Chesapeake Energy (CHK) is the second largest producer of natural gas in the U.S. with approximately 9% of the market. With the drop in natural gas prices in recent years it has tried to move more of its production from "dry" natural gas to NGL's and oil. It expects to reach 30% liquids production by the end of 2013. With the current low natural gas prices, CHK expects 60% of 2012 revenues to come from liquids production (NGL's and oil). Q4 2011 liquids production was approximately 106,000 barrels per day. This was up 76% year over year and 13% sequentially. CHK will distribute its drilling capex 15%/85% between natural gas and liquids plays in 2012. This is expected to result in another 74% growth in liquids production, which is expected to be 25% of total production by the end of 2012. Liquids production is expected to average approximately 150,000 barrels per day in 2012. That figure should go to 200,000 barrels per day in 2013. CHK is targeting approximately 250,000 barrels per day in 2015. My personal belief is that the 2015 number may be a large underestimate, but it is good that CHK management is being conservative. The chart below shows CHK's projected growth in production.
In response to the low natural gas prices, CHK is substantially reducing drilling activity in natural gas in 2012 to 24 rigs versus 75 rigs in 2011. By contrast CHK will average 133 rigs on liquids rich plays in 2012. CHK is reducing 2012 natural gas capex to $0.9B from $3.1B in 2011. Much of the natural gas drilling will be that necessary for HBP leases. CHK notes that 90%-95% of the necessary natural gas properties HBP (held by production) work has already been done, so there is little chance of losing leases. CHK is curtailing 1.0Bcf/d of its gross operated production of natural gas. It plans to defer new dry gas well completions and pipeline connections whenever possible. It expects all of this to result in a 4% decrease in its total natural gas production for 2012. It is hoping that this reduction will help to buoy prices.
Chesapeake Energy is not just sitting back and waiting for the situation to correct itself. It is actively working to advance initiatives such as the build out of "America's Natural Gas Highway System" with a $160 million investment in Clean Energy Fuels (CLNE). The current plan will add natural gas refueling pumps to approximately 300 truck stops. Only a 1000 more are needed for a national network. CHK plans to rollout its DNG (Diesel Natural Gas) technology this summer. Any diesel engine in the US can be retrofitted to run on a combination of natural gas and diesel. It is working with large OEM truck manufacturers and national trucking fleets to assist in the rollout of a full line of natural gas trucks. It is working with appliance manufacturers to release a CNG (Compressed Natural Gas) home refueling appliance that will sell for $1500 versus today's $5000. CHK has committed $50 million ($250K/station) with other truck stop and convenience store operators (beyond the above mentioned Natural Gas Highway initiative) to add CNG refueling pumps to 200 existing stations throughout the country. Plus it invested $4 million to date with Love's and OnCue to build 40 new CNG stations in Oklahoma. It is working with General Electric (GE) and Caterpillar (CAT) to rollout natural gas powered locomotives. It has invested $10 with 3M (MMM) to make enhanced CNG storage tanks for vehicles. It invested $150 million with Sundrop Fuels to build a demonstration plant that will convert natural gas and waste biomass to tank ready "green gasoline". CHK is doing a lot more than priming the pump for future natural gas demand.
With roughly 9 million net acres in unconventional natural gas plays in the U.S., CHK has an understandable interest in the grow of natural gas usage. With approximately 6.6 million net acres of liquids rich unconventional plays, CHK is far from completely tied to natural gas.
In addition to the above "side ventures", CHK has recently partnered with M3 Midstream LLC and EV Energy Partners LP (EVEP) to build the largest integrated midstream service complex in eastern Ohio for approximately $900 million. This complex will provide the necessary infrastructure to process natural gas and NGLs in the liquids rich Utica shale play in eastern Ohio. CHK has also recently partnered with Kohlberg, Kravis, and Roberts (KKR) to invest an initial combined $250 million to acquire and manage royalty investment opportunities. CHK will only contribute 10% of this. However, CHK will earn a significantly larger share of the partnership by providing its expertise in the energy field. KKR is one of the top investment management companies in the U.S. It is a compliment that they think so highly of CHK's expertise. It is also likely that CHK may improve its management skills through this partnership.
The IEA expects oil demand to rise 60% worldwide by 2020. Most do not believe that oil companies will be able to keep pace with this increase in demand. That means that other forms of energy will have to take up the slack. Natural gas and NGL's are the most facile substitute for oil in the near term. Natural gas demand is expected to grow three times as fast as that of oil from 2010 to 2030. In addition to the above uses for natural gas, NGL's are quickly taking over many of the industrial uses previously supplied by refining petroleum (such as the production of ethylene). The process is often simpler. Plus the NGL's typically sell for $40-$60 per barrel versus the $100+ currently for WTI (even more for Brent Crude). This is leading to an export industry on many of these products as US manufacturing costs are lower due largely to the much lower prices of natural gas and NGLs.
In the shorter term CHK is planning to bolster its balance sheet by continuing it sale of parts of its assets for much more than their original costs via JV's or sometimes just outright sales. It has done many of these in the past, so CHK's claims in this area are very believable. It plans to close on two monetizations in March 2012 for about $2B. One is a VPP (Volume Production Payment) on assets in the Texas Panhandle Granite Wash. Another is the formation of a new unrestricted subsidiary to hold a portion of CHK's assets in the Cleveland and Tonkawa plays. By the end of Q3 2012, CHK expects additional asset sale proceeds of $6B-$8B due to a JV on 1.8 million net acres in the Mississippi Lime play, a JV on 1.5 million net acres in the Permian Basin (or a complete sale of its Permian Basin assets), and various other asset sales. Further it expects monetizations involving a portion of its midstream assets, oil field services assets, and miscellaneous investments. These should amount to approximately $2B. The total of all of this comes to $10B-$12B. The balance sheet shows Total Current Liabilities of only $7.082B and Total Liabilities of only $23.874B. This $10 to $12B should make a substantial dent in those. It should also ensure that CHK can maintain its lucrative liquids development program.
By the numbers CHK sells at a PE of 10.82 and an FPE of 8.49. It pays a non-negligible dividend of $0.35 (1.40%). It is set to see EPS shrink by -35.40% this year (mostly due to low natural gas prices). However, EPS are expected to rebound strongly in FY2013 by 63.00%. Plus CHK has an impressive 13.21% five year EPS growth rate per annum. It is hard to tell exactly how the natural gas prices will behave in the near term. However, both the NatGas Act, which is gaining momentum in Congress, and the coming LNG export capabilities should help to spur natural gas prices higher. The NatGas Act may be approved as early as this spring after Obama included natural gas for trucking in his U.S. energy strategy in his recent State of The Union address. The coming LNG liquefaction (export) terminals in the U.S. and Canada due to start going online in 2015 should also help buoy natural gas prices. The continued increase in both oil and natural gas prices in emerging markets, especially China and India should help to push natural gas prices up. If oil hits $150+ per barrel again soon, which seems more certain daily, oil's higher price will spur the substitution of natural gas for oil in all possible venues. One barrel of oil is the energy equivalent of approximately 5.8mmBTU. This means U.S. natural gas is a huge bargain at today's Nymex Futures price of $2.30/mmBTU (5.8 X $2.30 = $13.34/barrel of oil equivalent) versus the Nymex WTI price of $108.32/barrel of oil. This is about one eighth the price of oil on an energy equivalent basis. On a historical basis, one barrel of oil sells for 6 to 12 mmBTUs of natural gas. The current ratio is 1 to 47 at today's prices. Longer term one would expect natural gas prices to rise at least four fold to get back to the low range of their historical average (8-fold to get back to the high end of the range). Low U.S. natural gas prices are not likely to last more than 1-2 years. The historical norms put US natural gas prices at approximately $9 to $18 per mmBTU based on today's oil price of $108.32.
In sum CHK has a bright future in the energy space. It's great growth in profits may still be a year or two away, but the light at the end of the tunnel is clearly visible at this point. The only real question with this stock is when to buy it. This question is very hard to answer. The market tends to act in advance of events. CHK will be much more profitable at a mere increase of US natural gas prices to $4/mmBTU. Given that LNG prices are roughly $15+/mmBTU in Japan, it is easy to believe that US natural gas prices will go back up to the $4/mmBTU level or higher within the next two years, especially if the NatGas Act passes this year. Even without the NatGas Act, it is clear that industry is making progress toward the adoption of NatGas as a transportation energy source. In my mind CHK is a buy, but it is a buy with the long term horizon in mind. Its 6.6 million net acres of unconventional liquids rich plays are enough to make this so on their own. However, its future is still clearly in natural gas (roughly 9 million net acres of fields) and liquids. CHK is proving itself a fiscally solid company even in adversity. It is the kind of stock that could easily be a 10-bagger over the next five years. In a worst case scenario I see it doubling or tripling in stock price. Plus you get the dividend, which is expected to grow. Peter Lynch was famous for buying stocks such as this before everyone else joined the parade. You might consider doing this too, but do it with a long term horizon.
The two year chart of CHK does not really elucidate the situation. CHK has been trending up lately. However, it was trending down before that on weak natural gas prices. Analysts were also concerned about its finances. However, last year's monetizations combined with those planned for 2012 have made many analysts come to see CHK as much more stable. The chart shows its stock price ($25.06) is near its long term base of $20-$22. The fundamentals tell you the odds favor upside from here. The base tells you there is likely little downside. I like this stock even for troubled times, but buy it with a long term horizon.
Good Luck Trading.