Chesapeake Energy: Production Growth And Cash Flow Growth Ahead

| About: Chesapeake Energy (CHK)

I was having a read of the Chesapeake Energy (NYSE:CHK) Q4 earnings results and as usual I was amazed at the size of the company's natural gas production growth.

Of course, the natural gas production growth for Chesapeake, like it is for many other American producers, is coming entirely from shale gas. And while the production growth for Chesapeake and several of its peers is amazing, it is also a problem. Production has grown so much that there is now simply too much natural gas supply. It has overwhelmed demand and has killed the price of the commodity these companies produce.

For the full year 2011, Chesapeake grew production 15% despite selling a large amount of producing properties during the year. If you were to add back the sold production, Chesapeake production would have grown 26% year on year.

Production growth of 26% year on year is an impressive amount of production growth for any company. When you consider that Chesapeake is the second largest producer of natural gas in the United States, it is astounding. This isn't a small production increase, it is a huge production increase and one Chesapeake manages to accomplish every year. Chesapeake basically adds production every year that is equal to the size of a top ten natural gas producer. Yet the stock price goes nowhere.

Looking at this production got me to thinking: Whatever happened to that 'shale gas ponzi scheme' that the New York Times was writing about last summer? I thought that there was a pending collapse in shale gas production coming once these shale wells started to age and reveal their true and not exaggerated decline curves? I thought that the production curves that the shale gas producers were modeling were supposedly greatly overstating production beyond the initial year?

Here we are at least three years into depressed natural gas prices caused by shale gas production, and yet we are in a worse case of oversupply now than at the start. These shale gas wells must not be collapsing, they must be outperforming. How else can you explain production stubbornly staying so strong in a declining price and rig count environment?

I'm a Chesapeake shareholder. I'm not in love with the management team and the questionable compensation practices of the Board of Directors, but I've learned to respect the value of the assets the company has assembled. And I have always been amazed at the quarter after quarter, year after year production growth the company has been able to create.

And as a shareholder, I'm excited for future production growth, but not natural gas production growth. I'm excited to see if Chesapeake can now grow oil and liquids production over the next five years, the way it grew natural gas production over the last five years.

In the Q4 earnings release Chesapeake laid out its aggressive oil and liquids growth plan:

As a result of continued strong operational results and increased drilling activity in liquids-rich plays, Chesapeake has increased its current liquids production to more than 110,000 bbls per day. The company projects that its 2012 net liquids production will increase by approximately 63,000 bbls per day, or more than 70% year over year, to an average of approximately 150,000 bbls per day. Additionally, Chesapeake projects that its liquids production will average more than 200,000 bbls per day in 2013 and 250,000 bbls per day in 2015. Relative to its liquids production rate of approximately 32,000 bbls per day in 2009, Chesapeake believes that its liquids production growth of approximately 220,000 bbls per day from 2009-2015 will represent the best track record of liquids production growth in the U.S. and one of the best track records of liquids production growth in the world during this period.

I think this is the biggest thing that the stock market is missing about Chesapeake today. Can you imagine how excited the stock market would be about an oil and liquids producer that was going to grow production from 32,000 barrels per day in 2009 to 220,000 barrels per day in 2015?

Instead, this high value oil and liquids growth is hidden inside a giant natural gas producer. I believe that once this oil and liquids growth starts showing up on the cash flow statement, the stock market will have to recognize the value. Remember that one barrel of oil and liquids production will create multiples of cash flow that an equivalent amount of natural gas produces. That increase in return on capital put into the ground will show up.

Chesapeake is going to go from a company with production growth but no cash flow growth (because of decreasing natural gas prices), to production growth and cash flow growth.

Net Cash Inflow From Leasehold Activity in 2011

One final observation I'd like to make about Chesapeake's earnings release. Chesapeake is always criticized for spending too much cash acquiring additional acreage. This is the number one analyst concern and a big drag on the stock price.

This issue is where I completely disagree with Mr. Market. I think Chesapeake's leasehold activity is the single best thing about the company.

I'll leave it to comments from Chesapeake CEO Aubrey McClendon that can be found in Seeking Alpha's conference call transcripts to explain why:

With regard to unproved leasehold, always a popular topic among observers of our company, we invested $3.5 billion during the year and collected $4.4 billion in sales of unproved leasehold, resulting in a net cash unproven leasehold inflow of $900 million. At the beginning of the year, I committed that our undeveloped leasehold sales would be at least equal to our undeveloped leasehold acquisitions during 2011. As you can see, I was off by $900 million, but off to the good side. I further commit that in 2012 and 2013, we will also likely generate more cash from undeveloped leasehold sales than we will spend in undeveloped leasehold. Please keep in mind that these numbers are cash-only and excludes the benefit of drilling carries that we receive when we sell portions of our undeveloped leasehold. If we included carries in our calculation of the leasehold sales, these numbers would obviously look even better. The final takeaway, I think, on leasehold investment should be this: Whatever we spend on leasehold acquisitions in a given year, we will more than offset it from undeveloped leasehold sales.

How are we able to continue doing this, you might ask? It's actually quite simple. Chesapeake is the best in the industry at finding new unconventional plays, acquiring big leasehold positions in the heart of the plays, and then selling off a minority interest to a bigger company from elsewhere in the world that cannot do what we do but has access to capital that we do not have. These are truly symbiotic relationships that benefit both companies, and I'm proud to say that Chesapeake was the first to recognize this extraordinary business opportunity back in 2008. Today, we have -- to date, we have entered into 7 JVs that have generated $7.1 billion in cash from undeveloped leasehold sales and $9 billion from drilling carries for a total value generated of $16.1 billion. Our cost basis in the assets sold was only $3.8 billion. That's an economic profit of $12.3 billion or more than a 3:1 return. However, again, due to the conservatism of full cost accounting, none of these gains are presented in our income statement.

In 2011, Chesapeake had a net inflow from leasehold activity. The company was able to add billions of dollars in acreage and get paid for doing it. And for some reason the stock market doesn't like that. Imagine if you could strike a deal to buy a farm, then sell 20% of the acreage of the farm for more than you paid, and still keep the other 80% of the farm. Wouldn't that be great? That is what Chesapeake is doing over and over again with natural gas and oil/liquids resource plays.

I'm not sure anyone needs to rush out and buy Chesapeake today, as natural gas prices are likely going to stay pretty low for the foreseeable future unless that shale gas ponzi scheme suddenly becomes real. But over the next several years I plan on being a shareholder so I can ride the Chesapeake conversion to oil and liquids to a higher stock price.

Disclosure: I am long CHK.