Today's Buy Opportunity: Ultra Petroleum

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Woody Allen once quipped that "Bisexuality immediately doubles your chance for a date on Saturday night." Similarly, I like to keep my options open in my investments, and look for stocks with multiple upside catalysts.

Enter my pick for The Motley Fool's "11 O'Clock Stock:" Ultra Petroleum (NYSE: UPL  ) , a natural gas-focused exploration and production company that makes its living drilling in Wyoming's Green River Basin and Pennsylvania's Marcellus Shale. Depressed natural gas prices, secular tailwinds on gas consumption, first-class assets with great potential, and a management team focused on shareholder value, combined with a compelling valuation, leave a lot of potential for things to go well.

Fast facts on Ultra Petroleum

Market Capitalization

$6.73 billion

Industry

Oil & Gas

Revenue (TTM)

$870 million

Earnings (TTM)

$351 million

Source: Capital IQ, a division of Standard & Poor's. TTM is trailing 12 months.

Economics paging reality
I know what you're thinking. "Natural gas prices have been low for a loonnngg time. Are prices ever going to recover?" In a word, yes. But to understand the future, join me for a brief (recent) history of natural gas.

Natural gas crested $12 per thousand cubic feet (mcf) in the heady days of 2008; exploration and production (E&Ps) companies loaded up on land and cranked up their drilling programs. The consequence: too much natural gas. When the U.S. economy imploded, commercial and industrial consumption of natural gas declined and concerns over the supply glut were exacerbated. Natural gas dropped below $4/mcf as natural gas stores swelled to the highest monthly level on record in November 2009 and investors worried over the economy's state.

This is a categorically unsustainable condition. It just cannot continue. Estimates peg the marginal cost of producing natural gas at $5-$7/mcf, and some point to $6-$8/mcf. In lay terms, the marginal cost is the natural gas price where higher-cost producers break even. At $4/mcf, E&Ps should've pulled rigs from the ground, which would've eased supply concerns and primed natural gas prices for a bounce (if the U.S. economy held its ground).

But that hasn't happened, as looming lease expirations and favorable hedges have compelled drillers to ignore economics, and keep drilling. In time, cold, hard economics will prevail, natural gas prices will eventually bounce back to $6 or $7 per mcf, and the earnings of natural gas-focused E&Ps will follow.

Remember how you hate oil?
Fossil fuels, oil in particular, have been a hot-button policy issue in recent years, as policymakers consider their carbon consequence and dwindling domestic oil supplies.

While natural gas may not be the alternative that environmentalists seek, its carbon footprint is substantially lower than its fossil fuel counterparts oil and coal. Because the economics of solar energy, ethanol subsidies, and olive oil cars are uncertain -- and natural gas comparatively predictable -- that makes it an ideal bridge fuel. Recent shale discoveries account for 1,000 trillion cubic feet of natural gas, enough to supply our nation's energy needs for 45 years. And so, while politicians and peak-oil theorists are fretting over our domestic oil-producing capacity, natural gas can fill the gap.

That makes a powerful secular case for increasing natural gas demand, and accompanying higher prices. ExxonMobil (NYSE: XOM  ) agrees: Its $41 billion acquisition of XTO Energy , a leader in domestic unconventional natural gas production, amounts to a levered bet on the future of natural gas.

Ultra: the ultimate
Ultra lives up to its name, since it possesses some of the lowest-cost assets in the business: its Green River Basin and Marcellus Shale holdings. Its 2009 all-in costs of production, at $2.61/mcfe, are some of the best in the business, and well below those of industry biggies Chesapeake Energy (NYSE: CHK  ) , Devon (NYSE: DVN  ) , and Southwestern (NYSE: SWN  ) . For investors, it means that Ultra makes good money even if natural gas prices muddle along, and even if they dip to $3/mcf.

Many growth companies, and growth-oriented E&Ps, pursue a growth-at-any-cost mentality, and returns are an afterthought. Ultra's different. Management keeps a ruthless focus on returns on capital, and unlike many of its peers, it opts for a conservative capital structure. The proof is in the numbers: Even as natural gas prices collapsed in 2009, Ultra posted 25% returns on capital. For shareholders, that's a recipe for value creation.

So what am I getting?
I'd wager that $6 natural gas is a reasonable long-term price. At that price, the estimated present value of cash flows from Ultra's proved reserves is $10.4 billion, compared to its $6.7 billion market cap. After netting the company's debt, that leaves close to 40% upside potential. Here's what that stat misses: A good chunk of those reserves are proved undeveloped, but even so, Ultra's only developed 13,000 of the 212,000 acres it holds rights to at last year's close. If Ultra drills its undeveloped acreage with even moderate success, the upside could be mammoth.

Add it up. Best-in-class assets, value-focused management, and a cyclically depressed commodity? That's the opportunity in Ultra. Count me in.

Previous recommendations (Click here for full list of recommendations and performance)

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"11 O'Clock Stock" is sponsored by Motley Fool Stock Advisor. The Motley Fool will wait at least 24 hours after this publication before purchasing shares of Ultra Petroleum. To see an FAQ on "Eleven O'Clock Stock," click here.

Mike Olsen owns shares of Ultra Petroleum, Chesapeake Energy, and ExxonMobil. Chesapeake Energy is a Motley Fool Inside Value pick. The Fool owns shares of Chesapeake Energy, Devon Energy, and ExxonMobil. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (64)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 04, 2010, at 11:12 AM, shivy1 wrote:

    Its free cash flow has been negative for the past three years, that is not a good sign at all.

  • Report this Comment On August 04, 2010, at 11:32 AM, TMFAgewone wrote:

    Hey folks,

    If you've any questions or comments, bring 'em. I'll be here.

    -Mike

    And in that spirit . . . .

    @shivy1: Those figures are a bit misleading. In recent years, Ultra's been engaged in an aggressive land acquisition and drilling program. While that's made them FCF negative, the reality is it's accrued significant value to shareholders, because those assets (and the cash they'll produce) are worth a whole lot. Think of this condition as you might a quickly growing retailer or restaurant, that's growing and generating high returns--are the shares without value because cash flow is weighed down by expansion, or will they become more valuable as consequence?

  • Report this Comment On August 04, 2010, at 11:56 AM, OilHot wrote:

    NG will fill the gap caused by Peak Oil? Ha. I love non-technical people who think things can ramp so quickly and with no capital investment.

    Sorry, the pain is coming. We humans don't like to change unless we absolutely must. And change we must.

    NG is not going to save us. Maybe reduce the pain a bit but having 3 nails pulled from your hand is almost as bad as having 4 nails pulled. ;)

  • Report this Comment On August 04, 2010, at 12:02 PM, OilHot wrote:

    To you Peak deniers,

    When do you think Peak global discovery occurred? Did you at least look up the charts (it's about 40 years ago if you are too lazy to Google it)? If you get those discovery numbers to trend back up, let us know. Until that happens, we are going to hit Peak soon enough.

    Do you have fire and flood insurance? Why not prepare for Peak Oil? The chances are multiple times greater than you experiencing a home fire or flood. Or, just put your head back into the sand. ;)

  • Report this Comment On August 04, 2010, at 12:16 PM, thomasjurisd wrote:

    Not trying to take the comments any more off topic than they already are, but peak discovery being 40 years ago is more tied to other factors...ahem... pardon me while I hug a tree...than to the depletion of reserves. Oil exploration is at the tip of the iceberg. Bank on it.

  • Report this Comment On August 04, 2010, at 12:53 PM, TMFAgewone wrote:

    @OilHot: I'm not denying the possibility of Peak Oil, and I'm not saying natural gas can fill the gap without substantial infrastructure build. That takes time, but any solution does.

    My point is that we have to do something if oil production is declining, whether it's because reserves are depleted or people don't like oil. In the absence of clear data on the viability of alternative technologies--and because we've got a lot of natural gas living in the earth--natural gas is one among many options, and one of the more cost-effective.

  • Report this Comment On August 04, 2010, at 2:56 PM, susan400 wrote:

    Opposing View

    N-gas isn’t depressed it is ~4.50, more normal vs the hyped phase of 4-10$ 2004-2008

    !990s saw .80 to 3$ gs.

    Additionally the tail wind is gascos like ULP are out spending cash-flow to make MORE not less gas. More equals lower prices.

    Why do you say gas demand tailwinds? Use is about the same as 5 yrs ago. Did you make that up?

    LNG will be coming in heavy within 2-3 yrs with a COP of 1.50

    UPL’s Marcellus position has some good acreage but much is shallower and thinner than the heart of the play. NW Tioga and 80% of Potter County are Grade C.

    The position they acquired in Clinton Cnty last November is saturated with folds/faults and won’t be easy nor inexpensive to drill. That is why they won it, others didn’t want that acreage.

    Last N-gas is in a bear market.

    Hey opinions vary, I research this daily.

    Susan400

  • Report this Comment On August 04, 2010, at 2:59 PM, susan400 wrote:

    I thought everyone knew, Peak Oil was about the peak in price, 2008, 150$.

    I think the book was written to bring in uninformed investors.

    Oil went to 30 after that book came out.

    Myth in a bad way, there is no peak. Technology revs up daily recovery rates rise, w have lots of oil., and TOO much gas.

  • Report this Comment On August 04, 2010, at 3:01 PM, susan400 wrote:

    also the Street knows, UPL's CEO is a bit on the hype side.

    cash flow doesn't matter because they ramped up ?

    yes they ramoed up when gas was 8 now it is 4

    = error.

    thetime to ramp up is when gas is2

  • Report this Comment On August 04, 2010, at 4:01 PM, shivy1 wrote:

    I understand FCF is negative due to the expansion, but it seems expansion has not paid off for the last 4 years. When do you expect to see these so called returns? I mean it seems I would have to wait 20 years for any of it really to kick in, or is it just that they dont know how to expand?

  • Report this Comment On August 04, 2010, at 5:22 PM, hankering2buy wrote:

    I think it is a little bit of a head-in-the-sand approach to deny that we are at, or near the peak in crude oil production (unless some of the alternative and not too accepted theories about oil creation are shown true); it's use is a creating a tremendous carbon load and cost t o the environment; there is a mass of coal out there but it is absolutely deadly to the environment without significant and as yet sparsely implemented and expensive pollution controls AND a way to manage ash; and some utilities are already converting or planning to convert from coal-fired to NG. You can argue about the $ to do it and the time frame but you guys know there is a money-maker in this pile of problems with carbon-based energy sources. So let's find it.

  • Report this Comment On August 04, 2010, at 5:30 PM, TMFBreakerRob wrote:

    I've been following NG for a while....I'd say susan400 is spot on regarding near to mid term gas. And, if LNG imports ramp up in the US as expected, it could get very ugly for these NG companies.

    Lots of risk getting bitten here. There are plenty of more certain investments to play in...why take an unnecessary chance in NG?

  • Report this Comment On August 04, 2010, at 5:33 PM, TMFAgewone wrote:

    @susan400: Thanks for your comments, but I’ll respectfully disagree. Comparing $4.50 natural gas today to the ‘90s or early ‘00s is not an apt comparison; it costs a whole lot more to extract natural gas today than it did in the ‘90s or earlier this decade, per my comments in the article. So, I’d say that makes natural gas cheap at $4.50. And while companies are producing too much natural gas (as you say), I think that’s part of our opportunity. A correction must occur, at some point, which will cause prices to move higher.

    On tailwinds: I don’t think I made it up. I hope I didn't. I’m not talking about use over the past 5 years, but the possibility of increased use in the future, for the reasons cited. As for LNG, I think we’ve heard this thesis before. U.S. markets—and many others—were supposed to flooded, but the cost of operating terminals proved so prohibitive that it never appeared. And I'm not sure $1.50/mcf cost of production exists anywhere in the natural gas game.

    On UPL’s assets: A lot of tight gas and coal-bed methane plays were considered too geographically complex to be economic some time back. Now they’re revered as some of the lowest-cost assets in the business. The point is that there’s a degree of special sauce in the E&P game: If you acquire leasehold cheap enough, and you’ve the technology/know-how, apparently unattractive assets can become attractive. And judging from the numbers, UPL has it.

  • Report this Comment On August 04, 2010, at 6:04 PM, tombarrett150 wrote:

    I'm wondering if the natural gas has to be obtained through hydrofracking. That is a highly controversial process which is receiving quite a bit of bad publicity and may not be allowed in many areas.

  • Report this Comment On August 04, 2010, at 6:47 PM, neamakri wrote:

    please excuse me...what is mcfe?

  • Report this Comment On August 04, 2010, at 7:17 PM, JavaChipFool wrote:

    Yes, Marcellus shale is a hydrofracing process. It will probably be allowed in upstate NY, because there is so much money potential. Its one of those things that can be done safely, but the regulators have to be on their toes. Make sure surface casing has a good bond, and is done with adequate casing weight, don't let the operators cut corners- plenty of recent press about what happens when they do.

    Any way, probably more info available out there- this is just off the top of my head. I have family with leaseable land in upstate, and they are waiting and seeing before they sign.

  • Report this Comment On August 04, 2010, at 8:54 PM, srpfool wrote:

    Peak oil is a myth. To the person who says look at discovery rates in short, no, and you need to do a damn sight more than google it to understand it. Oil is far more valuable when it is "rare", and oil companies aren't stupid enough to go around announcing publicly how much they have "discovered" unless they are ready to start detailed surveying exploratory drilling and extraction. And want their share price to rise. In case you didn't know the price of oil is not set by the "free" market, and managing the perceived "rarity" of oil is a key to how big oil manages price and profitability. How much oil they can extract should they want to is a trade secret and they sure aint telling google.

    Frankly the world is awash with oil more than we can imagine burning in centuries.

    Nor is there a case for "Natural Gas" catching up and being a bridge fuel. People frequently comment on how expensive oil will drive people to gas without considering HOW this switch will actually happen. Someone who has just invested 50 years building a gasoline distribution infrastructure for vehicles aint gonna suddenly spend hundreds of billions of dollars to start distributing gas. Power stations last decades. Someone aint gonna rsuddenly replace a half billion dollar asset with 30 years life left in it because gas was cheap for 18 months.

    Just exactly HOW is this mythical switch actually going to happen?

    From the published information I cannot see how this company is going to become cash flow positive in the foreseeable future, and I find the comment that it has acquired a lot of land intractable. You are recommending investing in a gas company to get exposure to land? Curious. But I will be staying away until this company demonstrates more than an ever upward spiral of under productive fixed assets.

    Having said all that, best wishes to anyone who does take the plunge.

  • Report this Comment On August 05, 2010, at 12:01 PM, kajupa wrote:

    I don't seem to find anything said about the actual process of getting this gas out of the ground, but as a resident of the West, I follow the debate about the environmental damage to places like the Powder River Basin. Precious water is used to force the gas up, also bringing dissolved salts to the surface of the land. The used water is not potable and helps distribute the salts across further land, destroying vegetation. Access roads to well sites have to be regulated to protect wildlife. Natural gas sounds like a great bridge, but it is not as clean and green as some promoters would like to think

  • Report this Comment On August 05, 2010, at 3:00 PM, XMFSmashy wrote:

    Just to clarify for a few commenters, Ultra generated $367.1 million in operating cash flow in the first half of the year. That's a 25% increase from last year.

    If you divide this cash flow by revenue of $501.5 million, you find that Ultra is running at a cash flow margin of 73%. This company is very, very profitable relative to peers. The company is certainly justified in reinvesting its cash flow at such strong rates of return.

  • Report this Comment On August 06, 2010, at 1:35 PM, TMFAgewone wrote:

    Further, returns on capital and proved reserves--two indicators of underlying value/value creation at E&P firms--have been quite impressive. Proved reserves have grown from just over 2 TCFE to almost 4 TCFE from 2005 - 2009, and per my comment, ROC was 25% (net of asset write-downs, per SEC convention) in 2009. Those are big numbers.

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