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Summary

  • Chesapeake Energy's recent results looked nice, but looks could be deceiving, as asset sales played a huge role.
  • Utica project, which the company viewed as a potential game-changer in its growth prospects is showing signs of a likely disappointment.
  • Gas prices, which rallied 53% to boost the company's Q1 revenues could tumble in the coming quarters.

Overview

Chesapeake Energy Corporation (NYSE:CHK) is an Oklahoma-based oil & gas exploration and production company.

The company operates through three business verticals. The Exploration & Production segment, which is involved in conducting oil field appraisals and producing oil and natural gas.

Marketing, Gathering and Compression segment, which markets products like compressed natural gas primarily from Chesapeake operated wells. And the Oilfield services segment - which provides services like contract drilling, oilfield trucking, hydraulic fracturing to third parties.

Chesapeake Energy focuses on unconventional liquid fields and unconventional shale reserves such as fractured carbonates and tight sandstones.

Looks could be deceiving

In the most recent quarter, Chesapeake Energy posted some impressive results, which to many would appear as though Chesapeake is indeed, about to complete its turnaround after a difficult campaign between 2012-2013.

Chesapeake Energy had oil production capacity of 244 mmboe (million barrels of oil equivalents) as of December 31, 2013. Oil and NGL (Natural Gas Liquid) contributed to 29% of total production while the remaining production was from shale resources.

The Q1 2014 results were released on May 7, 2014 which saw the average production increase 11% (adjusted for asset sales) over Q1 2013 to 675,000 boe/day (thousand barrels of oil equivalents per day). The adjusted EBITDA increased by 34% to $1.5 billion in Q1 2014.

The production capacity growth was flat without considering the effect of asset sales, but the higher revenues were due to better pricing of natural gas (53% high over last year) due to high demand from north-east region during the winter.

For the year 2014 the company expects 9-12% adjusted production growth. Higher operating margins are expected at a selling price of $96 per boe for liquids and $4.62 per mcf for natural gas.

The company's current focus is to achieve peak production capacity from its existing resources. There was no significant spending on expansion of pipeline in 2013. This led to decrease in capital expenditure by 37% over last year to $850 million, spent mostly for drilling oil wells.

The expected capital expenditure in 2014 is $5 billion, mostly in drilling new wells in Eagle Ford and Mid-continent oil fields.

The cash flow improved due to net proceeds of $520 million from asset sales. Also, about 40% of the capital expenditure is financed by debt, which helped to free more cash from operations. The leverage (debt/EBITDA) levels are expected to be around 2.5x in 2014 and 2015.

Chesapeake still has some $13 billion worth of debt on its balance sheet, compared to a total cash of $1 billion while its market value is pegged at just over $19 billion.

In summary, the company's production growth is almost flat without considering adjustment for asset sales. This is also what has been boosting the company's overall performance over the last few quarters, as attempts to bring the balance into shape continue.

The project pipeline does not envisage investment for new appraisals. Most of the investment is towards attaining peak capacity in existing fields.

Gas prices could tumble

Gas prices, which boosted the company's Q1 revenues could tumble in the coming quarters. Chesapeake Energy's higher revenue growth and margin in Q1 2014 could be offset by lower natural gas prices.

Analyst estimates indicate that NYMEX natural gas price could reach below $4 by Q3 2014. This could bring down the profitability in up-coming quarters while lack of progress in the development pipeline is a cause for concern for long-term prospects.

Now, with gas prices expected to decline in the coming months, and potentially in the long term due to oversupply, Chesapeake's prospects of conjuring the much-waited turnaround could be staring at an unexpected turn of fortunes.

Utica could underdeliver

The Utica Shale project is turning out to be something different from initial prospects. Earlier studies had suggested that the region could be rich in NGL, but now, it appears as though dry gas is the most dominant resource in the Utica shale project.

Some of the companies have already started suspending operations at the Utica region. Halcon Resources (NYSE:HK) with about 139k acres recently said that it would suspend its drilling program in the Utica this year. The company cited worse-than-expected test results in the northern region of Utica.

Another company, Hess (NYSE:HES), has already struck a deal to sell its 74,000 dry gas acres in the Utica to American Energy Partners LP. British Oil giant BP (NYSE:BP) on the other hand scrapped plans to develop its 100,000 acre in the Utica, and in the process writing off some $521 million worth of investments in the region as appraisal tests returned worse than expected results.

For this reason, it appears as though Utica is not what Chesapeake Energy imagined it would be in its business model. Chesapeake holds more than one million acres in the Utica shale project.

Potentially overvalued?

Chesapeake Energy closed on June 2, 2014 at $29.31 up 2.05% from last week's close. The stock is currently trading at 23x its trailing-twelve-months EPS. The EPS in Q1 2014 was $0.59 and the expected EPS for 2014 is $2 if the current level of EPS is maintained.

Lower gas prices could bring down the EPS up to $1.5. The P/E multiple of 23x is quite high especially considering the dimming growth potential for Chesapeake for the near-term future. This means that, Chesapeake could be potentially overvalued.

At the current price of about $29 per share, Chesapeake is just shy of its 52-week high of $30.48, and is within touching distance of its multi-year high of about $35 per share. This comes after a difficult campaign starting in 2012, through mid-2013.

The year 2014 has been exceptional compared with 2012 and 2013, as the stock has enjoyed some premium valuation, which I believe has been largely due to the progress made over the last two years in the divesting program in bid to fixing the company's balance sheet problems.

According to analysts the P/E levels are expected to reduce to 12x levels for a maximum price target of $24 in 2014. Note that $24 per share represents approximately 18% downside on the current price of $29. Any downside in EPS growth could bring down price to $18 per share, which means there is a potential 37% downside.

Conclusion

Now, without considering the impact of the current asset sales, Chesapeake Energy's production growth rate is almost flat while the project pipeline fails to envisage investment for new appraisals. This dims the company's growth prospects.

Many would argue that the company is selling its non-core assets to concentrate on maximizing on its yielding projects. However, from another point of view, the company's business model is almost changing from oil & gas producer to a real-estate agent.

While I agree that diversification is crucial for the company considering the unpredictable gas prices, I believe Chesapeake is an oil & gas production company; that is its foundation and changing it could be harmful to its long-term growth.

This is why I believe that at the current price of $29, and with no clear growth plans, Chesapeake could have rallied a little too far above its true valuation.

Source: Is Chesapeake Energy Overvalued?