There is a lot of talk about how natural gas prices have detrimentally affected exploration and production companies, but we rarely see raw numbers that describes how much it hurts these companies. In Ultra Petroleum's (UPL +0.00%) most recent earnings call, we got to see the full impact of what gas prices means to the company. Let's take a look at how a one-dollar change in gas prices means over $3.8 billion in value for the company, and what it really means for investors.
"2012 was a train wreck"
To be clear, those are the exact words Ultra CEO Michael Watford used to describe the most recent fiscal year. Ultra is one of the very few companies out there in the exploration and production business that has dedicated itself to the production of natural gas. While some business-minded people may applaud a company focusing on one element and doing it exceptionally well, there is one problem with this plan.
Henry Hub Natural Gas Spot Price data by YCharts
Natural gas supply gluts resulted in 12-year lows for natural gas prices back in April of 2012, and prices haven't rebounded much since that time. With prices dropping so low, several companies have had to do an asset writedown. Last quarter, both Chesapeake Energy (CHK +0.00%) and Devon Eenrgy (DVN 0.19%) had big writedowns. So far, Ultra has been one of the hardest hit; since the beginning of the fiscal year, the company has written down almost $2.5 billion in assets despite the fact that it only has a $2.4 billion market cap
| Company | Asset Writedowns in 2012 (in billions) | Market Capitalization (in billions) |
| Ultra Petroleum | $2.47 | $2.44 |
| Chesapeake Energy | $3.3 | $13.31 |
| Devon Energy | $1.12 | $23.9 |
Source: Quarterly Reports and Yahoo! Finance
Again, Ultra's woes for the year are mostly attributed to its natural-gas-only portfolio. Other exploration and production companies like Devon and Chesapeake have gone to great lengths to transition their business model to a more liquid-focused portfolio.
So how does one dollar translate to $3.8 billion for Ultra? This relates to how the company can report its gas reserves. Reserves can be reported in three ways: proven; proven and probable; and proven, probable, and possible. These are also known as 1P, 2P, and 3P reserves. The different categories are based on the technical and commercial viability of these reserves. For a more detailed explanation of each of these categories, click here (link opens a PDF).
Herein lies the rub: These numbers change not only with reserves found and used, but also with the current price of the commodity. As the value of natural gas increases, so too does the plausibility of these reserves. The same can be said when the price drops, and this is what Ultra experienced. Using two different price ranges ($5 and $6 per thousand cubic feet), the company projects a $3.8 billion drop in proven and probable reserves. This change in price means that the company needs to demote 2.3 trillion cubic feet of gas from proven to probable reserves.
Don't let the numbers fool you
Whenever a company needs to write its assets down, it does not mean that these assets have completely disappeared or that the company has sold them. It simply means that the current market does not make the assets commercially viable based on current technology. If prices were to go back up, the company will be able to promote those assets back to a higher status.
Despite the rough natural gas climate in 2012, and massive asset writedowns, the company did remain net cash positive from its operations. Ultra is one of the lowest-cost natural gas producers in the U.S., so it should be able to weather the storm of low gas prices even with a 100% natural gas portfolio. It will put its low-cost status to the test as it helps its operating partner in the Marcellus, Royal Dutch Shell (NYSE: RDS-B), bring down its well completion costs to more manageable levels.
What a Fool believes
It may take some time for natural gas to make the rebound many investors are hoping for. Exploration and production companies in the natural gas space have tried their best to slow production captial expenditures to bring up prices. According to Watford, that may still be a while:
... [There's] no doubt that there's tremendous amount of capital has been redrawn. And you'll see that as you continue through 2013, what I really think is going happen is, you're not going to get enough gas price response throughout '13, so you're going to have 2014 with the same lack of capital being invested. So we'll have 2 years of decreasing production.
The largest reasons for the long-anticipated lag time for increases in price are the time it takes to slow production and the even longer time it takes to create new markets for U.S. natural gas. Momentum for natural gas as a transportation fuel is making very slow progress; it has yet to make any real dents in demand. Also, Cheniere Energy (LNG 0.09%) doesn't anticipate its first liquid natural gas export until 2015, so we are at least two years away from liquid natural gas exports having any real effect either.
