Chesapeake, Spend Less

Summary

• Why Chesapeake Energy Corporation's stock price got clobbered after its earnings.
• Chesapeake needs to spend way less on capex.
• How Chesapeake can at least try to fix its biggest flaw.
• The company has a chance, a very slim one.

I'm going to start off going over what I see as Chesapeake Energy Corporation's (NYSE:NASDAQ:CHK) biggest flaw (and most irritating as a shareholder and/or future bag-holder), then I'll go into how that can be remedied. One of the biggest reasons Chesapeake Energy Corporation tanked after reporting its Q3 earnings is that it appears management still doesn't get it. Chesapeake Energy Corporation, spend less!

Weighing the cash flow versus capex situation

When the company first issued out 2017 guidance back in February, the goal was to spend between $1.9 billion-$2.5 billion, inclusive of $200 million in capitalized interest (the rest of its interest expense shows up on its income statement) on capital expenditures. A sharp jump from $1.697 billion spent on capex in 2016, justified (in theory) by the need to offset production declines across its portfolio due to subdued completion activity last year.

The low end of that budget would have still put Chesapeake on a favorable trajectory heading into 2018 as its production base would have stabilized around the middle of this year. If growth was a concern, Chesapeake could have allocated more to the Eagle Ford and less to the Powder River Basin (the Eagle Ford is its liquids growth engine, the PRB is a monetization opportunity).

Now Chesapeake aims to spend between $2.3 billion-$2.5 billion on capex this year, a bump up from $2.1 billion-$2.5 billion previously. A level that vastly outstrips the company's operating cash flow generation and compounds existing problems.

Chesapeake generated $337 million in operating cash flow in Q3 ($331 million including working capital changes), nowhere close to its capex of $692 million. An adjusted EBITDA figure of $468 million was touted, but that excludes Chesapeake's net (includes favorable hedging impact of $1 million) interest expense of $114 million for the quarter (different from capitalized interest, which shows up on its cash flow statement under acquisitions of proved and unproven properties).

Either way, ~$350 million in quarterly cash flow just isn't going to cut it. $1.4 billion in annual cash flow generation wouldn't even cover last year's spend rate.

Sure, Chesapeake's production base has now stabilized. It was up an adjusted 4% quarter over quarter, but a better gauge of that should include asset sales because those are still ongoing. In Q2, Chesapeake pumped out 527,600 BOE/d, including 88,400 bpd of crude. By Q3, its total production has climbed up to 541,600 BOE/d, but oil output slipped to 86,000 bpd due to the negative impact of Hurricane Harvey. Equal to total production growth of 2.7% sequentially.

From its conference call:

"[Chesapeake's] total production during the third quarter grew 3% sequentially and 4% sequentially after adjusting for asset sales. We look forward to the acceleration of this rate in the fourth quarter as we see the benefit of our significant Q2 to Q3 capital investments come on line, and we are well on our way to averaging 100,000 barrels of oil per day, up 16% from our third quarter oil production."

Management made sure to bring up that Chesapeake's production on October 30 stood at 584,000 BOE/d, including 99,000 bpd of crude, and that everything was on track for an average oil output rate of 100,000 bpd this quarter.

On a barrel of oil equivalent basis, crude and natural gas liquids production generates much more operating cash flow than dry natural gas. Assuming the firm's average total production moves up to 590,000 BOE/d (equal to 8.9% sequential growth) in Q4 as its oil output averages 100,000 bpd (16.3% jump sequentially), it wouldn't be unreasonable to estimate that Chesapeake's cash flow generation could jump by ~15% in Q4 versus Q3 (all else constant). Equal to $1.6 billion in annualized cash flow generation, which is still lighter than what Chesapeake needs.

This is where the recovering energy market thesis comes into play. Factoring in the impact of hedges (realized price with hedges/price without hedges), Chesapeake's Q3 realizations for oil ($52.33/$47.94 a barrel), natural gas liquids ($21.83/$21.26 a barrel), and natural gas ($2.52/$2.52 per thousand cubic feet) came as a mixed bag. While stronger (versus Q2 2017) oil and NGLs realizations helped out, weaker natural gas prices (with dry gas representing just under three-quarters of its production base) held Chesapeake back.

Henry Hub averaged ~$2.90/Mcf in Q3, with Chesapeake's realizations coming in lower than that due to pricing differentials in Appalachia. The firm's dry gas production out of the Marcellus and Utica plays fetches much lower prices to Henry Hub if it can't access out-basin markets (something management does try to hedge against).

Recently, that differential has come down as additional takeaway options are getting closer to being completed. Higher hedged gas prices in Q4 2017 and 2018 versus its Q3 2017 hedges, a smaller Appalachian differential, and a slightly stronger Henry Hub benchmark will provide an uplift to Chesapeake's dry gas realizations.

If West Texas Intermediate holds its ground at $55 (currently closer to $56 as of this writing), Chesapeake will see a material uplift in its liquids realizations. Chesapeake noted that 60% of its net oil production fetches prices based on the Louisiana Light Sweet benchmark, largely due to the Eagle Ford play (near the Gulf Coast) representing the majority of its oil production. LLS has seen its premium over WTI rise to over $3/barrel.

Combined with rising liquids production levels, that could really be key in Q4 and into 2018. But the liquids-heavy route to cash flow neutrality rests entirely on WTI trading in the $53-57 range, which comes with plenty of risks as that has proven to be a hard level to hold.

So you're saying there's a chance...

This is where Chesapeake's outlook becomes muddied. Yes, its cash flow generation is weak, its balance sheet is terrible, and it continues to spend too much per quarter. Yet the lurch higher in oil prices all of a sudden made the light at the end of the very dark and windy tunnel Chesapeake has to traverse far brighter. The one true bright spot of this earnings cycle had little to do with Chesapeake and everything to do with the macro picture giving the firm a chance. A slim one, but a chance nonetheless.

In order to make the most of that chance, management needs to follow through with the very vague guidance Chesapeake put out. Chesapeake won't release its 2018 guidance until February but did mention that it could grow its production base year over year while spending less. However, without knowing the actual figures, that leaves investors wanting. True, Chesapeake will have a lot of momentum going into 1H 2018 on the production front, but after that, its trajectory remains uncertain. Chesapeake's CEO commented:

"Looking to 2018, we expect to provide operational performance and CapEx guidance in early February. We anticipate reducing our capital expenditures during 2018 and still delivering a relatively flat to slightly increasing production profile for the year."

Final thoughts

Chesapeake Energy Corporation needs to start spending less on capital expenditures. The market is worried management won't cut capex by enough next year to make its financial position viable. A combination of production growth and better realizations may enable Chesapeake Energy Corporation to generate $450 million in quarterly cash flow, maybe even $500 million, and that should represent the ceiling of Chesapeake's capex budget.

Until Chesapeake Energy Corporation puts out its 2018 guidance, the uncertainty overhang will get in the way of upside being created by a recovering oil market.

Analyst’s Disclosure: I am/we are 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.