Ultra Petroleum Looks Cheap, but Is It Really?

Ultra Petroleum (NYSE: UPL  ) looks cheap. At first glance is appears that the company is significantly undervalued in comparison to its independent exploration and production peers.

Indeed, according to data supplied by Morningstar, Ultra currently trades at a historic P/E of 12.8 compared to the wider E&P sector average of 30.1. Moreover, the company trades at a forward P/E of 7.9.

The question is, is Ultra really as cheap as it seems?

Changing strategy
Ultra is yet another domestic U.S. gas producer pushing into the higher-margin crude market.

During the first quarter the company's total production stood at 57.2 billion cubic feet equivalent, of which 53.3 Bcfe was natural gas and the remainder was crude oil and condensate. Total production actually fell year on year by around 2 Bcfe. Crude oil and condensate production was up 145% year on year.

And the company intends to drive crude production higher over the next few quarters.

Transformation
Ultra's acreage is located within the Uinta formation, Utah. The company took over operations during December of last year and has gotten straight to work.

Since Ultra took over, the region's production has jumped from 5,000 boe/d to just under 6,000 boe/d, and further growth is expected through 2014. Specifically, Ultra expects to exit 2014 with the region producing in the region of 11,000 boe/d, 9,000 net to Ultra.

What's more, the company is planning to develop and leverage regional infrastructure to increase efficiency and widen margins.

Along with Ultra, Newfield Exploration (NYSE: NFX  ) is also highly active within the Uinta formation. The region's infrastructure is well developed, so as a new operator, Ultra should be able to easily ramp up output.

Newfield's plan is similar to that of Ultra, the company is looking to ramp up regional oil production by around 5% for full-year 2014, to 19,000 boe/d. During the first quarter year-on-year regional production jumped 15% to 20,500 boe/d, although as wells mature, Newfield expects this rate to drop back to the figure above.

Nevertheless, Newfield is in talks with a regional refinery partner to construct a 60,000 boe/d pipeline for the region, which should push down transportation costs, widening profit margins.

Last hope
To some extent, Ultra is relying on the success of its Uinta exploration and development program to rescue the company. Indeed, as the price of natural gas has collapsed so have Ultra's profits over the past few years.

Luckily the recent rally in natural gas prices, brought about by unseasonably cold weather, has boosted earnings, a welcome relief for Ultra, which is struggling under a massive debt load.

Actually, Ultra's balance sheet is extremely worrying. At the end of the first quarter the company had net debt of $2.4 billion, of which $100 million is falling due within the next 12 months.

Unfortunately, Ultra only reported a cash balance of around $7 million at the end of the first quarter. The company's current ratio stood at an eye-watering 0.3, so it would appear as if Ultra can hardly pay its bills. Shareholder equity is negative and the debt to asset ratio is close to 100%.

And this high level of debt is really hurting Ultra. Interest and debt costs are expected to crimp the company's profits per million cubic feet of gas produced by $0.45 to $0.47, 15% of total operating costs, but a staggering 40% of total lease operating costs. Strip interest costs out of Ultra's income statement and earnings would jump 27%.

Still, thanks to a high price of natural gas during the first quarter, Ultra was able to report a 131% year on year rise in earnings per share, 45% increase in revenue and 63% jump in operating cash flow.

It seems as if Ultra has become a victim of the wider trend; rising debt levels are strangling the domestic oil boom. This is a problem I have covered before, and it would appear as if Ultra's current low valuation reflects the company's high debt load.

The bottom line
So, at first glance it would appear as if Ultra is cheap compared to its peers. However, while the company is trying to convert itself into a major oil player, Ultra is still predominantly a low-margin natural gas producer.

Additionally, Ultra is gripped by a high level of debt. Until the company can throw off the shackles of this high debt load it's likely that Ultra's valuation will remain depressed.

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