Chesapeake Energy: Another $1 Billion Raised In Challenging Divestiture Market

| About: Chesapeake Energy (CHK)
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On July 3, Chesapeake Energy (NYSE:CHK) announced the long-anticipated divestiture of its Northern Eagle Ford Shale asset package for $680 million in cash plus retained economic interests under a farm-out agreement that is part of the transaction. The buyer is EXCO Resources (NYSE:XCO). Similar to several other recent divestitures announced by Chesapeake, the headline number is well below what many observers may have hoped for (some estimates have been quoted in the $1 billion-plus range). The transaction reflects the highly competitive divestiture market where many property packages are competing for buyers' capital as well as quality of Chesapeake's acreage. In a separate transaction, Chesapeake is selling to EXCO select Haynesville Shale assets for $320 million in cash.

The $3.6 billion of transactions announced year to date bring Chesapeake to a fully balanced 2013 budget, but fall far short of what would be needed to meet the high end of the earlier expectation that included substantial debt reduction. The impact of these asset sales on net production and capital expenditures was previously reflected in Chesapeake's May 1, 2013, guidance.

Eagle Ford Transaction

In the Northern Eagle Ford, Chesapeake has agreed to sell approximately 55,000 net acres in Zavala, Dimmit, La Salle, and Frio counties, Texas. The properties include approximately 120 producing wells, including 94 Eagle Ford wells, with average net production of ~6,100 Boe/d during the month of May.

Click to enlarge images.

Source: EXCO Resources' July 8, 2013, investor presentation.

EXCO's internally engineered reserves estimate for the property is ~29 MMBoe, of which approximately 60% is proved developed producing reserves (PDP). It is important to note that EXCO's "SEC reserves" estimate differs substantially from its internal case and is just 17 MMBoe. While the difference in natural gas pricing between the 2012 SEC case and current market is obviously one of the contributing factors, the very wide discrepancy for what is predominantly oil-producing assets is puzzling and may hint to some risk to the type curve being used in the "internal" case. This reminds us that the acreage is located deep into the play's oil window and not in the most prolific volatile oil fairway, and may be a significant factor contributing to the low overall valuation received in the transaction.

The PDP component of the acquisition equates to ~$350 million - $435 million, assuming $20-$25/Boe valuation and using EXCO's 29 MMBoe internal estimate for total proved reserves. That leaves ~$245 million to $330 million for the value of undeveloped locations. According to EXCO, the core development area (Area 1 on the image above), which includes just 21,000 acres, has additional ~300 drilling locations with potential for over 92 MMBoe. If no value were allocated to the ~34,000 undeveloped land outside of Area 1, the implied valuation per undeveloped acre within the core development area would be in the ~$15,000 to $20,000 per acre range (assuming 76% of the acreage remains undeveloped). This would also equate to ~$2.70 to $3.60 per Boe of potential. In light of EXCO's commentary that they see gross EURs in Area 1 in the 400-450 MBoe range with an average $7.2 million D&C cost per well (which is expected to decline in full development mode), the per-acre valuation appears adequate and at the high end of other recent transactions involving acreage of similar quality. However, the implied very low value for the 34,000 undeveloped acres outside Area 1 is a disappointment.

As part of the sale transaction, Chesapeake has also agreed to grant EXCO a farm-out option on an additional approximately 147,000 net acres that appear in early stages of evaluation at this point. No detail with regard to this part of the transaction was provided by Chesapeake. According to EXCO, under the farm-out agreement Chesapeake will retain a 2% override royalty in wells to be drilled on the farm-out acreage. The override will be convertible, at Chesapeake's option, into 25% working interest upon full payout of the drilling and completion costs. While the 2% royalty/25% working interest structure of the override would seem not unreasonable as compensation to Chesapeake on what appears to be largely "raw" acreage, the uncertainty of the option structure of the farm-out and lack of upfront proceeds are again disappointing.

The fact that Chesapeake was unable to sell its ~202,000 net acre position in Northern Eagle Ford as a single package indicates lack of pricing power in the divestiture market, particularly for acreage outside of the "core" fairway. EXCO's commentary on the acquisition call indicates that there are multiple other Eagle Ford packages currently on the market. "Raw acreage" valuation appears particularly vulnerable. This should not be completely unexpected given that many operators with proven Eagle Ford capabilities have been able to secure positions within the play's core fairway and are now focusing their capital on developing their multi-year inventories. As a result, Tier I and Tier II acreage finds itself in the "back of the development queue." As a consequence, valuations are heavily discounted.

Haynesville Transaction

In the Haynesville Shale, Chesapeake has agreed to sell to EXCO interests in approximately 9,600 net acres in Desoto and Caddo parishes, Louisiana for $320 million in cash. The transaction includes Chesapeake's non-operated interests in 42 units operated by EXCO (5,600 net acres) with 170 producing wells. Chesapeake is also selling its interests in 11 operated units (4,000 net acres) that directly offset EXCO's acreage. These units are held by production with one well per section. The acreage map is shown on the slide below. Average net daily production from the Haynesville properties to be sold was approximately 114 MMcfe/d during the month of May.

Source: EXCO Resources' July 8, 2013, investor presentation.

EXCO's internally engineered proved reserves estimate for the acquired properties exceeds 365 Bcfe, of which approximately 35% is proved developed. EXCO's "SEC reserves" estimate for the properties is 145 Bcfe, of which approximately 83% is proved developed. The difference is attributable to the wide differential in natural gas price assumptions between the two estimates. The transaction gives EXCO approximately 55 additional Haynesville drilling locations on the 11 CHK-operated sections plus an increased working interest in 75 EXCO operated drilling locations.

Valuation in the transaction appears adequate based on the reserves being acquired and futures price curve. The divestiture makes sense given Chesapeake's budget deficit and the non-operated nature of the significant portion of the interests being sold. The high degree of delineation and well control on the properties eliminates valuation ambiguity.

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.

Disclaimer: Opinions expressed in this article by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. The author's opinions expressed herein address only select aspects of potential investment in Chesapeake Energy or EXCO Resources securities and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.