Chesapeake’s $21 Estimate Bolstered By Natural Gas Outlook And Liquids Production

Things have been difficult for Chesapeake Energy (NYSE: CHK) this year. The firm’s stock has lost nearly a third of its value due to depressed natural gas prices, mounting debt and certain controversies surrounding the firm’s corporate governance. While it may take some time for the firm to see a complete revival, the broader industry trends and a change in the firm’s strategy have been encouraging.

The company has been diversifying its revenue stream by increasing its focus on liquids production, which offers better and relatively stable pricing. However, we believe the firm’s ability to capitalize on these trends will be contingent to its ability to control its mounting debt, manage its capital spending and realize fair prices for its planned asset sales.

Diversifying The Revenue Stream By Focusing On Liquids

Chesapeake has sharply increased its liquids production over the last year, in an attempt to de-risk its revenues stream away from volatile natural gas prices. Natural gas accounted for about 80% of the firm’s sales in the last quarter. While US natural gas prices are dependent purely on demand from the North American market, liquids prices are largely driven by global oil prices (natural gas liquids are to an extent on dependent natural gas prices), which have been relatively stable. Oil production has nearly doubled year-to-date while natural gas liquids (NGL) production is up by almost 30% compared to last year. This growth is commendable, given that it is generally difficult to raise the liquids output considering that the output profile of a well can fluctuate widely.

The liquids output is expected to grow further since the firm has beefed up its drilling activity. The number of rigs drilling for liquids has grown five fold since the beginning of this year to 80 rigs. There has been a shift in the firm’s proven reserves mix as well, given that the firm has been selling some gas assets. Natural gas now constitutes 70% of the company’s proven reserves, down from around 83% in the last year. A bulk of the liquids reserves come from the Eagle Ford Shale and assets in the Granite wash basin.

Prospects For Natural Gas Demand Look Strong

Over the last month, gas price have ticked higher due to a colder than expected winter and a temporary suspension of power production from some of the country’s nuclear power plants which are undergoing maintenance. Also, the long term prospects for the North American natural gas industry are looking better.

Replacing Coal Power Plants: The share of natural gas in the U.S. electricity generation landscape is expected to grow. As of 2011, gas accounted for about 25% of the U.S. power production and this year the number is expected to increase to about 30%. Coal power dominates U.S. electricity with over 40% share of the generation mix.

However, most of the coal fired plants are several decades old which make them expensive to run and maintain. Additionally, coal faces much stricter environmental regulations related to carbon dioxide and acidic gas emissions, requiring plants to install expensive pollution control equipment. To circumvent these issues, many utility companies are choosing to transition coal fired capacity with cleaner burning fuel like natural gas. Recent reports estimate that almost a third of U.S. coal generation capacity could be phased out in the coming years, potentially boosting natural gas demand.

Industrial Demand: Natural gas is used as a raw material as well as an energy source for industries like chemicals and fertilizers, and low U.S. prices are seeing manufactures relocate plants to the U.S., to take advantage of the abundant reserves.  For example, earlier this year, Dow Chemicals (NYSE:DOW) announced plans to build a multi-billion plant in Texas, for converting natural gas into raw material used in manufacturing plastics. ^[1] Industrial consumption accounts for about 27% of total U.S. gas consumption, and an increase in this demand could boost overall natural gas volumes.

Exports: Despite the sharp growth in U.S. gas production, the country’s natural gas exports remain small. Chesapeake is almost entirely dependent on the U.S. market. One of the reasons for the lack of exports is weak infrastructure like LNG terminals. However, given that prices in the US are less than $4 per million British thermal units (mmBtu), while imports in Asia cost as much as $15 per mmBtu, it  could prove to be a very strong incentive for the U.S. to develop gas exports to capitalize on higher global prices.

Asset Sales and Debt Reduction

Chesapeake holds some of America’s largest onshore natural gas and oil reserves, and the assets required to harness them. However, most of the asset growth has been funded by debt. The firm’s capital expenditures have exceeded cash flow for 19 of the past 21 years. This year, the firm’s long term debt has risen to nearly $16 billion (Q3 2012), up from just over $10 billion last year.

Given the firm’s lack of financial flexibility, we believe that a turnaround will hinge on the ability to monetize assets at fair prices and curb capital spending. Through the year the firm sold several assets including its midstream business and a large portion of its Permian basin acreage, raising a total of around $11 billion. But given the prevailing conditions in the natural gas market, price realization has been weak. For instance, the firm was expected to receive over $6 billion for its assets sales to Cheveron (NYSE: CVX) and Shell (NYSE: RDS.A) in West Texas. However, the final selling price was around $3.3 billion. ^[2] For next year the firm intends to reduce investments (capital expenditures) by almost a third and plans another round of asset sales.

We have a price estimate of around $21 for Chesapeake Energy, representing a 15% premium over the current market price.

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1. Chemical Makers Ride The Gas Boom, WSJ [↩]
2. Chesapeake Sells Permian Assets – At A Lower Price Than Hoped, Forbes [↩]