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According to a recent report by Reuters, the second biggest natural gas producer in the United States, Chesapeake Energy (NYSE:CHK), has started cutting down the royalty payment it makes to the land owners on the back of depressed natural gas prices. The energy giant is now transferring a greater share of its marketing costs to Pennsylvania's landowners. The current move is in line with the company's broader cost cutting efforts. Talisman Energy (NYSE:TLM) is also mulling royalty deductions while Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has been reducing the royalty payments to most of its Pennsylvania wells for quite some time.

Chesapeake has been eyeing a turnaround under the leadership of its new CEO Doug Lawler through a management overhaul, asset sale, debt reduction and cost cutting measures.

Management Changes

The new chief has fired at least four high profile employees, including Steven Dixon (the same Steven Dixon who was on the search committee which got Doug Lawler), and has brought in Anadarko Petroleum's (NYSE:APC) Chris Doyle and Jason Pigott. Lawler is himself a 25-year Anadarko veteran.

More Oil

Chesapeake posted better than expected results in its previous quarter in which its adjusted EBITDA increased by 77% from last year to $1.42 billion on the back of a 7% increase in production. The natural gas giant was able to top the Street's estimates due to a 44% year-over-year increase in oil production to 116,000 barrels per day. Nearly all of this increase (93.4% to be precise) was due to the rise in oil production at Eagle Ford. In these tough times of depressed natural gas prices, Chesapeake is increasing its reliance on liquids. The company is now operating more liquids-rich rigs than natural gas rigs.


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Investors should note that Chesapeake's average rig count will drop to 64 rigs in H2-2013 from 81 rigs in H1-2013. But Lawler has pointed out that "from a well count perspective, it has not decreased nearly as much as the rig count,"

By the end of June 2012, oil was 13% of Chesapeake's total production mix. Its contribution has now increased to 17%. The contribution of natural gas liquids to total production has remained fairly constant at 8%.

For the full year, Chesapeake expects to produce 38 million to 40 million barrels of oil, which will be, a 22% to 28% year-over-year increase.

Non-core affiliates

The company will continue to divest from its non-core assets and affiliates and increase its focus on its high quality projects. The new CEO has not discussed the details of what those non-core affiliates might be, but this largely refers to Chesapeake's complex network of joint ventures. Chesapeake will be reviewing those projects in terms of "long-term value creation" for the shareholders.

Asset Sale: $3.7 billion

Some of the recent sales are shown in the table below.


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Given the current level of cash it has raised from the sale, if Chesapeake touches its cash-flow-from-operations estimate in the second half of the year, then it will meet all of its capital expenditure requirements for 2013. This means that from now onwards, Chesapeake will mainly use the additional asset sales to strengthen its balance sheet.

In the first seven months of the current year, Chesapeake sold approximately $3.7 billion of its assets, including the disposal of assets at Haynesville and Eagle Ford. The funding gap was estimates to be around $3.5 billion, which is slightly below its net proceeds from asset sale. The asset sales have already covered the funding gap.

Asset Sale: Funding Gap

Chesapeake's funding gap calculation is based on its forecast of operating cash flows, which is expected to be about $5 billion in the current year. To secure its future cash flows, Chesapeake has downside price protection (through OTC derivative contracts) on 94% of its remaining oil and gas revenues, 79% of its remaining gas production at $3.70 per mcf and 94% of its remaining oil production at $95.64 per barrel.

Total capital expenditure for the current year is expected to be $7.2 billion, which will be 46% less than last year's $13.4 billion.

The company's shares had been up more than 50% this year, just $0.82 below its 52-week high when the markets closed on August 30. In these times, an equity sale could also be a good option to fill the gap. But so far, that looks unlikely as the management is primarily focused on asset sale.

Conclusion

Chesapeake Energy is showing its financial discipline and is in a much better position now than it was a few months ago. Under the new CEO, the company has shown strong earnings growth and better capital efficiency. Chesapeake is a company going through a major transition, which makes it an inherently risky investment, but the business has been moving in the right direction, and the markets have high expectations. I believe that its shares are currently a buy on a dip to low-$20s.

Sources: Relevant links provided. All other data has been taken from Chesapeake Energy's Q2-2013 Form 10-Q (available here)

Source: Chesapeake Energy: More Oil, Fewer Assets And Short Term Outlook