Against all odds, the management team at Chesapeake Energy Corp. (CHK) has continued to improve operations at the large oil and gas E&P (exploration and production) firm. Few people have been as tough on Chesapeake as I have been, doubtful that the company, with a history or little to no positive cash flow, high leverage, and struggling production, could make for a sensible long-term prospect, but those times are changing. Despite the troubles the business has faced in recent years, the picture does show continued signs of improving, even if the business does still have plenty of room it must run before being truly healthy again.
Chesapeake's mixed results
If you were to look solely at Chesapeake's basic financial figures, you might think the company's deterioration is continuing. In the first quarter of its 2019 fiscal year, for instance, the company saw its EBITDAX come in at $676 million. This represents a decline of 5.7% compared to what was seen the same quarter last year. According to management, this was driven by a few factors, including some higher costs. Production expenses, as an example, managed to rise from $2.94 per boe (barrels of oil equivalent) to $3.02. Although gathering, processing, and transportation costs fell nicely, declining from $7.15 per boe to $6.29 per boe, other cost items have increased. These include, but are not limited to, general and administrative costs, which expanded from $1.60 per boe last year to $2.20 per boe for the same time frame.
Not only did performance not come in so hot during the quarter on the cost side of things, but the company also saw its production year-over-year decline, falling from 49.88 million boe during the quarter to 43.60 million boe today. Add into this lower realized pricing for crude, natural gas, and NGLs, and it makes sense why EBITDA came in so low and why operating cash flow dropped from $588 million in the first quarter last year to $456 million this year.
In short, this data looks anything but great for Chesapeake, but investors also need to consider the major M&A activities the company has undertaken in recent months. On February 1st, management announced the completion of its more than $3 billion acquisition (in cash and stock, and excluding net debt assumed) of WildHorse Resources Corporation, and last year it completed the $2 billion sale of its Utica Shale assets. During periods of high activity like this, it's difficult to compare the company compared to some period in the past before said activities took place.
Some encouraging signs
When you dig down beneath the headline numbers, you will find that the picture for Chesapeake is, in many ways, getting better. Take, for instance, its Brazos Valley assets (formerly owned by WildHorse). Already, the company has touted average savings on D&C activities of $500,000 per well, with some wells seeing cost reductions in excess of $1 million. As a result of the firm's improvements here, it seems like management is well on its way toward achieving the $200 million to $280 million in annual savings associated with its operations. In Brazos alone, the company intends to allocate between $665 million and $685 million toward capex, with four rigs running and two frat crews on the job.
A big part of the reason why management is focused on Brazos stems from the fact that it's an oil-heavy asset of the company and that's where the opportunities exist for the business and its shareholders long-term. In a prior article, I went into detail about how management should focus on its oil assets and either divest of or decrease investment in its gas regions. It's no coincidence then that you would find out that its Brazos assets are, by output, 75% oil.
It's not just Brazos that Chesapeake is focused on though. The Powder River Basin continues to be a target of heavy investment by the firm, with management intending to spend, at the midpoint, $515 million toward capex. Even though only 45% of its output is oil, the company forecasted that this year it will see oil production roughly double compared to 2018. In South Texas, meanwhile, the company intends to invest around $525 million, and with 56% of its output being oil, management has dubbed the asset a "free cash flow machine".
Taken from Chesapeake Energy Corp.
As you can see in the image above, even as natural gas and NGL volumes decrease, the mix of output and total volumes from oil should rise, while in the image below, it's clear that the company is continuing to move toward its high-margin oil-growth assets. As a result of these activities, and thanks in part to higher oil prices, management has even gone so far as to increase guidance for this year, with EBITDA now forecasted to range between $2.55 billion and $2.75 billion. This range is $50 million higher than previously forecasted.
Taken from Chesapeake Energy Corp.
It's important to keep in mind that while Chesapeake is improving, the firm still has a long way to go before it's a prime investment prospect. With net debt of $9.97 billion, the midpoint of its EBITDA target would place its net leverage ratio this year at 3.76, while management is targeting a number of 2 or lower long-term. Not only that, but also the business has a history of spending significant funds on capex (this year it will spend between $2.085 billion and $2.285 billion, excluding capitalized interest of $20 million), only to see production flatline or even decrease. This year, oil production is forecasted to grow 13% compared to last year after adjusting for M&A activity, but it's still early to see if continued emphasis on oil will help the business to outgrow its bad reputation.
Taken from Chesapeake Energy Corp.
At this moment, I'm starting to like Chesapeake more and more, but I do have my issues with the company. On the whole, until we see what subsequent years might look like, I am a firm believer that there are better investment prospects out there than this. That said, the company does seem to be improving, and if it can continue growing oil production like this in a way that will allow meaningful EBITDA and operating cash flow expansion, and if it can reduce leverage through this growth, combined with additional asset sales (preferably of gas-heavy properties), then it could, in a year or two, become a really attractive prospect. Until then, I intend to sit on the sidelines and watch.
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Disclosure: I/we 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.