Questar (IL/A): Momentum increasing outside of Pinedale while resumption of Pinedale deep test nears - Goldman Sachs - April 27, 2006
While Questar (IL/A) continues to capitalize on the Pinedale Anticline, momentum is increasing in other less-focused E&P regions that have significant unbooked upside that could lead to more upside for STR shares. Further positive results with potential success from the Pinedale deep test well could provide momentum to STR shares in 2H 2006. We believe production guidance, while revised upwards, remains conservative. The recent pullback in natural gas prices makes STR hedges (68% of gas production hedged at a $6.21/Mcf wellhead price) more favorable, especially with increasing risk of widening Rockies basis differentials. The combination of these hedges with rising resource catalysts and cost control makes STR an interesting value opportunity, especially for those (unlike us) that believe we could see E&P equity valuations suffer from a meaningful leg down in near-term natural gas prices.
KEY COMPANY CATALYSTS
(1) Deep Pinedale success could add $12 to Questar's shares. With winter-access restrictions on the deep test well at the Pinedale Anticline coming to an end in May, Questar is expected to resume testing. In 2005, the wellbore encountered shale splinters while targeting the Hilliard shale; once the debris is cleared, Questar will continue testing for commerciality. If the Hilliard continues to create blockage, Questar will move up to the Rock Springs formation (which was the initial target to begin with). Given lackluster share price performance year-to-date and positive initial gas shows prior to the testing delays, simply unclogging the obstructions and resuming production testing could be an initial catalyst. Our net asset value analysis shows $12 in potential upside to Questar's shares if deep Pinedale resource becomes commercial. The encouraging results from Questar's well prior to the delay motivated Ultra Petroleum (IL/A) to drill its own well, expected later this year (though it is unclear if it will be completed and tested before winter restrictions begin).
(2) Increasing drilling efficiency from 10-acre spacing and potential from 5-acre pilots at Pinedale. We believe that year-round completion and increasing drilling efficiency in the Pinedale Anticline could lead to lower costs, stable cash flow and increased production. We believe if Questar can show credible evidence that limited completions last winter resulted in minimal surface disturbance, the Wyoming Oil and Gas Conservation Commission could expand year-round completions. Questar management believes that 10-acre spacing recovers less than half of hydrocarbons in place and that 5-acres could add to recovery rates. Encana (OP/A) is currently testing 5-acre spacing at the Jonah field, and Questar has plans to run its first pilot wells this year. Our net asset value analysis assumes development on 10-acre spacing, which adds $18 to Questar's shares versus 20-acre development, and the potential upside from 5-acre spacing will depend on the level of communication with 10-acre wells. While we are slightly concerned with rig and crew availability/costs in the future given growth from other basins in the Rockies such as the Piceance, Questar has managed both capital and operating costs well, evident by a reduction in the drilling time for Pinedale wells and in operating costs that rose much less quarter on quarter than other E&P peers. Questar expects to drill 45-48 wells this year, which we believe could rise given greater efficiency. We are currently assuming Pinedale production growth of about 22% in 2006.
(3) Consistent well results and lower costs in the Vermillion Basin. Drilling results from the Vermillion Basin thus far have been on track/encouraging. Management said it plans to drill 12 wells in the Vermillion Basin this year, some of which will test the Baxter formation (management indicated on the conference call that it may drill a Baxter horizontal well) while others will further determine the extent of prospectivity on Questar's 143,000 acre block. Thus far, wells are expected to recover about 4-5 Bcfe. Questar is focusing on improving drilling efficiency through a new drillbit that it believes may be able to drill one well in 30-35 days. Currently, drilling and completion costs are averaging about $4-$5 million per well, although this includes about $0.5 million of assembling/disassembling costs that wouldn't occur in a development program. We believe the results so far are consistent with Questar's identified probable and possible resource from its legacy Rockies properties, and further success could lead to upside. We believe the Uinta Basin could be an additional catalyst if Questar can successfully downspace and/or generate positive results from deep exploration tests. Questar is currently focused on the deep Mancos formation (16,000 feet) and has one well producing 1.2 MMcf/d after 40 days with another planned this year. Additional drilling in the Flat Rock area of the company's southern Uinta Basin acreage has also been positive. Outside of the Vermillion and Uinta, we were positively surprised by Mid-Continent production, specifically from the tight gas play in the Elm Grove field, and we now expect a higher plateau production rate as additional drilling locations could offset declines.
VALUATION AND HEDGING
Questar trades at an implied 2007 E&P EV/debt-adjusted cash flow of 7.3x versus 8.2x for Western Gas (U/A), 13.6x for Ultra Petroleum (IL/A), and 9.6x for Quicksilver Resources (IL/A). We believe part of this discount is due to an overfocus by the Street on proved reserves, with Questar receiving a discount because of its more conservative proved reserve bookings versus Pinedale peers, let alone its more conservative estimates of probable and possible resource. The combination of increased momentum outside of Pinedale with in-line to better-than-expected results from the company's midstream businesses make the April 27 outperformance of Questar shares warranted. We see 18% upside to a traditional peak value of $91, which does not include upside from deep Pinedale potential.
ADJUSTED EPS HIGHER THAN OUR ESTIMATE ON PRODUCTION, COSTS
Questar reported adjusted 1Q 2006 EPS of $1.57, higher than our estimate of $1.44 and First Call consensus estimate of $1.40. Questar's total production of 359 MMcfe/d was higher than our 334 MMcfe/d estimate, due mainly to greater Mid-Continent production (124 MMcfe/d versus our estimate of 110 MMcfe/d) and a one-time favorable gas settlement (8 MMcfe/d). Total costs were lower than expected at $2.82 per Mcfe versus our estimate of $3.17, stemming from lower than expected production costs and taxes. Operating income from other business were also above our estimates. Net debt-to-tangible capital is now at 37% from 43% in the previous quarter.
UPDATED ESTIMATES
We are updating our 2Q, 3Q, and full-year 2006-2007 EPS estimates on slightly lower costs, slightly higher production, and minor other company adjustments. Our new estimates are $0.93 ($0.90 previously), $0.93 ($0.92 previously), $4.96 ($4.78 previously) and $6.33 ($6.22 previously) respectively. We are also updating our 2008 (normalized) EPS estimate to $4.37 ($4.12 previously). There are no changes to our 2009 and 2010 (normalized) EPS estimates.
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 |
