In the second quarter, Chesapeake Energy (NYSE:CHK) saw losses on sales and impairments of fixed assets totaling $243 million, about thirty times the loss on this item it reported in the same quarter last year. This is discouraging as Chesapeake's second quarter accounting did not report significant impairments to the carrying value of its natural gas an oil properties since it was not required, but based on the current market such impairment will be due in the second half of this year. Though it will be a non-cash charge, it could potentially reduce Chesapeake's equity by a substantial amount.
What's worse is that Chesapeake will have a maximum $750 million cash flow surplus in 2013 according to its own estimates, and already knows it will be heading into 2014 with a carried loss from trades and premiums for call options of $185 million. The loss continues into 2015 at an estimated $110 million thanks to its devastatingly optimistic hedging strategy. According to Chesapeake CEO Aubrey McClendon, the investment decisions were made based on a belief that natural gas pricing "was unrelated to fundamentals in the U.S. gas market, and we thought we would take advantage of that." How McClendon and his management team failed to see oversupply as a fundamental is open to question, but the fact is that Chesapeake is now paying the price for the oversight, as are its shareholders.
Competitor GMX Resources (GMXR) is in a similar position. Although its liabilities are nowhere near the scale of Chesapeake's, viewed as a percentage of assets GMX is substantially hurt by its hedging activities; its current derivative liability on natural gas is $1.1 million, or nearly half of what it spent on lease operations in the second quarter. Its derivatives were a contributing factor to its $1.52 per share loss during the period, tied to its heavy weight towards natural gas and limited area of operations.
Compare these approaches to the approach of Devon Energy (NYSE:DVN), which does not engage in speculative trading except as an exposure management strategy, which precludes it from the requirements of hedge accounting. All told, its commodity, interest rate, and foreign exchange derivatives by fair value present $1 billion in assets to Devon, and just $45 million in liabilities. EOG Resources (NYSE:EOG) is similarly well positioned on derivatives, with $464 million in assets to $55 million in liabilities.
Chesapeake continues to market some of its best assets, and anticipates divesting $7 billion in assets by the end of the third quarter, with a further $6 to $7 billion to follow in the fourth. With its current deficit, Chesapeake badly needs to sell these assets to free cash for its debt as well as for continued drilling on the properties it intends to keep, which is becoming a struggle.
Total (NYSE:TOT) may be regretting its Barnett Shale joint venture with Chesapeake, as Chesapeake's struggles are precluding it from fulfilling its obligations under the venture. After agreeing to accelerate its agreed drilling carry to Chesapeake to allow Chesapeake to maintain the required twelve rigs on the play in exchange for a 9% reduction in the carry owed, Total's carry was exhausted in October 2011. This left Chesapeake solely responsible for continuing to run the rigs, but in January 2012 the firms agreed to reduce the rig count to six. In May 2012, the rig count was reduced to two. This reduced drilling is part of Chesapeake's catch 22, since the firm is still reliant on natural gas for revenues but is ever more frequently producing the commodity at a loss.
Adding to its woes, the Chesapeake Board of Directors continues to review McClendon's financing arrangements for his participation in the Founder's Well Participation Program. Based on the language within Chesapeake s 10-Q, it appears that this investigation is expanding into financing arrangements between McClendon and "any third party that has had or may have a relationship with the Company in any capacity." I think the expanded scope of the investigation may be related to the Securities and Exchange Commission's informal inquiry into the facts behind multiple lawsuits pending against Chesapeake and McClendon related to these financial transactions.
Chesapeake is currently trading around $19, with a price to book of 0.9 and a forward price to earnings of 9.2. Total is trading around $49, with a price to book of 1.2 and a forward price to earnings of 6.2. GMX is trading around $1 per share, with a price to book in negative territory thanks to its overwhelming liabilities over the past few quarters. Devon is trading around $58 with a price to book of 1.1 and a forward price to earnings of 8.7. EOG is the group leader, backed by investor confidence at $110 per share with a price to book of 2.2 and a forward price to earnings of 17.1.
In its current outlook, Chesapeake is indicating that in 2013 it plans to produce between 70 and 90 bcf less than it plans for 2012, while increasing its liquids production in oil and natural gas liquids in 2013 by between 14 and 18 mbbls, increases that approach up to 40% of current production. But looking carefully at the outlook, despite the increase in liquids production Chesapeake's overall production estimates indicate only the barest increase, by about 1% overall.
This is in part due to Chesapeake's planned asset sales, but also a strong reminder of how dependent Chesapeake is on natural gas for its revenues. Any decrease in natural gas production without substantial increases in oil production will have an outsize impact on Chesapeake, especially given that its hedging strategy is yielding losses for the firm.
Chesapeake is also maintaining an optimistic outlook on the NYMEX price for natural gas, estimating that by the end of 2013 prices will be at $3.75 per mcf. If its operating costs per mcfe of projected production are at the high end of its estimated range for each cost at the end of next year, Chesapeake will be producing natural gas at a loss of $0.20 per mcfe. Without significant moves to increase its oil weight and reduce its exposure to non-performing assets, Chesapeake may not be a going concern by this time next year. In the meantime it could be a value play; as the stock trends lower after its earnings report is scrutinized by investors, there may be an upswing in the next two quarters as investors react to what will hopefully be positive news related to Chesapeake's asset sales.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.