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Chesapeake’s (NYSE: CHK) profit margin for its natural gas production business has declined from a high of around 85% in 2007 to around -140% in 2009 due to the economic downturn which resulted in declining demand for natural gas and oil, as well as a steep fall in gas prices. The company’s operations are focused on discovering and developing unconventional natural gas and oil fields onshore in the US. Chesapeake competes with other oil and gas producers like Exxon (NYSE: XOM), ConocoPhillips (NYSE: COP), Anadarko (NYSE: APC), BP and Chevron (NYSE: CVX).

As economic conditions improve and demand picks up, we expect the gas division to return to profitability, with its profit (EBITDA) margin increasing to around pre-recession levels of 60% by 2013. However, if the margin recovers more slowly to around 35% as projected by the Trefis community, this could translate into a downside of around 60%. This clearly highlights the importance of the Natural Gas division to Chesapeake.

We currently have a Trefis price estimate of $25.01 for Chesapeake’s stock, which is in line with the current market price.

Controlling Costs Will Help Chesapeake Maintain Margins…

The company has been able to reduce operating costs through economies of scale, which has enabled it to maintain high margins. Prior to the economic downturn between 2008 and 2009, the company had maintained EBITDA margins consistently between 80-90%. The fall in EBITDA margin between 2007 and 2009 can largely be attributed to the declining revenues in the face of falling demand for oil and natural gas. As the price of natural gas picks up, the benefits of cost optimization should help improve the company’s EBITDA margins.

Also just last week, news broke that Carl Icahn had increased his stake in the company to over 5% raising questions about his ultimate intentions; however given his track record, he will certainly raise his voice if he feels management is spending too much or going in the wrong direction.

… But Large Scale Operations Have Higher Risk to Economic Downturns

However due to the large scale of operations, it is difficult for Chesapeake to cut costs drastically if its revenues fall sharply over the short term. As natural gas and oil demand and prices are highly volatile, any unanticipated economic downturns in the future can impact its EBITDA margins significantly, as seen during the recent economic downturn.

Created using the Trefis App on Seeking Alpha

Trefis Community Forecast

Trefis members forecast natural gas EBITDA margin will increase from -6% in 2011 to around 35% by 2013 and trend higher from there, compared to the baseline Trefis estimate of an increase from 20% to 60% during the same period. The member estimates imply a downside of 61% to the Trefis price estimate for Chesapeake’s stock. While we feel the downside case is overly pessimistic, it does point to how important gas profit margins are for Chesapeake.

Disclosure: None

Source: Chesapeake’s Stock Is Highly Dependent on Its Gas Margins