Chesapeake Energy (NYSE:CHK) reported 2nd quarter results a week and a half ago (see conference call transcript). This is one of my earlier research reports so I don't have a set of performance measurement standards laid out for them but will formulate them for this update going forward.
The big numbers were captured in the production and reserve boosts. Production increased 19.1% YOY and a whopping 9.4% just from last quarter. The company is claiming to be the largest independent US gas producer and number 3 overall, behind just ConocoPhillips (COp) and BP (NYSE:BP). The company has already reached their full-year 2007 reserves guidance of 10 tcfe. The company raised production guidance by 400 basis points going forward for both 2007 and 2008 and is estimating 10% organic growth in 2009 (from a much larger base). Earnings per share up substantially to $1.01 from $0.82 YOY. Adjusted for one-time gains, EPS came in at $0.71 which is 18% lower YOY, mainly due to lower natural gas prices and higher operating costs YOY. Compared to 1st quarter numbers, operating costs are flat to slightly down, which is good news. Operating cash flow [OCF] increased 18% YOY. Per share, OCF was basically flat.
Chesapeake is usually straightforward and transparent on business strategies but this conference call was especially illuminating. As I noted in the original investment report, the biggest risks to our investment are Chesapeake's capital structure and their dilutive tendencies. Company gave good visibility on both concerns as well as their hedging policy and future outlook for the industry.
Management is actively managing their budget gap. Their current ratio is poor and if you take into account their off-balance sheet obligations (about $400-500M this year, 20-25% additional to current liabilities), they've got a little funding problem. Management laid out three strategies for dealing with the funding shortfall: selling producing properties into the MLP market (they hope to cull $600M from a sale later this year), arranging 2nd sale leaseback transactions with their drilling rigs and compressor assets and selling volatility, i.e. their hedging program. They noted that selling 2009 $10 calls are returning $1 cash today. They anticipate reaching OCF:CapEx equilibrium in 2009.
CEO Aubrey McClendon and company are also acutely aware of the perception that CHK overly dilutes their equity. While they reserved the right to issue equity if it made sense, the management made clear that dilution is not the 1st or even 4th option in their playbook.
Some other interesting comments included Chesapeake's hedging program as it relates to the industry overall. McClendon sees natural gas trading in a range of $6-9 over the next few years and they welcome that prospect. Their stance is that higher prices lowers demand from utilities. He also suggested that even though natural gas supplies will be sufficient going forward, it's only a handful of companies in unconventional plays (like the Barnett Shale) that are driving production growth. Combining that fact with 35% depletion rates, they conclude almost no possibility of natural gas prices seeing a sustained (at least 6 months) drop below $6. In this environment, Chesapeake's play on natural gas volatility is beneficial for the company and historically, they claim a win-loss ratio on their hedges of 6:1.
They also revealed no desire to form a MLP due to governance and tax headaches (though they did rate that option as more attractive than issuing equity for raising funds). The company dismissed any thoughts of spinning off their most attractive growth plays or splitting up the company, citing economies of scale (they have in-house drilling, compression, seismic, etc).
My take on all this is fairly positive. Personally, I interpret McClendon's statements on natural gas supplies as an attempt to play down fears of peak gas. If peak natural gas is a possibility, it would make no sense to build natural gas plants to replace coal-fired ones. I see natural gas prices higher than their range so the hedging is actually a little negative. But even taking his comments at face value, our investment appears safe. The budget gap is a little worrisome but they have ample assets to make up any shortfall and if times got really hard, there's a lot of room to cut expenses. So I have confidence that they will handle their balance sheet and cash flow.
On the operational side, Chesapeake is a drilling machine. Since they handle much of the field services in-house (drilling, seismic, etc.), they should be able to control costs better than some of their competitors. Also, they admitted that their reservoir engineer tends to sandbag estimates so it's important to keep that in mind when discussing their production and reserves. Both should grow for the foreseeable future.
Future performance measurements:
No dilution. Keep an eye on their balance sheet, cash flow and hedging program. Hit guidance: reserves at 12-12.5 tcfe by YE 2008 & 13-14 tcfe by 2009 Production of 2.5 bcfe/day by YE 2009 as well as OCF:CapEx equilibrium Maintain 2:1 ratio on risked/unproved to proved reserves. Large decline may signal end of growth. Keep operating costs in-line ($2/mcfe all-in and overall $2.14 for rest of year)
Disclosure: Author has a long position in CHK
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