Chesapeake's Low Realized Commodities Prices Could Bring Down Its Earnings

| About: Chesapeake Energy (CHK)

Summary

Chesapeake recorded very low realized prices in recent quarters.

One reason is the high discount basis on natural gas prices.

Another reason is the company’s hedging strategy.

Chesapeake Energy (NYSE:CHK) didn't do well in the past quarter, as the company's earnings didn't reach markets expectations. This came even though its oil equivalent production rose by 2.6% to 63.2 mmboe, which was close to its updated 2014 guidance. The low realized prices of natural gas and oil dragged down its earnings. Looking forward, this issue could, over time, bring adversely impact its bottom line. Let's further explore this issue.

Second quarter prices

In the past quarter, the company's realized prices were very low compared to the market prices as presented in the table below.

Source of data: Chesapeake's website

Chesapeake addressed this issue in a news release before the publication of the second quarter earnings report and attributed the low realized natural gas prices to "basis discounts" to the Henry Hub at certain delivery points. The range of the discounts was wide - between $0.92 and $2.32.

But this is only part of the story. The other part is the company's hedging system, in which Chesapeake uses three way collar contacts (among other hedging strategies). The problem with this type of hedge is that if natural gas price rise above a ceiling price (in the second quarter the average ceiling was $4.38), the company needs to pay up. Of course, the exercise date and the prevailing market prices at that time are key issues to determine the actual loss or gain from these hedges, but the bottom line still reads a substantial hedging loss.

In the past quarter, the loss from derivatives in natural gas was $0.21 per mcf and $12.26 per bbl for oil. Based on these figures and the production recorded in the second quarter, the losses come to nearly $210 million. These losses dragged down the company's revenue in the past quarter.

First quarter prices

In the first quarter, the situation wasn't much better, with realized oil prices reached $85 a barrel, while the average market prices of oil were much higher at around $98 a barrel.

The table below summarizes the difference between the realized prices and market prices.

Source of data: Chesapeake's website

Moreover, in the first quarter the gap between the sales price of natural gas and the realized price was 59 cent per mcf. For oil prices, the difference was around $8.5 per bbl. Based on the natural gas and oil production in the first quarter, these losses came to nearly $240 million.

The company's natural gas operations account for nearly 45% of its revenue from production; oil also accounts for a similar share out of revenue.

The stock and commodities prices

Even though natural gas prices reached very high levels back at the beginning of the year, it seems that Chesapeake's earnings didn't benefit from these gains. But the company's stock benefited from the rise of oil and natural gas prices earlier this year. Further, the company's stock has a mid-strong correlation of 0.3 with natural gas and 0.2 with oil prices. An oil/natural gas index, which is a mix of 50% oil and 50% natural gas (a similar mix of Chesapeake's revenue from natural gas and oil), has a slightly higher correlation of 0.33.

The chart below shows movement of Chesapeake's stock with respect to this oil/natural gas index normalized to the beginning of the year.

Source of data: Google finance

As you can see, Chesapeake's stock movement is partly linked to the shifts of oil and natural gas, even though the company didn't benefit from the high prices earlier this year.

Other oil and natural gas producers including Anadarko Petroleum (NYSE:APC) faced losses from commodity derivatives. But the situation is less dire for Anadarko Petroleum: In the second quarter, the company had a $151 million (after tax) loss from commodity derivatives. Nonetheless, Anadarko Petroleum sold its commodities at a much higher price than Chesapeake: The average price of natural gas was around $4.16 and oil prices were at $102.04 per bbl (in the U.S alone the price was $98.69 per bbl).

Therefore, investors of Chesapeake should take into account the relation the company has with commodities prices and even if natural gas or oil prices were to resume their rally, it doesn't necessarily mean Chesapeake will benefit from this turn of events and show higher earnings in the coming quarters.

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.