Adding two unconventional gas companies with Questar as OP/A and Ultra as IL/A
Goldman-Sachs January 20, 2005
We believe that 2005 will see continued strong relative share price performance for unconventional natural gas companies, given the widening gap in asset quality compared to conventional producers. We have initiated coverage of Questar Corp. and Ultra Petroleum. We believe Ultra and Quicksilver Resources have the best development asset bases, though Questar and EnCana have the best combination of growth and free cash flow. We have confidence in the potential for Bill Barrett Corp. to transform its production potential through exploration. We continue to find Western Gas Resources the weakest at present, though we expect growth to increase sharply in 2006. Our order of preference is Questar (Outperform), EnCana Corp. (Outperform), Bill Barrett (Outperform), Quicksilver (In-Line), Ultra (In-Line) and Western Gas (Underperform). Our coverage view remains Attractive. We are publishing a detailed report, 'Where the growth is.' If you are on our e-mail distribution list, a .pdf will be sent today. If you are an institutional investor client of Goldman Sachs and not on our e-mail distribution list, please call 1-212-902-8259 or email a member of the team to receive a .pdf of this report.
GAP WIDENING BETWEEN THE "HAVES" AND THE "HAVE-NOTS" Unconventional gas remains the key area of production growth in an otherwise flattish North American natural gas supply picture. As more conventional companies struggle with finding new sources of production growth and rising costs, companies with strong unconventional gas positions should continue to be strategic partners of choice.
GROWTH, RETURNS, AND FREE CASH FLOW REMAIN KEY DIFFERENTIATING FACTORS While we see double-digit annual production growth potential for all unconventional gas companies under coverage, returns and free cash flow are also expected to be key drivers of stock performance. We expect the Street to begin to demand free cash flow from assets that are now more mature.
QUESTAR, ENCANA, AND BILL BARRETT ARE OUR TOP PICKS We believe that EnCana and Questar offer the best combination of growth potential, returns, free cash flow, and valuation. We have confidence in Bill Barrett's assets and exploration team and see significant upside to returns and proved reserves. Barnett Shale and Pinedale Anticline fundamentals remain strong, while the Powder River Basin continues to lag.
UNCONVENTIONAL NATURAL GAS SHARES CONTINUE TO TRADE AT A PREMIUM VALUATION, BUT WE BELIEVE THIS IS DESERVED We continue to see valuation as a function of mid-cycle returns among E&P companies of all sizes. While EV/gross cash invested (GCI) multiples are higher now than a year ago, this can be explained by the ability of unconventional gas companies to keep a greater amount of the increase in natural gas prices versus peers. Returns have increased more commensurate with natural gas price increases than for E&Ps as a whole. We believe that each of the companies' E&P businesses but EnCana's deserves an EV/GCI multiple of at least 1.0X (EnCana's lower multiple is due to lower returns, but we see upside when compared to other large-cap E&Ps).
QUESTAR SEEMS THE MOST UNDERVALUED, IN OUR VIEW With an E&P mid-cycle return of 13.7%, we believe Questar is the most attractive of the unconventional gas companies at present. We estimate Questar's E&P business trades at 1.00X mid-cycle EV/GCI, assuming about a 7.8X EV/EBITDA multiple for the company's midstream and regulated businesses. While Questar shares have increased in the past four months, we see continued positive production growth and free cash flow from the Pinedale Anticline. We believe that Questar's E&P business should be valued at a slightly lower level for a given return versus its peers, considering the likely lower probability of strategic partnership potential due to Questar's strong regulated presence. Nevertheless, the company's regulated businesses provide a sustainable free cash flow, which can be deployed towards dividends or further investment in the high-returning Pinedale. We see 4% upside to a $51 estimated mid-cycle value and 24% upside to a $61 estimated peak value versus 17% downside to a $41 estimated trough value.
WE VALUE BILL BARRETT BASED ON ITS EXPLORATORY RESERVE POTENTIAL Whereas our mid-cycle assumptions for Ultra Petroleum, Western Gas and Quicksilver are largely based on a discounted cash flow (DCF) analysis of the company's key development areas, this process is far more difficult for an exploration company such as Bill Barrett. We see 10 Tcf in unrisked reserve potential from Bill Barrett's 1,000,000 net undeveloped acres, though we classify about 85% of this as beyond possible reserves. Our mid-cycle value of $33 per share (4% upside from present) assumes that 50% of these upside reserves are considered possible reserves, while our $46 peak (45% upside) value assumes 75% of these reserves are considered possible. While this leads to an extremely high value per existing Mcfe of proved reserves, we believe that proved reserves can rise substantially with exploration success in any one of the company's key areas. Additionally, our $33 mid-cycle value is consistent with valuations paid in unconventional gas acquisitions over the past 10 months based on proved, probable and possible reserves.
WHILE WE SEE GREATER DOWNSIDE TO MID-CYCLE FOR QUICKSILVER VERSUS WESTERN GAS, WE BELIEVE THERE IS A GREATER CHANCE FOR UPWARD ESTIMATES REVISIONS AT QUICKSILVER While we see 24% downside to mid-cycle for Quicksilver (rated In-Line/Attractive) versus 8% downside to mid-cycle for Western Gas (rated Underperform/Attractive), we are more positive on Quicksilver versus Western Gas. Our Western Gas 2007 mid-cycle estimates assume production growth of 32% in 2006 and 39% in 2007. We believe there is less upside to these estimates, considering that growth has been below expected in the Powder River Basin in recent years. In comparison, we see potential for upward production growth and return projections from Quicksilver in 2006 and 2007 if Barnett Shale well results are better than expected.
ULTRA PETROLEUM VALUATION SEEMS FAIR While Ultra is certainly the best-in-class among unconventional gas companies due to its high returns and strong growth, we believe that there is greater upside from other stocks such as Questar and Bill Barrett. The ability to beat expectations for production growth at similar spending levels is key for further outperformance of Ultra Petroleum shares. Like all the unconventional gas companies, Street expectations for higher natural gas prices can significantly revalue Ultra higher, considering that Ultra can likely keep a greater percentage of the higher prices than can its peers. We see 15% upside to a $58 peak value versus 23% downside to a $39 mid-cycle value.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti.
Investment funds affiliated with The Goldman Sachs Group, Inc. have a principal investment in Bill Barrett Corp. (BBG). As a result of its position in BBG's securities, The Goldman Sachs Group, Inc. may be deemed an affiliate of BBG.
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Another temperature prediction map, FWIW
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