Company Leadership Makes Coterra Special (NYSE:CTRA)

Investment thesis

Coterra Energy (NYSE:CTRA) is a well-run oil & gas producer with a diversified portfolio of assets. The company’s management is one of their most attractive aspects, along with the flexibility to shift growth capital between basins based on their relative attractiveness as an investment. In this article, I’ll briefly size up the company and its management and then attempt to put a fairly conservative valuation on the shares. If you invest by the maxim of “buying great businesses at fair prices”, I think Coterra shares are relatively attractive at current levels. However, those looking for a wide margin of safety or “bargain” valuation might want to exercise patience and wait for a more favorable entry price.

Company Overview

Natural gas is firmly entrenched as an energy source for industrial processes, electricity generation and residential heating that has a long growth runway both domestically and internationally. The Appalachian basin, with an estimated 214 trillion cubic feet (TCF) of natural gas, will undoubtedly be a vital source to serve this demand for the foreseeable future. The largest companies producing gas in this region are EQT (EQT), Chesapeake Energy (CHK), Southwestern Energy (SWN), Range Resources (RRC), Antero Resources (AR), Coterra Energy (CTRA) and CNX Resources (CNX). I’ve already studied the soon-to-be merged Chesapeake and Southwestern entity, and today I’ll be focusing on Coterra Energy.

Coterra is an oil and gas exploration and production (E&P) company which was created through the merger of Cimarex Energy and Cabot Oil & Gas in 2021. The newly created company merged Cimarex’s Permian Basin operation with Cabot’s Anadarko basin and Marcellus shale assets to create a company with significant production in both oil and natural gas, as shown in the asset map below.

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Coterra first stood out to me when looking at the capital structures of the Appalachian shale E&P companies. The company’s debt levels are strikingly low compared with other Appalachian shale gas producers, with Chesapeake Energy (due to their recent bankruptcy) being the only other firm in their ballpark. This may be due to the relatively young age of the newly formed company, but I’m more inclined to attribute this to prudent decisions by the company’s management. Reading the annual report and listening to recent earnings calls, I’ve come away very impressed with Coterra’s boss, Tom Jorden. Here are a few quotes from his letter in the 2023 annual report that stand out.

Coterra shares are currently one of the best acquisition opportunities in our sector, driving our commitment of meaningful share buybacks. We have a long history of financial discipline and investment rigor. Everything we do is viewed through a financial lens and compared against alternative opportunities. We do not manage the Company to achieve production targets. Healthy production is the outcome of sound investments, which are stress-tested at low commodity prices. Over time, the combination of outstanding assets and financial discipline has bolstered our investment grade balance sheet. We aim to preserve and defend it.

Our industry is amid a significant wave of consolidation. Our goal is better, not bigger. The only meaningful test of a significant acquisition or divestiture is simple – Are our owners better off owning stand-alone Coterra or better off owning the reformed entity? … We are open to any transaction that creates value for our owners. Having looked at many opportunities over the past year, we have not found one that unequivocally clears the hurdle, and the bar remains high. Almost always, the most profitable growth occurs organically through the identification and exploitation of new productive zones, often on existing acreage.

And from the Q2 2024 earnings call:

Remember, we do not manage Coterra around production goals. Production is an outcome of sound investment decisions. Our existing production is the consequence of yesterday’s capital allocation decisions. We believe that it is never wise to make poor investment decisions to maintain or increase production, nor to assign any of our business units a budget that is there, “fair share of capital”. Today’s decisions should be based upon today’s reality. At current commodity prices, much of the Marcellus does not compete with other opportunities in our portfolio. Our core mission is to allocate capital prudently and prioritize our most profitable programs. The most profitable long-term Coterra will best be built by this disciplined capital allocation.

Adding quality assets to our portfolio would play to our strengths, and we have confidence that our organization would manage them exceptionally well. However, quality assets are only half the equation. The assets must come at a reasonable price, including a margin of safety. Buying assets at discount rates that are at or near our cost of capital at high commodity prices can be a recipe for disaster. Upswings in commodity prices, new technology or new geologic zones can save the purchaser, but disaster waits patiently on the other side. It will wait for a significant sustained downdraft in commodity prices and strike with lethal precision. Furthermore, disaster loves deals that are measured on single metrics, such as near-term free cash flow. We have seen this movie play out repeatedly in our industry. This is not a commentary on any particular deal, but a reflection on lessons learned through the years.

It’s hard for me to overstate the importance of Jorden’s approach to running Coterra. Listen to most earnings calls in the oil & gas E&P industry and it’s apparent that management is overwhelmingly focused on growth. Most will tout a recent acquisition (which is sure to be “earnings accretive”) or obligingly refer to operating efficiency; but I rarely encounter a CEO in any industry who speaks as intelligently about capital management as Jorden. You can tell that he gets it. And while I’ll acknowledge that it’s easy for investors to get swept off their feet by smooth-talking CEOs, who say all the right things, this guy is “walking his talk” in tangible, measurable ways. The low long-term debt levels speak to his commitment to wise capital management, as does the lack of any sizable acquisition since the company was formed in 2021, a period marked by high oil & gas asset prices. As Jorden mentions in his remarks, there is no margin of safety factored into the purchase price of most assets in the oil & gas patch right now. He also has a firm understanding of the value of the company’s own shares, and views share repurchases as an investment made for the benefit of ongoing shareholders – not simply a way to boost the share price or return excess cash.

Although I’m clearly impressed by the company’s management and conservative balance sheet, the operating cost in my chart above don’t appear to compare favorably to peers at first glance. However, it’s important to note that these operating costs are a simplified, catch-all measure that include all oil, gas and NGL expenses and are based on production on an MMcfe (Million Cubic Feet of Natural Gas Equivalent) basis which translates oil and NGL’s into an equivalent Million cubic feet of natural gas metric using a factor of 6 MMcfe/MBbl. Antero Resources (AR) and Range Resources (RRC) produce more NGL’s as a percentage of total production (roughly 30%) compared to their peers, and their operating costs on an MMcfe basis also appear high without context. NGLs and Oil each made up 14% of Coterra’s total production on an MMcfe basis and likely contributed to a higher value for this narrow metric. I’ll use these operating costs later when attempting to assign a value to the company.

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Coterra is not a pure-play Appalachian shale company, as 35% of production came out of the Permian Basin and 48% of 2023 revenue came from oil. Most of the remaining production (57%) came out of the Marcellus region, with the remaining 8% coming from the Anadarko. The diversity of revenue between both oil and gas has tempered the recent impact of extremely low gas prices on the company’s financial results.

Coterra is comfortable with their reserve position, stating in their 2023 annual report that they plan to develop current reserves over the next 15-20 years. Oil & gas E&P companies must constantly hunt for acquisitions to top up their inventory of undeveloped reserves, which increases the importance of managers that intuitively understand sound capital allocation principles. In that regard, investors in this company are in good hands.

Valuation

Coterra has plenty of reserves and the right management in place to develop them, but what is the underlying value of the business? To evaluate this question, I’ll look at what it might be worth across a range of commodity prices and settle on a conservative estimate that – to steal a phrase from Tom Jorden – leaves us with a margin of safety.

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The tables above represent my base case with a long-term assumption for the average price of each commodity. I assume that operating costs remain around their 2023 value of $2.58/MMcfe and that the company pays a 25% state and federal income tax rate. For interest expense, I’ve assumed that all of the company’s $2 billion in long-term debt has been refinanced at 5.6%, which is the rate at which they issued senior notes in March of this year.

Earnings per share under these assumptions would be around $3.25/share, but I prefer to evaluate a company on “owner earnings”, which adds back in depreciation, depletion and amortization (DD&A) and subtracts capital expenditures. Since DD&A has been running at about $1.65 billion over the past 2 years, compared with capex of around $1.9 billion, owner earnings in this scenario would be closer to $2.90.

Look back at historical earnings for any E&P company, and the prospect of projecting future cash flows seems senseless. For that reason, I’ll simply evaluate this investment based on the yield on my estimate of owner earnings from above. At the current share price of around $24, my estimate of $2.90/share represents a yield on owner earnings of 12% ($2.90 / $24). That’s decent for such a well-managed company, but the market hasn’t mispriced this one to an extreme that offers a great shot at outsized returns. If commodity prices overshoot my estimate or Coterra ramps up production organically, my estimate of earnings power is likely to be proved too conservative and investors will obtain great gains at this level. But my investing objective is to beat the market by a wide margin, and I’m not sure Coterra’s price meets my margin of safety objectives at the current level. Let’s look at the value of this company under a more pessimistic set of assumptions.

The charts above show oil and gas prices over the past decade (blue line) compared with my “base case” long-term forward price estimate (red line). While the spike in 2022-23 flatters the average, my estimates appear more aligned with market highs outside of that period. As additional oil supply from South America comes to market over the next decade and OPEC countries fight to keep market share, there is a chance that average oil prices are closer to $60/Barrel rather than my estimate of $70. And while demand for gasoline has remained stable and EV sales growth is starting to cool, US gasoline demand is likely to decline slowly as hybrid vehicles gain in popularity. Few are suggesting that oil demand will face any significant drop in the near-term, but weak demand growth may not be enough to offset new sources of supply in a market driven by international fundamentals.

Turning to natural gas – while I believe demand is likely to continue rising, supply too will remain abundant. While natural gas producers have been curtailing production, most of them mention on earnings calls that they’ll quickly be able to bring that supply back online should prices turn higher, which will keep a cap on domestic prices. Additionally, with natural gas being a byproduct of shale oil production in the Permian Basin, the economics of natural gas production are skewed with a certain amount of supply coming to market without respect to price. And while hype around LNG exports reached a peak in 2023, the recent pause on export licenses by the White House and soaring gas prices during 2023 may lead importers like Japan to seek other energy sources. Concerning LNG supply, the US is hardly the only country rushing to bring export capacity online, with Qatar, Canada, Mexico and Russia actively developing liquefaction and export facilities as well.

Given that gloomy set of assumptions, what would the value of Coterra be in a “low-expectations” case? If we assume gas prices average $3/MMBtu over the long-term and oil prices are closer to $60/Barrel, I estimate Coterra’s owner earnings would average around $2.20/share. The earnings yield on today’s share price in this scenario would be around 9% – decent, but not exceptional. The company’s shares were trading around $18/share in 2021 when bearish expectations such as these were the consensus “base case”.

Summary

While I’ve covered both moderate and “low expectations” scenarios for Coterra, I haven’t spent as much time discussing the upside. Just two years removed from the commodity bonanza producers experienced in 2022 (Coterra’s owner earnings were around $5/share that year), it’s not hard to picture a scenario where the company comfortably outperforms the market at its current valuation. Indeed, much of the allure of investing in Coterra is that base expectations will produce a respectable return while offering a chance at fantastic results if commodity prices exceed expectations. However, generating market-beating investment results in the oil & gas industry comes from purchasing solid companies when commodity prices are extremely depressed (think 2020) rather than when they’re fairly priced or even modestly undervalued. Coterra would be a great investment in a depressed environment because the stock price is likely to be lower, but also because they have a management team that would be well-placed to invest in quality assets at reduced prices. For that reason, I think Coterra is a good investment at $24, but a great one under $20.