Chesapeake’s Shale Reserves Could Carry the Stock Higher

Founded in 1989, Chesapeake Energy (NYSE:CHK) has grown to become the second largest producer of natural gas and one of the most active drillers of new wells in the U.S. Chesapeake competes with other oil and gas producers like Exxon (NYSE:XOM), ConocoPhillips (NYSE:COP), Anadarko (NYSE:APC), BP (NYSE:BP) and Chevron (NYSE:CVX). Chesapeake owns interests in around 44,100 producing natural gas and oil wells that are currently producing around 2.4 billion cubic feet equivalent (bcfe), 93% of which is natural gas.

Chesapeake’s main strategy remains to develop its ‘Big 6’ natural gas shale plays- Barnett, Haynesville, Bossier, Fayetteville, Marcellus, and the Eagle Ford Shale, which account for more than 50% of its total proved natural gas reserves of around 13.5 trillion cubic feet, as of end of fiscal 2009. As per 3Q 2010 data, Chespeake is the second largest producer of natural gas in the US, producing 2,748 mmcf/day. This compares to 2,234 mmcf/day for Anadarko, 2,190 mmcf/day for BP, and 1,820 for Conoco Phillips. ExxonMobil is the largest producer with 3,726 mmcf/day.

We estimate that Natural Gas Production accounts for around 75% of our $25.01 price estimate for Chesapeake’s stock.

Gas a cleaner substitute than oil and coal

Natural gas is a cleaner fuel than coal and crude oil and is becoming increasingly important with governments across the world encouraging the production and use of natural gas over coal and crude oil for energy generation. In addition to this, there is an increasing demand for liquefied natural gas (LNG), as it is becoming realized as an important source of fuel due to the ease in its storage and transportation. Though the EIA estimates natural gas prices to increase, natural gas prices are still expected to remain attractive relative to oil. ((EIA Annual Energy Outlook 2010: Natural Gas Demand))

The EIA in its Annual Energy Outlook 2010 report estimates that in 2008, natural gas accounted for 21% for the total electricity generation in the US, with the share of coal being around 48%. By 2035, the EIA estimates, the total electricity generation to increase by around 28% with natural gas remaining around 20% and coal falling to around 43%.

This translates into growth of natural gas use for electricity generation from around 880 billion kilowatt hours in 2008 to around 1100 billion kilowatt hours by 2035. Between 2009 and 2035, the total electricity generation capacity additions using natural gas as fuel is expected to be around 116 gigawatts, with around 20% of this increase coming between 2009 and 2015. ^[1]

For Chesapeake, its natural gas production volume increased from around 420 mcf in 2005 to 835 mcf in 2009, largely to support the growing demand between 2005 and 2008. However, as a consequence of the economic downturn, which reduced demand and prices significantly in 2009, we expect the natural gas production volume to decrease slightly in the short term and then increase, crossing 900 mcf by the end of the Trefis forecast period.

Upside to our estimates

However, the EIA estimates could provide upside to our estimates. Shale is playing a bigger role largely due to improvements in technology reducing lead times and costs of bringing natural gas produced from shale plays to the market.

The total natural gas production in the US is expected to increase from around 20 trillion cubic feet in 2008 to around 24 trillion cubic feet by 2035. The % contribution to natural gas production from shale plays is expected to increase form around 7% in 2008 to 25% by 2035. Chesapeake stands to benefit from this as a significant proportion of its natural gas reserves are in shale plays. ^[2]
If the Chesapeake’s Natural Gas Production Volume increases to around 1000 mcf by the end of our forecast period, it would mean an upside of around 15% to our price estimate for Chesapeake’s stock price.

1. EIA Annual Energy Outlook 2010: Electricity Demand [↩]
2. EIA Annual Energy Outlook 2010: Natural Gas Demand [↩]