Chesapeake Energy: Strong Q3 Natural Gas Volumes Defy Management's Declining Supply Thesis

| About: Chesapeake Energy (CHK)

One interesting takeaway from Chesapeake's (NYSE:CHK) Q2 earnings call: the Company is projecting its natural gas production to grow strongly into the third quarter this year and, after declining from its peak, to finish 2013 at a rate essentially flat with the Q2 2012 level.

Production growth is not the sentiment that some listeners, including myself, may have gotten from the Company's conference call. CHK's CEO Aubrey McClendon was very emphatic about the approaching industry-wide production downward trend:

"Based on the substantial gas drilling rig count decline that last week reached a 12-year low and an embedded high decline rate in the country's existing natural gas production base, we believe it won't be long until the EIA-914 data shows US gas production on a confirmed downward trend.

…The gas storage overhang is decreasing by an average of 2 to 4 Bcf per day each week. If this trend continues and we experience a normal winter, the US gas market could reverse its 900 Bcf year-over-year storage surplus established in April 2012 and reach a potential gas storage deficit in April 2013 of up to 900 Bcf. As a result of this potential storage reversal, rising demand for natural gas across the economy, and likely production declines from many gas producers as they continue shifting their CapEx towards more profitable liquids production, we expect gas markets to look very different during the next few years than they have looked during the past six months.

Chesapeake's management believes that based on the foregoing the US is likely in the very early stages of a multi-year upcycle in gas market fundamentals and clear evidence of this new upcycle is readily apparent."

I must say, the evidence of the declining volumes does not come readily apparent from CHK's own dry gas production figures:

  • Q2 2011: 2.57 Bcf/d (Q2 2012 10-Q)
  • Q3 2011: 2.76 Bcf/d, +7% q-on-q (Q3 2011 10-Q)
  • Q4 2011: 2,96 Bcf/d, +7% q-on-q (2/21/12 news release)
  • Q1 2012: 2.94 Bcf/d, -0% q-on-q, includes 0.33 Bcf/d curtailed during the quarter (Q1 2012 10-Q)
  • Q2 2012: 3.03 Bcf/d, +3.0% q-on-q , includes 0.33 Bcf/d curtailed during the quarter (Q2 2012 10-Q)
  • 2H 2012 peak (CHK projected): 3.40 Bcf/d, +12% from Q2 2012 as curtailments come back online (Aug. 2012 presentation, p. 8 and earnings call)
  • 2013 (CHK projected): 2.82-2.93 Bcf/d, -(3%-7%) (Aug. 2012 Presentation, p. 21)
  • 2013 exit (CHK projected): 2.97 Bcf/d, -(1%-3%) from Q2 2012 and -0.43 Bcf/d from 2012 peak (earnings call)

It is worth noting that the Company's dry gas (excluding the associated gas from the liquids) production stayed essentially flat in both Q1 and Q2, despite the massive curtailments and the painfully low price realizations of just $1.77 and $1.22 per Btu (excluding hedges), respectively.

Perhaps even more remarkable is the fact that CHK plans to arrive at its projected 2013 exit rate of 3.0 Bcf/d with just eight operated rigs drilling for dry gas in 2013 which represents a fourteen-fold reduction from January 1, 2010 when CHK's dry gas rig count stood at 110.

The components of the Company's production growth are illustrated on p. 8 of the Company's August 2012 Investor Presentation. The graph shows a spike in the dry gas (excluding associated gas) production in the second half of Q3 2012 as the Haynesville and Barnett curtailments are reversed. In 2013, the decline in the dry gas volume is substantially offset by the strong growth from the associated gas.

Chesapeake is an 800-pound gorilla as it comes down to its impact on the US natural gas supply. It is important to remember that Chesapeake's net volumes represent only half (approximately) of their operated gross production (which includes non-operating partner shares and royalties). In terms of gross natural gas output, CHK-operated volumes will increase by roughly 0.8 Bcf/d from its average in Q2 to the peak at the end of the Q3, a very meaningful amount.

One more factor should be taken into account. Chesapeake should be given credit for the very high quality of their natural gas assets and their proven ability to under-promise and over-deliver on production volumes. As recently as in February this year in their 2/21/2012 news release CHK stated:

"As a result of production curtailments and reduced drilling and completion activity, partially offset by growth in associated natural gas production in liquids-rich plays, Chesapeake projects that its 2012 net natural gas production will average approximately 2.65 bcf per day, a decrease of 100 mmcf per day, or 4%, compared to the company's 2011 average net natural gas production of 2.75 bcf per day."

It looks like CHK is on track for a massive beat this year relative to the earlier forecast, as its updated 2012 guidance shows an 18% y-o-y growth net of asset sales (which leaves me wondering, whether the 2013 guidance showing a 7% year-on-year natural gas decline should be thought about as "20% flexible.")

CHK is not the only company who will see their natural gas production grow in Q3. The Marcellus operators in particular will likely post strong volume increases. Cabot Oil & Gas (NYSE:COG) may see their gas volumes expand in Q3 in high single digits and has indicated that their 2013 production will be a staggering 35%-50% step up from 2012, while spending within their cash flow. Range Resources (NYSE:RRC) has guided that its Q3 natural gas production will likely increase by 8%. On the other hand, Ultra Petroleum (NASDAQ:UPL) is projecting a Q3 natural gas decline of approximately 6% driven mostly by deferred completions in the Pinedale.

I have argued earlier (my note "Natural Gas: 40 Rigs Can Maintain Haynesville Production Plateau") that a sharp industry-wide reduction in the number of rigs drilling for dry gas does not readily translate into an improvement in the natural gas fundamentals. CHK is a manifest illustration to that thesis.

There is no doubt that the extremely low prices during the first half of this year have curbed the break-neck natural gas supply build and the significant dry gas budget cuts will begin to filter through to the production volumes at some point. However, with the massive well backlog, the tangible recovery in the futures prices and active hedging by operators (including CHK) below $4, the storage deficits and the $5 natural gas price environment may be postponed for a little while.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is not an investment recommendation and does not provide a view on the value or price direction of any security.

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