Chesapeake Energy's LNG Bailout - It Might Not Be Enough

Apr.11.14 | About: Chesapeake Energy (CHK)


Chesapeake has been losing a lot of money over the past half decade on its shale investments.

The commencement of LNG exports starting next year will likely provide some favorable natural gas price gains from the point of view of producers.

A price increase in natural gas may not be enough to save Chesapeake and others from losing money, partly because maturing fields will cost more to produce.

I wrote some months ago about the over $2 billion writedown that Royal Dutch Shell (NYSE:RDS.A) suffered last year in regards to its Eagle Ford investment (link). I warned that Shell will by no means be the last victim of the fracking craze. There will be of course many companies which will likely do very well, but many will not. One of the largest shale oil and gas companies, Chesapeake (NYSE:CHK), is one of the candidates for possible failure to break even on the money invested over the years.

According to data found in Chesapeake's 2013 report, drilling expenses at an assumed average cost of $8.5 million per well came it at $7.6 billion based on 899 net wells drilled. I should note that Chesapeake estimated 2013 total capex at $6.9 billion. Operating costs, including the cost of oil and gas production which was $4.74 per barrel of oil equivalent, production taxes of $0.94 per barrel, administrative costs of $1.86 per barrel and interest expenses of $0.65 per barrel came out to a total of $8.19 per barrel. In the interest of presenting a somewhat simplified and easier to follow argument, I decided to exclude the costs related to depletion and equipment depreciation. I also ignored the leasing fees paid. That is not to say that these costs do not exist. Based on 244 million barrels of oil equivalent produced in 2013 total operating costs came out to a further $2 billion. Drilling and operating costs added up to about $9.6 billion in 2013 according to my estimate. It was just under $9 billion if we are to take Chesapeake's $6.9 billion capex estimate.

The 244 million barrels of oil equivalent produced through the year fetched an average price of $28.33 per barrel. The low price reflects the company's production profile, which is heavily tilted towards natural gas. Total revenue came in at $7.05 billion. This means that in effect Chesapeake spent $2.6 billion more in 2013 on extracting the oil than it received for its sales. Previous years were even worse in this respect, so the accumulated loss on investment so far is huge. This year we can expect more of the same. We are still looking at a roughly $0.5-1 billion gap depending on certain factors. According to the company's 2014 outlook, capex spending for 2014 is projected to be $5.2-5.6 billion, while production will only grow about 2-4%, therefore little change can be expected on the revenue side, unless current oil and gas prices change dramatically.

LNG exports may help with bottom line.

The first operational LNG export terminal will be inaugurated next year in Louisiana. It is being built and will be operated by Cheniere (NYSEMKT:LNG) with an initial capacity of 1 Bcf/d (link). Chesapeake is betting accordingly that it can profit from the trend by announcing it will deploy a further seven to nine additional rigs to the declining Haynesville field in addition to the three rigs it is operating there already. If further LNG projects will be finalized in the Gulf region it can logically be expected to lead to higher natural gas prices in the region. Although we should be cautious in assuming a much higher price because depending on what estimate we choose to accept in terms of total LNG production and shipping costs, US LNG may not be viable once the natural gas spot price goes past $6-8.

Will this be enough for Chesapeake to close the yearly revenue/spending gap and then turn a large enough yearly profit to eventually make up for the losses in previous years? An increase of the average sale price of natural gas produced and marketed by Chesapeake to $6 per million BTUs can potentially increase the company's total yearly revenue by approximately $1.5 billion, therefore at current production rate, the company would start seeing an actual gain, assuming drilling costs will not increase.

The assumption that drilling costs will not increase, but continue to decline instead is a well-established consensus among most shale oil and gas producers and investors. We have to remember however that no trend lasts forever. Continued innovation will likely continue to push drilling prices downwards but at the same time, the law of the low-hanging fruit commodity production pattern that dictates that the easy to produce stuff always gets produced first and then the harder to get to stuff gets tackled, tells us that eventually production costs will start to go up.

In the case of the Haynesville field where Chesapeake is looking to increase its drilling activity, it is already a field in an advanced stage of maturity. The EIA estimates for total Louisiana gas reserves, which mainly reflects Haynesville data, hovered between 20-30 trillion cubic feet in the 2009-12 period. The field already produced roughly 12 trillion cubic feet cumulatively and is currently producing at a rate of approximately 2.2 trillion cubic feet per year. Production costs in this field will rise eventually as companies will be forced to go after less and less favorable geological formations. At the same time, there are limits to how much more cost saving can be achieved by improving drilling technology and procedures. Most gains were already achieved, with only small relatively insignificant gains to be had going forward.

As we have seen with global crude oil production, the increase in the cost of production can be quite dramatic. Just a decade and a half ago the world was being adequately supplied with crude that was profitable to produce at $15-20 a barrel. We would be sorely disappointed today with production volumes if we were to have to rely on oil profitable to produce at $15-20 a barrel. We would probably lose as much as half of current global production even at $40-50 a barrel. The trend of rising cost continues globally as evidenced by 2013 results reported by big oil and gas companies such as BP, Exxon (NYSE:XOM), Chevron (NYSE:CVX) and Shell, all of which reported lower production volumes for the year and higher costs as I pointed out in a previous article. In the meantime, there is demand resistance to oil prices rising much above $100 a barrel, therefore many companies are getting squeezed with every year that passes.

Chesapeake claims in its 2014 outlook that it can produce in the Haynesville at a profit when the spot price for natural gas is $4.50. At the same time, $6 seems to be the price tolerance level for LNG projects and other industries being planned in the gulf region, such as Sasol's (NYSE:SSL) gas to diesel plant being built right now. The fact that Shell axed its own gas to liquids project in Louisiana last year, citing uncertainty in regards to future price levels and the fact that many LNG projects are not starting until they can secure long-term contracts at the right price, shows just how price sensitive these industries are.

A natural gas price increase to $6 would help Chesapeake and many other companies in a similar situation break even on total yearly capital and operational expenditures and perhaps even start making up for the huge gap incurred during the past half decade. As the shale gas fields mature and the return on drilling investment diminishes, or companies simply give up on drilling altogether, either costs will jump, or production will plummet, meaning that revenues will not be coming in as hoped. Starting next year, the race for Chesapeake will start towards the endgame of its shale investments. The next few years will determine whether the company will show a net gain on money invested into shale or whether it and many other companies might need another kind of bailout. Perhaps one that will involve the taxpayer more directly. At this point, my guess is that they will lose this race, but time will tell.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.