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Why This Gas Producer Could Be Hugely Undervalued

Though drastic reductions in spending have weighed on Ultra Petroleum's (NYSE: UPL  ) production, earnings, and stock price performance in recent years, the company's future looks a lot brighter. In addition to sharply improved earnings and cash flow expectations this year thanks largely to its acquisition of oil-rich acreage in Utah's Uinta basin, there is reason to believe that the company could be significantly undervalued on an enterprise value-to-proven reserves basis. Let's take a closer look.

Photo credit: Wikimedia Commons.

Big boost to proven reserves
Ultra boosted its year-end 2013 proven reserves by 18% to 3.6 trillion cubic feet equivalent, bringing its organic reserve replacement to an extremely healthy 307%. The year-over-year increase in proven reserves was due largely to higher gas prices and significant well cost reductions at its operations in Wyoming's Pinedale field. Several of Ultra's peers also reported significant growth in reserves.

For instance, Range Resources (NYSE: RRC  ) boosted its year-end 2013 proven reserves by 26% to a record high of 8.2 trillion cubic feet equivalent, or Tcfe, while Cabot Oil & Gas (NYSE: COG  ) saw a 42% increase in its proven reserves to 5.5 Tcfe and Southwestern Energy (NYSE: SWN  ) reported a whopping 74% jump in proven reserve estimates to roughly 7 Tcfe.

In addition to the higher gas price environment, all three companies cited improved well performance and cost reductions at their core operations as the reason for the improvements. While Ultra's growth in proven reserves wasn't as impressive, the value of the company's reserves increased by a lot more than their size -- the key indicator that Ultra could be undervalued.

Even bigger boost in value of reserves
As of year-end 2013, Ultra estimated the PV-10 value of its proven reserves -- representing their pre-tax future net cash flows discounted at 10% -- to be $4.1 billion, up 83% from a year ago. This is especially impressive considering that gas prices rose only 33% year over year and speaks to the high quality of Ultra's reserves.  

Further, the PV-10 calculation was based on a gas price of just $3.50 per Mcf. Using a gas price of $4.50 per Mcf -- closer to where the spot price is right now -- the PV-10 value of Ultra's reserves would rise to $5.7 billion. But it gets even better. Ultra performed a second sensitivity test on its proven reserves assuming the same gas price of $4.50 per Mcf but under an increased investment scenario.

Under this increased investment scenario, the company estimates that it could book an additional 3.5 Tcfe of reserves in the proven category, resulting in a PV-10 value of $8.5 billion. And with a gas price of $5.00 per Mcf, the company's total proven and probable reserves would rise to 10.8 Tcfe, yielding a PV-10 value of $12.3 billion.

While the latter scenario of $5.00 per Mcf gas may be overly optimistic, I think the company's PV-10 value of $8.5 billion under its $4.50 per Mcf gas and increased investment scenario is probably a more accurate measure of its current value. Given that Ultra's current enterprise value is around $6.3 billion, this suggests that the company could be meaningfully undervalued.

Ultra's best days lie ahead
This year should mark a major turning point for Ultra, as it ramps up spending and focuses on its highest rate of return assets, namely Wyoming's Jonah and Pinedale fields and its newly acquired oil-rich assets in Utah's Uinta basin.

In Wyoming, the company is expecting to generate returns in excess of 70% this year at a gas price of $4.50 per MMBtu, while in Utah, its returns could exceed 500% at a wellhead oil price of $80 per barrel. With these kinds of returns, it's no surprise that the company is forecasting 40% growth in EBITDA and cash flow this year.

What's more is that this guidance could actually prove conservative, judging by the company's exceptional initial results in the Uinta basin, where well performance and production have easily surpassed the company's expectations. With an attractive valuation and stronger, more oil-weighted growth on the way, Ultra should see its streak of underperformance end this year.

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Arjun Sreekumar

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.

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