It would seem to make little sense that Cabot Oil & Gas (NYSE:COG) stock is rallying right now. After all, U.S. stocks have plunged — and energy stocks have done even worse. The Energy Select Sector SPDR Fund (NYSE:XLE) has declined 54% in 2020 alone.
A price war in crude oil sparked by Saudi Arabia has been a key catalyst, with coronavirus-driven macro fears another cause. And yet, since Feb. 27, COG stock has gained 44%.
But the rally is logical for one important reason: despite its name, Cabot Oil & Gas doesn’t drill for oil. It’s a natural gas-only play. As a result, plunging crude prices actually can and will help the stock. And if they lead to a return of some kind of normalcy in the natural gas markets, Cabot Oil & Gas stock can and will keep rallying.
Plunging Natural Gas Prices
COG stock had struggled along with energy names — and, in fact, done worse than many of them. Shares touched an eight-year low on Feb. 28, and at that point had declined by two-thirds from 2014 highs.
The problem was plunging natural gas prices. Just like miner Barrick Gold (NYSE:GOLD) or shale oil producer Apache (NYSE:APA), Cabot Oil & Gas is dependent on the underlying commodity price. And natural gas prices have been heading in the wrong direction for years.
Indeed, in 2008 the widely-used Henry Hub spot price averaged almost $9 per mmbtu (one million British Thermal Units). Ten years later, it was $3.15. Prices dipped under $3 last year and under $2 this year.
The cause is not lower demand. Demand has in fact risen to record levels as coal-fired power plants are phased out and exports of LNG (liquefied natural gas) rise.
The cause is higher production. The shale boom in the U.S. has led to massive increases in exploration. Better hydraulic fracturing techniques have made it easier and cheaper to extract both oil and natural gas.
And so much natural gas is being produced that some explorers actually have to pay to have the gas taken away. Others just ‘flare’ (in other words, burn) the gas on site. Rising demand hasn’t been able to keep pace with soaring production. And so, as Economics 101 would suggest, prices have fallen sharply.
Why Sub-$30 Crude Helps Natural Gas Stocks
Falling crude oil prices on their own wouldn’t seem to help natural gas. And in the past, they haven’t. WTI (West Texas Intermediate) crude oil prices plunged in 2015, for instance. The price of natural gas kept falling anyway.
But it’s the pace of the recent decline, and the depths they’ve hit, that potentially changes the calculus. The move in WTI from an average of $93 per barrel in 2014 to $49 in 2015 didn’t impact production all that much.
Oil companies made less money, to be sure, a key reason why oil stocks plunged in response. But most shale wells remained profitable, if far less profitable than they were in the first half of that decade. And so production continued apace — as did byproduct production of natural gas.
WTI now trades at $27. At that price, crude production has to slow dramatically, because most shale producers will be losing money. As that crude production slows, natural gas production comes down as well. In theory, the price of that commodity should rise.
That, of course, will increase Cabot’s realized price, and its profits. That’s why the stock was the best performer in the entire S&P 500 for the week of Mar. 9. And that’s a rally that can continue.
Why COG Stock Will Rally…
When Cabot released fourth quarter results in early February, none of this had happened. Natural gas prices were at multi-year lows, and in response Cabot decided to cut back significantly on its capital spending.
Yet the company still forecast between $275 and $300 million in free cash flow for 2020, at a NYMEX (New York Mercantile Exchange) price of $2.25. At the midpoint of that guidance, COG stock trades at about 24x free cash flow. Boost the price, and thus free cash flow, and that multiple comes down in a hurry. Of course, it doesn’t require that prices double for FCF to do the same.
If production normalizes, it does seem at least possible that prices do double. In that case, free cash flow skyrockets. And in the middle of the last decade, with natural gas averaging $3-$4, COG stock touched $40, more than double its current price.
…And Why It Won’t
As always in the energy space, there are risks. It’s possible the Saudis will reverse their decision, or that Russia will come back to the table and OPEC (Organization of Petroleum Exporting Countries) will reinstate supply curbs. In that scenario, crude skyrockets, and COG likely plummets.
It’s also worth noting that natural gas prices — both on the spot and futures markets — haven’t yet incorporated the optimism being priced into Cabot Oil & Gas stock. That could hold going forward.
Shale production may stay enough to keep supplies elevated. Penny-pinching drillers may look to capture whatever revenue they can, and thus deliver instead of flare their gas. A warmer 2020-21 winter could pressure demand. LNG demand remains low, a key reason why Cheniere Energy (NYSEAMERICAN:LNG) has continued to slide.
This is a fluid situation, to say the least. Below $20, the rewards outweigh the risks. But history across the energy sector, and for COG stock, shows that investors need to stay on their toes. There are no slam dunks in this industry, but for bulls looking for exposure COG stock remains an attractive pick.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.