Chesapeake Posts Lower Earnings But Underlying Trends Are Encouraging

Chesapeake Energy (NYSE:CHK), America’s second largest natural gas producer, released its fourth quarter earnings Thursday. While quarterly revenues grew by nearly 30% from a year ago to $3.53 billion, net income declined to $300 million from around $472 million. While stronger oil production helped the firm boost revenues and profits, natural gas revenues were held back by hedging contracts which prevented the firm from realizing higher market prices. Overall, we think the underlying trends were quite encouraging and could be a sign of better things to come for Chesapeake.

Over the past year, Chesapeake’s stock has declined by around 18% due to a glut of natural gas in the North American market which led to depressed prices and lower profitability. Concerns regarding the firm’s corporate governance and mounting debt also didn’t do much to help investor confidence. However, over the past two quarters, there has been some progress with gas prices witnessing a slight recovery and the firm concentrating on increasing liquids production to offset the weakness in the natural gas business. Some of the dark clouds hovering over the firm’s corporate governance have also been cleared as CEO Aubrey McClendon announced that he will step down in April.

Hedging Weighs Down Natural Gas Business

While natural gas production for the quarter was up by around 3% year-over-year to 280 bcf, realized prices declined by nearly 46%. Gas prices actually rose during Q4, but Chesapeake was unable to capitalize on the trend since most of its production was hedged, bringing realized prices to around $2.07/mcf, down from around $3.87/mcf  last year.

We are bullish on the long-term outlook for natural gas demand in North America. Although gas prices are still well below their historical levels, they are attracting more consumers towards the fuel. The electric utility sector has been progressively substituting coal fired power plants with gas due to its lower generation costs and a better environmental profile. Demand from other industries like chemicals and steel is also poised to rise.

For 2013, the firm has hedged around half of its projected gas production at an average price of $3.62 per million British thermal units. Although this could limit the upside if gas prices rise, we believe this is a prudent move since what the firm needs the most at this juncture are stable cash flows to manage its working capital and service debt.

Liquids Production Shows Solid Growth

Things were much better on the liquids front as the firm increased oil production by nearly 69% over the last year while natural gas liquids (NGL) production grew by 3.5%. Oil revenues for the full year grew by around 180% and oil revenues alone exceeded those from the natural gas business. ((Chesapeake Form 8-K)) We believe this is an encouraging shift for the firm since oil prices have been relatively stable compared to gas. Oil prices are linked to international prices while U.S. natural gas prices are largely dependent on demand from the North American market.

Asset Sales and Capital Efficiency

Chesapeake embarked on an asset monetization spree, closing asset sales of nearly $12 billion in 2012.  This has helped to reduce long-term debt from $15.7 billion in Q3 2012 to around $12.1 billion. The firm expects to divest an additional $4-$7 billion in non-core assets this year as well while curtailing drilling capex to around $6 billion, down from around $8.8 billion last year.  These moves are imperative to shoring up the firm’s financial position given the firm’s high debt load and weak cash flows.

The firm has been focusing on improving the efficiency of its capital assets by utilizing technologies such as pad drilling, which reduce rig mobilization times and allow the firm to drill groups of wells more efficiently. The firm expects capital efficiency to improve by around 15% as its transitions to pad-based drilling. ((Seeking Alpha))

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