Coterra Energy Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 4/5

A U.S. focused independent oil and natural gas exploration and production company, primarily operating in the Permian and Anadarko Basins, with assets located across Texas, Oklahoma, New Mexico, Pennsylvania and other states.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Coterra Energy Inc. is not a particularly simple business to understand for the average investor because it is heavily influenced by commodity prices, its business model is quite specialized, and because the value of assets changes significantly, requiring detailed knowledge to really be able to do the appropriate calculations for it.

Business Overview:

Coterra Energy (CTRA) operates as an independent oil and gas exploration and production company. It focuses on the development, exploitation, and production of crude oil, natural gas, and natural gas liquids (NGLs). The company’s primary operations are concentrated in the Permian Basin of West Texas and New Mexico, and the Anadarko Basin, primarily in Oklahoma, as well as other areas of the U.S.

Revenue Distribution: Coterra’s revenues are primarily derived from the sale of crude oil, natural gas, and NGLs. Oil volumes tend to contribute to the majority of revenues. It is very sensitive to price fluctuations in these markets.
Industry Trends: The oil and gas industry is characterized by high cyclicality and volatility in prices. Demand, and, therefore prices, are affected by global economic conditions, geopolitical stability, and energy transitions. There is a significant focus on ESG, which has affected the cost of capital and may continue to do so in the future.
Margins: As is generally the case for commodity focused companies, Coterra’s margins are extremely susceptible to commodity prices. When prices are high, margins tend to be very high and vice versa. This high volatility makes the analysis more difficult for investors. Profitability is largely a function of being low cost on the production side and optimizing their operations. Companies in this business have very limited price power over their output, and therefore cost is the most important factor to long-term profitability.
Competitive Landscape: The oil and gas exploration and production sector is fiercely competitive. Coterra contends with a variety of publicly traded, private, and state-owned energy businesses. The barriers to entry are relatively low for many small producers but there are significant economies of scale and capital requirements needed to achieve the same per-unit production cost as some of the majors like EOG Resources or Pioneer Resources.
What Makes Coterra Different: Coterra was created from the merger of two sizable oil and gas producers, Cabot Oil & Gas and Cimarex Energy, back in 2021. They have very large holdings in the Permian and Anadarko basins, where they are one of the major producers. Further, the company is focusing on cost control and sustainability to differentiate itself and create a long-term value proposition. The company seems to be targeting a low-cost operator status. They also have a relatively lower debt profile compared to other similar companies. Another noteworthy observation is that management seems to favor stock buybacks rather than paying dividends.

Financials:

Coterra’s financials are complex and highly variable, and these fluctuations are inherent to oil and gas exploration companies. It’s important to examine the context of the most recent reports in terms of long-term results. The company faces significant challenges related to fluctuations in commodity prices, but has shown improving trends in profitability and operational performance.

Revenue: Revenue in the recent periods has been driven primarily by natural gas, oil, and NGL sales. Revenues are highly volatile as a consequence of volatile commodity prices. In general, revenues are a function of volume and price and have fluctuated accordingly with market conditions.
Expenses: The main operating expense drivers are transportation and exploration costs along with production. Operating expenses have also been volatile and have been primarily driven by inflation.
Profitability: The company has had some significant swings in profitability primarily based on the ups and downs of the industry. The 2020s have been pretty tumultuous for energy companies and CTRA’s margins have reflected that too. While the ROIC is decent during the peaks of the cycle, it can also be very low and at times negative during the troughs. It is imperative to take cyclicality into account when valuing the company. Management is attempting to lower costs which should give some cushion against downside prices.
Free Cash Flow: While the company has seen an increase in cash flow in the recent past, it has been volatile over time due to fluctuations in commodity prices and changes in the overall industry. Most of their capital expenditures are for exploration and acquisitions. Further, as the company has made no long-term commitments to debt repayment, a large portion of their free cash is going into share buybacks, making it all the more important that the shares bought are at reasonable valuations.
Capital Structure: The debt levels of the company are relatively low. They are targeting the leverage ratio to be at 0.5x net debt/ adjusted EBITDA or lower, which means that its balance sheet is relatively conservative. Cash holdings are also substantial for the company which provide good flexibility to management.

Moat Analysis:

While Coterra Energy possesses certain competitive advantages, their sustainability is questionable. Here’s a breakdown of my moat assessment:

Intangible Assets: The company has a proven track record of finding and extracting natural resources. They also have an extensive land footprint in the Permian Basin and Anadarko Basins. These provide some competitive advantage, but they are not unique or irreplaceable. Further, all other companies also have similar kinds of resources in their balance sheet, and many are even bigger.
Switching Costs: Oil and gas buyers face low switching costs because they are buying an undifferentiated commodity. Therefore, their is no direct advantage to the company from a switching cost perspective.
Network Effect: There is no network effect present in this business.
Cost Advantages: Coterra is trying to be a low-cost producer of oil and gas. The large scale of their operations gives them some advantage, but those advantages can and are easily replicated by other large players in the industry.

In summary, while Coterra has some of the pieces for a strong moat, the lack of significant pricing power and substitutable products makes it only an average business with a low moat. The company is susceptible to the boom-bust cycles of its industry as well as to competition.

Moat Rating: 2/5 The company possesses some advantages stemming from their size and operational experience, but their sustainability is questionable due to intense competition and the volatile nature of commodity prices.

Moat Risks:

Coterra faces several legitimate risks that could impair their moat and overall value creation:

Commodity Price Volatility: The most significant risk is the volatility of oil and natural gas prices. Large declines in commodity prices directly impact the company’s profitability and returns on invested capital.
Regulatory risk: Increasing regulations and environmental scrutiny can significantly impact operating expenses and costs of expansion. Further, government intervention and tax policies may drastically shift profitability.
Competitor Risk: The industry is highly competitive, with numerous companies vying for access to resources and sales. Increased competition can lower profits and lead to reduced long-term sustainable value creation. This industry is incredibly dependent on other players and is very quick to react to any one company’s gains, often leading to price wars that benefit no one.
Operational Risks: Coterra faces a risk of production decline and the costs associated with managing exploration programs, and any failure to manage it will lead to value destruction.
Debt Overhang: Although debt is relatively low now, a sudden change in economic conditions, as seen in the past, may lead to a situation of financial distress, as a result of which the value of equity would be highly reduced, even at the highest prices.
Technological Disruption: New technologies can render existing assets and business models obsolete. Rapid changes in extraction techniques, or increased efficiency in renewable energy, could pose a substantial threat.

Business Resilience:

Coterra shows moderate business resilience due to the following characteristics:

Asset Base: Coterra’s significant asset base and proven track record provide a base for recovery and adaptation to market conditions. However, the risk related to commodity prices makes it a highly cyclical business.
Cost Control: The management has shown a commitment to keeping their operations costs in check, which should ensure their profitability and sustainability even when market conditions worsen.
Experienced Management: Coterra’s management has considerable experience in the energy industry, which should allow them to navigate the choppy conditions of the market.
Flexibility: They have ample liquidity, and very little debt, enabling them to take advantage of opportunities as they arise in the future.

Understandability:

Understandability Rating: 2/5

While the basic business model of exploring and extracting oil and gas is understandable, the underlying technicalities of resource estimation, capital expenditures, tax regimes, and derivative accounting makes it extremely difficult for a non-finance trained individual to fully understand the value of this business. The fact that financial reports tend to be highly variable because they depend a lot on market prices adds to its complexity.

Balance Sheet Health:

Balance Sheet Health Rating: 4/5

Coterra has a relatively conservative balance sheet, with its debt to market capitalization ratio relatively lower than the industry average. It also has large cash holdings.

Debt: Debt levels are low and well-managed, providing financial flexibility.
Cash: Cash reserves are high, providing strong liquidity.
Liquidity: The company has good liquidity with adequate levels of current assets.

Additional Points:

ESG Concerns: As oil and gas companies, CTRA is facing increased pressure from investors and society in terms of environmental issues. While they have pledged to reduce the greenhouse gas intensity and other environmental impacts, the industry itself is not environmentally friendly. ESG concerns and transition to alternative energy could affect long-term investor sentiment and valuation. The management seems to be taking their responsibilities seriously.
Management Discussion: Management has consistently emphasized cost control, capital discipline, and delivering shareholder value through buybacks and not dividends. However, due to the volatility of commodity prices, they tend to be less transparent about future prospects. This can be seen as a sign of risk by a defensive investor.
Recent Controversies: Like other energy companies, Coterra’s performance has been subject to the volatile commodity markets and has suffered from large and unpredictable swings in price and profits, which can make long-term valuation very unreliable. There are also some concerns that the acquisitions and divestitures strategy of the company is not producing predictable results. Further, because the majority of its earnings come from the extraction of gas and oil, an energy transition to other sources may make the long-term prospects of the business volatile.
Future Outlook: Based on current estimates, management seems to be optimistic in the near-term, with continued operational improvements and expectations for sustained free cash flow, though they mention that their production will be below full capacity in 2024. However, they continue to focus on keeping costs in control.

While the company shows signs of decent future growth, it is imperative to understand the volatility related to commodity prices, and how that volatility translates to wild swings in profits and value. It is certainly not a stable and reliable source of income, but that is inherent to most commodity extraction businesses.