Chesapeake Energy CHK provided more color Monday on how it intends to bridge the sizable gap between cash flow and investment in 2012, although not much new information was revealed, nor were very many specifics. First up are $2 billion in planned monetizations of Mid-Continent assets, including a volumetric production payment deal and a financial transaction similar to the one previously executed in the Utica (under which investors owned perpetual preferred shares in a separate subsidiary). Chesapeake anticipates receiving proceeds from these deals in the next 60 days. The company also announced it is pursuing joint ventures across its Mississippi Lime and Permian Basin positions. Somewhat surprisingly, Chesapeake disclosed a near doubling of its Permian acreage since late last year, to 1.5 million net acres, and announced that it may consider an outright sale of this position if it receives a compelling offer. Between the joint ventures (or an outright Permian sale) and other minor asset sales, Chesapeake estimates potential proceeds of $6 billion-$8 billion by the end of the third quarter of this year. Finally, the company reiterated plans to monetize certain midstream and service company assets and other investments, which could generate $2 billion in proceeds. Combined, these transactions should effectively bridge the gap between estimated cash flow ($3.9 billion) and investment ($9.7 billion) in our model for this year. We have long believed it to be a mistake to bet against the Chesapeake asset sale machine, and this time is no different, despite a lack of clarity on timing and eventual sale amounts (none of the deals in Monday's press release are under binding agreements). Our fair value estimate is unchanged at $32 per share.
Thesis 12/16/11
Chesapeake is among the most aggressive operators in the U.S. E&P space, able to quickly build dominant positions in emerging plays through its vast network of land brokers and a general willingness to offer more favorable lease terms than its competitors. While this approach has helped Chesapeake amass a portfolio that comprises almost every leading unconventional play in the U.S., it has also led to ongoing questions about the sustainability of the firm's business model, given its propensity to outspend available cash flow. Despite the potential for some fits and starts over the next few years as Chesapeake works through how to best monetize its extensive inventory, we're bullish on the company's ability to increase production and reserves going forward, given management's knack for creatively financing its operations and the relevance (that is, the attractiveness to third-party investors) of its current leasehold positions.
Chesapeake's portfolio includes more than 14 million net acres of onshore oil and gas assets. The firm holds leading positions in the Barnett, Haynesville/Bossier, Marcellus, Eagle Ford, Niobrara, Permian, Utica and Anadarko Basin regions, among others, and continues to build its presence in liquids-rich plays as part of an ongoing strategy to diversify away from natural gas. Given impending lease expirations (or a sizable inventory of wells waiting on completion) in a number of its plays, we expect Chesapeake to push its drilling and completion plans hard over the next several quarters in order to hold acreage and bring production on line, especially in the Haynesville and Barnett regions. There is generally less urgency in Chesapeake's Marcellus, Eagle Ford, Utica, and Granite Wash acreage, although we expect joint venture considerations and takeaway commitments to drive drilling activity in these regions to a certain extent.
Chesapeake's "land rush" strategy has led to charges that the firm marginalizes the economics in its plays, given its willingness to accord higher royalties and pay top dollar for leases. Chesapeake would counter that it is locking up once-in-a-lifetime assets and would point to subsequent transactions that validate its above-market cost basis. We concede that Chesapeake appears skilled at securing large blocks of land within emerging plays--a combination of its "land machine" and technical skill--and find it hard to argue with the prices that have been paid by third parties for portions of its acreage. That said, Chesapeake's approach has at times led to serious problems for the firm, as in 2008, when a steep drop in natural gas prices forced the company to sell assets and raise external capital to help shore up its balance sheet. To Chesapeake's credit, the financing methods it put in place at that time--most notably volumetric production payments, or VPPs, and a handful of joint ventures--have helped the company stay afloat longer than most thought possible and served as an essential financing tool for the firm as it expands its operations. Nevertheless, we believe these financial maneuvers--in particular JVs--have benefited Chesapeake to the detriment of the broader E&P industry, in large part through carries that help support uneconomic drilling meant to achieve HBP status.
Based on the success it has had with such structures, we expect Chesapeake to continue utilizing JVs and VPPs going forward. The firm has entered into seven JVs and nine VPPs since late 2007, generating total proceeds of approximately $22 billion ($3.1 billion of which remains to be earned over the next several years in the form of drilling carries). Chesapeake's key JV partnerships include Statoil in the Marcellus, Total in the Barnett, and most recently CNOOC Ltd. in the Eagle Ford and Niobrara.
Chesapeake is more vertically integrated than most large producers. The firm takes an active stance on costs by investing directly in its service providers: Chesapeake holds interests in the fifth-largest rig contractor, the third-largest hydraulic fracturing company, and the second-largest compression business in the U.S. and also operates its own core sample testing center. In addition, Chesapeake owns and operates a good portion of its midstream pipeline assets, in part through a publicly traded master limited partnership (Chesapeake Midstream Partners, L.P.). We highlight the potential for takeaway bottlenecks in some of the firm's newer plays--particularly the Haynesville, Marcellus, and Eagle Ford regions--and note that we expect sizable ongoing midstream spend over the next several years.
In short, despite Chesapeake's past missteps and some ongoing uncertainty as to how the firm best realizes the potential of its inventory, we expect additional JVs, VPPs, and trust offerings to help fund drilling activity across the firm's 14 million net acres, leading to strong growth in production and reserves throughout our forecast period.
Valuation
We are raising our fair value estimate for Chesapeake to $32 per share from $29 after incorporating third-quarter results (which included an accelerated shift toward liquids and the successful execution of a JV in the Utica Shale). Our new fair value estimate implies a forward 2012 enterprise value/EBITDAX multiple of 7 times, and is based on our five-year discounted cash flow model and an assessment of trading multiples, comparable transactions, and longer-term resource potential.
We project average daily net production of 3.2 Bcfe in 2011, 3.5 Bcfe in 2012, and 3.9 Bcfe in 2013, representing an 11% compound annual growth rate over 2010 levels. Chesapeake remains one of the most active drillers in the U.S. exploration & production industry, with approximately 170 operated rigs across its acreage. The firm's push to achieve HBP status in certain plays, along with JV partnership obligations and minimum takeaway commitments, should continue to fuel high levels of drilling activity over the next few years, funded in part through Chesapeake's approximately $3.1 billion in remaining drilling carries. We expect the firm's Marcellus, Eagle Ford, and Anadarko Basin acreage to drive most of its production growth throughout our forecast period. Within the Anadarko Basin, we forecast net production of 602 mmcfe/d in 2011, 669 mmcfe/d in 2012, and 779 mmcfe/d in 2013. In the Marcellus, we forecast net production to increase from 381 mmcfe/d in 2011 to 549 mmcfe/d by 2013, driven by the $1.4 billion in drilling costs the firm will collect from JV partner Statoil. Across Chesapeake's Eagle Ford acreage, we forecast net production growing from 98 mmcfe/d in 2011 to 630 mmcfe/d by 2013.
Driven by production growth and an ongoing shift toward liquids, we forecast EBITDA of $5.2 billion in 2011, $4.6 billion in 2012, and $6.1 billion in 2013. Chesapeake's hedges cover approximately 20% and 40% of our 2012 and 2013 estimated natural gas production, respectively, and 40% and 30% of our estimated oil production, which should help reduce near-term cash flow variability.
Risk
Chesapeake's biggest risk is a substantial and prolonged drop in oil and gas prices, which would depress profits, slow development plans, and reduce the value of its properties. Other risks include a disruption in the asset market, which would limit the company's ability to monetize its acreage holdings, a shrinking universe of potential JV partners with which to transact going forward, execution risk within Chesapeake's emerging plays (in particular the Haynesville, Marcellus, Eagle Ford, Anadarko Basin, Utica, and Niobrara regions), potential midstream bottlenecks, especially within the Marcellus and Eagle Ford, and regulatory headwinds that could ultimately eat into profitability.
Management & Stewardship
Chesapeake is led by chairman and CEO Aubrey McClendon, who has served in these roles since co-founding the company in 1989. McClendon maintains a fairly visible--and, some would argue, controversial--presence in the E&P space, in part through his role as a de facto spokesman for the U.S. natural gas industry as well as his highly promotional approach to Chesapeake's business dealings. One of McClendon's key reports, CFO Marc Rowland, left the company in late 2010 after 18 years to become president of Frac Tech, a hydraulic fracturing company in which Chesapeake owns a minority stake. Rowland was succeeded by Domenic Dell'Osso, who joined the firm in 2008.
Chesapeake's stewardship has come under fire at times for what many view as a lack of focus on key per-share metrics and discretionary compensation practices that appear disconnected from company performance. Chesapeake's top officers routinely collect some of the biggest compensation packages in the E&P industry (executive perks alone make up more than $1 million of total compensation in certain cases), with each of Chesapeake's independent directors making in excess of $400,000 a year. The firm's decision to award McClendon $75 million in incentive pay in late 2008 was especially controversial and viewed by many as nothing more than a make-whole for McClendon in the wake of a margin call that forced him to liquidate substantially all his Chesapeake stock holdings. Collectively, the firm's top officers own less than 1% of common shares outstanding.
Overview
Financial Health:
Chesapeake has historically paired its aggressive operating strategy with a similarly aggressive financing strategy. From 2005 to 2010, the firm's capital spending significantly outpaced operating cash flow, resulting in net borrowing of $11.8 billion and the implementation of several nontraditional financing vehicles to help meet cash shortfalls. During this time, Chesapeake's debt/capital ratio averaged 47%, with average debt/proven reserves and debt/EBITDAX ratios of $0.91 per mcfe and 2.5 times, respectively. The firm has taken a number of steps to improve its financial position during the last several quarters, including the redemption of close to $3 billion in senior notes and the issuance of more than $3 billion in preferred securities.
We expect Chesapeake to continue its strategy of funding investment activity through a combination of operating cash flow, VPPs, JV transactions, asset sales, trust offerings, and debt financing through 2013, with free cash flow becoming positive in 2014. We forecast a debt/capital ratio of 40% in 2011, 47% in 2012, and 49% in 2013, with the firm's debt/proven reserves and debt/EBITDAX ratios remaining elevated, as well. We estimate the firm's outstanding obligations for its VPPs will be $1.8 billion by year-end 2013. (Note that none of the preceding credit metrics incorporates Chesapeake's ongoing VPP obligations.)
Profile: Chesapeake Energy, based in Oklahoma City, explores for, produces, and markets primarily natural gas within the United States. The firm focuses on unconventional plays, with large positions in the Barnett, Eagle Ford, Haynesville, and Marcellus Shales, as well as leaseholds in a number of liquids-rich basins. Chesapeake holds approximately 14.9 million net acres across its properties. At year-end 2010, the firm's proved reserves totaled 17.1 Tcfe, with daily production of 2.8 Bcfe. Natural gas made up 90% of proved reserves.
Thank you for writiing this
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