- Cabot's shares have been under pressure for a while due to the unusually warm weather this winter.
- The winter has ended and as expected investors' attention has turned to the supply side.
- The recent plunge in crude oil prices was added to the negative effect on US gas output in 2020.
All of my last articles are dedicated to the US natural gas market and Cabot Oil & Gas (COG). I am amazed by how the value in this stock could be ignored for so long in times when investors are inclined to buy almost everything. Of course, commodities markets are not popular at the moment and the recession is coming at some point in the near future. However, looking closer at the natural gas market's balance in 2020, I became more certain in extreme undervaluation of Cabot Oil & Gas and attractiveness of this investment even with all the concerns of an inevitable recession.
This Friday, the faith in my valuation was finally rewarded with some evidence. Cabot's shares rose about 10% while S&P 500 index was trading more than 3% lower during the day.
Just look at this Friday's move higher, in spite of the fact that the natural gas price fell with the index and the crude oil.
Other gassy producers caught the bid too. The justification is about how lower oil prices will force oily producers in Permian to spend less, and with lower oil production from fewer wells will come less associated volumes of natural gas. It is a good justification. There is always a good justification after a significant price movement.
Maybe I am a bit biased but it is likely more in that rising of Cabot's shares than just a reaction on Russia quitting OPEC+. As I mentioned in my prior article, the current natural gas output in the Permian is about 11.2 Bcf/d. The takeaway capacity is roughly 10 Bcf/d. Kinder Morgan's (NYSE:KMI) next major gas pipeline, the Permian Highway, is expected to bring another 2 Bcf/d of Permian gas takeaway beginning in October 2020, which will push Permian gas takeaway to 11.9 Bcf/d. So, the most part of the upside from Permian this year is already in place.
The high case for natural gas production forecast on the chart above is based on the $70 per barrel WTI scenario. Given the current level for WTI, close to $40 per barrel, there might be the possibility for some decline even this year. However, it does not look like a strong positive factor given concerns about the weak LNG market and even economic slowdown, which would inevitably weight on demand. If I understand it right, the excess volumes in the Permian are going to the market this Autumn with the pipeline's opening instead of being burned down because of the lack of takeaway capacity.
Additionally, if such a strong bull case for the natural gas market appeared, why did not more operationally and financially leveraged producers rise at least as strongly as Cabot Oil & Gas? The closest follower was Southwestern Energy (SWN) with a rise of about +4%.
It looks like it had been brewing for some time. The company has got two good quarterly reports in a row after the strange one at the end of the Summer when management decided to give guidance for CapEx in 2020 without additional explanations about a worst-case scenario for the market.
Now we know that Cabot's maintenance capital program of $575 mn is expected to deliver an average net production rate of 2.4 Bcf/d. Daily production in 2019 was 2.37 Bcf/d. At a $2.25 average NYMEX price, the program is expected to deliver $275-300 mn of free cash flow. Even after Friday's movement, company's market capitalization is about $6.5 bn. Hence, at low natural gas prices scenario, FCF yield is expected to be roughly 5% in 2020.
It was mentioned in the presentation for investors that the company continues to analyze the outlook for the natural gas markets in 2020 and beyond and is prepared to reduce capital spending further if market conditions warrant it.
Additionally, the company is lowering its production cash costs. In 2019 cash operating expenses were $0.93 per Mcf comparing to $1 per Mcf in 2018. According to management's expectations, it could be improved further to $0.83-$0.89 per Mcf in 2020.
By the way, in the last presentation for investors, the forecast by BTU Analytics is illustrated with overall flat associated gas production expectations.
One moment in the 4Q19 report looks negative. It is a quite high level for price differential of about $0.45 per Mcf. These concerns were eased by repeating the guidance for 2020 of $0.3-$0.35 per Mcf. It is a big difference for the company's financial results at this low level for natural gas prices.
The bottom line
The company looks in great shape financially. Even at low natural gas prices scenario, the FCF yield (roughly 5%) is quite attractive for commodity stock in the current environment. In my opinion, there might be positive surprises from natural gas prices going forward. The upside from associated natural gas is likely limited now after the Russian sabotage of OPEC+ deal. Even before the plunge in crude oil prices, the forecast for overall associated gas production was flat in 2020. There are risks from an economic slowdown and weak LNG market, but the company is well-positioned and can show some more days like what happened this Friday.
The undervaluation is extreme. My own fair valuation has not changed and stays at about $25 per share, taking into account the equilibrium price level for natural gas prices closer to $3 per Mcf.
Additional disclosure: This article is for informational purposes only. Please do your own due diligence before making any investment decisions.
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Analyst’s Disclosure: I am/we are long COG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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