Chesapeake Energy's Shift to Oil Won't Work Without Higher Natural Gas Prices

Last Updated Apr 15, 2010 5:43 PM EDT

Chesapeake Energy (CHK) believes it can transition more of its production to oil and natural gas liquids by focusing on leaseholds it already owns. But its strategy is only going to pay off if natural gas prices start rising again.

The nation's second-largest natural gas producer is looking to spud for liquids because oil and natural gas prices are heading in opposite directions: 1990 through 2007, the average price ratio of crude to natural gas was about 8.6 times, according to the U.S. Energy Information Administration (EIA); today, with oil for May delivery trading at almost $86 a barrel, the spread is more than 21 times.

"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 a recent energy conference.

McClendon admitted on the company's February earnings call that $5 per million BTU pricing on the New York Mercantile Exchange (NYMEX) equates to $3.50 gas at the wellhead. 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. The company is initially looking to shift 18 to 20 idled gas-focused rigs (from sub $5.00 gas wells) to high productivity shale plays in new unconventional prospects, such as its holdings in the Granite Wash formations of the Texas Panhandle and western Oklahoma.

In the various Granite Wash plays of the Anadarko Basin, Chesapeake is the largest leasehold owner with approximately 190,000 net acres and is also the most active driller and largest producer. Speaking at recent energy conferences, chairman McClendon identified particularly prolific gas- and oil-rich areas -- with reservoirs potentially loaded with upwards of 90 barrels per million cubic feet -- that have become the two highest rate-of-return plays in the company:

  • Colony Granite Wash (western Oklahoma): Drill-bit activity is primarily located in Custer and Washita counties in Oklahoma. Chesapeake anticipates more than doubling production to approximately 230 mmcfe net per day (420 mmcfe gross operated) by year-end 2011. Estimated pre-tax rate of return from a 5.7 bcfe horizontal well (almost 1.4 times Marcellus Shale reserves per well) drilled for $6.25 million in this play is approximately 141 percent.
  • Texas Panhandle Granite Wash: Chesapeake believes production of approximately 130 mmcfe net per day by year-end 2011 is attainable, up from existing yields of 90 mmcfe per day. The company's estimated pre-tax rate of return from a 4.75 bcfe horizontal Panhandle Granite Wash well drilled for $5.5 million is approximately 128 percent.
The stunning returns of Granite Wash, however, are predicated on natural gas prices of $7 per mcf, as the company still needs profitable takeaway of natural gas to push out the liquids! Reserves pricing sensitivity data found in its annual report speaks volumes to Chesapeake's continued addiction to natural gas:
A change in price of $0.10 per mcf for natural gas and $1.00 per barrel for oil would result in a change in the December 31, 2009 present value of estimated future net revenue of our proved reserves of approximately $500 million and $60 million, respectively.
True, the company has hedged about 60 percent of expected natural gas production in 2010 at average prices of $8.16 per mcfe - which should help cash flow from operations. Only some 11 percent of natural gas production for 2011, however, is locked in at profitable contract prices.

Chairman McClendon -- and many industry pundits -- believes "low prices will cure low prices" by next winter. In other words, the unprofitable economics of drilling at today's prices will lead to higher prices by an eventual rebalancing of supply - demand.

Available evidence doesn't support this classical economics approach: The number of rigs currently drilling for gas in North America is 169 greater than last year's level of 790, according to recent data supplied by oil services firm Baker Hughes (BHI). Energy Information Administration forecasts support this finding:

EIA expects the Henry Hub natural gas spot price to average $4.44 per million Btu (MMBtu) this year, a $0.49-per-MMBtu increase over the 2009 average, but a significant downward revision from the $5.17 per MMBtu projected last month. The price outlook is lower primarily because of an average 2 billion cubic feet per day (Bcf/d) upward revision to the 2010 domestic natural gas production forecast.
Many leases contain finding clauses -- drill or lose lease. In addition, companies keep pumping just to bring in cash flow to cover their electric bills and other fixed costs. Using Chesapeake Energy as an example, daily production for the 2009 full year averaged 2.48 bcfe, an increase of eight percent over the prior year; by comparison, year-on-year natural gas sales plunged 57 percent to $2.6 billion.

The backlog of drilled but uncompleted gas wells is growing, too, due to the inability of the oilfield service industry to meet the demand for completion equipment. This will only lead to more supply ready to flood the markets when prices reverse the downward trend. Speaking at the RMI Oilfield Breakfast, Dr. Jonathan Lewis of Halliburton (HAL) said that the company's fracturing horsepower was operating at the highest level ever. Dr. Lewis also described the phenomenon of a large backlog of these future wells as another form of natural gas storage since wells can be completed in the future when demand for the gas is present, according to RigZone.

With the outlook for oil expected to stay above $80 per barrel, McClendon's directive to move some production to liquids makes sense. However, with a light hedge book for 2011 and net cash flow negative every year since 2006, Chesapeake will unlikely be able to show capital restraint. Expect another debt and/or stock offering, plus a few asset sales (as part of joint ventures).

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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.