Many of this year’s top-performing oil and gas producers share one commonality: Significant exposure to the Marcellus Shale, a prolific play whose core has emerged as one of the nation’s lowest-cost gas-producing regions. Wells in certain parts of this formation remain profitable when gas prices hover around $3 per million British thermal units. Producers that hold the best acreage have consistently surprised investors by posting better-than-expected revenue and output growth in 2011.

For example, EQT Corp.’s Marcellus leasehold comprises 520,000 acres. That amounts to about 3.5 acres per every 1,000 shares. The firm will drill about 100 wells in the play in 2011 – 10 wells in northern Pennsylvania, 57 in western Pennsylvania and 33 wells in West Virginia. Each well costs about $6 million and allows EQT to book reserves of 7.3 billion cubic feet of gas. With natural gas prices at $5 per million BTUs, EQT delivers returns of 72% after taxes, gathering, transmission and drilling costs are subtracted. When natural gas dips below $4 per million BTUs, EQT still earns a positive return.

Cabot Oil & Gas – one of the top-performing E&P stocks in 2011 – also generates a significant amount of its revenue from the Marcellus Shale. The firm’s acreage in northeastern Pennsylvania produces primarily dry natural gas with little to no NGL content to boost wellhead economics.

But Cabot Oil & Gas’ production costs are so low that management estimates it earns about a 60% return on wells when natural gas trades at $3 per million BTUs. The company’s average well yields an initial production rate of 16.9 million cubic feet per day and an average 30-day production rate of 13.6 million cubic feet per day.

With a number of new pipelines slated for completion by the end of 2012, the Marcellus operator will be able to ramp up its production and drilling activity significantly.

As followers of this fanpage might already know, to identify the best E&P stocks I focus on the quality of a company’s reserves.

Shares of EQT and Cabot Oil & Gas have outperformed because analysts focused on the bearish outlook for natural gas prices and overlooked the low-cost nature of these firms’ reserves. At the same time, the premium valuations that these stocks command make them vulnerable to any disappointment, from lower-than-expected production growth and unexpected cost increases to delays in the construction of pipeline and processing infrastructure needed to accommodate their output.

Some analysts have also argued that natural gas prices are at a lesser risk of a decline than oil prices, which have more than tripled from their 2009 low. This investment thesis has two weaknesses. Only a U.S. recession in the second half of 2011 or early 2012 would send WTI to less than $70 per barrel or Brent crude oil toward $80 per barrel. But as I said back in the beginning of August in this article, we expect the U.S. economy to avert another pull back.

In the event of a recession, U.S. natural gas prices wouldn’t be immune to the carnage, as the industrial sector accounts for about one-third of U.S. gas demand. For example, the group’s natural gas consumption declined by roughly 12% from year-ago levels in the first half of 2009. Industrial demand also fell 9% in the first half of 2001. Producers would likely rein in drilling to reflect reduced demand, but these efforts wouldn’t affect natural gas prices right away.

With gas-focused E&Ps such as Cabot Oil & Gas trading at premium valuations, these names are unlikely to outperform oilier names if demand deteriorates.

However, a flurry of acquisitions in recent quarters has also heightened expectations that further consolidation in the shale gas space could drive stock prices higher. To avoid being blindsided by a major deal, we will forego shorting the major independent U.S. gas producers.