Chesapeake Energy (NYSE:CHK), the natural gas giant, has been a pioneer in unconventional shale gas drilling. As of late however, it has become increasingly concerned because of the declining output levels of many of its shale plays. These shale reserves have witnessed a significant fall in output within years of commencing production. For example, the Haynesville formation shed annual gas production by nearly 48% even though 724 new wells were added over the last 12 months. 
Chesapeake’s core business lies in the exploration and production of natural gas, but it is increasingly moving towards a better mix of dry natural gas and liquids, which includes natural gas liquids and oil. In this analysis we would like to see how the falling output of gas reserves can impact Chesapeake’s value.
We have a $21 price estimate for Chesapeake, implying nearly 10% upside to the current market price.
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Barnett, which is another shale formation in Texas, has also seen relatively flat production despite several new wells that have been put into operations. The Fayetteville formation too saw declines in production. However, one shale that has not seen drastic depletion rates is Pennsylvania’s Marcellus formation, which many believe is secure from depletion. At present it is not certain if the Marcellus shale play will start depleting, however in the future if it does indeed show signs of a decline, it will be cheaper to explore new wells in the Marcellus formation as extraction costs are significantly lower when compared to other shale formations.
Chesapeake has significant operations in several major shale plays (as shown in the above chart*). The company has been able to either maintain or increase the average peak production levels thanks to its expertise in exploring new wells. The exploration of new wells requires heavy capital expenditures and thus has taken a toll on Chesapeake’s capitalization. In Q2, we saw Chesapeake borrowing an additional $4 billion in short-term loans to fund its future operations. Due to its weak financial position, Chesapeake will have to sell a number of its assets to improve its liquidity position. In recent days, the company raised its projection for 2012 asset sales to $14 billion.
Chesapeake’s recent strategy of drilling more in oil rich reserves and stalling pure-play gas reserves seems to be a more reasonable bet given the weak natural gas price environment. The Utica shale in Ohio has been found to be relatively richer in oil and other liquids.  The company has thus redirected additional resources towards developing wells in the Utica shale.  A more detailed analysis on the Utica shale play can be viewed at Utica Shale Play Is Crucial For Chesapeake’s Future.
Chesapeake could get severely affected by the depletion of its assets but its ability to drill quickly and in unconventional ways could help it fend off significant depletion losses. Furthermore, it has traditionally been successful in executing asset sales, which could come to its rescue if its liquidity position weakens further.
In spite of several negative factors associated with the company, there has been a revival in investor confidence as the company reported improved results in the second quarter. The replacement of Chairman Aubrey McClendon with Archie Dunham was also seen as a positive by investors. The company has also been able to impress its investor with its seamlessly quick ability to diversify operating assets. Southeastern Asset Management, Chesapeake’s largest investor, recently raised stake in the company based on improved quarterly results. 
*boe/d = barrel of oil equivalent per day is a unit for uniform comparison among various energy sources.Notes:
- With other U.S. shale gas plays in decline, is the Marcellus next?, examiner.com, August 15, 2012 [↩]
- 3 companies drilling in Ohio report good results, msnbc.msn.com, August 9, 2012 [↩]
- Chesapeake Energy Plans To Increase Drilling In Utica, August 8, 2012 [↩]
- Chesapeake Energy’s Biggest Investor Raises Stake, thestreet.com, August 14, 2012 [↩]