Cabot Could Slip On Strategic Error

| About: Cabot Oil (COG)

Just recently, equity analysts at Tudor Pickering downgraded Cabot Oil & Gas (NYSE:COG) from "Buy" to "Accumulate", while analysts at Capital One lowered the rating from "Add" to "Neutral". May was not a good month for oil and gas exploration and production companies and I am of the opinion that the shenanigans at Chesapeake (NYSE:CHK) were at least partly to blame.

Shortly after restarting operations on the Marcellus Shale, following a suspension because of fire damage to the Lathrop Compressor Station, Cabot said that it was producing an average of 78 mmcf from five wells at the eastern edge of its Marcellus holding and this should ease concerns about the productivity of its eastern acreage. Cabot is using the zipper frack technique to maximize oil production from its relatively small holdings and initial results indicate that the company can catch up on its delay in making the transition from gas to oil.

Though fracking is generally considered safe, scrutiny is bound to intensify as more and more oil and gas producers begin to use the technique. Though the majority of producers ranging from the majors to companies like Kodiak Oil & Gas (NYSE:KOG) are using or testing fracking, smaller producers like Cabot, Range Resources (NYSE:RRC) and Chesapeake employ fracking almost exclusively for extraction. The increased scrutiny is bound to affect these smaller producers more than the larger ones.

Cabot's results over the past few quarters have been uneven and one reason for this is that it is actually increasing gas production, which brings in over three quarters of the revenue. It is true that production of liquids is also increasing, but the reliance on gas is worrying because of the rock bottom prices that are not expected to return to normal till the year 2014.

Cabot has made the strategic error of continuing to drill for gas when competitors such as SandRidge Energy (NYSE:SD) and Kodiak have been accumulating liquid reserves. Cabot maintains that natural gas production from the Marcellus acreage continues to be profitable and it is going forward with growths in natural gas production in combination with more attention on liquids.

Cabot is making moves to reduce costs by slashing capital expenditure for 2012 by $100 million, even as it reallocates more capital for spending on liquids. The total cost base has been reduced by 25% in the year 2011 and a further reduction of 20% has been targeted. Liquids are expected to account for 10% of total production this year. The spread of acreage in Appalachia, east and south Texas, Oklahoma, and Pennsylvania will provide lots of opportunities to increase production.

Cabot is also in the early stages of planning a natural gas pipeline in partnership with Williams Partners (NYSE:WPZ) with the intention of connecting production in Pennsylvania with users in the North-East markets. Cabot has also struck a $150 million deal with Williams to sell some midstream shale properties in the Marcellus Shale in Pennsylvania.

Cabot is a well-managed company and you should always keep in mind that it was the best performing stock last year in the S&P 500. Obviously, success in the past does not guarantee success in the future but, nevertheless, the company has to be seriously considered for the purpose of investment. The new initiatives in terms of liquid production should now offset the delay in making the move. The continued reliance on natural gas is worrying but, should the markets rebound, Cabot will be in the driver's seat in terms of taking advantage.

Though I am impressed by the past performance and the track record of Cabot, I would hesitate to recommend a buy at this point in time. The company is still highly vulnerable to the depressed natural gas markets and it remains to be seen when there will be a recovery in natural gas prices. The company has also been late in making the switch from natural gas to liquids, and we will have to wait and see whether it can make up for this strategic error.

Overall, I am still neutral on Cabot and require more clarity on the company's future prospects before making a further investment. If things improve, there will always be an opportunity to acquire the stock while there is still considerable upside. If you have an existing investment, I would recommend that you hold because there is every chance that you would see a reasonable return in the foreseeable future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.