A couple years back, it seemed that natural gas producers were doomed unless they switched quickly to liquids production. This fear was so great that even Chesapeake Energy (NYSE:CHK), one of the biggest natural gas producers in America (second to ExxonMobil), poured most of its capex into liquids-rich plays.
To keep up the momentum, Chesapeake Energy will continue to shift its production mix toward liquids. Part of this will be achieved by focusing on the best oil plays, like the Eagle Ford. Overall, 2014 will see Chesapeake Energy operate an average of 41 to 48 rigs on liquid plays versus just 14 to 17 rigs on natural gas plays.
While Chesapeake Energy has been aggressively moving away from dry gas production, Ultra Petroleum (NASDAQ:UPL) took a much calmer approach. This decision seems to have been vindicated, as North American natural gas prices have bounced off a low of $2 mmBtu to $5-$6 mmBtu due to extremely cold weather spurring demand for natural gas used for heating.
Gassed up, but headed down a different road
Ultra Petroleum's production mix was 96.5% weighted toward natural gas according to its latest quarterly update. While gas remains the base on which Ultra Petroleum stands, management seems optimistic about its oil production.
With the $649.8 million acquisition of oily Uinta Basin assets officially closed, Ultra Petroleum's management is guiding for a 40% increase in cash flow and EBITDA this year. This will be achieved through a tripling of its oil production through the development of its newly acquired acreage. Now Ultra Petroleum may finally be able to live up to its petroleum namesake if it can expand its oil output.
The timing couldn't be better, as soaring natural gas prices could help prop up future investment in oil plays. In 2013, Ultra Petroleum received a realized price of $3.57 mmBtu for its natural gas after factoring in hedging losses and gains. With gas prices on the rise, expect Ultra's realized natural gas prices to start trending upwards.
For this year alone, Ultra has hedged 118.4 Bcf of its natural gas production at an average price of $4.20 mmBtu. Through better realized prices, Ultra Petroleum will be able to move into oil production while cleaning up its balance sheet.
Salvage the balance sheet
While the future is looking bright this year for Ultra's bottom line, its balance sheet remains a problem. Being $2.5 billion in debt and having only $10.7 million in cash isn't something to be proud of, which is why Ultra Petroleum must boost its liquidity. If Ultra doesn't fix its balance sheet now, when the time comes to pay up, shareholder dilution or an unexpected sharp cut in capex could significantly hamper stock performance as growth is cut short.
Assuming everything goes well
If Ultra is smart and builds up its cash pile or pays off its debt while still growing oil production, then the next few years could be Ultra Petroleum's time to shine. With natural gas prices significantly above the cost of production ($3.08-$3.28 per Mcfe), margins will continue to expand.
Even with such a gas-heavy production mix, by controlling operating expenses Ultra was able to post a 55% cash flow margin and a 28% net income margin. As realized prices continue to climb much faster than costs, margin expansion will be a boon for investors.
The Uinta Basin offers the most upside for shareholders as Ultra Petroleum plans to use its new acreage to triple oil output. That's nothing to laugh at, even if it is off a low base. Last quarter's average daily oil output was around 3,500 bpd, so by the end of 2014 that should rise to over 10,000 bpd if management can live up to its word.
Ultra Petroleum has stood by natural gas to the bitter end, and luckily the supply demand situation continues to move in Ultra Petroleum's favor. 2015 will see the beginning of US LNG exports, which is what investors of all natural gas producers are closely watching. Shareholders of Chesapeake Energy and Ultra Petroleum are hoping LNG exports will provide a profitable floor for dry gas prices, allowing for a stable stream of cash flow beyond what hedging can provide.
This is the year of Ultra Petroleum, the year that it can prove it's fully capable of changing with the times while keeping a tight lid on costs. The market is moving in Ultra's favor while clever investments will support its guidance.
Callum Turcan has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum. The Motley Fool has the following options: long January 2016 $25 calls on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.