Earnings Preview: Low Natural Gas Prices Could Be Offset By Higher NGL Volumes, Efficiency Improvements For Chesapeake

Chesapeake Energy (NYSE:CHK) will publish its Q3 2014 results on November 5. We expect the company’s earnings to fall on a year-over-year basis, driven by lower natural gas and natural gas liquids price realization. The impact of lower prices could be offset somewhat by the movement of higher volumes and realization of efficiencies in the company’s cost structure. During Q2 2014, quarterly production revenues were up by around 10% year-over-year on the back of a 54% gain in revenues obtained from natural gas gathering, marketing and compression activities.  Lower natural gas and natural gas liquid realization resulted in a 67% decline in net income for the quarter. Below we present a brief look at some of the trends that could drive the company’s results for the  third quarter. ^[1]

See our complete analysis for Chesapeake Energy here

We have a $27 price estimate for Chesapeake Energy, which is about 25% above the current market price. We will be updating our price estimate for Chesapeake after the earnings release.

Natural Gas Liquids Should Drive Volumes Growth: For 2014, Chesapeake expects its overall production, adjusted for asset sales, to rise by around 9% to 12%. While oil production is expected to grow by 11% to 15% (production was 41.1 million barrels in 2013), natural gas production is only expected to rise by 4% to 6%. Much of the volumes growth will come from natural gas liquids as the company plans to boost production of the commodity by as much as 63% to 68% this year. The higher production should come on better production from the Utica Shale, where the processing and transportation infrastructure has been improving. ^[2]

Low Natural Gas and Natural Gas Liquids Price Realization: Basis differentials have a huge impact on the cash flows of a company like Chesapeake. Severe competition for takeaway capacity in the North Marcellus Area has meant that companies are having to settle for prices with a significant discount to the NYMEX settlement price. For example, Cabot, a competitor of Chesapeake, reported average natural gas price realization of $2.92 per Million Cubic Feet(Mcf), at a price discount of $1.14 to the NYMEX settlement price for the quarter. ^[3]

The majority of Chesapeake’s Marcellus and Utica natural gas production comes from the Marcellus North Area. In Q2 FY14, Chesapeake Energy experienced negative price differentials of between $0.92 to $2.32 per Mcf on key delivery points. The wide differential basis meant that after factoring in gathering, transportation and other costs, the Marcellus North production costs averaged $2.47 per Mcf lower than the Henry Hub benchmark price for the quarter, compared to the $0.18 per Mcf  discount for the first quarter. Given that, historically, Chesapeake’s gathering and transportation costs have always been higher than Cabot’s, its price realization for the quarter should be lower than Cabot’s.

Lower Per-Unit Costs: Chesapeake expects to make some significant progress on the cost front this year. Production expenses per barrel of oil equivalent (BOE) are projected to fall by 5% to around $4.50 (midpoint of guidance). ^[2] Some key drivers of these lower production costs include a shift to pad-based drilling as well as the company’s focus on drilling and producing from its most productive acreage such as the Eagle Ford shale and the Marcellus shale, where the rates of return are high. Pad drilling allows operators to drill multiple wells using a single rig and pads along which it can be moved. Pad drilling reduces drilling time and brings about economies of scale, since wells are located close to one another. The co-location of wells  also helps to cut costs associated with gathering and transportation. Chesapeake has also guided that general and administrative expenses will decline to around $1.20 to $1.30 per BOE, which would translate to a reduction of over 20% year-over-year. This improvement is likely to come on the back of better production volumes. ^[2]

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1. Chesapeake Q2 Earnings Release [↩]
2. CHESAPEAKE ENERGY CORPORATIONMANAGEMENT’SOUTLOOK AS OF AUGUST 6, 2014 [↩] [↩] [↩]
3. Cabot Oil & Gas Q3 Profit Up 44%, But Results Miss View, NASDAQ, October 2014 [↩]