The Wait For $5 Gas Could Be A Long One At Ultra Petroleum

By Stephen D. Simpson, CFA | June 26, 2013 AAA

Reputations, good and bad, can be surprisingly sticky. Ultra Petroleum (NYSE:UPL) has long been lauded for its high-quality operations, its cost leadership, and the quality of its properties/reserves. While the first part is absolutely still true, I have bigger questions about the quality of Ultra's properties and how the company will generate value over the long-term. While I will certainly acknowledge that higher gas prices will be the rising tide that lifts all boats in the natural gas space, I'm increasingly concerned that Ultra Petroleum is a high-quality operator with medium-quality assets and, as such, maybe not the horse to ride for the long term. Discipline At The Cost Of ProductionWe're long past the point where natural gas producers would drill at almost any price just to show production growth and/or hold leases. Instead, it's now all about cash return on investments and sub-$4 natural gas prices have made gas exploration and production a tricky proposition – particularly for companies like Ultra Petroleum, Southwestern Energy (NYSE:SWN), and Encana (NYSE:ECA) with “dry gas” asset bases. SEE: Oil And Gas Industry PrimerDue to lower prices, Ultra has been facing not only shrinking reserves (the size of an energy company's reserve base is based in part on prevailing oil and gas prices) but shrinking production. Ultra Petroleum has done a good job of reducing well costs in its traditional Pinedale region (down to about $4.4 million per), but management seems loath to commit to the $100 million or so it would require to get a third rig going in the region.  Likewise, development in the Marcellus is going very slowly. Neither Anadarko (NYSE:APC) nor Shell (NYSE:RDS.A) seem eager to get active in those areas where Ultra has a non-operating interest. This is not exactly surprising given that Ultra management has indicated that it won't allocate drilling capital to its operated areas in the region until/unless we see $5 gas. Are The Assets What We Think They Are?Ultra Petroleum has been lauded for quite some time for the quality of its reserves and property assets in Wyoming and Pennsylvania, but I'm starting to wonder if that praise is fully deserved. If Ultra's well results in the Marcellus have been “okay”, those of Southwestern and Cabot Oil & Gas (NYSE:COG) have been very good. In fact, I might try to argue that one of these two (I'd lean toward Southwestern) has the best dry gas assets in the Marcellus region. If you compare the production growth at these companies to the changes in the balance sheet, Ultra Petroleum doesn't come off looking so strong.SEE: Investing In Oil And Gas UITs That all makes me wonder whether Ultra Petroleum is a high-quality company with medium-quality assets. I realize that it's hard for anybody to make money in this environment for natural gas, but I have to wonder if Cabot and Southwestern will do even better if/when natural gas prices start rising again and making Ultra's assets more valuable. To that end, I'd also point out that Ultra management has talked about using its balance sheet not to develop its own properties, but to acquire other producing assets through M&A. The Bottom LineI've been generally bullish on Ultra Petroleum for a while, and I've owned the stock profitably in the past. Even so, situations change and I'm starting to wonder if Ultra Petroleum is the stock I really want to hold while I wait for higher gas prices. I certainly don't think Ultra should carry the premium valuation it held over most of the last three years, and on the basis of a 6.5x multiple to forward EBTIDA estimates, fair value would seem to be around $19. As it stands, I do think Ultra will do better in a high-gas environment, and I could see Ultra actually benefiting even more from higher prices than Cabot or Southwestern, as Ultra arguably needs those higher prices more. Even so, on a quality basis I'm no longer the bull on Ultra Petroleum that I once was and I'd encourage investors to dig a little deeper and judge for themselves whether the well economics, production growth, and balance sheet management stack up as well here as they once did.

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