Chesapeake Energy (NYSE:CHK) earlier in the year took a pounding due to a natural gas prices slumping to nearly 10 years lows. Further, high debt and mis-governance issues also led to a slump in the stock amid difficult times. However, natural gas prices have since then recovered considerably to nearly double from the lows seen this summer, which consequently triggered a rally in the company’s share price. With the share prices now hovering around our $21 price estimate for Chesapeake, we find it prudent to look at the company’s natural gas business and see the stock’s dependence it.
Chesapeake produces natural gas as a part of its upstream activities, which include oil and natural gas exploration, field development and production. Revenues from the natural gas division are driven by mainly two factors natural gas prices the company realizes and the natural gas production volume. One observation is that if the natural gas prices and production exceed our expectations, the stock value could jump by about 10% from our current price estimate.
10% Upside Scenario | $23 Trefis Price Estimate
1. Higher Natural Gas Prices (+5%):
Natural gas usage has consistently risen over the last two quarters, and this trend is likely to continue mainly because of two reasons: the environment friendly nature of the fuel and its relatively cheap price. Many utility companies have migrated to gas-fired power generation. Moreover, the Environment Protection Agency has imposed stiff regulations that require all upcoming power plants to adhere to reduced norms of carbon emissions. This is likely to result in a higher number of gas-fired power projects over coal-fired in the future. There have been initiatives by gas exploration companies to increase gas usage, especially in locomotives. All of these factors either have increased the natural gas demand or will continue to boost it.
But, in the recent past, advanced technologies led to discovery and exploration of new gas resources creating a supply glut. This heavily battered the price of natural gas as this supply far outpaced the increasing demand. While natural gas prices have recovered substantially since this summer, in line with our expectations, we expect a gradual increase over a long term period.
However, various producers including Chesapeake are closing several gas wells due to unprofitable operations because of low prices. As demand increases and supply declines, it will lead to a decline in a current demand-supply surplus or could even result into a deficit. This could push the natural gas prices to exceed our current expectations.
As the segment is the second largest value contributor and constitutes more than 35% to our price estimate, even a small out-performance with respect to our expectations will have a big impact on the company’s valuation. If the gas prices increase to historical levels of $5 per million cubic feet (approximately 25% upside from our current estimate $4) by the end of Trefis forecast period, it would lead to more than 5% upside to our price estimate.
2. Higher Natural Gas Production Volumes (+5%):
Chesapeake has been closing several gas wells because it was unprofitable to run those wells at low prices. That’s why in the near-term the company’s gas output is likely to shrink. However, the same wells that have been stalled will be put to operation once it is plausible to run those well, which is driven by gas price. Hence, the most dominating trend for this division is the price of natural gas. Generally, higher gas price has been followed by higher gas output, though with a lag. In our estimates we have incorporated that trend. So, we believe in the near-term, while gas prices keep recovering, Chesapeake will keep reducing its gas output.
However, if the gas prices increase considerably, the company may being to increase its production to benefit from the boom. If the production volume increases to 1.4 billion cubic feet (more than 10% from our current estimate 1.2 billion cubic feet) by the end of Trefis forecast period, it would lead to more than 5% upside to our price estimate.
Combining these two scenarios – 5% upside from higher natural gas prices and 5% upside from higher natural gas production – we arrive at 10% upside or a price estimate of more than $23 for Chesapeake.