Cabot Oil & Gas (COG, Financial) released disappointing quarterly results recently. The underperformance by the oil and gas company has resulted in a drop in the company's shares in the last three months. But this underperformance by the company on the back of different concerns can be a bright buying opportunity that is expected to generate strong free cash flow in the future.
The Problem
Cabot saw weakness in its business and posted weak results, disappointing many analysts. Low operational efficiencies resulted in a sluggish performance that also led to increasing concerns around its Marcellus differential, which has been wider than expected year to date.
Despite a poor performance Cabot is in a good position to fight back. It is still on track to produce 100% internal rate of return on its assets. This indicates that the company has a well-aligned management and operational strategies. Cabot is well aware of the areas where it has to improve. It is already focusing on working with new strategies for the future. Initially, Cabot is expecting weakness in the Marcellus differential, but expects an uptick in demand going forward.
Cabot expects the weakness to prevail in the short run. On the other hand, according to UBS analyst Betty Jiang, the differentials are likely to widen as the summer approaches. To be on the safer side in the future, Cabot has secured firm sale contracts on 900 MMcfd of gross Marcellus volume over the summer, which accounts for about 60% of its gross Marcellus production.
Strategies
Cabot is well in line with its strategies. But to secure short-term performance, the company has to secure shorter term contracts. Given the uncertainty and fluctuating market conditions, management has stated that all of its scenarios filter down to a 2014 all-in gas realization range $3 to $4 per million cubic feet equivalent (Mcfe).
Moving further, despite grave market conditions, Cabot is determined to attain good cash flow at the projected growth rate even at the prevailing low end rates. On the other hand, according to the analysts, 2014 is going to be a year when gas realization of about $3.50/Mcf is expected, which assumes an average differential of ($0.66)/Mcf. This is more conservative versus the consensus 2014 realization of $3.80/Mcf and in the middle of Cabot's estimate range.
The company is still convinced about gaining market share as investors are focusing on pricing and not on cash flow generation. So, despite a wider gas differential, Cabot is well in line to produce free cash flows which are expected to produce handsome gains by 2015.
Cabot's strategies are so concrete that it managed to generate organic free cash flow in excess of $200 million last quarter, despite a low average differential of ($0.66) this year and capex of $1.35 billion in 2014.
Cabot is working aggressively on take away solutions which are believed to limit the long term differential discounts. But on the other hand, management is expecting differential risk to continue for a finite period of time.
But, analysts expect that Cabot might face challenges in Marcellus as demand in the regional areas will increase in the hotter seasons. In response to this, the oil and gas company is working on securing long term supply contracts. This will help COG to reduce the basis risk in the long term.
Cabot is planning expansion of its pipelines to other regions also. The company is presently delivering gas into three interstate pipeline systems such as Tennessee 300, Transco and millennium lines. The plan to expand its capacity is believed to boost its firm capacity.
Analyst Jiang, on the other hand, is seeing good pace in gas storage, exiting the summer at about 0.05 trillion cubic feet (Tcf), which is 0.8 Tcf below the normal and is on track to match the lowest winter exit for storage inventories since 2004.
These stats show an increase in refilling demands in the summer and spring season, creating an incremental 4 billion cubic feet per day (Bcfd) of storage refill demand. This will result in an appreciation in prices, causing gas-fired demand to shift to coal in order to enable an adequate storage refill.
As per the present scenario, management is expecting weakness in production initially. The company had given a similar flattish first half guidance in 2013 and ended up growing production by an average of 11% per quarter in the first half of 2013, and then beat the mid-point of the full year range by 11%.
Conclusion
So Cabot has done better than expected in the past and it could continue doing the same in the future. While it trades at a premium EV/EBITDA multiple given the low gas prices, it's expecting multiple compression of about two turns per year in 2015 to 2016 given its sector-leading debt-adjusted cash flow per share growth. In comparison, the rest of the E&P universe is seeing an average of about one turn per annum compression over the same period. So Cabot could be a good buy for the long run.
