Cabot Could Slip On Litigation, Operating Results
Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Cabot Oil & Gas (NYSE: COG) was just awarded a ratings upgrade by analysts at Robert W. Baird, who moved the stock from neutral to outperform. Earlier this week, Cabot was also upgraded by analysts at Goldman Sachs (GS) from neutral to buy with a price target of $55, and saw its price target raised to $50.50 by JPMorgan Chase (JPM). This bullish streak comes as the multiple fracking lawsuits brought against Cabot and its peers, popular targets for litigation, precipitate what could be a major change in the industry.
Nationwide: No Fracking Way
Nationwide Mutual Insurance confirmed on July 13 that it will not cover damage related to fracking on personal or commercial policies. It appears Nationwide did not intend for this information to become public, as spokeswoman Nancy Smeltzer admitted that a Nationwide memo initially posted to an anti-fracking activist website was internal. According to the memo, Nationwide "determined that the exposures presented by hydraulic fracturing are too great to ignore."
The memo essentially covers all bases for denial of coverage; uncovered individuals and activities include landowners who lease mineral rights, contractors including haulers and their vehicles, and vehicle operators on fracking sites. Cabot is in the limelight with several highly publicized negative incidents related to fracking, including a well contamination suit in Pennsylvania related to its Marcellus drilling. Chesapeake Energy (NYSE: CHK) recently settled a similar case for $1.6 million, and Range Resources (NYSE: RRC) is attempting to work out an agreement over water contamination in Texas.
Earlier this year, Brian Martin of the Insurance Journal likened insurance risk over fracking to mass torts like environmental risks posed by toxic clean up hazards, which emerged in the 1980s and continue today. As Martin pointed out, one of the major risks in covering fracking for insurers is the duty to defend; even if the plaintiff filing suit cannot prove that the damages claimed were directly caused by the insured, the lawyers provided by the insurance company can easily run up millions of dollars in defense costs for a suit that is ultimately dismissed. This is where Anadarko Petroleum's (NYSE: APC) defense against an environmental suit brought by the Environmental Protection Agency, over legacy superfund sites that it did not originate, could be headed. Even if Anadarko is not forced to pay damages, the suit is already a multi-year, multi-million dollar expense.
The same thing occurs with fracking. If groundwater is contaminated by chemicals only associated with fracking, particularly synthetic chemicals, the case is relatively straightforward. However, if there are multiple operators in a small area, or if the chemicals are naturally occurring, who is to say where the contamination originated? There is no way to identify a specific driller in these circumstances, and as drilling on popular plays like the Marcellus becomes tighter, the burden of defense becomes heavier.
Nationwide is based in Columbus, Ohio, and while it insures globally the majority of its policies are issued east of the Mississippi River due to its location and history. As the east coast is home to the Utica and Marcellus shales, a number of its customers are likely involved with fracking. It also insures in other areas; Nationwide is the 7th largest homeowner insurer and 6th largest auto insurer based on premiums written, and for those located in areas with fracking activities it could be wise to consider Simon Lomax's, Research Director for Energy in Depth, reaction to the news: "I won't be buying home and car insurance from this company."
In addition to the above mentioned suit, Cabot is facing a wrongful death lawsuit in Philadelphia's Court of Common Pleas over alleged safety violations. The suit claims that Cabot and its joint venture partner Pioneer Natural Resources (PXD), as well as contractors Dean's Casing Services and Pioneer Drilling Services, LTD, a subsidiary of Pioneer Natural Resources, "failed to provide adequate" safety equipment for fracking operations and did not conduct safety meetings or thorough safety reviews, leading to the death of a worker on an elevated gas rig platform in Dimock Township, Pennsylvania in May 2010. The plaintiff, the deceased worker's daughter, is seeking over $50,000 in damages from each of the four companies named in the suit as well as wrongful death and survival action claims.
Nationwide's decision not to cover individuals or corporations for fracking activities could prompt other insurers to do the same. If so, independent exploration and production companies like Cabot could be facing an uphill battle as litigation claims pile up. Already, several insurers are offering specialized policies for the risks introduced by fracking, among them XL Group (XL), Ironshore, Chartis and Zurich Insurance Group, but with specialized policies come higher premiums, further eroding revenue from capital intense shale extraction. With 96% of its production dependent on natural gas extracted in the U.S., Cabot does not have the option of abandoning shale for less risky production. With operating margins already razor thin, Cabot is not able to afford the cost of large lawsuits without insurance protection, either - a similar situation to others who jumped in on the Marcellus early and then became stuck, like Chesapeake.
Cabot is currently trading around $40, which gives it a price to book of 4.0 and a forward price to earnings of 39.6. The high forward price to earnings is a function of low natural gas prices in the U.S., which will continue to erode Cabot's margins for the foreseeable future. Analysts are estimating Cabot's second quarter earnings around $0.10 per share, which would be a nearly 30% decline over the quarter a year prior.
I think that $0.10 might be on the optimistic side, and am prepared for Cabot to report lower when it releases its operating results for the second quarter on July 24. Since Cabot is currently trading above its value and will likely do so for the near future, I expect that the stock will slide lower before the picture improves, making Cabot a hold.
jordobivona has no positions in the stocks mentioned above. The Motley Fool has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Motley Fool newsletter services recommend Range Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.