Oil is expensive, gasoline prices are pushing $4 a gallon but natural gas is cheaper than it was in 2000.

And yet one the strongest-trending S&P 500 stocks belongs to a gas producer that has outperformed all the crude drillers and even most of the red-hot refineries.

Cabot Oil & Gas (NYSE: COG) is a leading natural gas driller in the Marcellus Shale, the energy-rich shale rock formation covering 60 percent of Pennsylvania and stretching into New York, Ohio, West Virginia and Maryland.



The Houston-based independent is coming off a record-setting year in which it boosted its production 43 percent, and grew cash flow from operations by 30 percent.

Much of this came courtesy of the Marcellus, which is now yielding a quarter of the US output of natural gas after production nearly doubled last year. Cabot’s slice of this new Eldorado amounts to a net of 200,000 leased acres concentrated largely in the Susquehanna County of northeast Pennsylvania between Scranton, PA and Binghamton, NY.

The Marcellus yielded 209 billion of cubic feet equivalent (Bcfe) of natural gas to Cabot’s 224+ wells last year, representing 78 percent of the company’s output. That’s a good thing, because the Susquehanna County and Cabot’s huge Dimock gas field there are, as CEO Dan Dinges puts it, “in the sweet spot of the most prolific natural gas field in North America.” The company had 15 of the top 20 producing wells in Pennsylvania’s Marcellus last year.


Source: Cabot Oil & Gas investor presentation

Cabot’s “rates of return in Susquehanna County rival or exceed all of the top U.S. liquids plays at current commodity prices,” the company said late last year in an investor presentation.

This year is looking even better than the last, with production forecast to increase another 35 to 50 percent while capital spending plateaus. That should allow Cabot to fund its development program largely from cash flow, which should comfortably outstrip spending needs down the road.

On the most recent earning call, when analysts weren’t drilling down into Cabot’s exceptionally strong drilling results and the (solid) prospects of duplicating them across the company’s undeveloped Marcellus acreage, they were wondering what Cabot might do with the excess cash flow it’s due to start piling up next year.

Given the company’s five-year development plan, “and looking at the amount of free cash we have and debt paydown that we can do, Scott [Schroeder, the CFO] just walks around the office with a big smile,” CEO Dinges responded.

Schroeder proceeded to tell the analysts that Cabot will use the cash to fund the construction of the Constitution Pipeline that will link its fields with the major Northeast and Canadian consumer markets in 2015, accelerate the Marcellus development fueling its returns and lastly consider “dividends of one form or another.”

Right now, Cabot seems awfully expensive on a nominal basis, trading at 50 times estimated 2013 earnings and 27 times analysts’ 2014 projection. But earnings per share are not the best valuation metric for energy companies writing off huge non-cash depreciation costs.

More informative is the EV/Ebitda ratio, which adds debt to the market capitalization to arrive at the enterprise value, then divides that sum by earnings before interest, taxes, depreciation and amortization, a proxy for cash flow. On that basis, Cabot is priced at roughly 21 times trailing Ebitda, not cheap but plenty reasonable for a company that’s increased production by more than 40 percent in each of the last two years and figures to make it three in a row in 2013.

And there’s lot of runway straight ahead: proved reserves rose 27 percent in 2012, to a number large enough to support 14 years of production at last year’s record pace. The company added more than four times the reserves it extracted last year.

The company sold its gas at an average of 3.91 per thousand of cubic feet equivalent (Mcfe) in the fourth quarter with modest help from hedges, while its total costs declined to $3.25 per Mcfe and are headed lower still as Cabot realizes operational and infrastructure efficiencies given its scale within a relatively concentrated footprint.

It has not hedged away the huge potential future upside should natural gas prices rise closer to the $5 to $6 per Mcfe average that prevailed in the US during the last decade before the shale drilling revolution. The US Energy Information Administration currently expects little upside to the current spot price through 2018, then a steady increase on the back of growing consumption and burgeoning exports.

But natural gas is a volatile commodity, overseas prices are much higher, and any combination of faster economic growth, hot summers, cold winters or a damaging storm in the Gulf of Mexico could cause a price spike.

In the meantime, Cabot has an embarrassment of promising drilling prospects in Pennsylvania, more than enough to keep it busy for the next two years pending the possible expiration of the moratorium on hydraulic fracturing in nearby New York state, which was recently extended until 2015.


The shale outcrop in Marcellus, NY, which lent the formation its name (Wikipedia)

Opponents of the practice have pointed to the environmental problems at Dimock in particular, where Cabot last year reached a confidential settlement with several dozen families alleging that its hydraulic fracturing contaminated their water wells with methane. But the company considers the settlement immaterial, an Environmental Protection Agency probe found that the dangerous chemical concentrations  in the well water can be neutralized with secondary treatment, and the company is drilling as fast as it wishes. The regulatory climate in Pennsylvania remains favorable, especially after the adoption last year of a drilling impact fee earmarked for municipal coffers.

The Constitution pipeline will give Cabot access to the lucrative urban Northeast markets in a couple of years, and the company has the potential to export via the Cove Point LNG terminal in Chesapeake Bay that’s being retrofitted to process exports.

Cabot also has promising niche shale oil plays elsewhere, including 60,000 acres in Texas’ Eagle Ford Shale that accounted for 4 percent of last year’s output, 70,000 acres in the Marmaton Shale in the Oklahoma and Texas panhandles, and a growing interest in the Pearsall Shale south of San Antonio.

But these are sidelines and potential sources of future financing from sales or joint ventures, whereas the natural gas from the Marcellus remains the bread and butter, and perhaps the caviar.

Cabot has an excellent track record of extracting more of it at a diminishing cost per unit, and its acreage within the Marcellus should support strong production gains for quite awhile. Higher natural gas prices down the road would be a bonus, albeit a potentially huge one.

The stock has doubled over the last nine months and is up 31 percent to a record year-to-date, so we wouldn’t have qualms with anyone waiting for a 5 to 10 percent correction before buying. But it’s likely to provide lots of future value even at current levels. COG is a new Growth Portfolio buy; add it below $72.