Questar Corp. (OP/A): Positive Pinedale trip with catalysts ahead - Goldman Sachs - September 11, 2005
We continue to believe strongly in returns and cash flow from the Pinedale Anticline and continue to recommend Questar Corp. shares following a field trip to the Pinedale on September 8. Beyond the normal favorable finding and development costs and strong production growth from the region (we believe Questar's 2006 production guidance is conservative), we believe there are catalysts in place both in and out of the Pinedale that can drive Questar shares towards our $91 estimated traditional peak value. By mid November, Questar should know more from further drilling in the Vermillion Basin, initial results from the Pinedale deep test and the status of its winter drilling program. We rate Questar Outperform relative to an Attractive coverage view.
KEY NEAR-TERM CATALYSTS
1.) Initial results from fracture stimulation of deep Pinedale test (November 15)
2,) Results from two wells drilling in Vermillion Basin (October 31)
3.) Startup of condensate pipeline and associated infrastructure (November 15)
4.) Results from use of more cost-effective fracture stimulation fluid (October 31)
5.) Potential sale/writeoff of section of Southern Trails pipeline (December 31)
CONDENSATE INFRASTRUCTURE STARTUP BY NOV. 15 KEY FOR WINTER DRILLING
Questar's ability to drill greater than 40 gross Pinedale wells in 2006 is contingent on receiving the green light from the Bureau of Land Management (BLM) for drilling through the winter on three pads. As part of the agreement with the BLM, Questar must startup by November 15 its gas/water/condensate separation facility and pipeline out of Pinedale which would replace trucks transportation (reducing annual truck runs for this purpose to zero from 25,000). Questar plans to startup the facility in late October, and our visit indicated to us that construction seems on track. If Questar does not get the facility operational by November 15, winter drilling would be restricted and its 2006 drilling program impacted.
WE BELIEVE 2006 PRODUCTION GUIDANCE IS CONSERVATIVE
Since we believe that Questar will meet requirements for winter drilling, we believe that the company's 2006 production guidance is conservative. Questar is currently estimating 2006 production of 120-122 Bcfe, representing growth of 7% from an expected 112-114 Bcfe in 2005. With the 2005 Pinedale drilling program on track and recent positive results from wells in the Uinta Basin and Vermillion Basin, we believe 2006 production could exceed 122 Bcfe, and we are currently assuming production of 125 Bcfe.
PINEDALE DEEP TEST BEGINS COMPLETION IN NEXT 2 WEEKS
Questar plans to begin completing its deep Pinedale exploration test in the coming weeks, and while we do not believe that each of the many zones will be finished by the time winter drilling restrictions begin on November 15, we do think that the company could get a sense of production rates from initial zones. We believe that company sentiment is positive regarding the well, which, this season, was drilled very proficiently with large gas flares though more lackluster well logs. We continue to believe that the existence of deep Pinedale potential could represent an additional $12 per share to Questar and $12 per share to Ultra Petroleum, which as a virtual pure play would benefit the most (this well is expected to be an analog for the entire field). We do not expect issues with the completion rig crew.
'SLICK-WATER' FRAC COULD REDUCE OPERATING COSTS
Questar is currently testing the use of a less viscous fracture stimulation fluid which, if successful, could reduce the $5-$6 million drilling and completion costs by $300,000. The "slick-water frac" has been used in other fields, but we do not believe it has been deployed in the Pinedale Anticline. Questar on Thursday used the new fluid, without any noticeable deterioration. However, a longer data set is required to deem the fluid commercial. We believe that a reduction of drilling and completion costs would be positive for shares of all Pinedale Anticline players. We expect the company to have greater information regarding the success of the frac fluid by the end of October.
QUESTAR'S RESERVE BOOKINGS STILL SEEM CONSERVATIVE ...
We continue to believe that Questar is very conservatively booking reserves at Pinedale. Questar is essentially assuming that 10 acre locations will generate just 4.8 Bcfe in reserves, a far cry from the almost 8 Bcfe being considered by Ultra. We believe that this wide difference is due more to Questar's conservatism than to Ultra's aggressiveness. Unfortunately, much of the difference is in later-year production rates, meaning that it may be some time before it becomes more obvious to both players what actual reserves should be. We do not expect Questar to book as significant an increase in proved undeveloped reserves as Ultra may. However, we continue to believe that Pinedale assets should be valued based on a discounted cash flow analysis, not on a reserves analysis given both disparities in reserve booking and to account for the timing of when Pinedale locations will be drilled.
... BUT COMPANY MORE OPTIMISTIC REGARDING SHALLOWER 5-ACRE SPACING POTENTIAL
We were surprised to hear Questar even discuss the potential for five-acre spacing at Pinedale, considering the company's normal conservatism. However, Questar believes that 10-acre spacing will only recover 50% of gas in place at Pinedale, meaning that the company at least theoretically believes in the potential for 5-acre spacing. Three fourths of reserves from current Pinedale drilling comes from the shallower Lance formation versus the deeper Mesa Verde zone, while just one third of drilling and completion costs are associated with the Lance formation. Because of this, the economics of drilling wells just to the Lance formation at five-acre spacing could prove economic even assuming that further communication between wells decreases per-well reserves. We do not expect a major move towards five-acre spacing in the near term pending further results from 10-acre drilling at Pinedale and EnCana Corp's five-acre pilots at the neighboring Jonah field.
INITIAL POSITIVE RESULTS FROM VERMILLION EXPLORATION
We view very positively results from the company's initial exploration well at the Vermillion Basin, and success from two additional wells which we expect to be announced by the end of October would be a positive catalyst for the stock. Questar has estimated its initial well will generate reserves of 4-5 Bcfe, a positive number. If further wells show similar reserve potential we believe the play could be commercial. Questar has drilled two additional wells and plans to begin completion shortly. We expect results by the end of October. While we do give some value to Questar shares for Vermillion potential, we believe there could be upside if there was the expectation these reserves would be converted to proved/monetized in the medium term.
WE WERE IMPRESSED BY MANAGEMENT'S FOCUS ON OPTIMIZATION
Because of Questar's midstream roots combined with issues last summer surrounding rig crew quality and additional costs on the Pinedale deep test, Questar at times has gotten a bad rap for E&P expertise versus its peers. We felt following our visit to Pinedale that the company is doing a very good job at optimizing its drilling and completion program to maximize wells drilled. The company already seems to have a leg up for the coming year, from the winter drilling plan beginning in December through next summer. We believe that this summer showed night and day improvements versus last summer, evidenced by the expectation for 35 Pinedale wells to be drilled this year and the an expected recovery in production versus expectations following a lower-than-expected 1Q 2005. Success at Vermillion and/or deep Pinedale would boost confidence in exploration expertise, considering that there are relatively few companies pursuing deep Rockies tests.
MIDSTREAM: FATE OF SOUTHERN TRAILS PIPELINE SECTION COULD BE DECIDED BY YEAREND
Questar has for some time been seeking a customer for the section of the Southern Trails natural gas pipeline from Long Beach to Needles, California. We believe that company could either find someone to take the capacity or write off the project by yearend. The company continues to pursue negotiations with Los Angeles area regulatory authorities, and we see additional potential from oil or LNG interests. We believe the stock would respond favorably if Questar were to earn a return on this investment, while we see limited downside in the event of a writeoff (the company has about $50 million invested in that section).
HEDGING LIMITS CASH FLOW UPSIDE VS. PEERS, BUT VALUATION REMAINS ATTRACTIVE
We continue to believe that Questar shares are attractive and we see upside to a $91 estimated traditional peak value and a $102 per share super-spike adjusted estimated peak value. As we have highlighted, these valuations could increase pending speedier monetization of non-Pinedale E&P assets, deep Pinedale potential, 5-acre spacing potential or any improvements to Pinedale drilling/completion costs. Questar trades at 9.5x 2006 EV/debt-adjusted cash flow, and assuming that its midstream/regulated business is valued at 8.0x 2008 normalized EV/EBITDA, Questar's E&P business trades at 10.3x 2006 EV/DACF. This 9.5x value compares to 15.3x for Ultra. Questar's near-term cash flow is adversely impacted by hedging relative to peers considering our $9 per MMBtu Henry Hub natural gas price forecast for 2006 and 2007, meaning that we continue to expect it to trade at a discount. Nevertheless, while Questar is not a pure-play Pinedale company, we believe its E&P business should trade at a higher multiple, especially if further Vermillion Basin drilling yields 4-5 Bcfe wells.
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. |
