Chesapeake Energy: Is The Worst Behind The Company?

Aug.22.14 | About: Chesapeake Energy (CHK)

Summary

In the last few quarters CHK has taken a number of steps to reduce the complexity of its corporate and capital structure.

Some of these actions combine with strong oil output have eased near-term liquidity concerns.

However, the share outperformance will depend on the management’s execution to improve capital structure through narrower focus on highest return projects.

Chesapeake Energy (NYSE:CHK), the second largest natural gas producer in the United States, has taken a number of actions in the last one and a half years to reduce the complexity of its corporate and capital structure. Some of these actions combined with strong oil output have eased some of its near-term liquidity concerns. A few of these steps included the divestiture of Chesapeake's midstream business, the sale of non-core oil and gas assets and investments, and the spin-off of the Oklahoma City-based company's oilfield services business to CHK's shareholders.

The company used the proceeds from these asset sales to eliminate various forms of financing including certain of its VPPs, operating and financing leasing, subsidiary preferred stock issues, and other debt. The company in the last one and a half year has considerably reduced its net leverage. Chesapeake's net leverage, including preferred stock and off-balance sheet obligations fell approx. $6.0 billion from year-end 2012 to 2Q14 (from approx. $21 billion to approx. $15 billion). The current approx. $15 net leverage includes $12 billion of senior notes, $1.5 billion of convertible preferred stock, and $2 billion of VPPs and operating/financing leases. Chesapeake accounts for its VPPs as asset sales and has already removed associated assets from its balance sheet and reserves.

Improving Financial Health

The company has effectively closed this year's funding gap via non-core asset sales announced to date. At the end of 2Q14, CHK had approx. $1.5 billion of cash which along with $700 million in expected proceeds from non-core asset sales will be used to finance $1.3 billion Utica preferred share repurchase as well as the $450 million PRB asset swap.

While these asset sales and strong oil output has eased some of the near-term liquidity concerns, solid production growth has also alleviated many operational concerns. The company has also announced major capital cost-cutting initiatives aimed at improving the company's financial health. Responding to a question during the company's second-quarter earnings call on the health of CHK's balance sheet, Doug Lawler, CHK's CEO, said,

"I'm a huge capital efficiency guy. And you know that I'm a huge cash cost leadership guy. And part of that whole cash situation with the balance sheet where we have obligations that consumer cash flow or consume cash. We are focused on continuing to improve."

Lawler further added that while the company has made improvements, he is still not satisfied with the current portfolio, with the current product mix and will continue to make improvements. One of the by-products of this balance sheet clean-up operation is investment grade rating. The company is trying to clean-up excessive debt on its balance sheet that can be a burden to its capital program both in a high and low price environments.

Production Growth Poised To Accelerate

CHK's production growth is now poised to accelerate from this point forward. The company bumped its 2014 production by 1.5%. CHK is looking at a strong 2H14 growth from the Eagle Ford shale following recent step up in production vs. the 2Q14 avg. The company should also see a pickup in Utica Shale growth as the start-up of new processing plants should allow CHK to turn online a large number of wells in 2H14.

This acceleration in growth in the second half of 2014, driven by reduction in uncompleted inventory, also sets Chesapeake up well to grow production meaningfully in 2015. The company expects to grow production at approx. 8% CAGR through 2019 with total production reaching about 1.0 MMBOE/d largely driven by liquids growth in the Eagle Ford and Utica shale and natural gas output growth in the Haynesville and Marcellus shale plays. The company is also expected to increase its leverage to liquids from 30% in 2014 to 36% of total production by 2020. This resulting greater degree of diversification, should in turn lead to more predictable future cash flows.

Conclusion

As I mentioned in the start of this article, Chesapeake has made significant strides in reducing the complexity of its corporate and capital structure since 2013. The company is in a much better shape than it was a couple of years back. Going forward, the key to outperformance of CHK's shares will be in investor confidence that the company can meet its long-term growth guidance without a meaningful increase in capex past 2015. Past 2015 Chesapeake will no longer have the benefit of a large backlog of uncompleted wells and past spending momentum.

CHK continues to simplify its capital structure and its efforts will provide greater transparency to measure its progress towards its other goal of improving capital efficiency. As the company continues to improve its balance sheet and simplify its portfolio, it raises an obvious question will the company be able to maintain production growth in the light of a sharp reduction in drilling activity. I believe as the company continues to take positive steps the share outperformance will depend on the execution of management's strategy to improve capital efficiency through a narrower focus on its highest return projects.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.