Chesapeake’s Big Turnaround Comes From Higher Gas Prices And Retired Coal Powered Plants

Chesapeake Energy (NYSE:CHK) has something to cheer about. The conditions in the natural gas industry have witnessed some improvement with natural gas futures having increased to a one-year high on reduced storage levels. Exploration and production activity has picked up as well with the number of gas rigs increasing by about 2% last week. More importantly, the long-term prospects for the natural gas industry are looking better.

A recent report released by the Union of Concerned Scientists (UCS) details that about a third of US coal fired power plants may retire over the next few years. A total of 40 GW of plants are already lined up for retirement while about 59 GW of additional capacity could be phased out in the near future. ^[1] We believe that this void could provide vast opportunities for natural gas fired power plants and gas producers like Chesapeake Energy.

Why Is Natural Gas Substituting Coal?

Coal dominates the US electricity landscape with a 42% share of power production. Most coal fired plants in the US are several decades old, making them expensive to operate and maintain. Moreover, the stricter environmental regulations stipulating the reduction of carbon dioxide, heavy metals and acidic gas emissions require coal plants to install expensive equipment, which are driving up the total cost of generation rendering coal less economical.

Natural gas on the other hand is a relatively clean and economical fuel which is abundantly available in the US thanks to the rapid increase in shale gas production. The capital investments required for gas based power plants per MW has also been declining sharply, making it an attractive option for electric utility firms seeking to phase out coal. As of 2011, gas accounted for about 25% of US power production and this year the number is expected to grow to about 30%.

What Could This Mean For Chesapeake?

Chesapeake stands to benefit significantly due to two reasons. Firstly, the firm has the resources to feed growth in gas demand. The firm is America’s second largest natural gas producer (market share of about 5%) and holds the largest natural gas resource base of about 21 trillion cubic feet equivalent. ^[2] Secondly, the firm’s gas plays are located closer to a bulk of the coal capacity that is being phased out. Most of the plants to be retired are located in the Southeast (can be served by Chesapeake’s Haynesville/Bossier Shale plays) and the Midwest and Mid-Atlantic (close proximity to Marcellus and Utica shales) regions of the US.

The firm’s gas production for next year has not been hedged presently, meaning  it could take advantage of the rising price trend. However, one risk that the company could face is that it has been curtailing new gas exploration, favoring growth of liquids production. If this trend continues, it could choke Chesapeake’s ability to cash in on rising gas prices.

Activist Investor Picks Up Stake

Separately, activist investor Carl Icahn increased his stake in the company from 7.5% to 9% last week. Icahn first invested in Chesapeake in May, after which he pushed for several changes in the firm’s corporate governance, including the appointment of new directors to the board besides stripping CEO Aubrey McClendon of chairmanship. Icahn’s increased stake in the company could bode well for investors given his track record of fighting for shareholder interests.

We have a price estimate of $20.60 for Chesapeake Energy, which is about 15% ahead of the current market price.

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1. U.S. Study Sees 59,000 MW of Coal Output Too Costly To Run, Reuters [↩]
2. Chesapeake Investor Presentation [↩]