Earlier this year, I identified Ultra Petroleum (NASDAQ:UPL) as one of the most undervalued stocks in the energy sphere, concluding that, "With an attractive valuation and stronger, more oil-weighted growth on the way, Ultra should see its streak of underperformance end this year."
So far, that forecast has panned out. Ultra has been one of the best-performing energy stocks of 2014, with shares up more than 35% year to date. Now the big question for investors is, how much higher can Ultra go?
Key drivers of Ultra's outperformance
Before tackling this question, let's first consider why the stock has outperformed this year. In my view, two of the biggest drivers of this gain have been higher natural-gas prices and strong oil production growth from the company's recent acquisition of oil-rich assets in Utah's Uinta Basin.
Higher natural-gas prices and increased oil production contributed to sharply improved first-quarter results, as Ultra's adjusted net income surged 131% year over year to $135.4 million, or $0.87 per diluted share. Operating cash flow jumped 63% year over year to $201 million. Cash flow and net income margin rose to 63% and 42%, respectively, up from 55% and 26% in the first quarter of 2013.
Higher gas prices also boosted the value of the company's reserves. As of year-end 2013, the PV-10 value of Ultra's proved reserves -- defined as their pretax future net cash flows discounted at 10% -- was estimated at $4.1 billion, assuming a gas price of $3.50 per Mcf. But with a gas price of $4.50 per Mcf, roughly where the NYMEX benchmark price is now, the PV-10 value of Ultra's reserves more than doubles to $8.5 billion.
The second key driver of Ultra's outperformance has been strong results from the Uinta Basin and the associated impact on Ultra's margins, EBITDA, and cash flow. Uinta net production averaged 4,524 barrels of oil equivalent per day in the first quarter, which helped boost companywide crude oil and condensate production by 145% and oil revenue by 135%.
More upside left?
Based on the factors that likely drove its year-to-date outperformance, I think additional near-term upside for Ultra Petroleum shares will depend primarily on two things: 1) higher commodity prices in the second half of the year and into next year, and 2) better than expected oil production growth.
Natural-gas futures suggest that prices will hold more or less steady through the remainder of the year at roughly $4.40-$4.60 per Mcf. However, if gas production growth isn't as strong as the markets expect and demand is higher than forecast, a significant shortfall in gas inventories as winter approaches could provide a big uplift to prices.
As for the second factor of oil production growth, Ultra expects net production from the Uinta Basin to grow nearly 75% from first-quarter levels by year-end, which means output would approach nearly 8,000 BOE/d. If the company can achieve this ambitious target, its full-year EBITDA and operating cash flow could approach $900 million and $760 million, respectively, representing a 50% increase in both.
This would also help greatly reduce the company's leverage, which has been a key concern for investors. As of year-end 2013, Ultra's long-term debt towered at $2.5 billion, which resulted in a worryingly high debt-to-EBITDA ratio of 3.5 times. But assuming the company can stick to its $560 million capital budget, it should generate some $200 million in free cash flow this year, which could be used to pay down debt.
In the first quarter, for instance, Ultra generated free cash flow of $75 million, which enabled it to reduce its debt-to-EBITDA ratio to 3.1 times . By year-end, it may be able to reduce this ratio to well under 3 times, improving its risk profile and credit metrics.
If commodity prices remain elevated through the year, and if Ultra can deliver higher than expected oil production, EBITDA, and cash flow growth that also helps reduce its leverage, I think the stock could end 2014 at $35-$40 a share. Absent these drivers, however, I see limited near-term upside for Ultra.