3 Key Reasons Chesapeake Is Positioned For Rising Natural Gas Prices

Sep.26.12 | About: Chesapeake Energy (CHK)

Natural gas prices are going up from the lowest levels in over a decade even though it's still the shoulder season. The reason is fears that we would run out of storage capacity this Fall are rapidly unwinding. The article Natural Gas Price Spike Will Be Bigger And Come Sooner Than Expected predicted storage fears were overblown and the article Natural Gas Storage Glut Could Become A Deficit By October details potentially how high prices of natural gas could rise depending on normalized weather. Chesapeake Energy (NYSE:CHK) is in great position to take advantage of a spike in natural gas prices for three key reasons. Out of favor Chesapeake has added five new directors to its board and has changed direction from all out growth to profitable drilling with a stronger balance sheet. Chesapeake has been successful with recent asset sales and is on the path to deleveraging its balance sheet.

The first reason is Chesapeake is the second largest natural gas producer in the lower 48 United States behind only Exxon (NYSE:XOM). Despite efforts to diversify to oil and liquids rich natural gas plays natural gas still represented 79% of Chesapeake's production in the second quarter of 2012. Whereas Exxon is a highly diversified company, Chesapeake is very dependent on the North American natural gas market which currently is constrained from participating in the global liquid natural gas markets with much higher prices. While the high degree of leverage to North American natural gas has been working against Chesapeake, a rise in natural gas prices will work for Chesapeake.

Next to its size and leverage to North American natural gas prices the second reason Chesapeake is in great shape to benefit from rising natural gas prices is Chesapeake is 100% unhedged for natural gas starting at the beginning of 2013. Any increase from current natural gas prices will fall straight to Chesapeake's bottom line. In Chesapeake's investor presentation the company estimates that for 2013 based on an $18 stock price and $90 West Texas Intermediate oil prices the company will have a price to earnings ratio of 50x earnings at $3 per mcf of natural gas, 15.5x earnings at $4 per mcf, and 9.2x earnings at $5 per mcf. While no one can predict the weather this winter, a normal to colder than normal winter will require rigs to return to the natural gas fields. According to Baker Hughes the natural gas rig count is currently 454, which is down by more than half from the 912 rigs drilling for natural gas one year ago. Chesapeake and most other Exploration and Production companies are shifting their drilling budgets to liquids rich fields from dry natural gas fields like the Haynesville. The unknown question is what price will natural gas prices have to rise to for companies to pull rigs drilling for oil and natural gas liquids and redirect them to dry natural gas. While some think $4 to $6 per mcf is sufficient, others think it could require prices of $10 to $15 per mcf based on the 6 to 1 energy conversion ratio of natural gas to oil.

The third reason Chesapeake is well positioned for natural gas price increases is Chesapeake not only has the number one or number two acreage positions in the Marcellus, Haynesville, and Barnett Shale gas fields, it also has multiple liquids rich drilling opportunities highlighted by its 490,000 net acres in the Eagle Ford Shale. Chesapeake plans to move 92% of its 2013 capital expenditure budget to its liquids rich plays that produce some natural gas known in the industry as associated natural gas. While Chesapeake's current drilling strategy will cause its total natural gas production to fall in 2013, the size of the decline is being cushioned by growing associated natural gas production. Chesapeake can drill for oil and natural gas liquids in 2013 and generate associated natural gas along the way, but Chesapeake can redirect to dry natural gas drilling if returns become competitive. A balanced acreage portfolio positions Chesapeake to benefit from a cold winter now, or to wait for natural gas prices to rise in the future. Most of the largest natural gas producers like Apache (NYSE:APA), EOG Resources (NYSE:EOG), Devon Energy (NYSE:DVN), and Encana (NYSE:ECA), have the same liquids rich drilling strategy in 2013 as Chesapeake. Therefore it is logical to conclude most of the largest natural gas drillers will also see a decline in their total natural gas production in 2013 just like Chesapeake. Most of the smaller natural gas producers like Crimson Exploration (NASDAQ:CXPO), Goodrich Petroleum (GDP), and Magnum Hunter Resources (MHR) also have the same strategy of shifting out of dry gas drilling to liquids rich drilling. Since few companies plan to focus on dry gas drilling in 2013, it is only a matter of time before the supply of natural gas is outstripped by demand.

Chesapeake and the other companies mentioned above also have exposure to oil and natural gas liquids prices. Additionally, these companies need access to capital and have exposure to the global financial markets. While investing in a natural gas exploration and production company could provide outsized returns compared to the underlying commodity itself, those investors looking for more direct exposure to natural gas should consider the United States Natural Gas ETF (NYSEARCA:UNG) or the United States 12 Month Natural Gas ETF (NYSEARCA:UNL).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.