Reviewing Chesapeake's Strong Quarter: Pre-Call Notes

Chesapeake Energy (CHK) - May 1 Close of $50.93

In A Nutshell. Chesapeake reported much better than expected bottom line results, costs were in line with guidance and reserve metrics were as good as anyone could expect except maybe one or two odd duck analysts. They also announced a new VPP and the expected sale of the Woodford acreage. The operations update was thin and we'll get a lot more color on the conference call.

The 1Q08 Numbers:

• EPS of $1.09 (ex item) vs $0.93 expected
• CFPS of $3.07 vs $2.43 expected
• 1Q08 Production of 2.244 Bcfepd (still 92% gas), vs guidance of 2.2 Bcfepd; up 1% from 2.219 Bcfepd sequentially,
• LOE (lease operating expense) of $0.98 / Mcfe vs guidance of $0.90 to $1.00; this was $0.88 in 4Q07. I highlight the LOE in red as it represents a pretty good uptick in operating costs and they are guiding full year to $0.95 to $1.05 per Mcfe now, up from $0.90 to $1.00 just a month ago. I expect some questions on the call about cost creep and I'd bet it's largely fuel prices in the field and/or electricity.

Reserves Update:

• 11.48 Tcfe, up 6% from year end 2007 reserves of 10.88 Tcfe
• 1Q reserve replacement: 395%. This is the amount of reserves they find or acquire relative to the amount they produce.
• All in F&D: $1.95 / Mcfe. That's very respectable and an improvement from their recent performance.
• They're guiding for reserve growth to 13 Tcfe by YE08 and 15 Tcfe YE09.

Capital Budget: actually down a bit from their projected range for 2008. This reduction is attributable to the expected sale of the Woodford Shale assets by 3Q.

• Woodford Shale Up For Sale: 170,000 acres remained as of year end with 1.3 Tcfe of unrisked proved reserves under them by company estimates. They expect to reap over $1.5 billion from a sale here.
• Another VPP Get's Floated: $623 for 94 Bcfe of reserves, a nice sale at $6.63/Mcfe.

Volumes Guidance:

• 2Q08: 2.275 Bcfepd, up 1% sequentially,
• 2008: 2.36 Bcfepd vs prior guidance of 2.34 Bcfepd. This equates to 21% annual growth.
• 2009: 2.74 Bcfepd, equal to prior guidance, (16% growth).
• 2010: 3.150 Bcfepd (15% growth) - this is their first official guidance here and likely to be conservative.

Hedge Position: Taking the risk out gas prices.

• 2008: 71% of expected gas production @ an average price of $8.77/Mcf, in line with volumes hedged as their last update.
• 2009: 40% of expected gas production ($9.13/ Mcf), up from 30% as of last quarter

Operations Update: The company only provided a handful of highlights.

Barnett Shale:

• 1Q08 avg net production of 410,000 MMcfepd is up 125% vs 1Q07.
• current production is 430,000 MMcfepd and they are targeting 650,000 for a 2008 exit rate.

Fayetteville Shale: Booming

• net production averaged 114 MMcfepd in the quarter, up ~ 700% YoY
• currently producing 130 and targeting a year end of 200 Mmcfepd (0.2 Bcfepd)
• they're drilling longer laterals, (averaged 3,363 feet during the quarter) and average peak production increased more than commensurately to 2.41 MMcfepd, up from 1.75 Mmcfedp in 1Q07.
• operating 14 rigs now and moving to 23 by year end

Haynesville Shale Play: Northwest, LA. Leasing acreage and adding rigs.

• Acreage now at over 300,000 acres, up from 200,000 acres as of March 24.
• 4 rigs in the play, moving to 12 by year end (this was last stated as 10 so we're getting a little more confident in the play.
• 4th horizontal well placed on line in the play in the last month, rate not given but hope to get more color on the call.

Marcellus Shale: About To Get Busy

• 3 operated rigs, this should go up soon
• 1.2 mm acres, planning to add another 200,000 acres

Conference Call: Friday 11 EST. Click here to listen.

Comments

[bellard]

Zman;
Thanks for the update. I will post my CHK blog on my CAPS page(bellard) after I listen to the CC. The one aspect that confuses investors is the gain or loss from CHK hedging program. I focus on cash flow analysis, so GAAP numbers are not very important to me. How should an investor look at the complex hedges? I buy puts on equities/indexes as a hedge/insurance for my long portfolio. Could we think of CHK hedges in a similar way? I mean CHK has already PAID for the hedge in prior period cash? No future cash flow impact?

Just curious on your take on the hedging program. Good write up.

[HarryJohnson]

Does anybody do math anymore ? Al of the following came from Chesapeake's 2007 Form 10K: Total expenses were $4.84 per mcfe, up from $3.77 per mcfe in 2005. Projected cost to develop proved undeveloped reserves was $1.85 per mcfe as compared to $1.64 per mcfe in 2005, and $1.00 per mcfe in 2003. If costs remain at the 2007 level (not likely), the cost to get reserves developed in 2008 to market will be $6.69 per mcfe (4.48+1.85). Chesapeake's average price received in 2007, excluding derivatives, was $6.71 per mcfe; the average price including derivatives was $8.40 per mcfe. Long term debt at December 31, 2007 was $11 billion versus $5.5 billion in 2005. PV @ 10% of proved reserves minus market cap and long term debt at the end of 2007 was just under -$10 billion, whereas the number was just under +$5 billion. Admittedly, this is all reality: whereas, as we all know, perception drives the market.

[HarryJohnson]

The =$5 billion was for 2005.

[bellard]

Harry;
I am confused, what are you getting at? CHK just reported huge eps, and huge positive cash flow - that means they current are receiving large spreads between ng costs per mcfe, and sales price per mcfe.

As the $$$ to extract kerogen from the earth increases, so will the price to those that need that particular hydrocarbon. Are you trying to say that the cost for CHK to extract their reserves will soon be more than they can charge for the NG? This is not really mathematically possible - its simple supply/demand economics....

[HarryJohnson]

bellard:

The numbers I quoted are theirs; not mine. I confess that 50 years in and around the oil and gas business has made me a bit skeptical, or at least cautious. Unfortunately, the price of hydrocarbons doesn’t always cover the cost to extract as you put it. Throughout several decades of the last half of the 20th Century, foreign oil had a finding cost of less than 10 Cents per barrel. It didn’t take long for 3,000,000 barrel tankers to start unloading that cheap oil on our shores, and it took even less time to destroy the domestic oil industry.

As for simple supply and demand, take a look at the current price of crude. In a little over a year, the price of crude has gone up 140%, while worldwide demand has increased less than 2% (check it out at eia.doe.gov.) No economics course that I ever took would suggest that such a minuscule increase in demand would cause a skyrocketing price. (Once again we have perception overriding reality.)

The same thing that happened to the domestic oil industry may be on the horizon of the domestic NG industry. There are huge under produced natural gas reserves in many places outside the U.S. Qatar’s reserves are among the highest, and Qatar will soon launch their 45th LNG carrier. Their smallest ship carries about 3 billion cubic feet; the largest about 5 bcf. Since we live and die by NYMEX futures prices, all supply is priced at the last incremental barrel or mcf of demand. The U.S. uses an average of about 60 bcf per day, so it doesn’t take much imagination to guess what will happen to prices when three or four 5 bcf carriers a week start dumping their loads here.

But, like I said, perception drives the market, and the CEO of Chesapeake has a vastly greater audience than I. He told the local newspaper this week that the stock will double, so don’t let my sterile analysis of facts cause you to miss the ride. Just be sure to act quickly when you see signs that the tide is about to go out.

[bellard]

Harry;
Its very simple - If firms can not charge a high enough price to cover the extraction of the hydrocarbon + profit, they will stop extracting. This means supply decrease - and with demand about the same - prices rise back to economic balance.

Oil is still priced is dollars, and with the dollar being weak, some impact on oil prices is expected - CHK is a NG firm, not oil. NG and oil is getting more expensive to extract, therefor the prices have risen even though demand has not jumped too much.

[HarryJohnson]

Sounds a bit like the philosophy of the big three auto makers a few years back. They just forgot that others can sometimes do the job less expensively. The fact that Qatar can land NG in this country at around $4.00 an mcf and still realize enormous profits scares me a little. Of course, that is probably a few years away.

[Scammr]

Enron's top brass also told employees what a great buy their stock was at the time! This outfit still scares me, but I probably can't get 1999-2000 off my mind.

[Mmarrkk]

Harry: here's the problem. That $4 gas that Qatar can land in the US can also be sold in Japan or China for $15. So, where is Qatar going to send the gas? Yep, Japan or China. Guess what? That's real life. Two brand spanking new LNG regas terminals just opened on the Gulf Coast and there are no tankers coming in!!!

While I won't argue your math, I will argue that using 2007 numbers is a bit off. This is 2008. Use 2008 Q1 numbers just released. They are producing gas for about $2 less than they are selling it for. Sounds like a winner to me. Yes, if prices decline, they will cut back on the drilling and the goofy SEC will force them to cut their reserves. But, the reserves will still be in the ground and when the price goes up, they will produce them. Also, OPEC can produce a barrel of oil for less than $10. Why are they sending it over here for $100?? Same will happen with LNG. That $4 gas from Qatar will come over here at the market price and that's going to be very very high.

Aubrey has large percentages of 2008 and 2009 production hedged at well over $8. Looks like they are fine for at least a couple of years. And bet on similar contracts being written as we speak for more and more gas and going in to 2010 soon.

[HarryJohnson]

If they are making so much money, why do current liabilities and long term debt keep climbing ? Last years financials aren'told hat. Unfortunately, with full cost accounting, judging performance by the last quarter is unreliable. For example, if a company spent a billion on drilling in one quarter, resulting in $200,000,000 in earnings, but payout from the reserves developed by the billion spent on drilling will return only $800,000,000 ultimately, this only shows up much later in D D & A. In order to determine if the produced reserves are truly being replaced at a cost below or equal to the cost of those produced reserves, it is necessary to look at the year to year trend in D D & A. Chesapeake's D D & A as a pecent of total revenues has gone from 28.6% in 2005 to 35.0 % in 2007.

I recognize that all of these numbers will only be looked at if CHK stumbles. I sincerely hope they don't, but the $1.5 billion growth in current liabilities from December 31, 2007, until March 31, 2008 (2.76 to 4.2) means that cash flow, whatever it is, is inadequate to support CHK's level of operations. If the loan window is closed, as it appears to be, this trend ca't be good news.

[HarryJohnson]

Forgot one other item: Dateline Oil & Gas Journal April 21, 2008.
"Two LNG tankers arriving along the upper Texas Gulf Coast within five days of each other are delivering cargoes for two new LNG terminals, one in Louisiana and one in Texas. These two terminals are the first land based terminals to open in the U.S. in 25 years. Two more terminals are expected to start late this year or first quarter next year. One is Exxon Mobile's and one is Sempra Energy.

Don't mean to rain on anybody's parade, but facts are afcts.

[HarryJohnson]

Even if they contain a typo from time to time.