Is Ultra Petroleum Making the Right Move by Buying Oil Assets?

On Monday, natural gas producer Ultra Petroleum (NYSE: UPL  ) announced that it is finally making a foray into liquids by purchasing oil-producing assets in Utah's Uinta Basin for $650 million. Though the markets didn't seem to appreciate the decision, with shares of Ultra down nearly 9% over the past week, let me explain why I think it may be the right move for the company over the long term.

Diversification into oil
First, the acquisition serves to diversify Ultra's commodity mix, which remains heavily weighted toward natural gas. As of year-end 2012, the company's proved reserves of natural gas and crude oil totaled 3.1 trillion cubic feet equivalent, of which 96% was natural gas.

But the Uinta assets, which are located in northeast Utah and are currently producing 4,000 barrels of oil per day from 38 producing wells, will add 9.9 million net barrels of proven reserves to that figure. If the company can double that level of production to 8,000 barrels of oil per day by next year, it could reduce the share of natural gas in its commodity mix to 93%, down from 98% currently, according to an analysis by Wells Fargo.

Excellent economics
Second, the Uinta assets feature solid economics similar to the company's gassy assets in Wyoming and Pennsylvania, with strong returns and relatively low development costs. At strip oil pricing and current estimated well costs of around $1.5 million per well, the company reckons that its Uinta wells will generate an internal rate of return in excess of 100%.

In fact, according to Ultra CEO Michael D. Watford, the company's Uinta asset will be cash flow-positive starting from year one and will completely pay for itself within five years. And with production from the wells expected to grow at a four-year compounded annual growth rate of 50%, Ultra reckons that the Uinta assets could be producing more than 10,000 barrels per day by 2017.

That level of production would generate some $220 million in operating cash flow versus about $70 million in capital expenditure, which is really impressive almost any way you look at it. And lastly, Ultra should also be able to leverage its knowledge of drilling techniques that have worked well in its Pinedale field in Wyoming, since the two plays share similar geological characteristics.

Cash generation
It's important to remember, however, that unlike other gas producers, such as Chesapeake Energy (NYSE: CHK  ) and SandRidge Energy (NYSE: SD  ) , which were once heavily focused on natural gas but are now aggressively growing oil production, Ultra isn't planning to become a liquids producer. Instead, it's simply looking to acquire a highly cash-generative oil asset that will provide it with decades of strong cash flows, which can then be reinvested into growing natural gas production as prices improve, paying down debt, and for other purposes.

In contrast, Chesapeake, which was once the nation's largest gas producer, is now allocating the largest portion of its capital to its properties in the liquids-rich Eagle Ford shale and Greater Anadarko Basin, as it seeks to boost oil production, while SandRidge is focusing about three-quarters of its drilling and completion capital to grow liquids production from its Mississippi Lime assets.

The bottom line
All told, I think Ultra Petroleum's decision to acquire assets in the Uinta is a smart move, as long as the company's debt and leverage remains manageable. Despite its industry-leading low cost structure and premier natural gas assets, the company has suffered in recent years from its heavy concentration in natural gas -- a commodity whose price has been depressed since 2008.

Its recent move not only offers some diversification into oil but also provides a crucial source of free cash flow for decades to come. In my view, the company's newly acquired Uinta asset should be a perfect complement to its existing assets in Wyoming and Pennsylvania, which feature some of the best economics over the full cycle, given their long reserve lives and incredibly low development and production costs.

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