Q2 2016 May Be The Turnaround Quarter For Chesapeake Energy

| About: Chesapeake Energy (CHK)

Summary

In Q1 and Q2 of 2015 Chesapeake Energy declared impairments of about -$5B per quarter for losses on reserves due to lower oil prices.

In Q1 2016, it declared impairments of only -$853 million on oil and nat gas properties - mostly due to the drop in the 12 month rolling average price of oil.

The price of oil has on a yearly average still been trending downward for two years; but this trend has been slowing considerably of late.

Further Chesapeake Energy has been cutting virtually all of its costs. It has gone to longer laterals in drilling, etc. This has allowed much lower development costs per boe.

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Chesapeake Energy Corp. (NYSE:CHK) is an oil & natural gas exploration and production company. It is one of the larger unconventional oil & natural gas drillers in the US, with 8,171,000 net acres of prolific oil & natural gas fields as of December 31, 2015. 4,128,000 net acres of the above 8,171,000 net acres are "developed" net acres. In other words, the leases are held by production.

In its Q1 2015 earnings report, Chesapeake Energy took an impairment charge of $4.976B. CHK wrote down the value of its oil & gas properties/reserves due to the large drop in the rolling 12-month, first-day-of-the-month average price of its commodities: oil, natural gas, and NGLs. In Q1 2016 it took an impairment charge of $853 million. This accounted for most of the net loss of $964 million for Q1 2016. This is a far cry from the more than five fold greater write down in Q1 2015. By itself, that is encouraging news. The net loss for Q1 2016 was only -$111 million without the reserves writedowns; and the reserves writedowns are clearly decreasing.

Almost all of the impairment charges were due to lower oil and natural gas prices. The article, "The Current Oil Outlook: Is It Time To Start Buying Oil Companies?", gives an in depth look at the near and medium term outlook for oil prices. Further Goldman Sachs (NYSE:GS) said it expected WTI oil prices to average $45/barrel in Q2 2016 and $50/barrel in 2H 2016. That should be a positive for a CHK turn around. Any writedowns in reserves should be less. Plus CHK now believes it can profitably develop at prices of $45 per barrel and above due to its technical advances over the last two years. In rough confirmation of this the EIA estimates as of June 7, 2016, that the WTI spot price will average $42.83/barrel for FY2016 and $51.82/barrel for FY2017.

However, one must take all estimates such as the above ones with a grain of salt. The US itself could easily ramp up production. China could stop adding to its strategic reserves. Libyan and Nigerian oil production could come back online, etc. Such factors will likely prevent oil prices from rising too quickly. Still, investors have to go with the best forecast they have; and slightly higher oil prices are the best forecast investors have right now.

Not only is the oil supply and demand situation forecast to get much better; but US natural gas prices have risen dramatically since mid-May 2016 from about $2.30/mmbtu to about $2.99/mmbtu at the close on July 1, 2016. The following chart of the Henry Hub Natural Gas Price Forecast shows that the EIA expects to see prices trending higher from $3/mmbtu in coming years.

As readers can see above, there is a lot of potential upside; but the expectation is for $3.00+/mmbtu for some time. Still this is probably a number that CHK can live with. The supply and demand forecast curve below shows where some of the surprises may come in.

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The above chart was from an April 7, 2016, Forbes article that predicted US natural gas prices would double. Of course, when it was written US Henry Hub natural gas prices were at about $2.20/mmbtu. Now they are at nearly $3.00/mmbtu. As of June 7, 2016, the EIA forecast for US Henry Hub Spot Prices for FY2016 was $2.29/mmbtu. For FY2017, the forecast is $3.05/mmbtu. The article is trying to point out that the expected supply deficit by November 2016 should push prices upward in the meantime; and it appears that the EIA agrees with it. Remember natural gas prices do tend to go upward as we move toward winter. Usage is considerably higher in the winter months.

Not only have the prices of oil and natural gas improved recently, CHK has been doing many great things to improve in engineering (cheaper and better) and in finance. Some of these actions are below:

  • CHK has sold $1.2B in assets so far in 2016; and it intends to sell at least $1.2B-$1.7B. In other words, it has already reached the bottom delimiter of its guided range. The net from the $1.2B in property sales will only be about $950 million. VPP contracts have to be repurchased (or may have been by now). This may sound bad, but it does simplify CHK's complexity of structure, which most consider good. Further, it only subtracts 35,000 boepd from FY2016 production and about $45 million from FY2016 EBITDA.
  • CHK got relief on its covenants when it amended its $4B revolving credit facility through at least March 2017. It is not subject to a redetermination until June 2017. It also got more flexibility in issuing new secured debt. In return, CHK pledged more properties.
  • CHK is actively trying to renegotiate its gathering and transportation agreements; and it is making progress.
  • CHK has allocated 50% of its Drilling and Completions capital budget in FY2016 for inventory drawdown (i.e., for completions of already drilled wells). This should mean it will bring more production online for a much lower cost in FY2016. It is also working on its engineering to reduce the base decline rate for wells by 10%. Capex was down 75% in Q1 2016. It is on track for a 50% reduction on the year. The chart below left shows the expected reductions in Capex; and the chart below right shows the production (unadjusted for asset sales) expectations.

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  • CHK is also planning to reduce its General and Administrative Expenses by -15% per Boe. It is planning to reduce its Lift Operating Expenses by -10% per Boe year over year. The charts below show the planned impacts of these moves.

  • CHK has been working continuously to decrease its Finding and Development costs. The charts below show the progress it has been making in its various development areas. The charts show D&C $/net EUR (Expected Ultimate Recovery) in Boe.

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  • As part of the above CHK has been improving its well development efficiency. It has been increasing lateral lengths for both natural gas and oil wells. These have been decreasing overall costs and increasing production from each well. For example, in the Haynesville field the long laterals provide a 63% increase in 160-day cumulative gas production. In another example, at $45/barrel CHK expects its FY2016 Eagle Ford development program to outperform its Eagle Ford program in FY2014 at $80/barrel. CHK expects a 25%-50% ROR.
  • CHK has reduced the amount of puttable debt maturing in 2017 by about $600 million from September 30, 2015 to March 31, 2016. CHK exchanged debt. It bought back its own debt when it was trading at a huge discount to face value. CHK also did equity for debt exchanges. Most expect more of the debt for later debt exchanges and more equity for debt exchanges. This last could lead to some stock dilution.
  • CHK has fairly good hedging for the rest of 2016. It has 476 Bcf of natural gas hedged at an average of $2.71/mcf (about 64% of the Q2-Q4 2016 natural gas production). It has about 18.2 million barrels of oil production hedged at $46.32/barrel (about 69% of Q2-Q4 2016 production). These are relatively good numbers, when you consider the statistics predicted for the Eagle Ford development in FY2016.The NGLs are approximately 38% hedged through 2016E. The FY2017 hedges acquired thus far are 73 Bcf at $2.92/mcf and 2.9 million barrels of oil at $42.53/barrel. This is a higher rate for natural gas and a lower rate for oil. This last is a bit worrisome. However, the current EIA average FY2017 WTI spot price is $51.82/barrel. This should mean oil prices will trend in that direction toward the end of 2016. It should also mean that CHK should be able to obtain swaps that are nearer $50+/barrel toward the end of the year. Only time will tell though.

The book value of CHK is given as -$2.56 per share for Q1 2016. This sounds terrible until you remember that CHK has been writing down book value for the last two years. If you ballpark estimate about $5B in writedowns per quarter last year, you get about $20B in writedowns. That equates to about $2.8 per share; and that is without taking into account the 2014 writedowns. Plus the lower development costs noted farther above should push more reserves back into "legal" existence. In a recent forecast, the IEA called for $80/barrel oil in 2020. It expects further increases after that. At that point, CHK should be worth a lot more in book value. CHK's price to sales ratio is only 0.25x. This is far below the industry average price to sales ratio of 5.75x (TD Ameritrade). That means CHK is a relative bargain by this measure. Finally natural gas prices are expected to go up longer term as more natural gas is exported to Mexico via pipeline. More will also soon be exported to places like Japan via LNG exports. Further US electrical capacity is expected to expand; and some of the expansion is expected to be in natural gas powered power plants. The EIA price chart estimates above are solidly trending upward (see chart further above).

In sum there can be no specific claims made about CHK's reserves at this time. However, a formerly much higher book value when oil and natural gas prices were higher leads one to expect that CHK's book value will recover significantly by 2020. More immediately the writedowns of reserves are about to cease. That means the losses by the company (-$964 million in Q1 2016) are set to cease if the -$853 impairment charge in Q1 2016 disappears. When you remember all of the strategies to cut costs and improve efficiency described above, the non-impairment related losses should not only disappear; they should turn into profits. I do not mean to say that all the future impairment charges have been taken. However, CHK should be getting close to that. Remember the Q1 2015 impairment charge was -4.976B and the Q1 2016 impairment charge was only -$853 million. It is easy to see the possibility and even the likelihood of a reversal to increasing reserve estimates (increasing book values) in the near future. When CHK technically becomes profitable again, that should mean a move upward for the stock. If there are further technology improvements, they should only speed up the process of regaining and extending book value.

The two-year chart of CHK provides some technical direction for a trade/investment.

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This chart shows that CHK appears to have bottomed. There does seem to be a slight uptrend. If oil and natural gas prices are expected to rise into 2017, then it makes sense that CHK's stock price should be able to rise too. If you evaluate the stock price based more on its price to sales ratio than on its book value or its P/E ratio, then it is easy to see a lot of upside for CHK from approximately here. If you are willing to think longer term, CHK is a BUY at this time.

We could see a recession. In fact, Deutsche Bank on July 5, 2016, said there was a 60% chance of a recession in the next 12 months. Readers should consider that. It could mean that oil prices will tank soon. That could put CHK in jeopardy of bankruptcy. On the other hand, CHK is looking increasingly profitable even at low oil and gas prices. It appears that it will be profitable by 2017. That in itself could cause a rise in the stock price. Plus with the likely profitability soon at low oil and natural gas prices, CHK should survive a recession. This could mean your investment will go nowhere quickly. However, if you are prepared to wait long term, CHK may provide a good return on your investment, especially if the IEA is correct about $80/barrel oil in 2020. With the recession possibility in mind, I would lower my rating of CHK to a LOW BUY. Still it looks better than a lot of other investments in the market currently.

NOTE: Some of the above fundamental fiscal information is from Yahoo Finance.

Good Luck Trading/Investing.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.