Another Spending Spree at Chesapeake Energy?

Chesapeake Energy intends to increase its exploration and production budgets for 2009 and 2010 by $400 million and $300 million. Although not known for its financial discipline in the last several years, the natural gas producer insists it can cover its capital spends through asset monetizations, joint ventures, and increased production. Chesapeake has demonstrated some success with asset sales to date, but can the company live within its cash resources if weak natural gas prices persist during the next two years?

Chesapeake's strategy is focused on discovering, acquiring and developing conventional and unconventional natural gas reserves onshore in the U.S., primarily in the "Big 4" natural gas shale plays: the Barnett Shale in the Fort Worth Basin of north-central Texas, the Haynesville Shale in the Ark-La-Tex area of northwestern Louisiana and East Texas, the Fayetteville Shale in the Arkoma Basin of central Arkansas and the Marcellus Shale in the northern Appalachian Basin of West Virginia, Pennsylvania and New York. In building what is the largest inventory of U.S. Big 4 shale play leaseholds (2.7 million net acres), the company has incurred high leverage: in 2008, the company went on a $3 billion spending spree - long-term debt of $13.5 billion was 52 percent of total capitalization at June 30, up from 47 percent at year-end 2007.

During the second quarter, Chesapeake generated $900 million in proceeds, principally from sales of mature wells and gathering assets and volumetric production payments (a financing structure where a buyer receives a non-operating interest in certain oil and gas properties in exchange for an upfront payment). Management expects to complete $2.35 - $3.05 billion in total asset sales for 2009 and sales in the range of $1.25 - $1.80 billion for 2010.

Asset deals, production growth of almost 8 percent, and drill carrying costs less than $1.00 per Mcf -- chief executive officer Aubrey McClendon optimistically predicted on the August earnings call that the energy company he co-founded could generate up to $2.1 billion next year in excess cash flow, too. Not withstanding Chesapeake's success' in pumping out more natural gas -- higher initial production and recovery rates from improvements in the fracture process used in horizontal wells -- in typical McClendon fashion he nonetheless downplayed the fact that increasing volume beyond current daily production of 2.45 Bcf will require total capital spends of almost $10 billion in 2009 - 2010.

To further develop its Big 4 shale leaseholds, Chesapeake plans to operate an average of approximately 101 rigs in 2010 to drill up to 795 wells. The current operating rig count is 83. The company has had some success in raising cash - and lowering its own drill bit costs - by selling investment interests on some of this acreage. For example, the company expects that its joint venture partner, StatoilHydro, will pay 75 percent of drilling costs in the Marcellus for 2010.

Chesapeake has hedged little of its 2010 production of natural gas (about 21 percent, at average prices between $6.78 - $9.78 per MMBtu). Given uncertainty in forward energy prices and asset sale guidance, Credit Suisse energy analysts warned in an August research report that calculated 2010 cash flows of $3.9 billion will still leave a funding gap of $760 million (which includes joint venture capex contributions) - and this number assumes a gas price of $6.50 per MMBtu! It is likely that the company will need to tap its revolver credit lines to bridge this deficit.

As mentioned in my BNET Energy post last week, Chesapeake is betting on higher energy prices to boost the health of its balance sheet: lower prices decrease the useful economic lives of the underlying natural gas properties (and decrease the value of estimated future reserves, too). Assuming flat NYMEX natural gas prices of $7.00 per mcf over the life of the well, positive economics do support the company's aggressive drill bit programs - longer-term. Estimated pre-tax rate of returns from its shale plays run from a low of 24 percent from a 2.4 bcf horizontal Fayetteville well (drilled for $3.0 million) to a high of 71 percent from a 4.2 bcf horizontal Marcellus well (drilled for $4.5 million).

Quarter-to-quarter, however, the company's ability to live within its means will depend on finding additional partners or higher cash flows: a change of $0.10 per mcf of natural gas sold results in an increase or decrease in cash flow of approximately $39 million, according to the according to the second-quarter 10-Q filing. McClendon & company are hoping that their optimism -- and higher energy prices -- prevail.