Is Ultra Petroleum Still Capable of Ultra Performance?

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(UPL), Range Resources(RRC), and Chesapeake Energy(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. (more)