Pinedale Anticline: Positive potential catalysts for Questar, Ultra, Western Goldman Sachs April 21, 2005
We continue to believe that the Pinedale Anticline is one of the top onshore fields to generate growth, returns and free cash flow and see positive catalysts ahead for key players. We continue to strongly recommend shares of Questar Corp. (OP/A), in part because of the company?s leverage to the Pinedale Anticline and in part because we continue to see a significant discrepancy between the valuation of Questar?s E&P business and those of other unconventional gas companies. We also expect continued best-in-class growth and returns from Ultra Petroleum (IL/A), and we believe that weakness in Ultra shares have been overdone. Western Gas Resources (U/A) remains the weakest of the unconventional gas companies in our view, though it like Ultra has underperformed and greater belief in the Big George or the emergence of a credible new area of development could be a positive catalyst.
10-ACRE SPACING IS KEY EVENT IN 2Q
We put a high probability that Ultra Petroleum will receive approval for 10-acre downspacing on its Pinedale Anticline acreage at its hearing before the Wyoming Oil and Gas Conservation Commission on May 10. If the company does not receive approval, we do not believe it will be because of geologic concerns. While the decision will apply solely to Ultra's operated acreage (on which Questar does not have a stake), we believe that the geology of the Pinedale is similar in both the northern and southern parts, meaning that we expect 10-acre spacing results to be similar at acreage operated by Questar and others. We believe that Ultra's aggressiveness on pursuing 10-acre spacing relative to Questar reflects the differences in corporate cultures, not a difference in asset quality. While Ultra uses more aggressive estimates versus Questar in booking Pinedale reserves, we expect that ultimately each company will end up seeing similar well results. Approval of 10-acre spacing could substantially increase Ultra's proved undeveloped reserves, although it would have a more modest impact on present value, given that the additional 10-acre wells relative to expectations for 20-acre spacing would not get drilled for years. Nevertheless, we are already assuming 10-acre spacing in our estimated trough, mid-cycle and peak values for both Ultra and Questar. We believe it is too early to assume any value for 5-acre spacing potential, despite approval for EnCana to drill limited 5-acre pilot wells at the neighboring Jonah field.
RESULTS OF DEEP TEST IS KEY EVENT FOR 3Q
Drilling of the Questar-operated deep Pinedale exploration well should resume in May, though is subject to government clearance that environmental conditions are satisfactory. We expect the drilling of the well to last at least 60 days, and therefore believe that it will be mid-3Q 2005 before results are announced. Success in the deep test would be a more positive catalyst for all Pinedale players than 10-acre spacing as drilling deeper does not involve drilling acceleration. Deep success could increase reserves per 20-acre location by 25%-50%. Even if Questar's deep test is unsuccessful, the well will yield results from the normal Pinedale sections, though dry hole expense would be incurred from at least the additional capital to drill the deeper zone. We estimate that if deeper Pinedale zones can increase recoverability by 50% assuming a $2 million incremental drilling and completion cost, our estimated mid-cycle and peak values would rise $6.00 and $9.50, respectively for Questar, $14.00 and $20.00, respectively for Ultra, and $3.50 and $5.25 for Western Gas.
KEY PINEDALE RISK REMAINS RIG CREWS, RIG AVAILABILITY
Rig crew quality and rig availability are the main concern of Pinedale players to executing 2005 drilling, seemingly overtaking permits and regulatory concerns. We are optimistic that Questar can participate in at least 30 wells and the Ultra can participate in 110. Theoretically, increased moves towards year-round drilling in the Questar-operated northern Pinedale area (Ultra does not have the seasonal environmental sensitivities in its operated acreage in the south) should lead to more consistent rigs and rig crews and lower (for Questar more than Ultra) drilling cost volatility.
QUESTAR: STREET EPS EXPECTATIONS COULD RISE FOR 2005, 2006
We believe that the company's quarterly earnings expected on April 27 after the close could be a positive catalyst for the stock, in the same way that it turned out to be a negative catalyst in early February. While we continue to argue that EPS guidance should not be a major driver of share price performance, we nevertheless believe that the pipeline investor/sell-side base uses the company's guidance which influences Questar shares. This is part of our thesis that Questar can transition to being thought of and traded as more of an E&P company versus a pipeline/gas utility in the future, and valuation continues to be attractive relative to other unconventional natural gas companies. We see three catalysts that could impact EPS estimates for 2005 and 2006: (1) Natural gas strip prices have risen since early February. We have seen an increase in actual natural gas prices in March and April relative to forward prices in early February, and forward prices for the remainder of 2005 have also risen since the company last issued EPS guidance. We believe that all-else equal (which in fact may not be the case), the company could raise its 2005 EPS guidance, currently at $3.10-$3.30, by $0.15 to $3.25-$3.45. We currently assume EPS of $3.45, though using the higher price deck in the second half of 2005. While it pains us to see price-related changes to EPS guidance to be either a positive or negative driver of near-term share price performance, we nevertheless feel some need to highlight it. (2) Increased hedging in 2006/07. Given the company's conservative attitudes towards hedging and managing earnings, we believe it is likely that management may have added additional hedges for 2006 in recent weeks. Given the declining price decks used by the Street for 2006 relative to 2005, combined with seemingly even greater conservatism from the pipeline community, we believe that additional hedges (which could have been done at NYMEX levels between $7.35-$7.75 per MMBtu thus far in April) could be a positive catalyst for Questar shares. As of February, Questar was about 40% hedged in 2006 gas versus 80% hedged for 2005. We believe the existing Street 2006 EPS consensus is considering a WTI oil price of $40 per barrel and a Henry Hub natural gas price of $5.75 per MMBtu. (3) Near-term production in Uinta, Mid-Continent. While the Uinta Basin and Mid-Continent regions are often overshadowed (and rightly so, for now) by the Pinedale Anticline, most of the Pinedale growth is expected during the third and fourth quarters of the year, meaning that non-Pinedale regions can take a greater prominence during the first half. We believe that potentially positive well performance in the Uinta from recent wells could be a positive driver of near-term production, though potentially offset by delays in the Mid-Continent. A key long-term catalyst for Questar shares is greater visibility on developing the company's surprisingly strong probable and possible reserve base from its legacy Rockies properties. However, we believe that there is likely to be clarity on development plans during 2005 while the company does further testing in its exploration acreage towards determining the right completion techniques and spacing. The implied valuation of Questar's E&P business (assuming about a 7.8x mid-cycle EV/EBITDA multiple for midstream and regulated businesses) is 6.5x 2006 EV/debt-adjusted cash flow versus 8.3x-11.0x for other unconventional natural gas companies. We continue to see a $76 traditional peak value for Questar which implies 34% upside.
ULTRA: SHARE PRICE WEAKNESS HAS CREATED OPPORTUNITY
We believe the selloff in Ultra shares, which has been offset somewhat by three strong days of performance this week, has been overdone. We do not at present see any lasting implications from the sudden departure in late February of Fox Benton, Ultra's then CFO, and we continue to see Ultra as best-in-class in returns and growth. The potential for approval of 10-acre spacing would be a positive catalyst for Ultra, though because we already value the stock assuming 10-acre spacing, we do not anticipate any changes to our $60 per share traditional peak value (implying 19% upside). Ultra is currently drilling an exploration well to test a 200 Bcfe potential Trenton-Black River play in Pennsylvania, with results expected in 2Q 2005, and will spud in May an exploration well in China which could add longer-term production. Ultra trades at 10.9x 2006 EV/DACF, a deserved premium in our view.
WESTERN GAS: CONFIDENCE IN POWDER OR EMERGENCE OF NEW AREA NEEDED
We continue to view Western Gas as the weakest of the unconventional gas companies due to lower netbacks and free cash flow, though we note that the stock has been relatively weak during the last month. This year represents another test of whether the company can meet its production target and at least maintain its expectations for 2006. We believe that regulatory concerns are less likely to be an impediment this year, turning the topic to performance from both the growing Big George and the declining Wyodak regions of the Powder River Basin. Western is a beneficiary of positive trends in the Pinedale Anticline, though less so relative to Ultra and Questar. We believe that if the Street gains confidence in growth, returns and free cash flow from the Big George and/or Western is successful in adding a new core area of development (it is currently doing stealth exploration as well as not-stealth drilling in the Niobrara formation), Western can reverse its recent underperformance. The implied valuation of Western's E&P business (assuming an 8.0x mid-cycle EV/EBITDA multiple for midstream assets) is 8.3x 2006 EV/DACF. We see 25% upside to a $42 peak value. While this upside is greater than Ultra, we have more confidence in Ultra's ability to achieve its peak value versus Western.
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. |
