Production storms ahead

Ultra in name and in performance as the group hit record output in the first half the year. Given that gas prices also rose this fed through to a strong financial performance. Further strong output increases are set for 2011 and 2012 which bodes well for the future and we therefore rate Ultra Petroleum a hold.

Ultra Petroleum stands out among peers as a low cost producer which has certainly served the group well in the last few years. US natural gas prices were relatively weak in 2009 as the US economy remained weak and extra shale gas supply came on stream. As such in 2007 Ultra’s realized gas price was 4.66 ($/Mcf) which rose to 7.11 ($/Mcf) in 2008 but then fell back markedly to 3.49 ($/Mcf) in 2009.

In the first half of 2010 the realized gas price came in at $4.71 ($/Mcf) providing a boost to the price Ultra was able to sell its output for. More recently the natural gas price has fallen back with many attributing this to a weaker than expected hurricane season in the Gulf of Mexico. Although Hurrican Earl is currently heading for the US East Cost. The Gulf region is responsible for about 45% of US natural gas production.

However, clearly natural gas is also a seasonal and volatile commodity and so it could well strengthen towards the end of the year. Furthermore, Ultra hedges its exposure and so is not too exposed to short-term movements. For the rest of the year about half the expected output is hedged to sell at $5.49 per Mcf. About half forecast production for 2011 is hedged at $5.83 per Mcf and both these hedge prices compare favourably with the current gas price of around $3.8 per Mcf.

Clearly natural gas prices are a key driver for Ultra petroleum and increased supply from newly accessible shale gas deposits does pose the threat of long-term low prices. However, the market should do its work by creating new demand from power stations and possibly automobiles. Clearly gas prices can also go so low as otherwise many firms in the industry will not become profitable.

Fortunately Ultra petroleum will remain relatively insulated from low prices as its all-in costs per Mcfe were the lowest of 30 peers at $2.61/Mcfe. The average of these peers came in at $5.41/Mcfe which is more than double Ultra’s cost structure and also means that many competitors become uneconomic at low gas prices.

Ultra Petroleum’s 2010 interim results:

Looking at the above table of Ultra Petroleum’s interim results and clearly the group has seen the key drivers all move in the right direction. The 42% increase in EPS is particularly noteworthy while the company also managed a 44% return on equity during the period and a 19% return on capital.

On a longer-term basis Ultra Petroleum has been a leader in its financial results with an average cash-flow return on investment between 2007 and 2009 at an average of 28%. Production growth has also been strong with it increasing from 75 Bcfe in 2005 to over 175 in 2009. If targets are met production will come in at around 215 Bcfe in 2010 and then rise further to around 300 Bcfe in 2012.

This kind of strong production growth highlights why natural gas prices have been weak. Indeed Ultra Petroleum is focusing on exactly the shale gas resources in the North East United States which have boosted gas supplies.

In any event Ultra Petroleum is financially strong with a return on equity far above peers at 43% in 2009. This compares to an average return of 12% among competitors in the same year. Furthermore debt at the half year stage was modest at only 1.53X EBITDA. Interest payments were also covered by 11.5X. A cost of debt of 6% highlights that Ultra is viewed as a low risk business by income investors.

The three year plan entails Capex of $1.4bn in 2010, $1bn in 2011 and $1bn again in 2012. However, this looks to be funded internally and as EBITA comes increases from $835m to $1.4bn in 2012. As such net debt stays stable from 2010 to 2011 at around $1.4bn and then falls to $1.15bn in 2012. A sign of strength is being able to expand while lowering debt and clearly Ultra Petroleum is able to meet this challenge.

Looking at the weekly chart of Ultra Petroleum we can see that the share price has broken below the 39 week/200 day moving average and the recent uptrend as it looks set to test the $34.50 support level. The weekly MACD is giving a bearish signal that has been further confirmed by the cross below the zero signal line.

Moving on to the daily chart of UPL we can see that the $42 support level was recently broken and may now provide resistance to any move higher. Since making a new 2010 low of $37.10 on the 25th of August the share price has bounced higher. This bounce has coincided with a move in the daily RSI back out of oversold territory. The RSI is still at low levels so there is scope for a continuation of the move higher. If the aforementioned $42 level is breached we would target a retest of the 50 day and 200 day moving averages.

Clearly, no matter how market conditions pan out for natural gas prices Ultra Petroleum is one company which will thrive. It is operationally successful and financially robust while having a cost structure that is the envy of peers.

Accordingly, Ultra Petroleum will remain firmly held in the Fat Prophets portfolio.