Chesapeake Energy Corporation: Non-Stop Drilling

On November 7, Chesapeake Energy (CHK) reported Q3 results (see conference call transcript):

Financial Results

• Once again, the Chesapeake team proved they know how to find gas and lots of it. Daily production increased 27% from Q3 2006 and up 9% from last quarter, to 2.026 bcfe/day. They also raised guidance for 2007 production growth by at least 3%, 2008 production growth by at at least 4% and reaffirmed 2009 production growth rate of 12-16% on a larger base, which is quite impressive.
• Earnings per share fell 39% to $0.76 YOY. Adjusted for one-time gains, diluted EPS came in at $0.69, down 17% from last year and down 3% from last quarter. On a year-over-year basis, operating costs are up markedly while realized prices are down nearly 10%. Compared to last quarter, the trend is not as pronounced but still valid. In both instances, increased production did not fully offset lower margins.
• Compared to last quarter, Q3 had a sharp jump in interest expense. Long-term debt has increased 47% to ~$11B. Obviously, the various current and debt ratios are moving towards a more leveraged reading as a result.
• Operating cash flow [OCF] increased 10% YOY and is holding steady from last quarter. Capital expenditures seem to have
• Ended the quarter with 10.6 TCFE in proved reserves, up 18% YTD, with a reserve replacement ratio of 415%.

From an operational standpoint, Chesapeake's performance this quarter was simply outstanding. For the third largest producer of natural gas to grow both production and reserves at such a rapid pace from a large size is truly noteworthy. The company's current risked potential to proved reserves ratio is 2.1 so there's ample room to run. Perhaps the amazing thing about this is how much room there is -- the company is squatting on 380,000 acres in the Deep Bossier play where Encana has found a monster well and paid $2.5B to acquire 55,000 additional acres. If Chesapeake's land has anywhere near the same potential, this could be a big growth factor.

But this performance comes at a price. The company's debt load has shot up to nearly $11B. Their debt-to-equity is at 0.91 and total-liabities-to-equity is sitting at 1.49, which is a good bit higher from the beginning of the year. Interest expense was up 57% YOY and up 40% just from last quarter. The company reported $715M in EBIT and interest expense of $115B (16% of EBIT).

Management laid out their financing plan for the rest of the year going into early 2008. First, the company will complete their sales & leaseback program. The company also plans on monetizing some mature Appalachian assets by YE 2007 for ~$1.0B. Finally, management aims to monetize their midstream assets with a private MLP, targeting an additional ~$1.0B by Q1 2008. All in all, Chesapeake plans on monetizing $4B of assets by the end of 2009, which combined with increased operating cash flow from higher production and higher credit facilities, should cover their operating costs. The company doesn't project any additional debt increases nor raising equity and should be cash flow positive sometime within the next few years.

While the company's capital structure is a little more aggressive, I think management has a good handle on this tightrope they're walking. They have a good chunk of future production hedged at good levels so cash flow on that front is solid. If they can close on these monetization transactions and increase production and reserves going forward (and they will), everything should work out. If the going gets rough, the company has a lot of flexibility in the capex program to cut back. They've already shut in 3 bcfe of production in the quarter and could shut in more wells, cut staff, etc. if circumstances warrant. McClendon reiterated his point that natural gas supply is robust so management will have to keep on top of their capex to ensure they don't flood the market while maintaining high spending levels.

At this point, I wouldn't bet against McClendon and his team so I think our investment is sitting pretty. I also think that Deep Bossier position could be a real sleeper as well but that's just a hunch so take it for what it's worth. If there is a sharp pullback in upcoming months due to warm winter, oversupply, Mr. Market, etc., it may be a good time to open or add to a position.

Future performance measurements
• Close monetization transactions:
  • Q4 2007: sales/leaseback program for 11 rigs
  • YE 2007: producting property sales in KY & WV -> $1.0B+
  • Q1 2008: private midstream MLP -> $1.0B+
  • Q1 2008: non-core E&P assets in the Rocky Mountains and some sale of Woodford Shale -> $300M
• Production expenses for 2007 to come in at $0.90 to $1 per mcfe.
• No dilution.
• Keep an eye on their balance sheet, cash flow and hedging program. The balance sheet should start to firm up and we should start seeing free cash flow in the next few years.
• Hit guidance: reserves @ 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 (Barnett < $2/mcfe all-in and overall $2.14 for rest of year)

Disclosure: Author has a long position in CHK

Comments

[Georealist]

Keep it up...decent analysis and some meat an investor can get his teeth into. At some near point Nat Gas will not be in such a plentiful supply mode and political events may take coal partially out of play in its favor. CHK (and many others) will really shine.

[jcrash]

CHK and HP, two sooner standouts.

Long both.

[phubaiguy]

CHK is now cutting back on domestic drilling for natural gas as the price has fallen..read this somewhere.