By Chad Tracy
Last August, StreetAuthority analyst Nathan Slaughter made a bold prediction.
At the time, the price of natural gas had reached decade-low prices just a few months before, falling below $2 per thousand cubic feet (or Mcf) in April of 2012.
Nathan predicted that natural gas was due for a rebound. He also spotted a huge disconnect between the rising price of natural gas and the share prices of the companies that produce it.
Since June 2012, the price of natural gas has doubled, reaching $4.40 in April before tapering off.
Now, if we were to take a look at the share price for the stock of a "pure play" natural gas company (as opposed to one that produces a combination of gas and oil), we might expect the share price to mirror the price of gas. After all, the spread between how much it costs for these companies to drill for gas and how much they are able to sell it for on the open market is how they make money.
But take a look at this next chart.
This chart shows the share price for Ultra Petroleum (NYSE: UPL) during the same time period.
While the chart does mimic some of the movement in the spot price chart, we have yet to see the same kind of run-up in share prices that we've seen in the price of gas. If those prices were more in sync, we could expect shares to be trading around $36 instead of $22.
Natural gas represents 96% of Ultra's reserves and 97% of its annual production. This makes the company as close to a pure play as you're going to find in the natural gas sector.
This designation offers both risks and rewards. The risks stem from a lack of diversification. Should the price of natural gas fall, the company doesn't have income generated from oil production to fall back on.
However, the upside potential for a relatively small energy company like Ultra, with a market cap of $3.3 billion, is very enticing.
The company operates in the Green River Basin of Wyoming and in the Marcellus Shale of Pennsylvania. The firm's geographic advantages and industry-leading cost structure allow it to produce gas for less than its competitors.
Ultra's operating costs for 2012 stood at just $2.79 per Mcf. For comparison, the average gas producing company has an operating cost of $7.31 per Mcf.
As Nathan pointed out in his August 2012 Scarcity & Real Wealth newsletter, this low-cost structure sets Ultra apart from its competition:
Ultra's growth outlook is solid, but that's not what distinguishes the company from its E&P peer group. What really set the firm apart are its low costs and superior operating efficiency. Those attributes sound dull -- until you see the impact on the bottom line.
Ultra's output has soared 41% annually over the past 13 years, and the company has a reserve replacement ratio of 339%. That means for every cubic foot of gas that is dug up and sold, its reserves are replenished with more than 3 new cubic feet.
The company owns proved reserves of over 3.1 trillion cubic feet of gas, and much of this potential has yet to be tapped. According to the company's most recent shareholder presentation, less than 10% of its acreage in the Marcellus Shale is currently producing, leaving lots of room for new wells to come online. Analysts estimate that Ultra's current reserves contain at least 20 years' worth of inventory.
Ultra's size also makes it a prime acquisition target. If gas prices continue to rise, major energy companies with deep pockets will be looking to add exposure to U.S. gas reserves.
Risks to Consider: Despite hedging efforts designed to insulate profits, long periods of depressed natural gas rates could damage profitability. Ultra is also subject to inflationary cost increases and potential changes to fracking regulations. In addition, the company does not pay a dividend, making this investment more suitable for growth investors.
For investors willing to stomach the ups and downs that come with investing in energy commodities, UPL rates a buy at today's prices with a price target of $40 over the next 18 months.
Disclosure: I am long UPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.