Chesapeake (NYSE:CHK) looks to be continuing the trend from the last year - the stock was one of the best performers in the sector with a total gain of about 63% during the last year. Year to date, Chesapeake has gained over 12%. However, those investors who bought the stock during the recent fall around February, has made as much as 22% in capital gains. In our previous articles, we have discussed the growing resources of the company and its capability to fund these resources. On the other hand, we have discussed the demand and supply of the company's product mix as well. In this article we will focus on the following areas: The changes in company's production levels and resources, the market conditions and future of NGL and the implications of Chesapeake Oil field services spin-off.
Better Product Mix Ratio
According to the 10-Q filings of Chesapeake, the production mix of the company has changed considerably. Due to high dependence on natural gas, the company was facing high risk as the prices of natural gas fluctuated. To counter this, the company decided to shift focus of production towards Oil and NGLs. In the last quarter, the company has taken another step towards its goal. Its natural gas production is down 4.8% while its Oil production and NGL production are up 6.4% and 55%, respectively.
However, Natural gas still accounts for roughly 70% of the company's total oil equivalent production of its product mix. But it is using most of the natural gas to convert to NGL such as propane and ethane to achieve its objective. The following table shows the percentages of revenues from different product mix of the company.
Source: SEC Filings
The above table shows that the company has very efficiently divided its product mix to complement its strategy. Chesapeake is using the surplus of total produced natural gas to make its derivatives NGL while taking into consideration the ups and downs of its demand. This ratio of product mix will help the company in mitigating the risk of price fluctuations for both natural gas and oil. Chesapeake uses derivative contracts to counter the risk from the fluctuating commodity prices. With the help of this product mix ratio, the risk is further mitigated. The following table shows fixed price swaps for the current quarter for both oil and gas.
Source: SEC Filings
Oil Prices Going Up?
Crude oil prices increased 2% on Thursday amid concerns that growing violence in Iraq, which is the second largest oil exporter, might upset the export of oil. Iraq's second biggest city was recently taken over by rebels. The group surrounded the country's biggest oil refinery and is now headed for Baghdad. If the situation continues, oil exports might get halted for some time. The political tension in the region might impact the supply of crude, resulting in an increase of prices, which will create an opportunity for the companies operating in the politically stable regions.
NGL Demand and Supply
Over 70% of the natural gas converts into Propane upon decomposition, while Butane accounts for between 4-11%. This high yielding percentage makes propane the most available gas on the supply side. This has created a surplus in propane supply and the prices have stagnated to some extent. According to a research conducted by Bentek Energy, this situation might continue over the next two years. However, from 2017 to 2021, five crackers are scheduled to be built in the NGL industry, which will impact the operations for some time and the industry will not be able to satisfy the market demand. As a result the prices of NGL will increase. The following table shows the predicted demand and supply of NGL till 2021.
Source: Bentek Energy
Oilfield Services Division
Chesapeake has joint resources in the richest lands for shale plays including Eagle Ford and Marcellus. The drilling is done by Chesapeake's oil field services division. As of March 31, 2014, Chesapeake had eight joint ventures - Chesapeake was also drilling for other companies under these joint ventures. The other partners of the joint venture pay specific percentages of the drilling and completion cost. As oil field services gets separated, it becomes an independent entity and it could charge for the drilling formally with a greater margin. For the first quarter, drilling and completion proceeds from other companies were roughly $17 billion and $5.4 billion more were to be paid. Oilfield services has a strong business model and already has a huge client base which includes, Freeport McMoRan (NYSE:FCX), Petroleum Exploration and Production (SINOPEC), Total S.A (NYSE:TOT) and BP America (NYSE:BP).
Anything Good Left Behind for Chesapeake?
Chesapeake's former CEO had been very aggressive in terms of expansion for which the company had to take huge debts. As Oilfield services gets separated, it would take away a huge part of debt with it. This would take away some burden of the company. Another way the company would benefit is depreciation which is not related to actual cash flow but it can spoil the income statement. As shown in the table below, 47% of the total depreciation and amortization expense incurred is accounted for by Oilfield services equipment. The separation of this unit would take out $37 million worth of cost out of the company's expense. As a result, the profit margin of the company would considerably improve.
Source: SEC Filings
Based on the discussion above, we believe that the company is heading in the right direction. The short-term opportunity offered by the oil market and the long-term demand growth of propane would make favorable conditions for the company in the future. Furthermore, Oilfield services spin-off will affect the company in a positive way. Chesapeake will continue to be one of the best performers in the sector in our opinion.
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