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Chesapeake Energy is one of the largest independent natural gas companies in the U.S. with proven reserves, in the third quarter of 2009, of over 12 trillion cubic feet equivalent, of which 92% is natural gas.^[1]Chesapeake has expanded by concentrating its capital in just a few geographic regions, allowing the company to gain an in-depth knowledge of the surrounding geology that has kept drilling success rates above 97% since 1991, and at 99% in 2008 and 2009.^[2][3] With drilling focused on a few key regions, the company also actively acquires new reserves that it thinks could yield in the future. This combined strategy of drilling and purchasing contributed to a reserve replacement of 91% in the third quarter of 2009.^[1] As of the second quarter of 2009, Chesapeake had the largest inventories of onshore leasehold and 3-D seismic in the U.S., with 36,000 net drill sites representing over 10 years of inventory for drilling projects. During the same period the company owned interests in 43,300 wells producing oil and natural gas of approximately 2.5 bcfe per day.^[4]

Though much of the company's previous growth was financed through debt, Chesapeake has sold assets that did not fit its long-term goals, a plan that allowed the company to spend on exploration and drilling without borrowing money. That strategy effectively reduced the company’s level of risk. With natural gas prices on the decline, in April of 2009 the company cut production by 13%.^[5] Production was cut in order to sell in the future, when prices are expected by investors (reflected in higher NYMEX forward strip natural gas prices) to be higher due to increased economic growth. Looking forward, lower gas prices during warmer winters depress margins. In the medium to long term, renewable energy has the potential to take away demand from oil and natural gas. Natural gas has been touted as the next big fuel, as it burns cleaner, more efficiently, and can be cheaper than oil. A transition away from the black gold and towards natural gas would make Chesapeake very rich in comparison to more oil dependent competitors like Devon Energy, but gas isn’t cleaner than renewables like solar and wind, which are getting cheaper every day.^[6]

Business and Financials

Chesapeake has grown significantly in the past few years, with about 50% revenue growth from 2005 to 2006, and operating income nearly doubling in the same period.^[7] However, like the other majors, Chesapeake was hard hit by the fall in natural gas and oil prices. From 2007 to 2008, net income fell about 50%, even while revenues grew nearly 50%.^[8] Net income for the third quarter of 2009 was down 94% to $186 million when compared to the same period in 2008. Excluding one time items net income was $440 million down from $495 million for the third quarter of 2008. Revenue was down from $7.49 billion to $1.8 billion due mainly to decreases in demand and lower gas prices, while output was up 7% to 2.483 billion cubic feet of gas per day, as compared to the same period the previous year.^[9]

The company has a three-pronged growth strategy:

• Drilling and Exploration: In the third quarter of 2009, Chesapeake claimed to have the industry's most active drilling program drilling 853 of its own wells and participating in another 864 wells operated by other companies. The success rate for both operated and non-operated wells was 99%. In the same quarter the company invested, through drilling, completing and equipping costs, almost $2.54 billion in operated and non-operated wells through the use of 102 operated rigs.^[1]

• Acquisitions: In 2006, the company acquired 6.5 trillion cubic feet equivalent worth of reserves at a total cost of about $14.3 billion^[13]. More recently, the company acquired the Kerr-McGee Tower from Anadarko Petroleum, and then sold it to SandRidge Energy after determining it wasn't worth the energy to develop. Acquisitions allow the company to focus capital resources on exploration in its own areas of interest. Continuing its acquisitions, Chesapeake entered into another JV with Epsilon Energy to drill and develop its Marcellus Shale Highway 706 Prospect project. Recently rather than buying out companies Chesapeake has entered into JV's with various companies such as S.A. Total TOT. ^[14]
• Regional Scale: Most of Chesapeake's holdings are concentrated onshore within Oklahoma, Arkansas, Kentucky, West Virginia and Texas and the company is one of the largest independent gas companies in the world. Its regional focus allows it to build expertise in the geological characteristics of its operating areas, resulting in an inordinately high drilling success rate of 97% over the last 17 years.^[15] Additionally, the location of its properties onshore in the U.S. protects the company from political turmoil of foreign countries and damage from hurricanes, which can be devastating to many off shore producers.^[16]

• Mmcf: Million cubic feet
• Mbbl: Thousand Barrels
• Mmcfe: Million cubic feet equivalent

Chesapeake Wants to Fund its Growth Internally

Chesapeake's sale of the Kerr-McGee property in July 2007 highlights a major part of its new growth strategy. The company is selling off some of its properties and rigs; the resulting cash could help the company grow without increasing its debt. By the end of 2009, Chesapeake wants to sell about $4 billion worth of assets (for cash); it has commenced its plan, selling 37 rigs in the third quarter for $235 million^[20] , as well as a volumetric production payment for some Appalachian holdings in early January to Deutsche Bank AG (DB) and UBS AG (UBS) affiliates for $1.1 billion.^[21]

Trends and Forces

Falling Oil & Gas Prices Will Soon Shrink Chesapeake's Margins

Oil and gas prices have fluctuated heavily over the past few years, though the most recent trend is a fall in prices. Third quarter earnings were still higher than those of the previous year, at $7.5B in 2008, compared to $2B in 2007.^[22] However, prices were still high during the beginning of Chesapeake's third quarter. Expecting continued high prices, Chesapeake invested heavily in early 2008, boosting production from unconventional, expensive-to-produce reserves to 1000 Bcfe per day,^[23] but invested just as much in the rest of the year, announcing in June 2008 a $178 million JV with Goodrich Petroleum to develop the Haynesville Shale^[24]. With prices on the decline, Chesapeake has been forced to liquidate some of those reserves to finance continued expansion and to maintain production of 980 MMcfe per day out of its conventional reserves, which are much cheaper to extract from than unconventional reserves. With the global economy growing much slower than was once expected, demand growth for petroleum and natural gas has also slowed. Absent a radical innovation in renewable energy, the long term trend for energy prices till points upwards, but for now prices are the lowest they've been since 2004.

Improvement in U.S. Natural Gas Rig Count Signals Positive Industry Movement

U.S. Natural Gas Rig Count 10/2009^[25]

In the third quarter of 2009 the number of active natural gas rigs increased by 14, potentially signaling positive movement in the industry. Active rig counts reached a peak of 1,606 rigs in the second half of 2008. In October 2009 rig counts were down to 726, 55 percent lower than peak levels, but steadily rebounding. During the same period inventories hit a record high of 3.66 trillion cubic feet (Tcf).^[25]

Over the first half of 2009 companies had scaled back oil and gas drilling operations due to falling commodity prices and restriction on access to credit. This increase in drilling activity is a sign that companies are bringing oil and gas rigs back online and could be a signal of industry stabilization and improvement.^[25]

Chesapeake's Chips are on the Barnett Shale

With the company's production in the resource at over 400 MMCfe net per day, the Texas Barnett Shale^[26], is already one of Chesapeake's main unconventional production centers. Oil shales, like Barnett Shale, are more expensive to produce because the oil has been absorbed into sedimentary rock, and must be released through a complex heating process. In a high-price market, the Barnett Shale growth has been phenomenal, as Chesapeake's June 2007 production in the region was only around 230 MMCfe^[27]; production has nearly doubled, and with 20% of its capital to be concentrated in the area, the company expects growth to continue.

In a sign that Chesapeake has a long-term commitment to developing the Barnett Shale, it has entered into a $2.25 billion agreement with Total S.A TOT. As part of the terms of the agreement Total will give $800 million to Chesapeake upon closing of the deal, and will acquire a 25% stake in Chesapeake's upstream Barnett Shale holdings. Additionally Total will pay 60% of the development and operation costs of Barnett Shale projects, up to an upper limit of $1.45 billion.^[28]

Anti-Fracking Legislation by Congress May Force the Company to Restructure Natural Gas Extraction

Congress is currently examining the possibility of banning "fracking". "Fracking" refers to the process where water, sand, and hydraulic fluids under great pressure are used to create fractures that allow the gas to be collected. The method is widely used to collect natural gas, especially from the Marcellus Shale which is thought to contain 500 trillion cubic feet of natural gas. The method has come under fire, because it is thought that the chemicals and fluids used to fracture the shale contaminate nearby water supplies. This contamination has led congress to investigate a ban on the method ^[29].

This is a key method through which natural gas companies are collecting gas and oil from shale reserves. It's importance is highlighted by the fact that Exxon-Mobil's $31 billion dollar takeover of XTO would be terminated if congress were to prohibit or make "fracking" commercially unviable^[30].

Seasonal Natural Gas Price Declines Sometimes Lead the Company to Shut Down Production

In September of 2006, Chesapeake announced it would temporarily shut down some of its gas production, in order to hedge against a decline in gas prices. Gas prices fell to around $5.50 per 1000 cubic feet, from around $8 in June^[31], possibly due to unseasonably warm weather reducing demand for heating gas. Chesapeake was forced to do the same thing a year ago: in September of 2006, Chesapeake announced it would temporarily shut-in 6% of its gas production, or about 100 MMCfe per day^[32]. In order to shut-in production, Chesapeake must give up the use of some of the rigs it has been contracting. Though high oil prices have led to growing rig capacity, driving growth in the oilfield services sector and making it easier for companies like Chesapeake to get back in the game in case of an upturn in prices, there would still be a delay between the price increase and when the company was back at full production. Because of this, Chesapeake's shut-in is risky; reducing production helps margins when prices are low, but at the cost of losing out on greater profits when prices rise.

A Natural Gas Future Would Yield Big Bucks for Chesapeake

Natural gas, as a source of heating energy, is cheaper^[33] than oil and more abundant. Furthermore, natural gas can be touted as environmental; in terms of "dirty" emissions like sulfur and nitrogen oxides, natural gas is far cleaner than oil or coal. In 2006, Chesapeake was the third-largest independent natural gas producer in the U.S., with 92% of its daily 1.7 billion cubic feet equivalent coming from the oil substitute^[34]. With the vast majority of its business resting on natural gas, the company could end up a huge winner if the energy market swings away from oil and toward this cleaner form of petroleum, as it would have less to lose than other, more oil-dependent competitors.

Increased Production and Higher Cash flow

In the last several years, Chesapeake went on an acquisition binge. The company snatched up land at favorable prices during a time when natural gas prices were falling. CHK funded a significant amount of this land expansion with the use of debt and preferred instruments that eventually convert into equity. This has resulted in the share count doubling over the past five years. Since then, net income has increased five-fold, yet EPS has only doubled. The dilution has caused frustration for some investors.

However, share dilution is not always negative. As long as the capital raised from the dilution creates more value than the amount of value diluted, then it’s a positive move. For example, if EPS is $1, but a share issuance doubles share count and reduces EPS to .50, then value will be enhanced when the proceeds generate new $1 EPS, increasing total EPS to $1.50. Dilution caused the outstanding shares to double, yet investors are better off because EPS increased 50%.

Chesapeake has completed its land acquisition phase and is now focusing on development of those reserves. Production will increase, and in a pro-rata basis, capital needs should be reduced. Increased production will generate higher levels of cash flow further reducing needs for external capital. CHK has also announced its intentions of using asset sales as a source of funds, and not accessing the public capital markets. Not only will this drastically slow the rising pace of the share count, but enhance value though the asset dispositions.

Reserves that have little or no future upside for CHK can be sold at almost 2x the level as implied by CHK’s share price. Going forward, CHK will capitalize on the assets that came at the expense of diluting the equity and produce returns justifying those actions. This should quell apprehension among investors and remove any overhang in the stock price that may have arisen from it.^[35]

The "Green Revolution" Could Prove Troublesome to Chesapeake in the Long Run

Whether it’s because of the desire for energy independence, the rising price of oil, or fears of climate change, people are becoming more and more disillusioned with petroleum. Environmentalists have been calling for a shift to renewable energy for years, and though the river of change is running slow, it is running deep. Internationally, the Kyoto Protocol has started a shift toward cleaner sources of energy, and though the U.S. isn't partaking Kyoto's changes, the recently passed Energy Independence and Security Act of 2007 is the first step towards a grander series of changes. By forcing automakers to achieve 35 mpg by 2020 and setting a Renewable Fuel Standard of 36 billion gallons of biofuels in 2022^[36], the Act could greatly reduce the growth of the petroleum industry - and environmentalists, who have deemed climate change to be "Our Generation’s Defining Moral Challenge", will continue to push for greater change. In emerging markets like China and India, however, the drive for economic growth supersedes environmental concerns. Since emerging markets are growing more quickly than developed economies at the moment, they are where a substantial number of future opportunities in the global economy lay, especially for energy companies like Chesapeake.

Competition

• Anadarko Petroleum - Another large-cap independent petroleum company, Anadarko produces in the U.S. and internationally, with one of its major hubs in the OPEC nation of Algeria.
• EnCana - A Canadian oil company that is heavily invested in natural gas, EnCana is highly sensitive to the Canadian-U.S. exchange rate, as well as to Canadian regulation of the fossil fuels industry.
• Comstock Resources - Comstock is too small, as of yet, to effectively compete with Chesapeake, but its big bet is on deepwater oil exploration, a sector that could yield big in the future.
• Apache - Apache's strategy is a unique one; the company buys up "mature" properties from oil majors and then extracts more from them, taking advantage of the high price level to keep margins up despite the use of expensive technology.
• Cabot Oil & Gas - Since it left the Gulf of Mexico to focus on onshore reserves that lose in the Devonian Shale, Cabot is in direct competition with Chesapeake, especially with 90% of its production coming from natural gas^[37].
• Devon Energy - Since the Canadian government raised royalties on the Alberta oil sands, Devon has been planning to transfer much of its capital to the Barnett Shale; already the largest landholder in the resource, Devon's plan to increase its capital in the area directly challenges Chesapeake. Devon is also one of the largest property holders in the Lower Tertiary of the Gulf of Mexico, making it a major player in the budding deepwater market.

Notes

1. ↑ ^{1.0 1.1 1.2 1.3} "Chesapeake Energy Corporation Reports Financial and Operational Results for the 2009 Third Quarter," Chk.com Press Release, November 2, 2009
2. ↑ CHK 2006 10-K, Item 1, Page 3, http://sec.gov/Archives/edgar/data/895126/000119312507043979/d10k.htm#tx87427_2
3. ↑ CHK 2008 10-K, Item x, Page 35
4. ↑ CHK 2009 10Q 2Q, Pg. 41
5. ↑ CHK Investor Relations - Chesapeake Energy Corporation Further Curtails Natural Gas Production in Current Low Price Environment
6. ↑ Wealth Daily - Grid Parity: Renewables vs. Coal
7. ↑ CHK 2006 10-K, Item 1, Page 7, http://sec.gov/Archives/edgar/data/895126/000119312507043979/d10k.htm#tx87427_2
8. ↑ ^{8.0 8.1} CHK 2008 10-K, Item 6, Page 33
9. ↑ ^{9.0 9.1} Jelter, Jim, "Anadarko Petroleum, Chesapeake Energy's profits plunge," Marketwatch.com, November 2, 2009
10. ↑ CHK 2007 10-K, Item 6, Page 30
11. ↑ Chesapeake 10Q 2009 Report
12. ↑ CHK 2009 10Q 2Q, Pg. 3
13. ↑ CHK 2006 10-K, Item 1, Page 2, http://sec.gov/Archives/edgar/data/895126/000119312507043979/d10k.htm#tx87427_2
14. ↑ Epsilon Energy Ltd. Signs Letter of Intent on Highway 706 Marcellus Shale Joint Venture Project with Chesapeake Energy Corporation January 18, 2010
15. ↑ CHK 2006 10-K, Item 1, Page 3
16. ↑ Scheidt, Zachary, "Chesapeake Cuts a Deal With Plains Exploration & Production: 'Lump Sum Please,'" Seeking Alpha.com, August 11, 2009
17. ↑ Chesapeake Energy 10K 2008 Pg. 34
18. ↑ Chesapeake Energy 10Q 2009
19. ↑ Chesapeake Energy 10Q 2009 Pg. 40
20. ↑ Chesapeake Energy, News Releases, "Chesapeake Energy Corporation Reports Financial and Operational Results for the 2007 Third Quarter", http://phx.corporate-ir.net/phoenix.zhtml?c=104617&p=irol-newsArticle&ID=1073515&highlight=
21. ↑ Chesapeake Energy, News Releases, "Chesapeake Energy Corporation Announces First Monetization of Producing Properties", http://phx.corporate-ir.net/phoenix.zhtml?c=104617&p=irol-newsArticle&ID=1090415&highlight=
22. ↑ 2008 Q3 CHK, 10-Q, Item 1, Page 3
23. ↑ Chesapeake Energy, News Releases, "Chesapeake Energy Corporation Reports Financial and Operational Results for the 2007 Third Quarter", http://phx.corporate-ir.net/phoenix.zhtml?c=104617&p=irol-newsArticle&ID=1073515&highlight=
24. ↑ MarketWatch: "Chesapeake paying $178 mln for Haynesville Shale lease"
25. ↑ ^{25.0 25.1 25.2} "U.S. Rig Count Continues to Climb," Zacks.com, October 13, 2009
26. ↑ Chesapeake Energy, News Releases, "Chesapeake Energy Corporation Announces Transaction with Paloma Barnett, LLC in the Barnett Shale While Chesapeake's Barnett Shale Production Hits 600 MMcfe Per Day Mark" http://phx.corporate-ir.net/phoenix.zhtml?c=104617&p=irol-newsArticle&ID=1093776&highlight=
27. ↑ Chesapeake Energy, News Releases, "Chesapeake Energy Corporation Reports Financial and Operational Results for the 2007 Third Quarter", http://phx.corporate-ir.net/phoenix.zhtml?c=104617&p=irol-newsArticle&ID=1073515&highlight=
28. ↑ Chesapeake Energy Corporation Announces $2.25 Billion Barnett Shale Joint Venture With Total S.A.'s Total E&P USA, Inc. January 4, 2010
29. ↑ http://www.alternet.org/water/144492/damning_new_evidence_raises_concerns_about_threats_to_new_york%27s_water_from_gas_drilling?page=1 Damning New Evidence Raises Concerns About Threats to New York's Water from Gas Drilling December 11, 2009
30. ↑ | Exxon Can Cancel Deal if Drilling Method is Restricted
31. ↑ Chron.com, NewsWatch: Energy, September 5th, 2007, http://blogs.chron.com/newswatchenergy/archives/2007/09/producers_turn.html
32. ↑ MarketWatch.com, "Chesapeake to shut-in part of near-term nat gas production", Sept. 27th, 2006, http://www.marketwatch.com/news/story/chesapeake-shut-part-near-term-nat-gas/story.aspx?guid=%7B843F9EEE-9852-47A1-AFB6-F53C754BF602%7D
33. ↑ http://en.wikipedia.org/wiki/Natural_gas#Cost_comparison_with_heating_oil_in_the_USA
34. ↑ CHK 2006 10-K, Item 1, Page 1, http://sec.gov/Archives/edgar/data/895126/000119312507043979/d10k.htm
35. ↑ Chesapeake- A top energy play
36. ↑ WhiteHouse.gov, Fact Sheet: Energy Independence and Security Act of 2007, http://www.whitehouse.gov/news/releases/2007/12/20071219-1.html
37. ↑ Morningstar Report, COG, July 23rd, 2007
38. ↑ [Wikinvest Data: Operating Metrics]