Chesapeake Energy (CHK) is now the twelfth largest oil producer in the US, and it wants to become the fifth or sixth largest within the next three years, while retaining the number two spot in natural gas production. So far, Chesapeake CEO Aubrey McClendon's predictions about a natural gas recovery are woefully off the mark; in November 2011, he predicted "when we move into winter, people are going to see that $3.34 natural gas is too low," adding that he thought the market "already [saw] the worst." This spring showed just how much worse the market could get, and pushed Chesapeake towards a new strategy.
It isn't necessarily that natural gas is unprofitable at current levels; many producers, Cabot Oil & Gas Corporation (COG) among them, make a healthy profit even when natural gas is selling around $3 per mcf. For most operators, it's just that the profit margins on shale oil are much more attractive in the current market. Chesapeake's story is slightly different.
Its rapidly escalated cash crunch due to the slide in natural gas demand and the resulting price declines that Chesapeake, at least, did not foresee, put investors into a near panic, which in turn panicked potential partners and financiers from helping Chesapeake when it needed it most. This provoked the continuing sell-off of Chesapeake's non-core assets, and paired with accusations of misgovernment by McClendon and the previous Chesapeake Board, led to a board takeover, further spooking investors.
The good news is Chesapeake is positioned to climb back into the ring. Natural gas seems to be regaining its footing ahead of any further upheavals, and year to date, Chesapeake divested $11.6 billion in assets for net proceeds of $6.9 billion.
One Company Can't Goose Demand, But Can Multiple Joint Ventures?
Despite its oil goals, Chesapeake is still firmly a natural gas company, as much as it would like to transition more quickly. A good deal of Chesapeake's current natural gas drilling is only undertaken so as not to lose the leasehold due to inactivity. Others, such as EXCO Resources, Inc. (XCO), are in a more painful position, forced to continue drilling under joint ventures signed hurriedly when natural gas was riding high.
Yet McClendon continues to be optimistic, pointing out that the trend in the US is to "transition away from burning diesel," especially as engines become more efficient. Now Chesapeake's focus is on building demand for natural gas, and the major way Chesapeake is trying to influence the market is through nudging the transportation industry towards natural gas fuels.
Most recently, Chesapeake unveiled a new concept, "CNG In A Box", through its affiliate Peake Fuel Solutions in cooperation with General Electric Company (GE) at the National Association of Convenience Stores 2012 Annual Show. Chesapeake claims that the CNG In A Box system can reduce fuel costs by up to 40% and is a "plug and play" solution for retailers to add CNG fueling options to existing stations with minimal upgrades and high margins.
However, there is a high barrier to adoption at present since the CNG In A Box system requires a hook up to an existing natural gas pipeline, with CNG compression occurring on-site at the retailer; additionally, the footprint of the system is 8 feet by 20 feet, a great deal of space to ask retailers to devote to what remains a largely experimental undertaking. Due to these problems, I believe that for most fuel retailers, CNG In A Box will remain a concept. For Chesapeake, it might be the first step towards driving CNG adoption, but I do not think it will have a meaningful impact on its current revenue.
Though innovative, Chesapeake is not the first to attempt commercial natural gas to transportation fuels conversion. Royal Dutch Shell (RDS.A) operates the largest such conversion plant, known as Pearl GTL, in the world. The plant continues to edge towards full production, at which point it will produce and process 1.6 bcf per day of natural gas into 140,000 barrels of gas to liquids products and 120,000 barrels of natural gas liquids and ethane per day, amounting to some 3 bboe over the facility's lifetime.
By comparison, the Pennsylvania GTL plant in which Chesapeake is involved, representing the second prong of Chesapeake's strategy to increase natural gas demand, is expected to produce 1,000 barrels of GTL products per day. While ConocoPhillips (COP) beat Chesapeake to the domestic punch, ConocoPhillips' test project is not commercially viable, producing just 400 barrels a day. Given greater consumer acceptance of fuels that can run in existing engines, I believe Chesapeake has a better bet with its GTL approach - but it should still be focusing on oil.
Chesapeake is currently trading around $20 per share, giving it a price to book of 0.9 and a forward price to earnings of 11.4. For comparison, Shell is trading around $67 per share, with a price to book of 1.2 and a forward price to earnings of 10.9. Exco is trading around $8 per share with a price to book of 2.3 and negative price to earnings in the face of near-total reliance on natural gas. Cabot is trading around $43 per share with a price to book of 4.2 and a forward price to earnings of 49.7. ConocoPhillips is trading around $57 per share with a price to book of 1.5 and a forward price to earnings of 9.0.
McClendon blames "people with agendas," by which he presumably means investors, shorting Chesapeake stock as a bet against natural gas for Chesapeake's low price. I think this is unfair, to put it mildly; Chesapeake has bigger problems that actually support a short position, such as the $4 billion bridge loan it still isn't entirely repaying even after recent asset sales, despite the threat of a 3% interest hike and trigger clauses. I do agree that repaying the majority of the loan now is better than waiting to repay it later, as the current 8% interest Chesapeake is paying is not cheap by any means.
McClendon notes that Chesapeake is in "transition to a business strategy that has moved from capture to harvest," and it's selling off of non-core properties fits into that strategy. All told, Chesapeake expects to divest assets totaling more than its market cap, with properties sold between 2012 and 2013 to total up to $18 billion. To accomplish this, Chesapeake will institute a tighter operational focus and better governance. After Chesapeake's recent shockwaves, better governance is absolutely something investors can stand behind.