Chesapeake Energy (NYSE:CHK) is the second largest producer of natural gas and the tenth largest producer of natural gas liquids in the United States. The company, which is one of the most active drillers of wells in the U.S., principally participates in the discovery and development of unconventional natural gas and oil fields onshore in the U.S. CHK also owns positions in several natural gas shale plays and unconventional liquid rich plays in the U.S. Historically, the natural gas assets developed by the company have been highly lucrative, but this business has suffered in recent times because of the low natural gas prices prevailing in the market. Many natural gas producers have been deliberately overproducing for a while, in a bid to push out weaker suppliers from the market. The supply glut created by this strategy has resulted in low prices and hence low margins on natural gas sales for these companies. As a result, the company has shifted its focus to oil and natural gas liquids, investing heavily in building liquid rich and oil assets.
We have a price estimate of about $28 for Chesapeake Energy,in line with the current market price.
Downward Trend In Natural Gas Prices
In the first quarter of fiscal 2014, Chesapeake’s earnings benefited from the more than 30% increase in natural gas prices, on the back of severe winter weather conditions in the Northern and Eastern parts of the country, which brought about higher heating related demand. This high growth rate may come down in the coming quarters as the price of natural gas is expected to drop. Storage levels of natural gas had been falling since November 2013 and had dropped more than 50% below the average level for the last five years by the end of March 2014. This decline was caused by the high demand for natural gas from commercial and residential sectors. 
However, storage levels have since started to increase, in turn bringing down the price of natural gas. The residential and commercial sectors together account for nearly 50% of the demand for natural gas in the U.S. During the first two months of 2014, demand from these sectors for natural gas grew by about 16% year-on-year, as the unusually cold winter season brought about need for more heating.  However, this only forms an isolated event that does not represent the underlying behavior of these sectors. Consequently, the demand from these sectors for natural gas is expected to decline in the coming months. Additionally, the U.S. Energy Information Administration(EIA) also forecasts the demand from the power sector, which accounts for 20% of the demand for natural gas in the U.S., to decline in the coming months. 
Since natural gas accounts for more than half of Chesapeake’s total sales, the drop in prices could curtail Chesapeake Energy’s sales growth in the coming quarters. One factor that might offset the impact of declining natural gas prices on CHK’s profitability is that Chesapeake’s price realizations have grown faster than the broader market since the company benefited from some firm gas transportation contracts that it held on the Spectra pipeline in the North East. ((Chesapeake Energy Q1 2014 Earnings Conference Call, Seeking Alpha, May 2014)) The benchmark gas price on this pipeline, which carried some of Chesapeake’s output from the North Marcellus, is based on the TETCO-M3 hub, which has been seeing a significant premium over NYMEX prices.
Increased Production Of Natural Gas Liquids
Natural gas liquids (NGL) was the major growth driver for CHK in the first quarter, with production rising by about 55% year-over-year to 7.6 million barrels. This growth has come from strong production in the Utica and Southern Marcellus regions. Infrastructure has for long proved a bottleneck at the Utica shale, and the commencement of shipments on pipelines such as the ATEX pipeline (which provides connectivity to the Gulf) during the quarter has provided much-needed takeaway capacity from the shale. Chesapeake’s output from the Utica shale increased by around 422% year-over-year, and natural gas liquids production has accounted for roughly 30% of its Utica volumes. Chesapeake also raised its 2014 total production growth outlook to 9–12%, up from a previous estimate of 8-10% on the back of better natural gas liquids volumes. 
Additionally, the company’s NGL production could also be helped by higher ethane recovery from its natural gas production. Low ethane prices made natural gas companies recover less ethane from the gas they shipped onto pipelines, resulting in a richer and higher value (since ethane has a higher energy content) gas. However, this year, Chesapeake has indicated that it would be recovering a greater percentage of ethane from its gas stream, which could lead to lower gas prices while boosting natural gas liquids production. NGLs contain a mix of hydrocarbons such as ethane, propane, butane, isobutene and pentane, which have different applications and fetch different prices in the market. Ethane is typically the largest component of NGLs (roughly 40%, could vary by producer) followed by propane.Notes: