Chesapeake Energy: The Bright Side

 |  About: Chesapeake Energy Corporation (CHK)
by: Russ Fischer

So, Chesapeake Energy (NYSE:CHK) announced earnings last Thursday and promptly got pounced upon and mauled by the ever present bears. The stock was down 8% during Friday.

The decline is understandable since the GAAP loss was $2.1 billion. 90% of this was non-cash write downs on proved reserves. Any natural gas producer has been or will be subject to these same write downs due to the persistent low prices of natural gas. Natural gas prices are recovering and natural gas production is finally flat or declining, so NG prices should continue to improve. Presumably, if they improve enough, there should be an asset write up down the road. In any case the write down is non-cash and doesn't affect daily operations of CHK one little bit.

All the negatives have been covered by the multitudes. The asset sale delays were a disappointment to the instant gratification people and probably drove the price decline along with the affect that the New York storm situation was having on NG and oil prices.

Now let's look for some hopeful specks of data in the earnings release and the conference call Friday morning:

Non-GAAP earnings were a dime per share, beating estimates by a penny. OK, that doesn't justify rushing to buy CHK, but is an indicator of the recovery of the company.

I find it interesting and incredibly important that liquids made up 61% of production revenue in the quarter, up from 31% a year ago (from ER). So, of the $3 billion in revenue, $1.8 comes from liquids. That is an increase of $900 million in liquids quarterly revenue in one year. There is good reason to expect that 3rd quarter of 2013 will be at least another $900 million increase in liquids. Natural gas today is nearly double the price used in the 3rd quarter 2012 report, so that will increase 2013 NG revenue by 2X.

Putting it all together, 3rd quarter of 2013 should be the $3 billion of the quarter just finished, plus $900 in new liquids production, plus $1.2 billion in additional NG revenue due to the doubling in price and no limiting hedges. The total revenue estimate for the 3rd quarter 2013 adds up to be about $5.1 billion. Liquids will be 53% of revenue, down from this year only because NG prices will be up substantially.

Annualized, CHK becomes something like a $20 billion+ balanced energy company in 2013. This is beginning to look like the mirror image of the perfect storm over the past five years that nearly put CHK out of business.

Another tidbit disclosed during the CC is the average time to drill a well is down to 15.5 days. That means that each of the 80 rigs targeting liquids (from CC) can punch 23 holes in the ground each year. I don't know what the readers think about this, but I find that number absolutely astonishing, given that many of the wells are of the 15,000 Ft horizontal variety. 80 rigs times 23 wells is 1840 liquids wells drilled in a year. I'm going to take the conservative liberty to reduce that number to 1500 liquids wells/per year. Each of these wells come in at an initial "flush" production of anywhere from 700bbl/day to 2000 bbl/day. They all rapidly decline to, in the case of CHK, about 250bbl/day and decline slowly from that level for years.

The 250 bbl/day number can be derived by dividing the increase in production from 2nd quarter 2012 to 3rd quarter 2012 of 1.671 million bbl by the number of new wells connected during the quarter (from the CC we get 124 new wells connected during the quarter. Since they didn't all come on at once we can approximate a linear rate of connection from zero on day one to 124 on day 92, for an average of 62 wells operating the full quarter) and then divide again by the 92 days in the quarter. The result of the arithmetic is 292 bbl/day. Since some of it is flush production, I have again cut it back to 250 bbl steady state/day.

Now, here is where it gets interesting. Forget the flush production. Not all 1500 wells come on for the full year, but using the averaging technique above, 750 could be producing for the full year, producing 250 bbl/day is 187,500 bbl/day of new liquids production for 2013, making the total for 2013 a combination of 2012 production (100,000 bbl/day) and the 187,500 bbl/day of new production as described above for a total 2013 liquids production of nearly 300,000 bbl/day.

Aubrey McClendon has an often stated goal of producing 250,000 bbl/day by 2015, yet simple, reproducible arithmetic returns a number that is higher than that by the end of 2013. Is this what is called sandbagging?

The CHK turnaround story is gathering momentum at a surprising rate and Mr. Market doesn't see it.

The asset sales will get done, or in the alternative the company is considering a total buyout and is putting all asset sales on hold while negotiations and DD proceed. The $2 billion loan effort revealed last week would provide the necessary cash to get to the end of the negotiations.

This last speculation has a low, but not zero possibility of happening.

I'm buying some shares and lots of call options of different strikes and expirations.

Disclosure: I am long CHK. 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.