In my pre-earnings analysis for Chesapeake Energy (NYSE:CHK) I mentioned that investors should watch for hedges and production. Today the Chesapeake released Q2 results, and while the management made some improvements, they were only satisfactory in one of those areas.
As expected, 2016 hedges decreased, showing one quarter of "usage." Open oil (NYSEARCA:USO) swaps for the remainder of 2016 decreased from 18,239 Mbbl to 12,144 Mbbl and open natural gas (NYSEARCA:UNG) swaps for the remainder of 2016 decreased from 476 Bcf to 358 Bcf. Previously I mentioned that the management should establish more hedges to ensure the stability of future cash flows. Given the above declines, it's clear that the management didn't add much 2016 hedges.
There was a big jump in long-term swaps. Crude swaps more than doubled from 2,920 Mbbl to 7,665 Mbbl and natural gas swaps increased from 73 Bcf to 267 Bcf. However, these additional hedges will cover less than a quarter of production (8000 Mbbl/quarter of oil and 270 Bcf/quarter of natural gas), so we have no visibility beyond early 2017.
Absolute production fell slightly quarter over quarter. Oil production dropped from 9 MMbbl in Q1 to 8 MMbbl in Q2, natural gas production dropped from 276 Bcf to 269 Bcf. A big contributor was the various asset sales that the management announced earlier in the year. Adjusting for those asset sales, production was essentially flat quarter over quarter. Moreover, H1's adjusted production actually increased by 1% year over year. A stable production rate is paramount for Chesapeake, as any declines will offset any positive impact from commodity prices.
The management is also guiding for a potential increase in production for the entirety of 2016, adjusted for asset sales. Previously they were expecting a decline of 5% to 0%, now the expectation is bumped to -3% to +2%. Evidently, the management has done a very good job of managing the natural decline of production.
Debt has always a source of concern with Chesapeake. The company ended the quarter with $8.7 billion of debt, with $1 billion due over the next year (including the puttable bond). I have no doubt that the company can afford to pay off this debt given $3.9 billion of undrawn capacity on the credit facility. Furthermore, the management announced additional asset sales, bumping expected asset sales in 2016 from $1.5 billion to more than $2 billion. However, it's important to understand that the company remains exposed to fluctuations in commodity prices. As mentioned at the beginning of the article, the hedges are not complete. 30% of 2016 production remain exposed and only a quarter of production is protected in 2017, assuming most of the long-term hedges fall in 2017. Considering that there may be another redetermination as soon as June 2017, the company is far from immune.
Overall, I believe that it was a satisfactory quarter. The management has made some progress on hedges, but I would feel far safer had they established more protection. The expected increase in production was a nice surprise, this ensures that Chesapeake will be able to capture future appreciation in oil and natural gas. The company is in a good liquidity position. With $3.9 billion of capacity left on the credit facility and future asset sales, the short-term outlook remains positive. However, the company will still be exposed to future fluctuations in commodity prices, which could negatively impact cash flow and the result of the next redetermination.
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