Chesapeake (CHK) announced its outlook for 2014, which did not impress the market and the stock fell more than 6% before the close of trading yesterday. The most important thing in the outlook was a reduction of about 20% in capital expenditures for the next year. In the previous quarter, the company reported that it was shifting its focus primarily from natural gas to form a reasonable product mix which may protect them from the market uncertainty and price fluctuations. Chesapeake suffered a lot due to the fall in prices for natural gas and the company has been making efforts to get back to its previous highs. As a result, we have seen considerable changes in the strategy over the past two years. Let's see how the change in capital expenditures will affect the company.
Decrease in Capex and the Impact on Production
Chesapeake spent massive amounts on acquiring natural gas assets during the shale revolution. However, as the supply outpaced the demand, natural gas prices started to fall and it hit rock bottom. As a result, some of the assets that company acquired became economically unfeasible and resulted in substantial write-offs. Chesapeake then decided to shift its natural gas heavy portfolio to an oil heavy portfolio and the company has been making efforts to move to liquids. Over the years the company has been spending a lot on capital expenditures. Capital expenditures are an extremely important metric in the oil and gas sector as the market keeps an eye on how the companies are replacing depleting reserves and what will be the trend in future production. Naturally, the reaction to a decrease in capital expenditures will be negative as it may raise questions about future production volumes.
The company has predicted under the new capital expenditure program the production volumes would serve the company's strategy to have a proper balance between its products mix. The growth in production of natural gas liquids would be between 44% and 49%, growth in oil production would be between 8% and 12% while growth in natural gas production should be between 4% and 6%. Overall, the company will be able to achieve production growth of 2-4% on an absolute basis, which will take its daily production rate to 680-695 thousand barrels of oil equivalent. The most important thing to notice here is that despite a decrease in capital expenditures, the company is meeting its goal of increasing production of liquids. As a result, the total contribution from liquids will increase towards the total production of the company.
Serving the Long-Term Strategy?
During the last year, Chesapeake's product mix consisted of 70% natural gas alone and the remaining 30% was taken up by oil and natural gas liquids. In the fourth quarter, the company increased its oil and natural gas liquids production significantly, but the growth in natural gas was negligible. This current outlook of the company would serve its long-term strategy perfectly. While we have seen a colder than expected winter and natural gas prices are on the up. It remains a seasonal commodity and the volatility in price is high. As a result, a decision to decrease natural gas production is correct in my opinion.
On the other hand, demand for natural gas liquids is much more solid and stable as it is used in the areas where natural gas is not available as a substitute to it. The demand of natural gas liquids has been increasing greatly all over the world, especially in Asia. Shifting production focus on natural gas liquids is a good idea to capitalize on this increasing demand. The current product mix gives the company streamlined production, which should enhance the revenue growth. The demand for natural gas liquids is on the up, the outlook for oil prices is favorable and the prices of natural gas are also getting better. Furthermore, the company will continue with its strategy of selling assets in order to generate cash.
Chesapeake has come a long way from where it was standing two years ago - investors had lost confidence in the management and everyone was jumping ship. However, since the installation of new management, the company has followed an impressive strategy and the execution has been good. As a result, the stock has gained substantially over the last twelve months. I believe the long-term impact of the strategy will be positive for Chesapeake and the stock will continue to go up.