I remember vividly the early summer of 2008. Natural gas was over $10 per mm/btu and Chesapeake Energy (CHK) was sitting on top of the world with a newly announced $3.3 billion joint venture with Plains Exploration (PXP) and a $60 stock price. And then the world that Chesapeake was sitting on top of fell apart. Natural gas prices started falling relentlessly and are still, three years later, in the dumper at around $4 per mm/btu. Chesapeake’s CEO Aubrey McClendon in the fall of 2008 lost virtually all of his ownership interest through margin calls relating to money he had borrowed to buy shares of Chesapeake. And the share price of Chesapeake collapsed to as low as $11.32.
The financial panic and great recession were the main cause of the initial collapse in natural gas prices. What has kept prices so depressed is the flood of natural gas that is now available because of the success of Chesapeake and other companies in developing shale gas resources.
It has to be frustrating to have accomplished what Chesapeake and others have in amassing massive shale gas resources only to have the value of those assets reduced because there is now too much of the product.
Chesapeake is at the head of the class when it comes to shale gas. Consider the following:
It's the second-largest producer of natural gas in the United States (amazing for a company that was a tiny independent a decade ago); is the #1 driller of horizontal wells and #1 driller of horizontal shale wells; has the #1 acreage position in the Marcellus shale; has the #1 acreage position in the Haynesville shale; has the #2 acreage position in the Bossier shale and the #2 acreage position in the Barnett shale.
Given the massive natural gas resources Chesapeake has, if natural gas prices were to improve from the current level of $4 per mm/btu and stabilize in the $6 to $7 per mm/btu range, tens of billions of dollars of value would be created for Chesapeake shareholders. And Chesapeake, the company that had the lead role in killing natural gas prices with oversupply, seems determined to take the lead role in fixing the price of the commodity that they broke.
There are two parts to Chesapeake fixing the price of natural gas, the first of which is to make natural gas a bigger part of fueling United States transportation. Chesapeake recently made a couple of announcements relating to steps it's taking to get the United States to embrace natural gas as a transportation fuel. Chesapeake isn’t going to sit back and wait for the government to help push along a move to natural gas-fueled transportation. Chesapeake is going to get this program jump-started.
One big challenge to moving the United States to natural gas as a transportation fuel is the simple lack of natural gas fueling stations. Chesapeake is trying to help with this by partnering with Clean Energy Fuels (CLNE) specializing in providing LNG fueling infrastructure. Chesapeake has agreed to invest $150 million in newly issued convertible debt of Clean Energy Fuels, which will use CHK’s $150 million investment to accelerate its build-out of LNG fueling infrastructure for heavy-duty trucks at truck stops across interstate highways in the U.S., thereby creating the foundation for “America’s Natural Gas Highway System.”
This investment alone is projected to help underwrite approximately 150 LNG truck fueling stations, increasing by more than tenfold the number of publicly accessible LNG fueling stations and providing a foundational grid for heavy-duty trucks to have ready access to cleaner and more affordable American natural gas fuel along major interstate highway corridors. Chesapeake believes $1.5-2.0 billion of LNG truck fueling stations puts entire heavy truck fuel demand market in reach for natural gas substitution. More detail can be found here.
An alternative is to find a method to convert natural gas into a liquid form that can be used in our transportation infrastructure. Chesapeake has ventured down that road with an investment in Sundrop Fuels Inc. that is attempting to create a “green gasoline” from natural gas and cellulosic material. Chesapeake has agreed to invest $155 million for a 50% ownership stake in Sundrop Fuels, Inc. The investment over the next two years will fund construction of the largest nonfood waste biomass-based “green gasoline” plant in the world, capable of annually producing more than 40 million gallons of ultra-clean liquid transportation fuel from natural gas and waste biomass. The plant will utilize Sundrop Fuels’ proprietary gasification process coupled with proven methanol-to-gasoline process to produce gasoline, rather than the more expensive Fischer-Tropsch process producing a wide variety of hydrocarbons that require further refining or processing.
For the past three years, there has been a lot of drilling for natural gas in resource plays that is not economic or barely profitable. A big driver of this drilling has been that companies like Chesapeake under lease terms had to have a producing well drilled on a given piece of land or the lease would expire. So while the wells being drilled aren’t economic, in the future they likely will be, and it was imperative for these companies to hold their acreage through production.
That forced drilling is coming to a conclusion. Chesapeake is the perfect example. At the high point of its drilling, Chesapeake was using 36 rigs in the Haynesville and Bossier resource plays to drill wells and hold acreage. It's now down to 33 rigs, nine of which are drilling their last wells and by the end of the year Chesapeake expects to be down to 15 wells.
Chesapeake is the single most active driller in the United States and isn't the only company that is shutting down natural gas drilling and moving those rigs to unconventional oil plays. This is going to start to have an impact early next year as unconventional gas wells have very high first-year decline rates and a big drop in drilling is going to show up in production.
If natural gas goes back to $7, Chesapeake is a home run. One thing I know for certain: If we get a big rebound in natural gas prices, Chesapeake is going to be a home run investment at $30 to $35 per share. It looks like factors that will create that rebound in natural gas are starting to line up.
Disclosure: I am long CHK.