Description

Ultra Petroleum (UPL) is a vehicle to profit from a recovery in natural gas prices.  This is strictly a commodity play.  If you believe that North American natural gas prices are permanently capped at $4.00 per MMBtu, or if you are not comfortable with commodity play investments, you should stop reading.  However, if you believe that natural gas prices will be significantly higher in the next two to three years, then read on.

Thesis.  The investment case for UPL can be summarized as follows:

• Low U.S. natural gas prices have (finally) resulted in reduced drilling, leading to declining production, which in turn will lead to significantly higher gas prices in the next two years.
• UPL is highly levered to natural gas prices, with natural gas constituting 96% of its reserves and 97% of its production.  Approximately 30% of its 2013 production is hedged, while none of its 2014 production is hedged. 
• UPL is a low cost producer, will generate free cash flow in 2013 at $3.50 gas (i.e., unlike many E&Ps, UPL is not currently outspending its cash flow), and has the ability to increase production and booked reserves if and when gas prices rise.

Natural Gas.  At the risk of being pedantic:  production from existing natural gas wells declines over time; thus, unless new gas wells are continuously brought into production, natural gas production will decline.

While there are exceptions (e.g., parts of the Marcellus), at sub-$4.00 gas, it is unprofitable, or marginally profitable at best, to drill for dry gas in most domestic gas plays, and drilling activity reflects these economics.  Rig counts have fallen in the Barnett, Fayetteville, and Haynesville, and the number of new wells drilled in the Barnett and, especially, the Haynesville has plunged.  The Haynesville is a leading indicator of future production trends, with daily production in December 2012 down over 12% from daily production in December 2011.  Drilling activity has switched to more profitable oil and liquids plays, such as the Bakken, the Eagle Ford, the PermianBasin, and the Midcontinent oil and liquids plays.  Given the returns and drilling inventories available in these oil and liquids plays, it will take significantly higher gas prices to divert drilling away from these plays and back to gas.

The natural decline of currently producing wells and the character of current drilling activity point to a coming decline in natural gas production, and as production declines, prices must increase to incentivize new drilling.

This is described in more detail by Utah in his March 14, 2013 natural gas write up, which can be found here:  http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/93255.

UPL Properties and Operations.  UPL is incorporated in Canada, but its headquarters are in Houston, Texas, and its operations are located in the United States, in the tight sands of the Green River Basin of southwest Wyoming and the Marcellus Shale in Pennsylvania.

UPL holds oil and natural gas leases totaling approximately 84,000 gross (49,000 net) acres in Wyoming's Green River Basin.  Most of this acreage covers the Pinedale and Jonah fields.  Approximately 62,000 gross (39,000 net) acres of the Wyoming acreage are undeveloped.  All of the Company’s leases within the productive area of the Pinedale and Jonah fields are held by production.

UPL holds oil and gas leases covering 497,000 gross (261,000 net) acres in the Pennsylvania portion of the Marcellus Shale, of which approximately 362,000 gross (185,000 net) acres are held by production.  Approximately 386,000 gross (203,000 net) acres of the total position are undeveloped.  UPL operates approximately 84,000 gross (58,000 net) acres of the total position; the balance is operated by third parties (Anadarko and Shell).

Reserves and Production.  At YE 2012, UPL had 3.0175 bcfe of proved reserves, of which 96% were natural gas and 61% were proved developed.  In 2012, UPL had 257 bcfe of production, 97% of which was natural gas.  2012 production was 5% higher than 2011 production, while UPL expects 2013 production to decline by 9%, with the entire decline attributable to the Marcellus (Wyoming production is projected to be flat).

Capital Expenditures.  UPL has budgeted $415m for capital expenditures in 2013.  This compares to $835m for 2012 (which was down from $925m budgeted at the beginning of 2012) and $1.5b for 2011.  This is striking evidence of the impact of low gas prices on natural gas drilling; UPL's 2013 production guidance, in turn, demonstrates the effect of reduced drilling on production.

The 2013 budget includes $365m for development drilling:  $260m in Wyoming and $105m in the Marcellus.  The $105m budgeted for the Marcellus will be spent mostly on completions.  Anadarko stopped drilling in July 2012.  Shell is down to one rig in the Marcellus and UPL may elect (and has elected) not to participate in wells drilled by Shell when the well economics are not favorable.  Thus, if gas prices remain at current levels, Marcellus spending will likely fall further in 2014.

According to UPL, the $260m budgeted for Wyoming is sufficient to maintain flat production.  UPL has stated that, if gas prices remain at current levels, the company will maintain flat production in Wyoming, at an annual cap-ex of $250m to $260m.  Conversely, UPL has the drilling inventory to ramp up spending and production in Wyoming if justified by higher gas prices.

UPL will generate free cash flow in 2013, assuming gas prices of $3.50 or more.  Going forward, if gas prices remain at those levels, and UPL maintains flat Wyoming production, it will remain free cash flow positive, even with reduced Marcellus production.

Hedges.  As of February 28, 2013, UPL had hedged approximately 68 bcfe of its production from April to October 2013 at an average price of $3.65 per mcfe.  UPL's 2014 natural gas production is unhedged.

Valuation.  A comparison of UPL to two gas-heavy E&Ps, Southwestern Energy and Range Resources, is below (based on 4/10/2013 closing prices):

On most metrics, UPL is cheaper than SWN and RRC.  Notably, although the PV-10 per mcfe of UPL's proved reserves is higher than the comparable figure for SWN and RRC (i.e., UPL's proved reserves are more valuable), the price one pays for UPL's proved reserves is materially less than the price paid for RRC's reserves, and substantially less than the price paid for SWN's reserves.

The upside in UPL's shares is best demonstrated by the PV-10 of its 2P reserves at $5.00 gas, which the company estimates at $9.9b.  This yields an NAV of $50 per share, without regard to the company's significant 3P potential.

Short Interest.  Over 17% of outstanding shares are sold short.  The relatively high short interest can be viewed as a positive, as short covering may amplify the effects of positive surprises.

Risks and Downside.  If I am wrong about natural gas prices, UPL is overpriced:  at permanent $3.50 gas, UPL is a $10 stock at 4x cash flow.

Further, if gas prices settle at $3.50 on a permanent basis, UPL is at risk of violating loan covenants in 2014 or 2015 (debt to EBITDA is capped at 3.5x).  However, by my projections, UPL generates sufficient cash flow at $3.50 gas to repay debt to levels required for covenant compliance.

Catalyst