Chesapeake Energy Pre-Call Notes: Another Quarter, Another Beat

Chesapeake Energy (CHK) - July 31, 2008 Close of $50.15  (the stock was actually higher ($50.93) before they announced  earnings results)

In A Nutshell. Chesapeake reported better than expected top and bottom line results with production exceeding the top end of CHK’s guidance and CFPS exceeding the top end of the Street’s forecast range. Costs were in line with guidance and reserve metrics were again better than expected.  They hit the high points in the main basins and released a little more Haynesville data including the first production projections but we should get a lot more color on the call. They did not talk about their oil shale activities but oil production continues to creep up…hopefully more color on the call there as well but it looks like Aubrey will continue to play that one close to the vest until his acreage is place or he’s outed by a competitor.

The 2Q08 Numbers: 

• EPS of $0.89 (ex items) vs $0.88 expected
• CFPS of $2.77 vs $2.37 expected, beating the top of the range of $1.94 to $2.68
  

• 2Q08 Production of 2.328 Bcfepd (still 92% gas), vs guidance of 2.26 to 2.29 Bcfepd. On an apples to apples basis (netting out the impact of volumetric production payments) this is up 5% sequentially and up 29% from 2Q07.
  

• LOE (lease operating expense) of $1.03 / Mcfe vs guidance of $0.95 to $1.05. Per unit LOE is up 5% from the first quarter but they maintained prior guidance for the out years with assumption being that higher volumes offset increased electricity and other expenses.

 Reserves Update:

• 12.17 Tcfe, up 11.48 Tcfe, up 700 Bcfe from last quarter and up 1.3 Tcfe (1,300 Bcfe ) from year end 2007.
• 1H08 reserve replacement: 410%. This is the amount of reserves they find or acquire relative to the amount they produce.
• Drilling and Net Acquisition F&D: $1.49 / Mcfe.  That’s just stunning. During the first half of 2008 they sold reserves for an average of $5.53 / Mcfe in the ground but they bought reserves for a lowly $1.44/Mcfe.
  
• Their drill bit only F&D costs for the first half were $1.89 Mcfe. Again, very strong.
  
• They continue to guide for reserve growth to 13 Tcfe by YE08 and 15 Tcfe YE09. Given recent performance and well results described below these numbers appear to be in the bag.

CHK Now The Largest Producers of Natural Gas In The U.S. This is worth mentioning only because they are maintaining cost discipline. Growing an E&P company’s volumes just for the sake of growth is non-sense. If you don’t gain efficiencies out of it, like the ones you obtain, from being the first or second most active driller in the plays you dominate, or generating substantial cash flow which allows you to dominate new plays and obtain first mover status, then why bother being big, especially if you let your costs run wild. In Chesapeake’s case, they are obtaining these efficiencies and beating the competition to the core assets before the plays take off….so congrats to Aubrey on obtaining the #1 spot in gas sales.

Transactions Update: Another VPP. CHK float another Volumetric Production Payment, monetizing 93 Bcf of long lived but low upside Anadarko Basis reserves for $605 million or $6.50 per Mcfe. While the ratings agencies may consider this a form of stealth debt, I would point out that they lack an understanding of both time value of money (monetize it now) and a good deal when it is starting in the face. Putting that capital to work in inarguably higher projects like the Haynesville, Fayetteville and other shales makes a world of sense.

Volumes Guidance:

• 3Q08: 2.36 Bcfepd, up 1.4% sequentially…given where they saw production volumes are in the Barnett at present, this looks like another easy beat.
• 2008: 2.36 Bcfepd, up 21%. Same as prior guidance. I would point out that they did not reduce annual guidance for the 50 MMcfepd of production that goes away with their sale of their Woodford Shale assets to BP or the 50 MMcfepd of production associated with the Anadarko Basin VPP outlined above.
  
• 2009: 2.81 Bcfgepd, up 19%. Same as prior guidance.
• 2010: 3.34 Bcfepd, also up 19%. Same as prior guidance.

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

Barnett Shale: Now producing half a Bcfgpd net; 2008 exit rate climbs

• 2Q08 avg net production of 466 MMcfepd up 13% from the 410 MMcfepd 1Q08 average and up 125% vs 2Q07.
• current production is 500 MMcfepd net (yep, half a Bcfgpd) and they are targeting 675 MMcfepd for a 2008 exit rate. This exit is up from 650 MMcfepd as of the 1Q call.
  
• They have 45 rigs running, up 4 from last quarter and complete a well in the play every 14 or 15 hours.

Fayetteville Shale: Booming

• net production averaged 136 MMcfepd in the quarter, up 425% YoY
• currently producing 150 MMcfepd and targeting a year end of "at least" 200 MMcfepd (0.2 Bcfepd)
• operating 17 rigs now and moving to 21 by year end
• no per well economics divulged in the press release this time

Haynesville Shale Play: Northwest, LA.  More well results and the first volumes projection.

• Acreage now at  450,000 acres and still acquiring
  
• 11 horizontal wells producing 45 MMcfepd gross, 35 net.
  
• Setting a year end exit rate of "at least" 75 MMcfepd gross
  
• Latest well, the Milton Crow 27-1H, is producing 14 MMcfepd, 5,800 psi on a 24/64 choke, no completion details given and I don’t expect to hear much in this regard on the call
• 8 rigs in the play (up from 4 as of last quarter), moving to "at least" 12 by year end. This will put them on track to completing one Haynesville Shale well every five days. Someday, given their history and their confidence in this play, this distance between well completions will be measured in hours as it is now in the Barnett as they move towards their 2010 goal of 60 rigs here.
  
  Marcellus Shale: Soon to "significantly increase drilling activity"
  

• 1.6 million acres now
• Completed 2 horizontal wells during the quarter which are producing at a combined rate of 7 MMcfepd. This is the first rate out of CHK I have seen on the Marcellus although they did say before these are 4 Bcfe type wells and they sound pleased with the results saying they plan to significantly increase drilling activity here in 2008 and 2009.

Check back later today for CHK's Q2 conference call transcript.

Comments

[tonyinbrazil:]

All the goodies above AND the CEO (by and large considered one of the best in the country), spending millions of his own money to buy up shares of CHK on the open market???

What more do you need to know???

Shorting CHK is madness.

Holding makes damn good sense.

Buying (especially at these prices) is as close to a sure thing as anyone's going to get in this world.

2008 Aug 01 05:15 AM

[Ozarker:]

What Tony said!

2008 Aug 01 07:29 AM

[Harlan Levy:]

I've owned CHK for more than 10 years, and made a ton of money day-trading it, but a few months ago a friend I consdier a superior investor and a manager of a huge fund suggested I take loads of dough out of CHK and spread it around the sector, investing in XTO, GDP, HK, and PXP, where I could have made a whole lot more compared to solely sticking with then slow-moving CHK. Adn that's what I did. Unfortunately, using my usual secret day-trading method that had netted me over $100,000 in cash and $250,000 in paper profits in three months suddenly turned useless, and just like that the roulette wheel that is day-trading turned against me, and I lost all of it and $50,000 more. I then decided to get back into CHK as a sole holding,since I feel I'm safe with the company and being diversified doesn't always work. In fact it truly sucked! So now I'm back long with a manageable margin that I figure will disappear once CHK hits $60 and then it's off to the races again, heading to $100 at which point I'm back to my prior high level. Why such a long story? Just to say to others who diddle around like me in the day-trading world that doing it with CHK can kill you if you're not careful and makes the stock more volatile than it should be, affecting ME!!! So cut it out and learn from an old gambler... whose friend is a wonderful 9-almost 10-year-old Portuguese Water Dog named Zoe.

2008 Aug 01 08:22 AM

[fxtrader07:]

@Zoedog: daytrading in ANY stock or market is for losers and suckers. Imho 99% of the people daytrade because they cannot control their desire to 'do something' when in fact doing nothing would produce the best results - which is the case for about 80% of the time.

2008 Aug 01 08:50 AM

[viva:]

The EOG earnings call transcript of this week has some specific to Barnett Shale information which may be relative to CHK as well.

2008 Aug 01 09:02 AM

[CT Programmer:]

I've always been confused about CHK. They've actually lost money in both of the last two quarters because of "hedging". I'm no expert on hedging, but I always thought it was used to limit your downside risk and the tradeoff was limited upside potential. So how are they losing money then because of this? Also, if they are so big and so great, why is their dividend a paltry 0.64%? XTO is 1.04%, and even that pales compared to COP at 2.34% (I know COP is both gas and oil). Not that I don't like Chesapeake. I bought them back in February for $45 and had the sense to push the sell button at $63 at the start of the oil selloff early July (a lesson I learned from Gold earlier this year). I started looking again when they got below $50, but XTO just seemed such a better bargain (as far as fwd PE) and their dividend is twice CHK's. CHK's fwd PE has ranged anywhere from about 14 to the current 28, which I don't think is such a bargain. So I bought XTO. I'm not knocking CHK. Everyone is bullish in general on CHK, and I'm definitely bullish on gas for the next decade. But when everyone is going on about how great any given company is, that's usually when my internal warning lights start blinking.

2008 Aug 01 09:40 AM

[CT Programmer:]

Correction... CHK's fwd PE is 14.6. Their current PE is 28. Their current PE has ranged from 14 to the current 28, although from my watching them their fwd PE has tended to be higher than others in the field as well.

2008 Aug 01 09:44 AM

[User 236069:]

I have recently sold every stock I own except CHK and moved all of my investments into CHK. Diversification has done nothing for me over the years but dilute good returns from winners by ensuring there are some losers in the mix. CHK is a winner, and I am looking forward to the ride. My only regret is that I am fully invested now and cannot buy more shares.

2008 Aug 01 11:40 AM

[CT Programmer:]

User 236069: If CHK tanks and you lose a ton of money, then you will learn the value of diversification. Putting all your eggs into one particular stock --- ANY STOCK --- is playing roulette. Think of someone two years ago that said the same thing you said, but plugged in BAC or GE or C in place of CHK because they were doing great at the time. You'd be out a ton of money. Even if you're bullish on gas, there are a lot of good gas stocks out there. CHK isn't the only game in town. And the world doesn't revolve around just natural gas.

2008 Aug 01 12:48 PM

[JJSpano:]

First off diversification is key for numerous reasons including decreasing a portfolio's stdev and decreasing a portfolio's VAR of losing money. This matters for both mathematical, psychological, and realistic reasons which I won't go into depth on.

leacabrerra - You make a lot of great points, and I would love to know more about these "FOUNDER WELL PARTICIPATION PROGRAMS". I researched it before I bought the stock and wasn't too worried about it at the time, but I'll look into it again. One major point I'd like to make however is that Enron had large positive [Total Accruals (basically NI - CFO)/Total Assets] ratios before going under, and CHK doesn't ( Q2/2008 = (-1,649 - 1,256)/38,023 = -7.64%) which puts them on different planets to say the least. Enron was accruing large amounts of income it was "suppose" to obtain years later through actual cash flows. Almost like a company saying this year that they are going to accrue let's says billions of dollars right now because they have a psychic who says in a few years they are going to land billions of dollars in contracts, this makes a company who should have negative net income display positive net income (Wiki accrual accounting for those unfamiliar with this process). Chesapeake is in the opposite category which is good because they're most likely not making up false accruals to impress net income lovers (the market), and instead are reporting more losses which are tax deductible and thus have tax benefits!! Also, you state:

"Aubrey McClendon has boasted that CHK has a fair value of $100. If so, then why did he sell out the shareholder for 57.25 cents on the dollar? Was CHK that desperate for cash?"

The answer is probably in the last question you asked. Remember debt covenants are a serious issue, and CHK sold shares to pay off debt I believe so that banks couldn't demand their money back. Otherwise you could have what has happened to banks lately. Now the $100 believed price to $57.25 offering is another issue that needs addressing. I'm going to write it in bold as what I'm about to write confuses many-

WHEN A COMPANY SELLS SHARES FOR LESS THAN A COMPANY IS INTRINSICALLY WORTH, THIS DOES NOT NECESSARILY MEAN SHAREHOLDERS ARE LOSING VALUE. FOR INSTANCE, IF A COMPANY'S SHARES HAVE A MARKET PRICE OF $75 AND AN INTRINSIC VALUE OF $100 THAN SELLING NEW SHARES AT $75 ACTUALLY INCREASES THE VALUE OF THE SHARES THAT ARE ALREADY OUT WHEN >>> THAT NEW EQUITY ALONE HAS AN INTRINSIC VALUE OF MORE THAN $100 WHEN RECEIVED BY THE COMPANY. YES, THIS IS POSSIBLE.

But new shares were sold because of debt covenants, and that helps preserve value so it wasn't necessarily that big of a deal. I have talked with professionals about this, however, and they think something interesting is going on to (some say this is good and some take the counter argument).

CT
Programmer- Nice scolding, hopefully you'll save a lot of future pain for that user! I mean psychologically alone it could kill you watching just one stock move up and down by swings of 30% or more in a matter of weeks (CHK recently did this). Warren Buffett suggests stocks you could sleep on for years with no worry for this reason. Now to answer some of your questions. Okay hedging is confusing to many, and especially how it is reported on financial statements which is I believe your question. SFAS 115 (I know this as a CFA Level II Candidate although you can google it) states that trading securities (futures,forwards, and swaps fit this category) must be marked to market. So it appears CHK is losing tons of money when in actuality it is just making less than it could have at market prices. For example (simplified heavily), lets say you hedge natural gas at around $9 for one year later as a natural gas producer (look on the sec's edgar database for actual numbers for CHK) which means you are taking the short side (selling so that you are guaranteed $9/MMBtu at a future date of one year no matter the price), if the price of natural gas goes to $10 that means a paper loss of $1 per future or $1 billion per billion futures. Now if that natural gas is delivered at $10 then is that really that bad for a natural gas producer. No (remember the price could have gone the other way!). The natural gas producer produces the underlying, so they'll just deliver the goods (or sell at $10 and deliver the cash above $9, which is the same thing). So if it costs CHK $3/MMBtu to produce natural gas (this includes fixed costs like salaries as well as variable costs), they eventually will make $9-$3=$6/MMBtu when they could have made $7/MMBtu without the hedge. Even though these hedging effects won't take place until a year later, the natural gas hedger must take the losses now. This is why CHK posted over $1.6 billion in losses. In fact looking on CHK's latest SEC filing you can see they had a realized price of $8.55/Mcfe (not MMBtu, otherwise it would be more), and costs were about -4.94/Mcfe so they are making money not losing it. Now if they hedged more than they produced, that would be a different story. Then those losses would be "real". I hope this clears up any confusion although reading back through what I wrote it seems quite messy :-).

Joe

Visit My Blog At:
oneupperinvesting.blog.../

2008 Aug 01 03:49 PM

[CT Programmer:]

I'm still not quite getting the futures thing. They earned roughly $500 million this quarter. Yet they marked down $2 billion in futures losses. That's a ratio of 4:1. That would mean they'd have to have the margin between the real price of gas and the price set on the futures exceed the actual profit by 4 times? If their actual cost was around $3 as you say, and we know real prices got up to around $10, if they futured at $8 the futures losses would only be $2 per unit ($10 - $8), yet they'd be making $5 per unit ($8 - $3). I know its not that simple, but even so in this case that's only a ratio of 2:5. Even if you pulled out other expenses maybe it would go down to 2:4. Yet their actual losses are 4:1. So I'm still not quite getting how they could have marked losses on futures that exceeds their actual profits by 4 times.

2008 Aug 01 05:06 PM

[Lea Cabrerra:]

$2 billion dollars in hedging losses is startling beyond belief. In one quarter CHK has just destroyed the earnings reported during the previous 7 quarters. Remember, those quarters earning INCLUDED hedging gains.

If you are going to argue that one should focus on the numbers excluding the hedging losses then you must be consistent and not consider the hedging gains included in previous quarters earnings. If that is the case then previous quarters earnings must be discounted. Either way, in the vein of consistency, CHK has just destroyed 7 quarters of reported earnings.

This presents a huge disconnect. It also illustrates the precarious position CHK is in. If the counter parties to CHK's hedges had lost confidence and presented CHK with a margin call, CHK would have been forced to come up with $2 Billion. Thats scary, considering CHK only had $1 million on 12/31/2007 and $4 million on 3/31/2007.

$2 Billion of hedging losses begs the question, "how much production was CHK hedging?" Is it possible that CHK was actually speculating and speculated wrong?

Many claim that CHK is the closest thing there is to a sure thing. I think its important to consider that CHK might be a speculative bet.

There is nothing of a "sure thing" about a company that feeds endlessly and erratically at the troughs of the the capital markets. In fact, its a huge red flag.

2008 Aug 01 06:17 PM

[JJSpano:]

So here's the thing, looking at their financial statements you can see they are hedged into 2010 (at varying prices). Thus the losses on their income statement reflect the losses on the rest of their '08 & '09 & '10 hedges. Why? As per SFAS 115 which requires trading securities to be mark to market, unrealized gains or losses are also included in net income (*this is most likely the confusion*), not just 2nd quarter 2008 hedges (which are realized losses, and that was reflected in the realized $8.55/Mcfe value I gave you as they sold natural gas at $10.55/Mcfe). 2nd quarter unrealized losses taken from CHK's earnings release were $3.404 billion (these unrealized losses won't effect cash flows until later, and in fact could turn into gains!!!). 2nd quarter realized 2008 hedge losses are also given in CHK's earnings release and this number is $423 million or $2.00/mcfe, so they lost real money this quarter of that amount not the total amount deducted of $3.827 billion ($3.404 + .423). Looking at cash flows in this case is much more informative. Or look at adjusted earnings of $.89/share which is $491 million. I'm pretty sure you're going to want to know how that is calculated so I did the math and here is how it adds up approximately: -$1,649 billion (NI Loss) + .615 (1-Tax Rate) * -$3,404 billion = $444.5 million ($444.5 is my number CHK's is $436M) for just taking into account what would have happened with no unrealized losses taken into account (this would be $444.5M + .615*$423M = $705M if CHK didn't hedge at all) and CHK also adds preferred stock losses back to reach $491M in adjusted gains. Out of all those numbers I would use $436M to be on the safe side, and maybe add the interest amount they will gain on the tax benefits they recieve. Now hopefully you can see why net income and p/e ratios are often worthless to value a company; cash flow numbers aren't perfect either as depreciation and amortization numbers can be distorted when costs that should have been capitalized are instead depreciated or amortized and then added back to cash flows! The best method for valuing stocks is a stochastic DCF model with adjusted cash flow predictions that make Free Cash Flow to Equity, Free Cash Flow to the Firm, Dividend Discount, and Residual Income models all equivalent (as they should be!!!). Monte Carlo programming is used to make these models stochastic, since you're a programmer this maybe something you can do. But remember Garbage In - Garbage Out, so that is one reason most stick to a deterministic dcf model. Visit my blog in the future (sometime in the next month) as I'm about to post some simplistic models for prospective employers to look at. Also, I'm working on collecting thousands of samples of ratings (through html parsing) from value line to determine the value of their stock grades. I already have a morningstar review posted. Please leave some feedback, constructive criticism is welcomed.

JJSpano
Blog-oneupperinvesting.blog.../

2008 Aug 01 06:34 PM

[racerz:]

Lots of good reading here -- I'm now long CHK, and continue to add to my holdings, which also include ACI and BTU. All three up in afterhours trading, especially the coal. CHK's McCLendon appearance on Mad Money helps tonight, along with Cramer's continued support of this company. It's only a matter of time, and CHK is back to 60...and then up it goes into the dead of winter.

2008 Aug 01 06:55 PM

[nycDem:]

Great comments here. JJSpano, really good stuff. I, too, lost some $$ on both CHK and XTO (re: Zoedog). I was asleep at the wheel, and when NG plunged...well, I kept thinking it was a two or three day "correction."

Eh...not really, right?

However, read this article for NG information: www.bloomberg.com/apps...

According the article we're at seasonal lows for NG.

I like this quote: "Our rule of thumb is no matter how bleak it is, or how bearish people are talking [about NG], don't be short after Labor Day.''

As far as CHK's merit as a stock, I'm long...and I will do some more analysis per JJSpano's info. I'll check out his blog.

Good luck to everyone.

2008 Aug 01 09:08 PM

[JWD:]

Hedging Liability at 3/31/08 is Negative $2.1 Billion. By the end of the 2nd qtr becuase gas prices went higher to end at $13.25 MCF, CHK hedging liability increased another $2.1 billion to a total of $4.2 Billion on 6/30/2008. But gas prices fall from $13.25 on June 30 to to $10.25 on July 25. The $3 difference times the 1.5 trillion prouction volume hedged (over next 2.5 years) results in a Mark to Market gain of $4.7 Billion (see earning release)reversing entirely the first half 2008 hedging loss. Long story short CHK does much better in the next two years if the price stays at $10 per MCF or lower.

2008 Aug 01 11:05 PM

[CT Programmer:]

JJSpano: Thanks for the info. I'd be lying if I said I understood it all. I am a programmer, but you're talking some heavy-duty statistics and accounting and I'm not experienced in all the hard-core technical analysis. JWD's blurb also sheds some light, thanks. I'm not necessarily bearish on CHK. But I'm also not so bullish either. I can understand why CHK would hedge so much. They are looking to fuel their growth and would rather lock all that in for steady expansion versus roll the dice and gamble on a big payout or coming up short and having to go to the money markets to get expansion cash. But the paltry dividend still bugs me. With so much production, you'd think Aubrey would kick some cash back to the holders. Rapid expansion or not, not having extra cash on hand to pay a good dividend is a significant indicator. I mean, this isn't some startup tech company. We're talking the largest domestic NG producer. If they're so tight on cash, that makes me nervous re-investing back into them. Which is why I went XTO and COP this time around.

2008 Aug 02 09:03 AM

[Itsonlymoney:]

CT, if you are looking for dividends I suggest you look to the Royalty Trusts highlighted by Kurt Wulff at www.mcdep.com. They have taken a beating along with most NG plays so this could be a good entry point.

2008 Aug 03 12:04 PM

[cook503:]

This is probably the most volatile non-tech and non-financial stock that I have seen in a long time. However, I am bullish in the long run. Oil prices will sway, but unless China and India decide to go back to third world status, they're not dropping below $70 any time soon.

Right now is a historically weak time for natural gas. Wait it out and see what happens in the winter heating season.

2008 Aug 04 01:17 PM

[mouth:]

Hedging discussions to a novice, reminds me of last year discussions on the fancy mortgage discussions last year. Be happy, do not worry this will all work out. Never buy a stock when it is going down

2008 Aug 04 03:41 PM