Cabot Oil & Gas: Capture The Rise Of Natural Gas

Summary

• Natural gas markets started the first half of this year on a weak note as poor demand impacted the commodity.
• Gas is setting up for a strong rally as production has corrected to the point where prices will need to rise to satisfy the market.
• COG is unhedged through 2021 which sets them up as a strong way to trade the rally in gas.

As you can see in the following chart, it’s been a strong (but volatile) year for Cabot Oil & Gas (COG).

While this year has already seen a good degree of upside momentum in COG, I believe that this momentum will carry through into the next few quarters. Based on both natural gas fundamentals as well as the specific market approach to COG, I believe now is a good time to buy the stock.

Natural Gas Fundamentals

Let’s start this piece off with a deep-dive into natural gas fundamentals. The reason for this is quite simple: COG is a large producer of natural gas and its share price has a fairly strong correlation with changes in the price of natural gas.

What the above chart shows is a very clear relationship between what happens to the price of Cabot in relation to changes in natural gas. Put simply, a fairly strong degree of the variability of returns (around 40%) is exclusively explained by what happens to natural gas prices, which means that if you have an idea of where gas prices are headed, you have a good idea of where COG is likely headed as well.

Let’s start this piece off with an updated look at the short and long-term fundamentals for natural gas. We are fortunate in that the EIA has recently released its latest authoritative monthly figures of gas fundamentals, so we have greater clarity behind where we currently stand.

Put simply, short-term fundamentals are still coming in as bearish in that natural gas inventories are climbing versus seasonal benchmarks like the 5-year average and the figures from 2019. As you can see in the following chart, the pace of builds is actually still very strong in that each weekly rate of change is still either above the 5-year average or very near it in most weeks.

There have been a few underlying drivers of these above-average inventory figures throughout this year. First off, the weather was very mild as evidenced by the drop in demand in the January-February time frame.

Natural gas is an interesting commodity in that it has varying seasonal patterns of demand; however, winter demand for heating remains one of the largest drivers (as seen by inventory draws during the winter and builds during the summer).

What the above chart conveys is that while January was fairly strong, February demand utterly collapsed as winter failed to pull through and materialize. The EIA data is released a few months in arrears, so we don’t have the latest authoritative figures, but based on temperatures this year, this trend likely continued through the end of winter.

And starting around March-April, the spreading coronavirus led to a collapse in industrial demand – a collapse which we can extrapolate from the recent weekly figures, but again, will need to wait for a few more weeks before it arrives in the monthly release.

However, I believe that we are in store for a very large step change in the fundamental story over the next few months. Specifically, I believe that the bearish fundamentals seen this year are poised to reverse fairly sharply due to declining production and the cyclical pattern of inventories.

First off, in case you’ve somehow missed it, natural gas prices are down strongly since the start of the year, continuing a few years of price declines.

This drop in the price of natural gas has been driven by inventories, which have been ballooning against the 5-year average.

The data is fairly conclusive in that if you know where inventories are going on a seasonal basis, you’ve got a pretty good idea of where natural gas is headed during that time period. For example, as stocks rise, prices fall.

While this relationship makes sense and has explained a good degree of the recent changes in natural gas, I believe we are reaching a seasonal peak as seen in longer-term data. For example, if you look at the below chart, you’ll see a clear trend at work in which natural gas inventories are generally bound between two extremes in terms of how much they move on a year-over-year basis.

As you can see, on a year-over-year basis, gas inventories tend to see maximum levels of 750-1,000 BCF gains. What is happening beneath the surface is that as gas inventories rise, prices tend to fall. This trend occurs until prices reach unsustainably low levels and production falls off. This decline in production ultimately leads to a correction in inventories because the seasonal pattern is still at work in the data – that is, demand continues to function even if supply is impacted by price. You can see this pattern of “low prices fixing low prices” in 2012 and 2016. We are now at a key inflection point in the data in which it would suggest that we are primed for a bounce in gas price once again – a bounce that will play out over the next few quarters.

To frame up the potential numeric impact of what we could see in natural gas over the next year, here is a study that takes the data in the prior chart and shows the average return in the year following a specific inventory level.

Over the past few weeks, we have seen inventories in the far right bucket with year-over-year changes reported in the 800s. Historically speaking, natural gas prices rally by around 48% following similar levels of year-over-year changes in natural gas inventories. The key driver here is pretty straightforward: when gas prices rise, production is hampered which sows the seeds of future price rallies. We are seeing this trend at work in the data once again as the rig count continues its collapse.

Put simply, I am bullish on natural gas (and therefore Cabot) because higher gas prices have historically translated into a higher share price for the stock. However, let’s dig into the positioning of COG to see how cash flows may evolve going forward.

Cabot Oil & Gas

When I examine a commodity producer, I want to know two key things – 1) the price outlook for the commodity and 2) the extent of hedging activities of the producer. The reason why I ask these questions is that I am ultimately attempting to understand the degree to which the changes in the price of a commodity will be reflected through to shareholders in the form of cash flows to the company.

When it comes to COG, here is its current hedging positioning as seen in its quarterly earnings presentation.

There are a few noteworthy things here which make me quite bullish on Cabot. First off, I am attracted to the fact that overall hedging volume is fairly low. In its recent earnings call, the company indicated that the current hedges in place are protective in the event of ongoing demand destruction from the coronavirus and are short-term (as seen by the chart above). However, it is entirely unhedged in 2021 in that it shares my same bullish price outlook for natural gas.

This has me fairly bullish on COG in that I strongly agree with the unhedged approach for 2021 to capture the rally in natural gas. In the analysis of my prior section, I believe that the price of Henry Hub will increase by around 50% into the middle of 2021 from this point, which means that the cash flows of COG will likely increase proportionally as well in that revenues will track closely with the realized price of production. Of the other gas producers I’ve recently covered, COG represents what seems to me to be the most “pure play” on natural gas. Based on its unhedged position and the bullish outlook for gas, I believe COG is a solid trade at this time.

Conclusion

Natural gas markets started the first half of this year on a weak note as poor demand impacted the commodity. Gas is setting up for a strong rally as production has corrected to the point where prices will need to rise to satisfy the market. COG is unhedged through 2021 which sets it up as a strong way to trade the rally in gas.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in COG over the next 72 hours. 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.

Comments

[Short Dog]

I am not sure we count count on the storage/gas price cycles presented to repeat itself with all the associated gas from shale oil wells now being produced. Where before, conventional gas wells would be shut-in (or workovers delayed) when gas prices were bottoming, now those wells are kept online for the oil and it's much more difficult to flare gas than a few years back.

The tipping point to high gas prices will need to come from the NGL demand side as more NGL loads are exported. As most of the NGL sold from USA does not have long term commitments, a good percentage of these loadings have been canceled with the pandemic. It's going to take a while for this all to this to sort itself out. My guess is next winter.

[javkoza]

Natural Gas has fallen by ~25% YTD, yet COG is up more than 10%.
The same can be said for most Natgas stocks.
So my question is whether they have got too far ahead of the yet-to-be-realized surge in natgas!

[User 21793061]

The increase shown in the strip will already be priced into the stock. After all it is an easy pair trade for any hedge fund. Arbitrage opportunity.

Only if you expect better than strip recovery, will you get outsized returns in the stock. And certainly over the years, this has been a very bad trade by the permabulls as natty (sustained over weather variation) has moved down from 10 to 6 to 5 to 4 to 3 to 2.5. Of course at some time it has to stop. But I don't see any reason why massive amounts of dry gas in the Haynesville and Marcellus come on line if natty tries to establish a sustained 3+ price.

P.s. And yes, nobody can predict the future. Maybe this winter is very cold. Maybe very warm. But the strip will have been priced based on average winter.

[ak4097]

What about $AR and $RRC? Aren’t they more levered to price of gas? Their stocks are up huge while COG is up only 25-35 percent.

[Nathan5]

ak,
What makes those 2 so levered, is because they both have very weak balance sheets and high debt coming due. In actuality, both are heavily hedged(especially AR). COG is the exact opposite: very strong balance sheet and little debt, and almost no hedges at all. Clearly, COG is the strongest financially of the 3, and can afford to play the gas price unhedged. Hence, it is the purist play on NG prices. By the way, COG is THE quality name in NG, being also the lowest cost producer, and the only one with FCF.