Chesapeake Energy Turns Tail on Natural Gas, Looks for Oil Instead

Last Updated Apr 6, 2010 3:30 PM EDT

Chesapeake Energy (CHK), the nation's second-largest natural gas producer, plans to shift more of its 2010 capital spend towards oil exploration in coming months, due to the widening divergence between gas and oil prices.

Currently utilizing 118 operating rigs, Oklahoma City-based Chesapeake is the most active driller in the continental United States, responsible for one of every seven gas wells spudded in 2009. The news is of particular interest, too, as 93 percent of its massive 2.4 billion cubic feet equivalent (Bcfe) of daily production comes from natural gas reserves.

"The economics just compel you to look for oil rather than natural gas right now," chairman and chief executive officer Aubrey McClendon told attendees at Hart Energy's annual Developing Unconventional Gas conference in Fort Worth last week.

McClendon admitted on the company's February earnings call that $5.00 per million BTU pricing on the New York Mercantile Exchange (NYMEX) equates to $3.50 gas at the wellhead, once differentials like gathering and compression costs are included in the cost calculus. "Even $3.50 gas at the wellhead does not create enough cash flow in the industry to maintain today's drilling price -- even for the best-managed shale plays," he said.

Excluding takeaway-pipeline expenses (like gathering and compression costs), Chesapeake posted, on average, production and development costs of $3.47 per Mcfe, according to the company's 2009 annual earnings report.

To mangement's credit, they have mitigated the risk of a prolonged slump in natural gas prices and have provided more predictable future cash flow stream from operations through a hedging program for 2010. As of February 17, 2010, the company had hedged through swaps and collars approximately 60 percent of its expected natural gas and oil production in 2010 at average prices of $8.16 per thousand cubic feet equivalent (Mcfe).

The price of West Texas Intermediate (WTI) crude oil generally is denominated in terms of barrels, where one barrel has an energy content of approximately 5.8 million Btu. With the price of natural gas (at the Henry Hub), in contrast, denominated in million Btu, assuming ceteris paribus, on the basis of their energy contents, the ratio of the crude oil price to the natural gas price would be approximately 6.0 times. From 1990 through 2007, the average price ratio was about 8.6 times, according to the U.S. Energy Information Administration (EIA) (Factors Affecting Natural Gas Prices, as detailed in a recent EIA report.)

Why is a U.S natural gas producer such as Chesapeake suddenly priming the drill-bit for oil? In futures trading Monday on the NYMEX, oil for May delivery settled at $86.62 a barrel -- twenty times the May delivery closing price of natural gas (of $4.27 per Mcfe).

In keeping with its $4.1 billion (+) capex budget for 2010, the company is initially looking to shift 18 to 20 idled gas-focused rigs (from sub $5.00 gas wells) to the finding and exploration of oil and natural gas liquids in new unconventional plays, such as leases in Granite Wash in the Texas Panhandle and western Oklahoma and Eagle Ford in south Texas.

Chairman McClendon, whose actions often leave the observer thinking hubris is his moral imperative, crowed on recent conference calls that the company is likely already sitting on more than one billion of "liquid rich reserves." Extracting these reserves, however, could prove more problematic -- but more on that in my next Chesapeake post!

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  • David Phillips

    David Phillips has more than 25 years' experience on Wall Street, first as a financial consultant and then as an equity analyst for several investment banking firms. He sifts through SEC filings for his blog The 10Q Detective, looking for financial statement soft spots, such as depreciation policies, warranty reserves and restructuring charges. He has been widely quoted in outlets such as BusinessWeek, The International Herald Tribune, Investor's Business Daily, Kiplinger's Personal Finance, and The Wall Street Journal.