Cabot Oil & Gas (COG) surged earlier this week on a brief rise in natural gas futures and the announcement of its joint venture with Osaka Gas Co., Ltd. Cabot remains primarily a natural gas producer, despite gains in liquids growth, which helps explain why Cabot is experiencing a volatile year. At a recent event, Exxon Mobil (XOM) CEO Rex Tillerson warned that continued low natural gas prices could force some companies to stop drilling altogether, admitting that even Exxon Mobil executives are "losing their shirts" on natural gas -- the same situation that Cabot is in. Cabot's joint venture with Osaka will help Cabot maneuver through the next year, but Cabot's future growth depends as much on natural gas prices returning to normal levels as making wise investment decisions.
Osaka JV Terms Favor Cabot by a Wide Margin
Cabot's joint venture with Osaka transfers a 35% non-working interest in 50,000 acres of Cabot's Pearsall Shale holdings to Osaka for $125 million in cash and $125 million in future drilling costs under a carry. The Pearsall Shale underlies the Eagle Ford Shale at depths between 7,000 and 12,000 feet, with a significantly thicker window than the Eagle Ford Shale at 600 to 900 feet. Since Eagle Ford drilling began in earnest right at the time that natural gas prices began their precipitous drop, the Pearsall Shale is nowhere near as active as the Eagle Ford Shale, even though the two shales are largely contiguous. Pearsall is so underexplored compared to Eagle Ford that, although major players including Encana (ECA) and Anadarko Petroleum (APC) are exploring the area, drilling on Pearsall remains slim.
ConocoPhillips (COP) and Apache (APA) were among the first drillers on Eagle Ford, though both of these companies' early focus was on formations above and below the true Eagle Ford Shale. Now most U.S. based oil and gas independents maintain one or more positions on the Eagle Ford Shale, as the shale contains both oil prone and gas prone layers. By the end of 2010 most core areas in Eagle Ford were leased, which helps explain the premium that Osaka paid for its joint venture acreage.
The initial plans of the Cabot and Osaka joint venture are to focus on the Buckhorn and Powderhorn areas, which the companies estimate will provide, on average, up to 40% gas and 35% natural gas liquids, with the remainder of production made up by oil and other condensates. Initial production numbers are only publicly available for Cabot's well testing in the far southwest curve of the Buckhorn area, but here Cabot reported initial production between 451 and 740 barrels of condensate per day on four wells. In my opinion this seems low for what Osaka paid to form the joint venture, but this could be made up by sheer well numbers since the joint venture plans to operate two rigs beginning next month, with another rig scheduled for 2013 and a fourth rig to be added in 2014.
Cabot expects that the $125 million carry will be spent by the end of 2013 due to this aggressive drilling schedule. According to Dan O. Dinges, chairman, president and CEO of Cabot, "the Pearsall Shale could prove to be an additional liquids rich catalyst in our portfolio and [we] are pleased with the results we have seen to date." Under its agreement with Osaka, Cabot will retain all of its lease rights in the Eagle Ford shale.
Jefferies & Co. also believes that the joint venture is favorable to Cabot, since the price works out to $14,000 per acre. In a statement released by Jefferies the company indicated that price is "very robust, in our view, given the play is still in proof of concept phrase." Jefferies' also noted that the price "may be a sign of greater conviction than can be supported by publicly available data."
According to EnergyStrategyPartners, leases on significant oil acreage in the Eagle Ford will be expiring in the third and fourth quarters of 2012 for any acres that were not drilled according to the original lease. EOG Resources (EOG) is one of the leading companies on this play that may have significant exposure to acreage loss due to its early buy up. As fall approaches, the industry might see a pick up in joint ventures and leasehold sales, since this spike in available leases could continue well into 2014. Since Pearsall has a respectable oil and liquids mix as well as natural gas, few companies would turn down acreage close to existing infrastructure if the price was right.
Cabot's oil production increased from about 2,400 bpod at the beginning of 2011 to about 5,500 bopd at the beginning of 2012, based largely on its focus on Eagle Ford and Marmaton. Its hedges are keeping its natural gas margins above the cost of production; Cabot reported its natural gas prices with hedges at $3 per mcf earlier this year. However, as these futures contracts expire, Cabot will be badly exposed to the continuing natural gas price depression.
Cabot is currently trading around $40 per share, which gives it a price to book of 4.0 and a forward price to earnings of 39.7. Given that its estimated earnings could drop precipitously as its hedges expire, an investment in Cabot is not for the faint of heart. Since the stock peaked at its resistance level earlier this week and appears to be entering a downtrend, I think there may soon be an opportunity for a reasonable value buy near $30, where Cabot was earlier this month, before natural gas demand picks up again in the fall and drives natural gas producers higher once again. Cabot will release its second-quarter 2012 earnings report on July 24.