Chesapeake Revised To $15 Per Share On Lower Oil Prices, Slower Production Growth

We recently revised our price estimate for Chesapeake Energy (NYSE:CHK) to $15 per share, which is almost in line with its current market price. The key factors driving our price estimate for the company are lower oil prices and slower projected volumes growth due to reduced capital spending. Chesapeake is the 2nd-largest producer of natural gas and the 11th-largest producer of liquids (crude oil and natural gas liquids) in the United States. The company’s operations are focused on discovering and developing unconventional natural gas and crude oil fields onshore in the U.S. It owns positions in the Barnett, Fayetteville, Haynesville, Marcellus, and Bossier natural gas shale plays, and in the Eagle Ford, Granite Wash, Niobrara, and various other conventional and unconventional liquid-rich plays across the U.S. The firm has interests in over 45,100 natural gas and crude oil wells that produce approximately 729 thousand barrels of oil equivalent per day (MBOED), net to Chesapeake. At the end of 2014, Chesapeake’s proved hydrocarbon reserves stood at almost 2.47 billion barrels of oil equivalent, with 75.5% of these reserves categorized as proved developed. ^[1]

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Lower Oil Prices

Global benchmark crude oil prices have fallen sharply over the past few months on slower demand growth and surging tight oil supplies from the U.S. The front-month Brent crude oil futures contract on the ICE has declined by more than 51% since hitting a short-term peak of $115 per barrel in June of last year.  Going forward, we expect oil prices to remain suppressed in the short to medium term on global oversupply, as we do not expect the decline in production growth, relative to the demand growth, to fully offset the oversupply situation anytime soon. Our current 2015 full-year average Brent crude oil price estimate stands at $70 per barrel, which is based on the global demand-supply scenario and the marginal cost of production.

This would imply lower price realizations for Chesapeake on the sale of crude oil, weighing on its exploration and production (E&P) margins and revenue growth significantly. We expect the company’s E&P margin, which stood at around 78.4% last year, by our estimates, to decline to around 73.1% this year. The company witnessed a similar decline in E&P margins when natural gas prices in the U.S. fell sharply in 2012. Since then, it has focused more on growing its crude oil and natural gas liquids (NGL) production, compromising on natural gas production growth for better returns. As a result, the proportion of liquids in Chesapeake’s total sales volume has increased from 16.1% in 2011 to 29.1% in 2014. This has increased the sensitivity of the company’s valuation to global crude oil prices. ^[1]

Reduced Capital Spending

Since the independent oil and gas companies do not have downstream operations, they are relatively more exposed to the volatility in global crude oil prices, compared to the integrated players like Exxon Mobil (NYSE:XOM). This is also reflected in the fact that the S&P Oil and Gas Exploration and Production Select Industry Index (SPSIOP) has declined by almost 39% since the WTI crude oil prices peaked at around $100 per barrel in June last year, while the NYSE Arca Oil & Gas Index (XOI), which includes both integrated and independent players, has declined by just 22% over the same period. This is because, unlike the integrated players, these companies do not have a relatively stable stream of cash flows from refining and chemical production operations. This means that in a commodity down cycle, such as this one, these companies see a sharp decline in their operating cash flows, which lowers their capacity to invest in future production growth. Therefore, capital expenditure (which is the biggest single cash expense item in this business and the primary driver for future production and earnings growth) plans of independent exploration and production companies are far more dependent on the short to medium term outlook for global crude oil prices.

Chesapeake’s net annual capital expenditure has declined from more than $5.7 billion in 2011 to -$0.4 billion last year. This has been primarily because of the offsetting impact of proceeds from divestments, which the company has carried out over the last few years to pay down its debt and improve free cash flows to the firm. For example, last year, Chesapeake spent over $6.6 billion on drilling and completion of wells, acquiring proved and unproved reserves and other additions to property, plant and equipment. However, these expenses were more than offset by proceeds of around $7 billion from the sale of its interest in hydrocarbon reserves and other property plant and equipment. Chesapeake has announced that it will spend around $3.5 to $4 billion in gross capital expenditures this year, about 45% less than what it did last year. Since the company has not yet announced any divestitures so far this year, we have currently factored in the full gross capital expenditure target in our price estimate. Going forward, based on our current long-term outlook for crude oil prices, we expect Chesapeake’s net capital expenditures to gradually increase to around $4.2 billion by the end of our forecast period. ^[1]

Lower capital expenditures mean lower investment in future production growth. Therefore, while lower capital spending will improve its free cash flows to the firm, we believe it will also slow down the company’s short to medium-term production growth. For example, last year, Chesapeake’s liquids production grew by almost 21% y-o-y, but we expect it to decline by around 16% this year, followed by a 4.5% average annual growth beyond that. The steep production decline this year is expected mostly because of the asset sales that the company completed last year. Chesapeake sold certain assets in the southern Marcellus Shale, and a portion of the eastern Utica Shale, to a subsidiary of Southwestern Energy Company for aggregate net proceeds of approximately $4.975 billion last year. The company sold approximately 413,000 net acres of property and approximately 1,500 wells in northern West Virginia and southern Pennsylvania, of which 435 wells are in the Marcellus or Utica formations, along with related gathering assets and property, plant, and equipment. ^[1]

Overall, our current price estimate for Chesapeake reflects the combined effect of all these factors, and our 2015 full-year Non-GAAP earnings per share (EPS) estimate for the company stands at $0.13, compared with the consensus estimate of $0.01 per share reported by Yahoo Finance. ^[2]

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1. Chesapeake 2014 10-K, sec.gov [↩] [↩] [↩] [↩]
2. Chesapeake Analyst Estimates, yahoo.com [↩]