By Mark Hansen
Ongoing U.S. oversupply combined with mild winter weather has weighed heavily on U.S. natural gas prices over the past few months. Nymex Henry Hub is currently at $2.50 per thousand cubic feet, 50% below this time last year, with gas prices down 30% since November alone. Not surprisingly, the stock prices of dry gas producers such as Ultra Petroleum (NYSE:UPL), Range Resources (NYSE:RRC), and Chesapeake Energy (NYSE:CHK) are all down 20% or more in the past few months.
Uncertainty about the extent of oversupply over the next few years is adding to the current bearish sentiment on natural gas. Unknowns include exploration and production efficiency (getting more production from less investment), gas associated with liquids production, well inventory waiting on completion, weather (always a wild card), and the potential uptick in demand to absorb excess supply. Oversupply may end up being less bad than the futures market predicts over the next several quarters, thanks to marginal gas producers pulling back on drilling activity (in part because of hedge books that have rolled off) and E&Ps achieving held-by-production status in regions like the Haynesville.
While there's no question current natural gas prices are below most everyone's expectations, we think the market is assuming unreasonably low long-term gas prices. By our math, Ultra's current stock price assumes gas prices of $4.00-$4.25 per mcf in perpetuity. The Nymex Henry Hub futures curve hits $4.50 beginning in mid-2014 and only increases from there, however, which would imply much more bullish expectations about the long-term picture for natural gas.
We arrive at our $60 fair value estimate for Ultra primarily through a five-year discounted cash flow analysis, supplemented by an assessment of longer-term resource potential, trading multiples, and comparable transactions. Near-term gas price weakness represents a challenge, but Ultra's balance sheet, hedge book, and low maintenance capital expenditure requirements should help the company get through the next several quarters relatively unscathed. We think Ultra's current trading price represents a reasonable entry point for longer-term investors, with a handful of near-term catalysts that could lead the market to revalue the stock this year.
Ultra is a small, independent E&P that holds some of the best assets in North America in the Pinedale Field of Wyoming and Marcellus Shale of Pennsylvania. Almost all its production is dry natural gas. Ultra's acreage should support a decade or more of double-digit production growth, given the tight spacing required for full development in the Pinedale and the emerging nature of the Marcellus. Low development and production costs and improved pricing should support strong cash flows and outstanding returns over the full cycle. We estimate Ultra's fully loaded cash break-even point to be $2.70 per mcf, which compares favorably with average 2012 and 2013 Nymex Henry Hub strip prices of $3.28 and $3.97, respectively.
Calling short-term moves in oil and gas prices is a difficult proposition at best, and we're as surprised as anyone (including most producers) at current trough levels. That said, we remain bullish on the out-year case for a significant improvement in U.S. natural gas prices.
We think the long-term price (marginal cost) for U.S. natural gas is closer to $6.50 per mcf; at this price, Ultra's fair value works out to $60 per share. We're not blind to the fact that long-term intrinsic value needs to be balanced with relative value considerations over the short term, however, in part because of the inherent difficulty of making a long-term call on a commodity like natural gas. At the current stock price of $24, investors are paying a little less than 6 times our estimated 2012 earnings before interest, taxes, depreciation, and amortization ($955 million, which includes realized hedges), 12.9 times 2012 earnings per share ($1.86), and $0.98 per mcf equivalent of proved reserves (20% less than Ultra's cost to find and develop new reserves). These earnings assume production volume of 826 mmcfe per day (up 22% from 2011) and use an average Nymex Henry Hub price of $3.28 per mcf (which works out to $4.04 once hedges are factored in).
Management has said, "It will be very difficult for us not to grow production in excess of 290 Bcfe (792 mmfce/d) in 2012," which serves as the basis for our forecast. In our opinion, the stock is trading at a reasonable price for one of the highest-quality E&P companies that Morningstar covers, one whose earning power is likely to increase significantly over time, especially given our view on out-year natural gas prices.
Higher Gas Prices Aren't the Only Answer
We don't think Ultra will depend solely on natural gas prices to drive a recovery in the stock. We've identified a handful of potential catalysts that could lead investors to revalue the shares over the next 12 months.
In the Marcellus, 2012 could be an inflection point for production, going from less than 10% of Ultra's production in 2010 to 30% in 2012. Ultra's operating partners could execute better, including working through the large backlog of wells waiting on completion. There could be a surprise regarding the 2011 exit rate, depending on the timing of year-end well connects. Also, we could see continued outperformance from Marcellus type curves.
In the Pinedale, there could be a potential surprise regarding drilling efficiencies, which Ultra is likely to address in the first quarter. And while it's still early, a potential sale of Ultra's Pinedale liquids gathering system could garner estimated proceeds of $200 million.
Another catalyst is initial vertical drilling results in Ultra's newly established Niobrara position. Also, while it's a much lower-probability event, Ultra has long been one of our top takeover candidates, given the quality and scalability of its assets; the recent addition of a large, prospective Niobrara position only increases its attractiveness, in our opinion.
Our 2012 production number is predicated on management's previous guidance; its formal outlook for this year won't be released until mid-February. If at that point management signals a meaningful pullback in new drilling activity, it would have a negative impact on production but would not significantly affect the firm's financial profile.
Also, Ultra estimates its 2012 maintenance capital expenditures to be just $300 million, in part because of its overinvestment in the Marcellus in 2011. In the event gas prices collapse even further, Ultra should be able to maintain a strong balance sheet.
Regardless, we expect management to remain rational, prudent, and focused on rates of return accordingly -- that is, good stewards of shareholder capital--and although value creation might be pushed out a few quarters in the event of a pullback in drilling, we're still bullish on Ultra for the long term.
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