Chesapeake Energy Can Make Money At These Prices And Lower

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About: Chesapeake Energy Corporation (CHK)
by: Long Player
Summary

The bears come out when the stock goes down.

The merger and increasing percentage of oil production make this a good speculative bet.

Management has demonstrated cost reductions and improved performance of the acquired properties.

Off balance sheet liabilities are dramatically decreasing.

This speculative stock now has a reasonable path to investment grade.

Predictably, the answer to a declining stock price is the "piling on attitude" that something just has to be wrong. Chesapeake Energy (CHK) just made an expensive acquisition and the bears just cannot wait to show that the acquisition was a total failure. But expenses show up first and benefits show next in most acquisitions. In the meantime, a smart investor can take advantage of the market worries to buy a speculative recovering stock at a good price.

Source: Seeking Alpha Website June 7, 2019

The merger with WildHorse Resource (WRD) was completed February 1, 2019. The very first thing that happens with a merger of this size is that Chesapeake Energy has the privilege of writing a whole lot of checks for this acquisition. The benefits of the WildHorse acquisition only begin after the company begins to improve operations and accomplish all the things management promised.

As shown on the stock chart above, clearly Mr. Market is in a "show me" state of mind. There was some initial euphoria along with the rising oil prices. That euphoria vanished with the sinking oil prices. However, the industry is changing so fast that costs continue to drop. What was regarded as previously unprofitable oil pricing is now very profitable.

But the oil wells already in production did not magically change to the new designs and new output. Chesapeake has to drill the new wells to obtain the benefit of the latest knowledge. Indeed, management admitted that in the conference call:

"On the production side, we have already started to redesign completions, namely by reducing fluids used and maintaining sand volumes and combining this with better choke management . Early results are extremely encouraging, and have seen on the Easy Rider pad in Burleson County where our choke management efforts have already delivered a 35% initial production uplift to historical wells in the area."

(Quote From Frank Patterson, Executive Vice President of Exploration and Production)

"During the last three months, we have rapidly integrated the new asset into our portfolio, eliminating approximately $500,000 in cost per well with improved drilling and completion techniques, highlighted by new records and drilling rate of penetration and number of fracture stimulation stages completed in a day."

(Quote From Doug Lawler, President and Chief Executive Officer)

Finally the cumulative future effect of the above (and a lot more).

"As Doug highlight, our production stream for the first quarter was 22% oil, compared to 19% in the 2018 fourth quarter and 17% oil a year ago. While the first quarter is traditionally our highest EBITDAX quarter for the year, it's important to note that margin improvements we are recognizing are not simply a function of the price. Our mix will continue to shift oil throughout 2019 and 2020 as the Powder River Basin, Brazos Valley grow and have a greater contribution to the total.

We expect to exit the year around 26% oil, the margin of this high oil content is meaningful with our oil assets approximately $30 per BOE EBITDAX margin lead by the Brazos Valley reaching over $37 per BOE due to its low structure and access to Gulf Coast premium pricing."

(Quote From Domenic Dell'Osso Executive Vice President and Chief Financial Officer)

None of the above quotes remotely suggest that most of the latest merger benefits are there at the end of the first quarter. The only thing that really mattered was the sale of the Utica Shale followed by the merger with WildHorse Resource did increase the oil percentage of total production immediately. Even then that oil production was only present for roughly two of the three months in the quarter.

Management did state that the merger would be accretive, but they did not state that the merger would immediately solve all of the company's problems and shareholders would live happily ever after.

Even more importantly, the replacement of the mostly gas Utica Shale with the Eagle Ford oil increased the margin as shown in the last quote. On a BOE basis, management is lucky if gas has a EBITDAX margin of $15 BOE. The Brazos Valley production is expected to have a margin far higher. Therefore, there is considerable room for an oil price downdraft before the benefits of this merger disappear.

Finances

The bears are having an absolute field day with the finances because the long-term debt increased as a result of the merger. However, a slightly longer view than the time between breakfast and lunch reveals a materially different picture.

Source: Third Quarter, 2018, Earnings Press Release

As shown above, the only reason that the long-term debt decreased at the time of the third-quarter reporting was because the working capital deficit was increasing. Many analysts take into account the working capital deficit when reporting debt progress. Hence, there really was no debt progress shown above.

The sale of the Utica Shale leases was announced and closed in the fourth quarter. That sale provided a temporary reduction in long-term liabilities, including the ones classified as current, until the merger with WildHorse Resource completed.

In fact, the only time this company made debt reduction progress was through major asset sales. This author had noted in several previous articles that really no debt progress on the balance sheet had been made for some time and the situation was looking grim. This was a stock that offered volatile and seasonal trading opportunities only.

Until the latest merger jump started oil production increases, this company was in a debt spiral. It really could not sell assets in an accretive manner to work its way out of the debt.

Net cash provided by operating activities had improved to more than $500 million in the third quarter as payments for judgments and some onerous contract terminations began to decline (hopefully cease entirely). But that was not enough to service debt that many believed had totaled $10 billion or so for some time when including the working capital deficit.

Source: Chesapeake Energy First Quarter, 2019, Earnings Press Release

Some sharp eyed readers will notice that the long-term debt is actually slightly lower than it was when compared to the third quarter of 2018 shown above. It is probably a little too soon to make a conclusive statement because Chesapeake needs time to settle all the merger details.

In effect, this company sold less profitable mostly gas production and replaced that production with far more profitable oil production while keeping the long-term debt (and working capital deficit) picture basically stable. Many readers would agree that the oil production increase provided by these transactions definitely provided a step in the right direction.

Source: Chesapeake Energy Annual Meeting Slide Presentation May 2019.

Those covering Chesapeake have long wondered about the value of onerous off balance sheet liabilities. It should be noted that the recent quarterly statement showed yet another decline in the gathering and transportation costs as yet one more onerous contract disappeared with a major lease sale.

Even though the balance sheet has not shown progress for some time, the off balance sheet mess is clearly cleaning up. There is probably still some more work to do in that area. But it no longer appears capable of sending the company to bankruptcy by itself.

Who Cares About Margins?

The way the stock price has acted, Mr. Market appears to care less about margin improvement.

Source: Chesapeake Energy First Quarter, 2019, Earnings Press Release

Notice that even though the average price of oil decreased about $7 per barrel, the overall oil equivalent increased before hedging. This is important because that indicated a potential source of long-term profitability increase. Oil as a percentage of production does not have to increase much to raise the average selling price per barrel. At each price point for oil, the company profitability should increase. That alone should lower the company breakeven in the future as production increases from the drilling activity.

Source: Chesapeake Energy First Quarter, 2019, Earnings Press Release

Similarly, the cash flow and EBITDAX amounts did rather well considering all the consolidation activities that follow a material merger. Oil prices took a dive and still there was decent cash flow compared to the year-ago period.

Typically, a large merger has adjustment costs for at least six months post merger. That means that probably the fourth quarter will provide the first clear view to shareholders of the merger benefits. In the meantime, there are lot of preliminary indicators that mark this merger as a very good deal for Chesapeake Energy.

Drilling And Production

Even more important is that more rigs are now drilling for oil. The Eagle Ford now has all the rigs that were drilling for oil for WildHorse before the acquisition plus the Chesapeake rigs.

Source: Chesapeake Energy First Quarter, 2019, Earnings Press Release

Brazos Valley had 23 MBBL of oil per day in the first quarter. However, had those assets been available for the full quarter, the figure would have been closer to 30 MBBL of oil per day. In short, the percentage of oil produced will increase just by having the Brazos Valley production for a full quarter.

Chesapeake management has also expressed a current objective to operate 4 rigs once the well design and operational details to support the program are completely worked out. That oil production will therefore grow relatively quickly. Even though production decreased overall due to the sale of the Utica Shale leases, there is every chance that cash flow will increase this year significantly unless oil prices sustain a dramatic decrease from current levels.

The first-quarter press release noted that some wells drilled were gas wells. Those rigs have now been deployed for maximum oil output drilling. The change will not happen overnight because Chesapeake is a large company. But management does have an often stated goal to end the year with 26% oil production. If that goal is met, the effect on company netbacks and cash flow should be significantly positive.

The Future

Short of an unforeseen depression or major recession, the margins are going to improve "by force". That increasing oil percentage of production will have a positive impact on margin.

Source: Chesapeake Energy Annual Meeting Slide Presentation May 2019.

Free cash flow neutrality is finally an achievable goal. The emphasis on oil production appears to make properly servicing the debt a reasonable goal over the next two years or so. Current financial ratios make this company speculative. But the path to investment grade is reasonable. The process could be accelerated with another acquisition and sale. Whether one happens at a reasonable price is anyone's guess.

Source: Chesapeake Energy Annual Meeting Slide Presentation May 2019.

When production of just oil exceeds 800 BOD for the first 90 days, then you are beginning to see production that will pay for the cost of the well in less than a year. Combine that with the impressive cost savings that Chesapeake is showing on these wells and that is fuel for speculation about some very impressive returns on wells drilled in the Eagle Ford.

It used to be exceptional when a well produced 100,000 BO in the first six months. Now companies are aiming to produce 200,000 BO in the first six months. Some like EOG Resources (EOG) report that accomplishment routinely. Chesapeake management is clearly "gunning" to catch up with the industry leaders in production. As shown above, management is definitely on the right path.

WildHorse Resource has some great oil-rich leases. At times, management reports as high as 91% oil produced as the total well production. Chesapeake will improve both total production results and average liquids percentage of production results as technology improvements continue to sweep the industry.

Chesapeake has an advantage with the Brazos Valley leases because the Eagle Ford does not have the competitive bottlenecks of the Permian. In fact, the Eagle Ford is probably much more profitable to drill without the oil price discounts and the lack of gas takeaway capacity. That could change quickly in the future. But right now Chesapeake appears to have made a great acquisition that dramatically changes the company prospects.

Large companies like Chesapeake need time, though. This low priced stock will be volatile. This has been illustrated by the rally from late December to nearly $3 per share and then back to the current price.

However, management appears to have a very reasonable path to show some dramatic improvements when compared to previous quarters. This momentum based market loves great comparisons and Chesapeake is well positioned to supply very positive earnings and production comparisons for the foreseeable future.

Current trade talks have put pressure on oil and gas companies amid worries about the next recession. But as Louis Rukeyser used to state on his show "Wall Street Week", "the market correctly predicted 11 of the last 7 recessions". I currently believe that the latest nervousness has no basis. The economy looks pretty good and trade talks should reach a rational conclusion before serious economic damage is done. I continue to hope that congress will do something about that deficit. Even so this country has so many more positives than negatives that the future remains bright.

Therefore, the outlook for this stock remains every bit as good as it did at Christmas time. I do believe that oil prices will rally again as they inevitably do. If there is an economic slowdown, it will be short lived and would represent a solid buying opportunity. In the meantime, this stock appears to be a long-term speculative bargain again.

The president and CEO, Doug Lawler, pulled off a near miracle in salvaging this company from what looked like certain bankruptcy. He will probably lead the company back to what it once was several years ago. That will probably take some time. But he has demonstrated a far superior leadership ability so far. He appears to be worth long-term investor money for the foreseeable future.

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.

Additional disclosure: Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.