Chesapeake Energy Bets on Higher Natural Gas Prices

Aubrey McClendon, chief executive of Chesapeake Energy, told analysts on the August earnings call that he expected natural gas prices would rise to between $6 and $8 per thousand British thermal units (MMBtu) by summer of 2010. As natural gas comprises 92 percent of its total energy production, the company stands in good stead to take advantage of any recovery in prices -- especially since it has ample recoverable reserves and the lowest drill bit finding costs in the industry.

Cash prices for natural gas were bouncing off seven-year lows last week, trading in the $2.50 -$2.70 per MMBtu range as underground storage and domestic gas supplies remained stronger than the fundamental demand for existing volumetric production. Working gas in storage as of Friday, September 4, was 3,392 billion cubic feet (Bcf), according to the Energy Information Administration (EIA). Stocks are 503 Bcf above the 5-year average of 2,889 Bcf, due to cool summer weather and slack consumption (from the economic downturn).

Nonetheless, there is emerging consensus among industry veterans that McClendon's optimistic call on gas prices going forward could be prescient. Natural gas for October delivery on the New York Mercantile Exchange has rebounded sharply in the past week, closing at $3.76 per MMBtu in trading on September 16. The result of Fed Chairman Ben Bernanke stating that the U.S. recession has probably ended (helped also by an anticipated reversal in the supply picture from the lag-effect of curtailed industry production).

Chesapeake is one of the leading producers of natural gas in the United States, with interests in approximately 43,300 producing natural gas and oil wells pumping out approximately 2.54 bcf per day (a five-percent increase over last year). As the operator with the lowest domestic drill bit finding costs-a reported $0.87 per Mcf in the second quarter-and few hedge positions (about 21 percent of anticipated 2010 gas production), small changes in natural gas (and oil prices) have a significant impact on the company's natural gas (and oil) revenues and cash flows, according to its second-quarter 10-Q filing:

Assuming the Current Period production levels, a change of $0.10 per mcf of natural gas sold would have resulted in an increase or decrease in revenues and cash flow of approximately $40 million and $39 million, respectively, and a change of $1.00 per barrel of oil sold would have resulted in an increase or decrease in revenues and cash flow of approximately $6 million without considering the effect of derivative activities.

By calculation, the recent $1.00 run-up in the price of natural gas would increase sales and cash flows by an estimated $400 million and $390 million (assuming constant production)!

Over the next two years, Chesapeake intends to increase its liquidity and reduce its financial leverage-long-term debt was 52 percent of total capitalization at June 30-through asset sales (in the range of $2.35 to $3.05 billion in 2009 and $1.25 to $1.8 billion in 2010) and growth of its proved reserve base (currently 12.5 trillion cubic feet). The company currently carries a Ba2 bond rating by Moody's, defined as one step below junk status (reflecting the credit rating agency's opinion that the E&P's debt "obligations contain speculative elements subject to high credit risk"). Readers should note, however, that at quarter-end Chesapeake had drained 79 percent of its $3.5 billion revolving credit facilities.

Going forward, a debt reduction strategy combined with higher energy prices would considerably reduce the risk for its debt holders. Although aggressive in objective, the stated management goal of a stronger balance sheet with investment grade metrics by at least year-end 2010, including a key agency metric of long-term debt to proved reserves (of less than $0.75 per Mcf) is within reach-but will likely require $6.00 per MMBtu NYMEX gas.