Chesapeake Energy (NYSE:CHK) will report its earnings for Q2 on August 6, and we expect the results to be severely impacted by the decline in natural gas prices, which slumped to its decade-low figure in April. The company has revised down its forecast for gas production in its outlook for FY2013. Alongside, it is significantly raising its oil and natural gas liquids (NGL) output. We expect the quarterly results to be mediocre as the company is in transition from being a natural gas company to a company with a balanced mix of gas and liquids. Here we discuss about the trends in Q2 and the long-term outlook for the company.
We have a Trefis price estimate of $19 for Chesapeake, which is in line with the current market price.
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Trends in Q2
The company reduced its gas production drastically as it is not profitable at such lower levels of gas price. As of May 1, 2012, Chesapeake’s rig count reduced to 154 rigs, which is expected to further reduce to 125 rigs by Q3 2012. Gas prices have meanwhile seen a steep incline since its slump in mid-April and one needs to keep an eye on how fast it can reach $5 per BTU levels, beyond which the company is likely to start increasing the gas output. 
Alternatively, the company has raised its liquids output during the quarter and would continue to focus on liquid-rich plays for the rest of the year. It plans to dedicate nearly 85% of the total capex allocated for 2012 to develop liquid-rich assets as opposed to 45% expended last year. Chesapeake expects liquids to contribute nearly 55% of the revenues in 2012.
The company’s outlook depends primarily on four factors: its ability to fund its capital expenditure through assets monetizations, raise output, reduce debt, and improve margins.
Capital Expenditure and Debt
Chesapeake’s budgeted capital expenditure for 2012 stands at $7.5–$8 billion, of which $2.5–$3.5 billion is allocated for midstream and oilfield services and $1.6 billion for undeveloped leaseholds. It has exhausted approximately $968 million on acquisitions of unproved properties and $2.5 billion for drilling and completion in Q1. This implies that $4 billion of capital expenditure is still pending for the rest of the year. As of Q1 2012, it has long-term debt of $13 billion and during the quarter it availed another $4 billion of short-term debt.
The company still intends to stick to its 25/25 plan, according to which, it plans to raise output by 25% and reduce debt by 25% each year. Meeting this plan means reducing debt to $9.5 billion alongside spending heavily on capex. It needs to execute the planned asset monetization in time.
Year-to-date, it monetized Anadarko Basin Granite Wash through a 10-year volumetric production payment (VPP) for $745 million and managed $1.25 billion in cash in exchange of 1.25 million preferred shares, and a 3.75% overriding royalty interest (ORRI) obligation on its Cleveland and Tonkawa play leasehold. It also sold leasehold in the Texoma Woodford play in Oklahoma for approximately $572 million in cash. In June, Chesapeake sold its stake in Chesapeake Midstream Partners and Chesapeake Midstream Development for a sum of $4 billion.  Recently, it announced another deal to sell 3,300 acres of its Barnett Shale assets.  Chesapeake has significant stakes in quality assets in Eagle Ford Shale, Utica Shale (See Utica Shale Play Is Crucial For Chesapeake’s Future) and Mississipi Lime. We expect Chesapeake to be able to sell some of its assets to stabilize its balance sheet and fund its capital expenditure, going forward. However, if the company fails to realize the asset sales, it could get financially distressed.
The company’s ability to vertical integrate its operations has helped it keep a check on its expenses. It has developed pipeline transportation for all of its projected production in Eagle Ford Shale. This will reduce transportation cost significantly as it can bypass truck transportation altogether. The continued attempts at cost saving will help improve margins in the future.
We are cautious about the near-term outlook for Chesapeake as it relies on many things going in its favor. However, the company is gradually becoming one with a equitable mix of operating assets. Increasing gas prices are another positive trend for Chesapeake as the majority of its existing assets are in dry natural gas. We believe Chesapeake can emerge as a solid company provided it can surpass its current financial muddle as U.S. energy needs are going to heavily rely on gas in the future.Notes:
- Natural gas spot price chart, Bloomberg [↩]
- Chesapeake Midstream Partners, L.P. Announces Closing of Global Infrastructure Partners’ Purchase of Chesapeake Energy Corporation’s GP and LP Ownership Interests, Chesapeake Energy press release, July 2, 2012 [↩]
- Chesapeake Energy Buys More Drilling Rights In Ohio, valuewalk.com, August 1, 2o12 [↩]