Chesapeake’s Better Efficiencies And Liquids Focus Will Lift Margins

Over the past two years, Chesapeake Energy’s (NYSE:CHK) profitability has been weighed down by low natural gas prices and high drilling costs. In 2012, the firm posted a sizable operating loss of around $1.7 billion. However, it has been taking steps to get back on track by concentrating on the core portions of its most important plays, boosting its liquids production and also focusing on improving drilling efficiencies. During the first quarter, Chesapeake saw a marginal improvement, posting an operating profit of around $217 million. ^[1] Here is a quick look at some factors that can positively impact the firm’s profitability going forward.

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A Strong Asset Base, But Drilling And Production Efficiencies Have Room For Improvement

Chesapeake has invested heavily on building its asset base. Over the last 10 years, the company spent nearly $20 billion on leases and is now the largest U.S. onshore leasehold owner. ^[2] Chesapeake is also one of the most active drillers in North America and is the world’s largest driller of horizontal wells. The firm also holds around 33 million acres of 3-D seismic data. Despite the massive spending, Chesapeake still trails some large oil companies in term of production efficiency. For instance in 2012, Chesapeake had a recycle ratio of around 0.97 compared to Exxon Mobil‘s (NYSE:XOM) 4.5. ^[2] The recycle ratio divides a company’s profit per barrel of production by the cost of discovery and extraction.

However, Chesapeake has been making steady progress in boosting efficiencies by adopting technologies to improve the drilling and production process. The firm has adopted pad drilling in some of its plays, allowing  it to drill groups of wells more efficiently. Pad drilling helps to cut down on the drilling cycle time and also improves economies of scale. Over the past year, the average time taken to drill a well in the Eagle Ford shale fell from around 25 days to around 18 days and the company eventually expects to cut this down to around 13 days. ^[3] This has also had a positive impact on well construction costs, which have reduced from around $9 million per well in the initial stages of the play to around $7 million currently. Chesapeake expects this to further improve to around $6.5 million. ^[4] Given these improvements, the company is curtailing its drilling capex from around $9 billion in 2012 to around $6 billion currently.

Focus on Liquids Will Aid Margin Stability

Given the volatility in gas prices over the past few years, Chesapeake has been focusing on boosting its oil and natural gas liquids (NGL) production. Unlike natural gas prices which are largely dependent on demand from North America, oil prices are linked to international prices and are relatively more stable. The company’s liquids production growth has been quite commendable so far. In Q1 2013, oil production grew by around 54% year-over-year while NGL production grew by 14%. Liquids production is expected to increase further as the firm operates over 60 drilling rigs targeted at liquids and has cut down the number of rigs drilling for oil to around 10. Chesapeake expects to allocate more than 80% of its drilling budget for 2013 towards liquids.

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1. Chesapeake SEC Filings [↩]
2. Bloomberg [↩] [↩]
3. Chesapeake Investor Presentation [↩]
4. Seeking Alpha Chesapeake Q1 2013 Earning Call Transcripts [↩]