Coterra Emphasizing Buybacks and Fixed Dividends in Capital Return Strategy

Director

Dave Meats

Revenue segments as reported by the company.

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Coterra was formed after the 2021 merger of Cabot Oil & Gas and Cimarex Energy. The combined business produces oil and natural gas in three U.S. regions. Natural gas is the primary target in the Marcellus Shale (Pennsylvania), where Cabot was focused. But the firm's legacy Cimarex assets, in the Permian Basin (Texas and New Mexico), and Anadarko Basin (Oklahoma) are more oil-weighted. Management believes the combined business will be stronger because of geographic diversificaton and overhead synergies.

Coterra's Marcellus assets are ideally located in the northeast portion of the play fairway, which mainly yields dry gas with very little condensate or natural gas liquids content in the production stream. Wells in this part of the field are typically characterized by very high daily production rates, which also enhances returns. This puts the firm at the low end of the U.S. cost curve for natural gas, but there's a catch: the firm's acreage doesn't have too many lucrative Lower Marcellus drilling opportunities left. So management has been layering in wells targeting the overlying Upper Marcellus layer, which are typically up to 30% less productive. But the firm can reuse existing roads and pad sites, and as there are no well configuration constraints in this undeveloped interval, it can enhance returns by drilling longer laterals. As a result, we think lower well costs can offset the dip in flow rates, leaving potential returns unchanged.

In any case, the firm has abundant inventory in the liquids-rich part of the portfolio. Activity is concentrated in the Delaware Basin, within the Permian. The firm holds almost 200,000 net acres, which is prospective for the Wolfcamp, Bone Spring, and Avalon reservoir targets. Like peers, management is attempting to maximize capital efficiency by optimizing lateral lengths, pad sizes, and interwell spacing. The firm will also begin utilizing electric completion spreads in 2022, lowering its own fuel consumption and improving well costs.

Business Strategy & Outlook

Coterra is one of the few exploration and production companies to earn a narrow moat rating. The ability to deliver maintainable excess returns on invested capital is a hallmark of moaty companies, and the firm is expected to earn its cost of capital for at least the next 10 years. The recent merger with Cimarex slightly diluted our ROIC projections, but we still expect the firm to earn its cost of capital through our 10-year forecast.

Coterra's acreage in the Marcellus Shale is characterized by low operating and development costs, putting it at the lower end of the U.S. natural gas cost curve. The main factor that differentiates the northeast portion of the Marcellus, where Coterra operates, is the lack of oil condensate or natural gas liquids. The production stream consists entirely of dry natural gas, with no liquids content at all. Because natural gas flows more easily out of a reservoir than liquid does, these wells are typically characterized by very high initial production rates and projected recoveries. So Coterra's costs are spread more thinly, pushing up its margins and returns. And because there are no NGLs, the firm doesn't need to pay for cryogenic processing fees (saving it around $0.20/mcf).

Playing devil's advocate, we would highlight that the firm's Marcellus acreage only contains a few more years' worth of Lower Marcellus drilling opportunities. As a result, the firm is pivoting to the less productive Upper Marcellus, and those wells do not typically perform at the same stellar level that Lower Marcellus wells do. The good news is that well costs in the Upper Marcellus are expected to be commensurately lower on average, keeping returns at around the same level. There are two reasons for that: (1) Surface facilities (pad sites, roads, and so on) were already paid for during the Lower Marcellus development and can probably be reused, and (2) there are no constraints on the length of the horizontal portion in the Upper Marcellus, as it is basically "dry powder" with very few pre-existing wells to get in the way, so it can be developed with more profitable longer laterals. So, we would not expect a step-change in profitability when the firm's Lower Marcellus inventory is exhausted. Management is managing the transition by blending Upper Marcellus activity in now to optimize it before the Lower Marcellus is exhausted in this area.

Further, though the firm does have exposure to potential environmental, social, and governance, or ESG, issues that could threaten its moat, we believe there is enough of a spread between projected returns and the firm's cost of capital to provide a comfortable margin of safety. For Coterra, the most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills).

Greenhouse gas emissions are unavoidable for oil and natural producers. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce CO2 volumes being released into the atmosphere during the extraction process. But because downstream emissions are beyond producers' control, there's really no such thing as a "clean" E&P company. As consumers get more averse to fossil fuels, the reputational risk grows for producers and the probability of widespread substitution away from fossil fuels increases. This also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base-case forecasts, but the impact is potentially material.

In contrast, spills are not a major concern for firms operating exclusively onshore, as Coterra does. There is no chance of a devastating accident like the BP Macondo disaster in 2010. Nor would the firm be on the hook for adverse events during long-haul transit, like the Kalamazoo River (Michigan) spill, which also occurred in 2010. This activity is typically outsourced to midstream firms that operate regional pipelines. Instead, Coterra is more vulnerable to spills at or around the wellsite. These tend to be frequent but relatively minor. Costly legal challenges are unlikely for this kind of event and we see little chance of significant value destruction.

Narrow

Economic Moat

Coterra Energy

Coterra Energy Inc. is a diversified energy company, which engages in the exploration, development, and production of oil and natural gas properties. Its portfolio includes projects in the Permian Basin, the Marcellus Shale, and the Anadarko Basin. The company was renamed to Coterra Energy Inc. on October 1, 2021 in connection with the merger involving Cabot Oil & Gas Corp. and Cimarex Energy Co. Coterra Energy was founded in 1989 and is headquartered in Houston, TX.

Earnings data Q2 2023

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