Lower Natural Gas Prices Could Weigh On Chesapeake’s Q3 Earnings

Chesapeake Energy (NYSE:CHK) will report its Q3 earnings on November 2, and we expect the results to be severely impacted by the decline in natural gas prices which were significantly down on a y-0-y basis. While higher oil prices will lend some support to the earnings, the company is still in transition from being a natural gas company to a company with a balanced mix of gas and liquids. Let’s look at the impact of some of the important trends on individual divisions during Q3 in more detail.

We have a $21 price estimate for Chesapeake, which is in-line with the current market price.

See our complete analysis for Chesapeake

Trends in Q3

We might see lower natural gas production volumes in the quarter owing to the company’s strategy to reduce gas production drastically as its operations were not profitable at such low gas price levels. The company had plans to reduce its rig count to 125 in Q3 2012. While gas prices have seen a steep recovery since its slump in mid-April, the average realized prices will still be lower on a y-o-y basis. Lower production and low prices will be a drag on revenues.

Alternatively, the company might have raised its liquids output during the quarter and will continue to focus on liquid-rich plays for the rest of the year. The company plans to dedicate nearly 85% of 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 revenues in 2012. Further, while oil prices have been on a roller-coaster ride this year, they were mostly higher in Q3. This could offset some of the concerns for the natural gas division.

Low natural gas prices may keep pressure on margins even as the company’s ability to vertically integrate its operations has helped it to keep a check on expenses.

Outlook

Chesapeake is no longer the high flyer it once was as things seem to be getting harder for the gas driller with each passing day. The company was severely hit by falling natural gas prices in the last few months. We are cautious about the near-term outlook for Chesapeake as it relies on many factors including natural gas prices, its ability to fund capital expenditure through asset monetization, and reduce debt.

The company has been selling its assets to pay off huge debt, and its total debt exposure is expected to come down to $9.5 billion by the end of the year from $14 billion currently. But, without higher gas prices, the company may not be able to fund the complete $7 billion or more it is planning to spend on drilling next year, and asset sales and new debt may no longer remain a viable option. While the company is gradually becoming one with a equitable mix of operating assets, natural gas still constitutes a significant chunk of the company’s total reserves. (Read Chesapeake’s Assets Sales Give It A Breather, But Not For Long)

However, the company’s strategy of betting more on liquids drilling than natural gas will pay off in the long term. Read the discussion here. Further, it has developed pipeline transportation for all of its projected production at Eagle Ford shale. This will reduce transportation costs significantly as it can bypass truck transportation altogether. The continued attempts at cost savings will help improve margins in the future.

We believe Chesapeake can emerge as a solid company provided it can surpass short-term headwinds and the financial muddle as the U.S. energy needs are going to heavily rely on gas in the future. But, for the short term, higher natural gas will be the best way for the company to get back into a better position and, for now, it seems to be at the mercy of volatile gas prices.

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