Chesapeake (NYSE:CHK) has been hit over the last month due to the falling natural gas prices - the company still has a gas heavy portfolio. Although Chesapeake has been attempting to achieve an optimum product mix between natural gas, NGL's and oil; natural gas still makes up for a major portion in the company's product mix at about 39% of the total sales as of the first quarter. In our previous articles, we have covered many aspects of the company including the impact of the separation of its oil field services and have also talked about the transition in the product mix. The prices of natural gas have a seasonal trend and the prices are likely to remain weak over the summers. However, as the company has been increasing the liquids in its portfolio, we believe the medium-long term prospects of Chesapeake are good. We are also expecting a rise in natural gas prices as the winter season approaches and also the export prospects of natural gas continue to get better.
Current Natural gas Prices and Hedges
According to Henry Hub natural gas spot prices, natural gas prices have been falling in the recent months and now stand at a year-low of $3.84. During a tough winter, natural gas supply was running low, which caused the prices to reach almost $7. This motivated the natural gas producers to produce more. However, the production levels rose past the required point and the market went into an oversupply position. It is expected to continue with the same trend until the demand and supply moves to equilibrium or some new demand comes. Trends suggest that prices start to rise in the last two quarters every year. Since we are already in an oversupply position, we fear it might take a little longer to clear out the built up inventories. Therefore, the prices might stabilize late in the third quarter and start to rise in the fourth quarter. Following is the chart representing current Henry Hub natural gas prices.
Chesapeake has been taking measures to tackle the expected fall in natural gas prices and the hedges have played a part in reducing the losses of the company from falling natural gas prices. The company is only exposed to 36% of the current prices and is protected by different price swaps for the rest of the 64% of its anticipated natural gas production. Specifically, 40% of these hedges are priced at $4.08/mcf swaps, 22% three-way collars priced in the range of $4.10-4.38/mcf, and 2% collars priced in the range of $4.51-5.25/mcf. With these hedges and the current low price of natural gas, the company is getting an average price of $4.04/mcf, which is still better than the current market price of natural gas. A break up of these hedges and exposure is given in the chart below.
The current prices of oil are at $98.452 for WTI and $105.56 for Brent Crude oil. However, both show a downward trend on a one month time frame and have now started to stabilize. We expected oil to be a high growth potential area for the company due to its increasing demand. According to EIA, distillate fuel consumption grew 90,000 i.e. (2.5%) in 2013 due to economic growth and cold weather. This year, this growth is expected to be even higher i.e. by 120,000. Now that we have discussed demand, let us take a look at the supply side.
According to EIA, forecast suggests that the total crude oil production in the U.S. will be 8.5 million bbl/d this year. Last year, crude oil production beat EIA's estimate of 7.4 million bbl/d, reaching 7.9 million bbl/d. This year, production has reached 8.36 million bbl/d, which suggests that it will go past the current year estimates as well. This might keep the oil prices stable but it might not grow significantly this year.
Chesapeake's exposure to spot oil prices is only 30% while for the other 70%; it is protected at $94.32/bbl. With this figure in mind, the market is still doing well in terms of prices and if the company's contingency is planned at $94.32/bbl, we expect that the company will be achieving optimum profits as well. Even if the prices of oil were to fall in the future, the company is mostly protected which makes it a safer investment.
According to the above discussion, we believe that Chesapeake is protected from the spot prices of commodities which makes it a less risky investment. The company is going through huge changes in its structure and focusing primarily on growth areas on product mix level as well as sub-product mix level. We believe that this will allow the company to grow exceptionally in the next few years. Furthermore, the rise in the natural gas prices in the second half of the year will give support to the stock price and it will prove to be a solid investment.
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