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  • Roger S. Conrad

Gas-Heavy Producers: Still on the Sidelines

By Elliott H. Gue on Nov. 1, 2015

Under the leadership of the outspoken and free-spending Aubrey McClendon, Chesapeake Energy Corp amassed huge acreage positions in a number of prominent shale plays, including the Eagle Ford Shale, the Marcellus Shale and the Utica Shale.

But the company also accumulated acreage in plays that fell out of favor (the Barnett Shale, the Haynesville Shale and the Granite Wash) or never really took off (the Mississippian Lime).

With ownership interests in about 45,500 producing oil and gas wells, the company is the second-leading US natural-gas producer and the 11th-largest producer of NGLs.

Although McClendon deserves credit for having the foresight to be an early mover in the shale land grab, his focus on acquiring vast swaths of prospective acreage reflects his collector’s impulse and a lack of long-term strategy. Securing this leasehold required a massive drilling program that, at its peak, involved 175 rigs.

Returns-based decisions about capital allocation and a culture of operational excellence were nonexistent at Chesapeake Energy, resulting in years where capital expenditures were as much as three times the firm’s revenue. Keeping the party going required a lot of creative financing that, invariably, caused even more problems.

Activist shareholders ousted McClendon in early 2013, and his successor, Robert Lawler, who came over from Anadarko Petroleum Corp (NYSE: APC), took the helm in June 2013.

Lawler deserves credit for his efforts to divest noncore assets, shore up the company’s balance sheet, improve operational efficiency and allocate capital in a manner that maximizes returns for the company and its shareholders.

Part of this process has involved ramping up development of the firm’s liquids-rich assets in the Eagle Ford Shale and the Utica Shale, though natural gas still accounts for 71 percent of its production mix.

The company has delivered impressive cost reductions, in large part because the firm was so far behind the rest of the industry. But in the Utica Shale, the company has overtaken its competitors in terms of drilling and completion efficiency, despite sinking wells with longer laterals.

The severe downdraft in energy prices has made this turnaround effort all the more pressing. Although the company grew its average daily production by 13 percent from year-ago levels (excluding asset sales) in the second quarter, operational cash flow tumbled by 52 percent from year-ago levels to $606 million.

Like many of its peers, Chesapeake Energy responded to these headwinds by slashing its overall capital expenditures and its drilling- and completion-related spending.

Chesapeake Energy also reached an agreement with Williams Partners LP (NYSE: WPZ) to remove the onerous minimum volume commitments on its gathering contracts in the Utica Shale and Haynesville Shale and replace cost-of-service agreements with fee-based contracts.

These renegotiated deals should help to limit expense acceleration in these plays. Management continues to work with Williams Partners on alternatives to its minimum volume commitments in the Barnett Shale, a mature play where Chesapeake Energy has slowed activity dramatically.

The company has also curtailed its output in the Marcellus Shale by about 500 million cubic feet per day and the Utica Shale by about 200 million cubic feet per day because of insufficient takeaway capacity and depressed in-basin price realizations.

The exploration and production company’s capital budget contains a few head-scratchers—namely, why management continues to drill in the Mississippi Lime, a play that generates some of the weakest returns in its portfolio. Perhaps these efforts aim to highlight the acreage for a joint venture or eventual sale.

Management has indicated that improving well results in the Haynesville Shale—a product of longer laterals, tighter spacing between fracking stages and more silica sand—could help the firm to attract a partner to help develop this asset base.

Chesapeake Energy has made a great deal of progress in recent years, but its diversified portfolio includes significant exposure to basins with challenging economics and/or inferior rocks.

Efforts to divest these assets have yet to pan out, though the company did get a good price when it sold high-quality acreage in the Marcellus Shale to Southwestern Energy Corp (NYSE: SWN).

Although Chesapeake Energy holds about $2 billion in cash equivalents and should be able to handle its near-term refinancing needs, the company failed to generate enough operating cash flow to cover its interest expense in the first half of 2015.

We prefer to own only best-in-class names in this difficult operating environment—preferably when they retrench to our dream prices. Investors should stand aside on Chesapeake Energy Corp’s common equity.

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    • Elliott H. Gue

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Roger S. Conrad

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor