Chesapeake Results Confirm Liquids Shift; Updated $21 Fair Value

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Chesapeake Energy

Chesapeake Energy (NYSE:CHK) reported its earnings for Q2 on August 6, which was significantly impacted by increased liquids output. [1] While natural gas sales fell by nearly 65% y-o-y to reach $354 million, oil sales nearly tripled to reach $1,626 million in comparison to Q2, 2011. Indeed, oil sales could more than offset loses in natural gas sales, raising overall revenues by 2% for the quarter. Natural gas liquids (NGL) sales, however, increased marginally. The company reported a more than 100% in net income as it realized a $1,030 million as gain on sale of assets primarily relating to sale of its stake in Midstream Partners.

The company looks to be right on track to achieving its 25/25 plan which entails a 25% increase in output and 25% reduction in debt by end of FY2012. Its average daily production increased to 3.8 Bcfe per day from 3.6 Bcfe showing nearly 25% y-o-y growth. The growth is primarily met by 65% growth in Liquids production (Oil and NGL put together) while natural gas production remained flat. Liquids now form nearly 22% of production and 70% of total revenues for Chesapeake compared to 16% and 40%, respectively in the same period last year. The company displayed improvement in its EBITDA margin this quarter riding on nearly a 20% reduction in marketing, gathering and compression costs. Its EBITDA increased from $1,422 in Q2, 2011 to $1,652 million this quarter, implying a 16% rise despite meagre 2% increase in total revenues. Let’s look at the emerging trends for Chesapeake in more detail.

We have recently revised our forecasts for Chesapeake based on Q2 earnings and outlook reported by the company. We now have a price estimate of $21 for Chesapeake. The key changes we made in the model include an increase in forecasts for oil and NGL production, and natural gas production while reducing gas price and increasing oil and NGL average price. Natural gas EBITDA margin has been reduced compared to previous estimates to reflect the decline in realizable natural gas price. We have also increased the forecasts for capital expenditure as % of EBITDA. Other revisions include an update of balance sheet entries like cash and debt and the new share count after stock-split.

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Diversification and Margin improvement

During Q2, Chesapeake displayed its flexibility to alter operations as it diversified its production assets. It is no longer entirely dependent on natural gas, even though a majority of its production is still dry natural gas. The maximum contribution in this quarter’s revenue came from oil production. The company has a significant asset base in major oil and gas basins including Eagle Ford Shale and Marcellus Shale, enabling it to vertical integrate its operations. It has developed pipeline transportation for all of its projected production in Eagle Ford Shale. This is likely to reduce transportation cost significantly as it can bypass truck transportation altogether. These efforts will collectively help in saving costs and expand margins for the company in the future.

What to expect in FY2012

For the rest of the year the company is likely to cling to liquids production, in particular oil production to help it overcome the massacre of natural gas prices while equally focusing on asset monetizations. The company’s improved capital expenditure plans in conjunction with plans to reduce debt could pull it into a funding shortfall position. However, looking at the company’s track record at selling assets, it would not be surprising if it can achieve all of its asset divestitures it in time. Besides that, company’s capital expenditures to pump up the liquids production have been optimal as it materially raised output. In its recently published outlook, it has considerably raised the overall production volumes for the years 2012 as well as 2013 compared to previous estimates published in May, 2012. [2] Looking at the company’s turnaround in such a short period of time, we believe, it is headed for a bright future. Moreover, if natural gas prices recover in the meantime, it will have significant upside. One must, however, need to keep a keen eye on how successfully Chesapeake executes its asset monetizations to maintain a healthy balance sheet and avert cash short fall.

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Notes:
  1. Chesapeake Energy Corporation Reports Financial and Operational Results for the 2012 Second Quarter, Press Release, August 6, 2012 []
  2. Current Outlook, Chesapeake Energy, August 6, 2012 []