Chesapeake: Lower Production Outlook Not A Major Concern

| About: Chesapeake Energy (CHK)


By decreasing the capital spending budget and selling liquid producing assets, Chesapeake is set to deliver an adjusted production growth of 8%-10% in 2014.

The company is targeting a nearly 97% multi well pad drilling utilization in the Eagle Ford shale, 98% in the Marcellus shale, and 93% in the Utica shale.

The reduced capital budget will certainly lower production growth and consequently, the earnings and cash flow of the company, but it will also improve the balance sheet position.

The spin-off of the oil field services division will not only result in a debt reduction of $1 billion, but will also allow higher visibility and market valuation.

Over the past several years, Chesapeake Energy (NYSE:CHK) has made considerable progress in becoming a more liquid based producer, primarily due to increased activity in liquid rich plays such as the Eagle Ford and Utica shales, while reducing activities in less economical gas plays such as the Haynesville and Barnett shales. However, the company recently shared in its investor presentation (linked below) that the crude oil production will slow this year.

The lower production growth outlook disappointed many investors, but in my opinion, by lowering the production outlook, the company is making deliberate efforts to ensure it benefits in the long term. Let's discuss the factors that compelled Chesapeake to lower the production outlook.

Why Lower Production Should Not Be a Big Concern

The company has sold assets worth $11 billion over the last couple of years and plans to sell an additional $1 billion this year. Although the company described these assets as non-core, many of them were contributing to the production and were located in liquid rich plays such as the Permian Basin and Mississippi Lime.

In addition, the decline in the production forecast can be the result of reduced spending. Chesapeake has reduced its capital spending budget from $13.4 billion in 2012 to just $6.7 billion in 2013. Chesapeake is further determined to reduce spending by an additional 20% to $5.4 billion in 2014.

So even though the company has sold a number of assets and is determined to reduce its capital spending, it still expects to deliver production growth of 2%-4% on an absolute basis. However, after adjusting for the assets sale, Chesapeake is set to deliver production growth of 8%-10% in 2014.

Improved Operational Efficiency

The production growth projections are primarily due to the improving operational efficiency of the company. It has been able to improve spud to spud cycle times from 21 days in 2012 to 18 days in 2013. In 2014, the company expects to further lower the cycle time to 14 days.

Moreover, the company targets 97% multi well pad drilling utilization in the Eagle Ford shale that is considered to be the key driver of oil production growth. In the Eagle Ford shale, the company plans to operate 15-18 rigs in 2014, and average well cost is expected to be lower by $0.5 million from $6.9 million in 2013 to $6.4 million in 2014.

A Spin-off Will Improve the Company's Operations

Chesapeake Energy has recently announced that it has filed a registration statement on Form 10 with the SEC for the possible spin-off of its oil field services division. The company plans to convert Chesapeake Oil Operating LLC (COO) into a separate publicly traded company under the name of Seventy Seven Energy. The company plans to distribute 100% of the spin-off shares to its shareholders on a pro rata basis. Let's discuss the possible impact of this spin-off on Chesapeake.

Chesapeake has been trying to offload the huge burden of debt that equates to approximately $13 billion. In doing so, the company is closing its capital expenditure funding gap by selling assets and lowering its drilling spending. With the successful completion of the spin-off, the company would be able to reduce approximately $1 billion of debt.

Balance Sheet Improvement

The lower capital spending budget will adversely affect the production growth, and this will be translated in the company's bottom line and equate to smaller cash flows. However, this is just one side of the story. On the other hand, it will also improve its balance sheet. The figure below represents the net improvement position of the company.

Source: Investor Presentation

The company also managed to improve its net debt /adj. Ebitda from 3.3 times in 2012 to just 2.4 times in 2013. Moreover, in 2014, further improvements are also expected. The spin-off of COO will result in a debt reduction of $1 billion. Similarly, the lower capital spending will also serve to reduce the company's funding and liquidity concerns.

Concluding Remarks

Chesapeake recently announced a lower production outlook that is generally perceived as a negative development. However, while I believe that it can affect the company's valuation in the short term, as far as the long-term prospects are concerned, the fundamentals are still intact. Its huge debt position is the only problem, but the company has implemented initiatives to address this issue. With the recent developments such as the spin-off of the oil field service, coupled with the lower capital spending budget, I believe that Chesapeake is headed in the right direction. Therefore, I recommend buying the stock.

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.