Quick Update On Chesapeake Energy

Chesapeake Energy (CHK) reported earnings last week. The company didn’t have a complete set of financial statements but I direct readers to the company’s website for a closer look at the numbers or Zman’s excellent numbers breakdown at his blog. I will be focusing on the prospects for this investment.

Key takeaways from the earnings release and conference call:

  • The company revised its outlook down again from its December update, projecting 20% lower cash flow from operations combined with 5% higher cash outflows. As an analyst pointed out during the conference call, CHK is dependent on asset monetizations to cover the gap between its projected cash flow and expenditures. The company will benefit from having its JV partners (BP, PXP, STO) foot the bill for much of 2009′s drilling spend but yet still cannot manage a neutral/positive cash flow profile, which is somewhat disturbing.
  • Chesapeake is actively seeking a joint venture partner for its Barnett Shale operations. If prices linger at current levels ($4/mcf as of today), the company may have to look at reducing its operations in the Barnett. Exacerbating the situation is the wide pricing disparity (Q4 avg > $2 / mcf) between gas located in the Barnett compared to the Gulf Coast or Appalachia regions.
  • Management asserted they have no need to raise capital from the markets — famous last words, perhaps?
  • CEO Aubrey McClendon threw down the gauntlet in terms of completing planned asset monetizations. The market is clearly skeptical of CHK and McClendon will have to deliver to maintain whatever credibility he has left.
  • Management projects driving drilling and servicing costs down at least 25%, with pressure on the service companies accelerating in recent weeks. This cost reduction is not reflected in the updated outlook. The company made it clear that if these cost reductions come through, CHK will pocket the savings rather than drill more wells for the budgeted allocation.
  • The prospective oil plays mentioned by management last year don’t look promising at this point as one prospect has already been discarded and the others are uneconomical at current oil prices.
  • McClendon seems to be on a new marketing kick, touting CHK’s leading “Big-4 shale” position. The big-4 tagline may be slightly misleading as their Marcellus position, while large in acreage, is not in the sweet spot of the play (75% risk factor as compared to 15% for the Barnett and 40% for the Haynesville).

The key quote during the conference call was this tidbit from McClendon:

“I would like to emphasize that the bias is towards keeping hedges on because I think we have to run the business with more attention, of course, to the down side than the up side.”

While McClendon and company have amply demonstrated their ability to find natural gas, they need to demonstrate the ability to responsibly manage a large, mature organization. It is common for founder-CEOs to struggle with the organizational shift from an entrepreneurial mindset to a more bureaucratic structure that accompanies size. I share the market’s “show-me” stance toward CHK in this respect.

Finally, while Chesapeake seem fairly well-positioned with hedges in place for most of 2009 production and roughly half of 2010 production, I am concerned about the outlook beyond the next two years if gas prices don’t recover for a time. The company clearly expects a rebound in gas prices toward late 2009 into 2010 as spending cuts begin to curb supply.

While I agree with this assessment, I would like to see management address downside scenarios. After all, just a few months ago, McClendon asserted that $6 gas couldn’t “happen in reality.” In the latest investor presentation, CHK fails to include any projections below $5 natural gas, a full dollar above today’s price. If management intends to live up to its talk of managing for the down side, they will need to do more than just talk the talk.

Performance measurements:

  • Meet cash flow projections:
    • 2009: $3.9B – $4.0B $5.4B – $5.7B ($5.8B – $6B)
    • 2010: $5.0 – $5.4B $6.25B – $6.75B
    • FCF positive by 2010
  • CapEx (do not outspend cash resources in 2009/2010)
    • 2009: $4.2B – $4.7B  $5.7B – $6.5B
    • 2010: $4.6B – $5.2B  $6.1B – $6.8B
  • Asset monetizations:
    • 2009: $1,500 – 2,000M
    • 2010: $1,000 – 1,500M
  • Production
    • 2009: 875 – 885 bcfe
    • 2010: 976 – 1,016 bcfe
  • Hit reserves guidance @ 13-14 tcfe by 2009
  • Maintain 2:1 ratio on risked/unproved to proved reserves. Large decline may signal end of growth. This ratio is currently closer to 4:1.
  • Operating costs (per mcfe):
    • G&A: $0.33 – $0.37 $0.43 – 0.49
    • DD&A: < $2 for 2009/2010 ($2.50 – $2.70)
    • DD&A (non-oil/gas): $0.24 – $0.28  $0.20 – $0.24
    • interest expense: $0.30 – $0.35 (increases $0.05 in 2010) $0.50 – $0.55
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Read more on Chesapeake Energy at Wikinvest

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