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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 14.254 trillion cubic feet equivalent, of which 95% is natural gas and daily production of 2.4 billion cubic feet.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. With drilling focused on a few key regions, the company also actively acquires new reserves that it thinks could yield in the future. During the fiscal year 2009 this led CHK to have a reserve replacement ratio of 343%. 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.
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%. 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.
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. 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%. Net income for the third quarter of 2009 was down 94% to $186 million when compared to the same period in 2008.
In the 4th quarter of 2009, Chesapeake energy beat analyst expectations with earnings per share of 77 cents. Chesapeake increased daily production 13% year over year to 2.62 billion cubic feet. The increase in production drove the better than expected results since prices that Chesapeake receives have declined 15% in a year over year comparison. Along with better production, Cheseapeake managed to cut its production expenses from $1.09 per million cubic feet to $0.86 
The company has a three-pronged growth strategy:
|Chesapeake Production Breakdown|
|3Q 2009||2Q 2009||1Q 2009||2008||2007|
|Natural Gas (Bcf)||210||204||196||775||665|
|Average Realized Natural Gas Price ($/Mcfe)||6.04||5.56||3.44||7.74||6.29|
|Average Realized Oil Price ($/Bbl)||66.42||56.72||35.99||95.04||68.64|
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 , 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.
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. 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, 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. 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.
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).
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.
With the company's production in the resource at over 400 MMCfe net per day, the Texas Barnett Shale, 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; 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.
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 .
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.
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, 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. 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.
Natural gas, as a source of heating energy, is cheaper 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. 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.
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.
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, 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.
|Anadarko||Comstock||Apache||Cabot Oil & Gas||Chesapeake Energy|
|Oil and Liquids(Barrels)||80M||1.01M||95.9M||78.2M||775B|
|Natural Gas (cf/d)||750B||53.9B||592B||90.4M||11.2M|