Why Ultra Petroleum Could Outperform in 2014

Despite the recent rally in shares of natural gas producer Ultra Petroleum (NYSE: UPL  ) , the company's stock price is still down by nearly 30% over the past five years. But thanks to major strategic changes, Ultra should be able to significantly grow its cash flow and EBITDA this year and hopefully end the streak of underperformance.

Source: Flickr/Nicholas A. Tonelli.

Uinta to drive oil production growth
The main new driver of Ultra's expected cash flow and earnings growth will be new oil-rich assets in Utah's Uinta basin, purchased for $650 million last October. Similar to the company's gassy resources in Wyoming and Pennsylvania, the Uinta assets feature strong internal rates of return and relatively low development costs.

Though it has barely been two months since the Uinta transaction closed, Ultra is already reporting major improvements. The company reported that it is drilling new wells at record speeds thanks to significant efficiency improvements resulting from its implementation of 24-hour frac operations. For instance, it recently drilled a Uinta well to total depth in less than three days.

To date, Ultra has brought online nine Uinta wells and is already producing more than 7,100 barrels of oil equivalent per day, or boe/d, from its 54 producing wells in the play, compared to initially expected production of 5,000 barrels per day going into 2014.

Based on this impressive well performance and cycle time reductions, the company raised its production guidance and now expects to produce an average of more than 7,000 net boe/d from the Uinta this year, with a targeted year-end exit rate of 9,000 net boe/d. As a result of increased activity in the Uinta, Ultra expects its oil production this year to triple compared to last year's levels.

A change in capital allocation
In 2014, Ultra plans to withdraw capital from its Pennsylvania operations and accelerate activity in Wyoming and Utah. Of its $515 million drilling budget, roughly $395 million will be allocated to gas-rich drilling Wyoming and $95 million will go toward oil-rich drilling in Utah. Meanwhile, Marcellus capital spending will decline from more than $100 million in 2013 to just $25 million this year.

The main reason behind this change in capital allocation is that the company expects to earn much stronger returns from drilling in Wyoming and Utah than it does in the Marcellus. In Wyoming, Ultra expects returns in excess of 70% with a gas price of $4.50 per MMBtu and well costs of $3.8 million per well, while in the Uinta, it expects returns in excess of 500% assuming a wellhead oil price of $80 per barrel and well costs of $1.5 million per well.

The company's returns in the Marcellus are significantly lower due largely to the impact of widening basis differentials. Ultra's Marcellus wells currently earn an internal rate of return between 25% and 50% with a wellhead gas price of $4 per MMBtu, which, while nothing to scoff at, pales in comparison to some of its peers.

For instance, Range Resources' (NYSE: RRC  ) Marcellus wells earn internal rates of return in the range of 96%-106% at a wellhead gas price of $4 per MMBtu, while Chesapeake Energy's (NYSE: CHK  ) northern Marcellus drilling program generates a 117% rate of return at the same gas price. Cabot Oil & Gas (NYSE: COG  ) , however, blows them all out of the water, with returns in excess of 100% at a wellhead gas price of only $3 per MMBtu.

Catalysts for stock growth
While Ultra's earnings, cash flow ,and production have suffered over the past couple of years due to a drastic reduction in spending, 2014 should mark a major inflection point for the company as it ramps up spending in Utah and Wyoming. Oil-weighted growth from the Uinta assets should result in 40% cash flow and EBITDA growth this year, which could be a catalyst to propel Ultra's shares higher.

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