Sizing Up Chesapeake's Permian Basin Asset Sale

| About: Chesapeake Energy (CHK)

Chesapeake Energy (NYSE:CHK) recently announced its intention to sell its Permian Basin assets. The Permian is a well-established basin with oil and gas activities originating in the early 1930s. It is composed of a number of sub-areas, including the Northwest Shelf, The Midland Basin, The Central Basin Platform and the Delaware Basin, with the two basins sitting on each side of the platform.

Originally, a significant portion of conventional activity occurred on the Central Basin Platform and later enhanced oil recovery techniques were applied to this area and others. In recent years, the industry has increased non-conventional production in the Midland and Delaware Basins.

The Permian is a liquids rich play, with most companies in the area reporting about 75% of non-conventional production coming from oil and NGLs on a volume basis, with oil making up a clear majority between the two at about 40%-45% of the total. With the differential between oil and NGLs growing over the past year, the importance of oil has become even greater in evaluating plays and in this regard the Permian is one of the better shale plays in the U.S.

Chesapeake holds 1.5 million net acres in the Permian, making it one of the largest landholders in the area. In the Midland Basin, the company holds land in the Wolfcamp, Spraberry and Stawn plays, while in the Delaware Basin, the company holds land in the Wolfcamp, Bone Spring and Avalon plays. The Wolfcamp play straddles both basins although the majority of activity is in the Midland Basin.

Chesapeake has stated that its Permian assets represent about 5% of total production. Looking at public well records, it appears the company's oil properties in the region constitute a couple percentage points over the company's quoted 5%, implying that Chesapeake's natural gas share is lower than 5%. Since the play is liquids rich, this appears sensible. Another fact gleaned from public well records is that current production seems weighted toward the Midland Basin, with decent activity in the Spraberry play.

Although Chesapeake is a major landholder in the Permian, its share of production is much smaller. This follows from the company's claim that it is a top three landholder and only a top 10 producer, but can also be cross-checked by looking 5%-8% of the company's 2011 liquids production of about 85 mboe/d, which implies 4.2 to 6.8 mboe/d of Permian production. Even doubling this figure to account for the natural gas leaves the company far short of competitor's production per net acre. Devon and Apache both maintain about 1.5 million net acres and have production of about 53 and 84 mboe/d day in the Permian, respectively. Not all acreage is created equal however, and it is possible that Chesapeake's acreage, while large, is of lower quality, but it is more likely that it is just undeveloped.

Considering these facts it becomes apparent that Chesapeake's desire to sell its Permian assets is due to the likely low cash generation profile due to lack of development. The company has established a nice land position, but without production, it represents idle capital. In order to develop the resource, the company would need to invest significantly, which represents a problem due to Chesapeake having more projects than it can currently finance. Another related issue to consider is the lack of takeaway capacity in the region as the majority of pipeline capacity is filled at the present time. Although new pipelines are under construction, many players are also fighting for that new capacity as they ramp up their capital plans in anticipation.

One of the larger, established players in the Permian may find the Chesapeake assets represent a good investment and potential shareholders may be able to benefit from a sale that does not come at a premium. There are six large players in the region that are possibilities:

Occidental Petroleum (NYSE:OXY) is the largest company of the six, with an enterprise value of $70 billion. The company has 2.4 million net acres in the region with production of 204 mboe/d, mostly in enhanced oil recovery of conventional resources and has 26 rigs working. Given Occidental's size, it would not be an issue to acquire Chesapeake's holdings in the area, regardless of its current cash position or credit metrics which are sound. The major issue for Occidental is to what extent it wants to press its bets on non-conventional production. The company maintains 1 million acres of land in areas associated with such production in the Delaware and Midland basins and adding substantially may be more than it is willing to contemplate.

Apache (NYSE:APA) is the second largest player in the Permian in terms of local production with 84 mboe/d. The company's enterprise value is $40 billion, giving it the muscle to make an acquisition, although the company is light on cash and has been involved in a number of large acquisitions in the last several years. While rated A3/A-, after the acquisition of Cordillera, management stated that the amount of equity issued in the deal was directly related to keeping its rating; therefore, it can be inferred that the company would like to maintain its current rating. In order to acquire the Chesapeake properties, it is likely an equity issuance would be required, but given the low multiple the stock is trading at, it is likely in my view that the company would refrain from a transaction at this time unless the terms were quite favorable.

With the recent purchase of Three Rivers, Concho Resources (NYSE:CXO) controls production of 83 mboe/d in the Permian, its only resource basin. The company's enterprise value is $11.7 billion, making it one of the smaller companies under consideration. In addition, the company's credit rating is non-investment grade at B1/BB+. Without question, Concho would need to issue a significant amount of equity to acquire the Chesapeake assets, and given the recent $1 billion acquisition of Three Rivers, Concho is not likely to be a high bidder, even if it chooses to bid.

Pioneer Natural Resources (NYSE:PXD) produces 62 kboe/d in the Permian Basin and has one of the most aggressive drilling programs with 44 rigs in operation. The company has a net acreage position of 900k and is a major player in the Spraberry Trend of the Midland basin where Chesapeake has a portion of its assets. Pioneer has an enterprise value of about $16 billion and carries a split Baa3/BB+(Fitch) rating. Given its rating and lack of cash on hand, an equity issuance would likely be required to make a deal happen; however, this may not leave Pioneer much flexibility to develop the assets, given its middling size and somewhat limited financial flexibility.

Devon Energy (NYSE:DVN) is a large acreage holder in the Permian with 1.5 million net acres, but its production is only 53 mboe/d. The company is targeting an aggressive expansion in the Permian and is committing significant capital to the effort. With a $27 billion enterprise value, $7.1 billion of cash on hand and a rating of Baa1/BBB+, Devon could likely make an acquisition with limited or no equity issuance. However, because the company has $4.1 billion of short-term debt, it would likely seek to term out a portion in connection with a deal. Because of the flexibility, Devon may have an easier time submitting a winning bid, since equity issuance costs, only a portion of which are the direct costs the issuance itself, would be small.

EOG Resources (NYSE:EOG) is only a small player in the Permian, but as a large company with $30 billion of enterprise value, it has the capability and existing local platform to make an acquisition work. EOG currently has a six rig program split between 240k net acres in Wolfcamp and Bone Springs which matches up well with Chesapeake's assets. Given EOG predilection for liquids, a major expansion in the Permian could match up well with management's strategy. Unfortunately, the company does not maintain much of a cash position, but is rated A3/A- and given its size the Chesapeake assets could be digestible with limited issuance of equity.

Among companies with interests in the Permian, Occidental, Devon and EOG are likely in the best position to purchase the Chesapeake assets, in my view. A buyer looking to build a new platform in the area is a possibility, but the assumption is that Chesapeake has already shopped the assets on this basis since it has taken the original idea of a JV off the table. The major problem with the asset in my view is that it is really is more of a collection of land with only limited existing production. That does not make it the best platform for a new entrant to the play because it would have to build the production capability themselves. A JV with Chesapeake could have achieved to that end, but since the company has changed direction, it is likely an acquirer will be more of a financial buyer that will be focused solely on the IRR. In that case, a company with extensive existing operations in the area will have the synergies to drive returns past the hurdle rate.

For investors looking to take advantage of the Chesapeake sale, a position in Devon or EOG may make the most sense. First, to take Occidental off the table, while it could very well acquire the assets, the impact on the stock price would be quite limited, given the size of the company relative to the Chesapeake assets.

Returning to Devon and EOG, all else being equal, a successful acquisition of these assets should be value positive and represent a big enough absolute amount to move the stock. Equity issuance is also a concern because it could erase any short-term gains associated with an announcement, but this will depend on perception and price. Still, the opportunity here is not double digit in percentage terms. Either company will ultimately pay very close to fair value. In my view, however, that is a positive valuation factor for investors looking at either Devon or EOG.

Disclosure: I am long APA.

Additional disclosure: I may initiate a position in OXY, DVN or EOG over the next 72 hours.