has increased dramatically in recent years due to new extraction techniques and discoveries of new reserve sources. Some of these newly discovered fields are immense, giving the U.S. a rightful claim to the comparison with Saudi Arabia's vast oil reserves.
Of course these increases in production and the newly developed extraction techniques that make natural gas profitable to drill has led to much over-production. As a result, the price of the commodity has plummeted in the commodities exchanges. Companies with lower costs of extraction hold an advantage over their peers. Cabot has a huge amount of proven reserves in areas such as the Marcellus and Eagle Ford shale fields - two areas with relatively low-cost access to the natural gas there.
In fact, Cabot has some of the lowest-cost drilling assets in the business. Compared with competitors such as Chesapeake (CHK), Anadarko (APC), Devon Energy (DVN) and Ultra Petroleum (UPL), Cabot has a relatively low cost of extraction. In addition, the amount natural gas reserves for Cabot is near the high end of all competitors, at more than three trillion cubic feet proven.
The entire natural gas industry has been facing tough times of late. With the economic downturn, the demand for natural gas fell sharply, just as production was hitting all-time highs. The result is a commodity price that has hit 10 year lows recently. Many E&P companies simply can't compete profitably at those levels. Some will undoubtedly go out of business, while others will get absorbed. It's the nature of cyclical industries and capital markets.
Cabot however, has the ability to withstand these tough times due to its lower cost of production and the size of its reserves. In a worst-case scenario, they get bought out by a larger rival at a premium to the current stock price.
Another challenge that faces the entire natural gas industry in the U.S. is the negative attention being given to the process of hydraulic fracturing of the rock to extract the oil and gas trapped there. This so-called "fracking" is said to leave behind chemicals and to force methane gas into ground water reservoirs. Currently, the Energy Information Agency (EIA) is looking into these claims. If fracking is restricted or eliminated, many E&P companies that rely on this technology will find it difficult to operate.
What will follow is likely to be a huge increase in the cost of production and a resulting increase in the price of natural gas. The companies that can survive in this scenario are likely to benefit mightily from this increase in revenue. Of course, the elimination or even a restriction on fracking is very unlikely in the current environment. Again, Cabot is in a position to benefit regardless of the ruling.
With a market cap of $6.2 billion, Cabot is a mid-sized producer in this category. As such, they are more affected by the swings in price of this volatile commodity. In 2011, Cabot saw huge share price gains of more than 100%, making it the biggest percentage gainer in the Standard & Poor's 500 stock index. Since then, shares have fallen to a recent price of around $32 a share.
The first quarterly report for 2012 was less than rosy and caused the sharp sell-off in price. I believe this offers bargain investors a chance to pick it up at a value level. The company's long-term expected growth rate of 34% is impressive, and makes up for the higher than normal P/E ratio of 40. I believe the actual growth rate of this company will be closer to the published growth rate at its Marcellus Shale field of 55% in 2012.
Most analysts were caught off-guard by Cabot's stellar 2011 performance and few of them expect a repeat in 2012. I think that they still don't get this company and its tendency to under-promise and over-deliver.
A Brighter Future
With all of the challenges and uncertainty surrounding natural gas production, there is a glimmer of hope on the horizon. As the price of oil from unstable areas of the world continues its rise, the politicians are finally beginning to take heed. The president has lately been touting the benefits of this vast natural resource at our fingertips. Congress will no doubt be pressured to respond favorably to any proposals that aim to increase our energy independence at the same time as it creates more U.S. jobs.
Although it is still a carbon-based fuel, natural gas is cleaner than both petroleum and coal fuels. Our electricity generation plants use natural gas more than any other fuel source. This clean energy source is tailor made for our environment as well as our economy. Natural gas and the E&P companies who explore for and produce it are part of the solution to our energy needs, and Cabot is a huge part of that contingent.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.