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Chesapeake Energy (NYSE:CHK) has been shifting its focus from natural gas to oil and natural gas liquids (NGL) over the last few quarters. While the move has been paying off for the company given the higher price realizations and margins that oil commands, we believe that the firm’s natural gas business could still prove to be a dark horse over the long run. Chesapeake is still America’s second-largest natural gas producer with one of the largest gas acreages in the country. We estimate that the natural gas division accounts for around 40% of the company’s value. Here is a brief overview of how the business has been doing over the past few quarters and the long-term opportunities that we see for this business.

An Overview of Recent Performance and Trends

During the second quarter, Chesapeake’s natural gas production remained largely flat year over year at around 278 billion cubic feet (bcf), and the company expects production for the year to decline by around 3% since last year to between 1,080 bcf and 1,100 bcf. However, prices realizations have been relatively better with the company receiving wellhead prices of around $2.62 per thousand cubic feet (mcf) during Q2, up from around $2.13 per mcf in the previous quarter and $1.88 per mcf last year.

Things have also been better on the production cost front with average production expenses during Q2 declining by around 20% to about $0.78 per thousand cubic feet of natural gas equivalent (mcfe), thanks in part to lower saltwater disposal costs. The company has downside hedged almost 80% of its natural gas production for this year at around $3.70 per MMBtu (NYMEX) and this is likely to be positive for the company since gas prices are currently ruling at around $3.50 per MMBtu.

Chesapeake has a total drilling and completion capital expenditures of around $6 billion for this year, of which less than 15% will be targeted at gas based drilling. However, the company will be focusing its drilling activity on the core areas of these plays where the rates of returns are among the best. Chesapeake primarily produces gas from four plays -- the Barnett Shale in Northern Texas, the Bossier and Haynesville shales that lie across Eastern Texas and Louisiana and the Marcellus Shale in the North East.

Consumption of Gas From Electricity Has Declined of Late

The electric utility sector, which accounts for around one-third of overall U.S. natural gas use is viewed as a significant growth area for natural gas consumption, however consumption from this sector has declined slightly of late. While total natural gas consumption in the United States for the first five months of this year was up by around 3.5% over the last year on account of a relatively cold winter, the consumption from the electricity sector actually declined by around 16% as gas prices rose causing utilities companies to burn more coal.

However, we see this decline as only a short-term trend. Coal-fired generation, which presently accounts for the largest portion of U.S. electricity generation and significant amount of carbon emissions is likely to fall as new norms governing greenhouse gas emissions for new as well as existing power plants are introduced. (See also "How Obama’s Climate Action Plan Impacts The Energy Sector.") Natural gas emits much less carbon dioxide compared to coal and gas-fired plants are also cheaper to install on a per megawatt basis. This could cause utility companies to transition from coal to natural gas rather than investing in adding pollution control equipment to some of their aging power plants.

Disclosure: No positions.

Source: How Is Chesapeake's Natural Gas Division Doing?