Chesapeake Faces 3 Daunting Risks

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Read any energy article about Chesapeake (NYSE: CHK) and it quickly becomes clear: Chesapeake is a company on the mend.  Low natural gas prices, high capital expenditures, crushing interest rates, and a host of other factors are plaguing the company. 

In addition, Chesapeake also faces other business risks, which the company identified in its November Investor Relations report.  To succeed in turning the company around, CEO Aubrey McClendon must effectively disarm these threats.

Oilfield Shortages

Chesapeake’s report cites:

Oilfield services shortages and transportation capacity constraints and interruptions that could adversely affect our revenues and cash flow.

Chesapeake is moving from producing natural gas to producing oil, which is more profitable in today’s market.  To drill for oil, companies have to explore and get proper permits, and also move their rigs.  In addition, oil producers need rigs and oil services. 

Halliburton (NYSE: HAL) is a company that provides such services.  Halliburton’s services, for example, run the gamut from coring and hole enlargement to pipeline and process services and reservoir testing and analysis.  A spectrum of the services can be found here.

To succeed in oil drilling, Chesapeake needs to properly execute in these areas, and to do so quickly.  If Halliburton has a shortage or becomes delayed, for example, this means less oil production for the day, resulting in reduced revenues. 

Further, Chesapeake must also transport the liquids to downstream refining centers.  If the oil services supply shrinks, even for a term as short as a few days, this hurts Chesapeake’s cash flow – and its profits.

Natural Gas Volatility and Hedging

The volatility around natural gas is one reason that Chesapeake’s price was more than cut in half from its most recent high.  Oversupply and low prices make it difficult to justify booming capital expenditures for a plentiful commodity that is quickly falling in price.

Unless the U.S. is permitted to export natural gas to other nations, where it can earn a price multiple times higher than in the U.S., Chesapeake is better off focusing on oil.

In terms of hedging its natural gas production, however, Chesapeake has taken a stance.  According to Chesapeake’s November report, the company has hedged 76% of its estimated fourth quarter natural gas production.  The downside is that the hedge price is just $3.06 MMbtu, nearly 19% below the current market price of $3.77.  In 2013, Chesapeake has hedged 0% of its natural gas, giving the company enormous potential to participate in any upward price swings.

In terms of oil, Chesapeake hedged 76% of its fourth quarter oil production at a price of $99.14, noticeably higher than the current market price of $86.28.  In addition, the company hedged 69% of its 2013 oil production at $96.01.

Cash Flow Constraints

In 2012, Chesapeake moved from a strategy of “asset identification and capture” to “asset harvest.”  In short, the company is trimming its portfolio of holdings in exchange for cash.

In August, Chesapeake upped its asset sales goal to $17-19 billion, and it hopes to reduce its net long-term debt to $9.5 billion through its “monetization program.”  The problem is that selling rich assets to fund cash deficits – even though part of the cash goes toward capital expenditures – is not a long-term strategy.  However, the plan provides opportunities for other oil and gas giants.

Chevron (NYSE: CVX), for example, and also Shell, bought a chunk of Chesapeake’s rich natural gas assets in Texas’ Permian Basin.  There is also opportunity for ConocoPhillips (NYSE: COP) and Exxon Mobil (NYSE: XOM) to acquire natural gas assets as Chesapeake spins them off to improve cash flow. 

Note that Chevron, ConocoPhillips, and Exxon all saw lower liquids growth, an area currently more profitable than natural gas, compared to its peers from Q2 2011 through Q2 2012.  Of course, these players are already heavily involved in liquids, but it demonstrates that Chesapeake is running fast towards liquids.

Chevron has already scooped up some of Chesapeake’s gas assets.  ConocoPhillips and Exxon have an opportunity to eye areas where they want to produce gas, then purchase Chesapeake’s more certain assets, instead of exploring themselves.  Since natural gas prices have taken a dive, Chesapeake’s assets will be cheaper, giving these firms the opportunity to use any excess cash to eye natural gas assets and to “buy low.”

A Risky Proposition

With Chesapeake up to its eyes in debt – and with yields as high as 9.5% for its Senior Notes due in 2015 – Chesapeake is in need of a turnaround.  The hurdles to overcome are many, but investors willing to scoop up shares while the company faces hardships could see strong returns if Chesapeake pulls off its ambitious strategy.


ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Halliburton Company and ExxonMobil and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, long JAN 2014 $30.00 calls on Chesapeake Energy, long JAN 2014 $30.00 calls on Chesapeake Energy, and short JAN 2014 $15.00 puts on Chesapeake Energy. Motley Fool newsletter services recommend Chevron and Halliburton Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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