Chesapeake's Future Profitability in Jeopardy
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The fire sale has started at Chesapeake Energy (NYSE: CHK). But the fire is not as hot as it appeared three or six months ago, and a path out of the company's dire cash flow crisis is at hand. Let's take a look at second quarter earnings for this, the nation's second largest natural gas producing company, and see how its capital plans are likely to impact its future.
Chesapeake somehow missed a few years ago how its own leadership, in developing hydraulic fracturing and horizontal drilling technology, would lead to a huge increase in available gas supplies and crash the price of the commodity in this country. The company had leveraged itself heavily late last decade in shale rich real estate around the country, amassing some 15 million acres. Earlier this year, natural gas prices plunged to about $2 per mmBTU, and it became apparent the company's founder and leader, Aubrey McClendon had engaged in self-dealings. As a result, Chesapeake's board of directors was fundamentally altered, and a partial liquidation plan was conceived to help relieve the company's crushing debt burden.
In the second quarter of 2012, Chesapeake posted GAAP earnings of $929 million, or $1.29 per share. But one time factors, chiefly a gain on the sale of Chesapeake's midstream assets, resulted in profits of just $3 million, or six cents per share. Earnings per share a year ago came to $0.76 per share, and the difference was almost exclusively due to higher prices a year ago. In the second quarter of 2012, the average realized price for Chesapeake's dry gas sales was $1.88 per mmBTU. A year ago, Chesapeake's average realized price was $5.19.
The fear with everyone knowing that Chesapeake needs, quite desperately, to liquidate large chunks of its holdings is that Chesapeake would not be able to realize adequate pricing for the sold parcels. The $4 billion that was achieved for the midstream assets to privately held Global Infrastructure Partners was far from a fire sale price, and portends well for the future of Chesapeake's partial liquidation.
Chesapeake has divided up its massive Permian Basin assets into three separate segments, with hopes to exact as much as $7 billion dollars from the sales. All told, the market reacted positively not to the six cents per share announcement, but rather that Chesapeake has increased its asset sales target for this year to as much as $14 billion this year, instead of the $11 to $12 billion range it had suggested earlier.
Management has also committed to focus more on higher priced liquids instead of its traditional dry gas business. But that is not such an easy switch to make. Many of the new liquid byproducts of natural gas extraction, such as ethane and propane, are suffering from their own oversupply gluts and price collapses. Ethane, for instance had reached a three year high price of $0.95 per gallon in October of last year, but had slid to an average of $0.40 per gallon in the second quarter. Both it and propane are currently selling at ten year lows. Chesapeake has also increased its oil production by over 80% in the second quarter to 7.32 billion barrels, from 3.9 billion barrels. But the percentage of the company's oil production as a percentage of overall production increased from only 9% a year ago to 13% in the just completed quarter.
Chesapeake is not an oil company. The good news though for the company is that the assets sales will not just retire its extremely expensive, $4 billion bridge loan it took this spring from Goldman Sachs (GS). It will also allow Chesapeake to reduce its outstanding long-term debt by about $5 billion down to the neighborhood of $9.5 billion. My concern though, is that Chesapeake, in selling its “crown jewel” Permian assets, is reducing its future profitability. In the short run, there are still numerous SEC and even IRS investigations ongoing, as well. There is too much uncertainty for me at this time to endorse Chesapeake, especially since there are many other alternatives in the natural resource area.
I believe that natural gas has a bright future as a fuel of choice in this county. Many states either have or are considering renewable energy mandates, but for the foreseeable future, the bulk of base load energy production is going to come from coal, natural gas, and nuclear sources. Natural gas has cost advantages over nuclear, and environmental advantages over coal. Utility scale use of natural gas has been ramping up, helping to lift the cost of natural gas, which is right about $3 per mmBTU as I write this. Another thing to bear in mind is that Chesapeake is at a competitive disadvantage compared to companies that drill in Asia and Europe, where natural gas prices are three to five times higher than domestic gas prices.
Exxon Mobil (XOM) is the largest natural gas producer in this country, but that is such a small percentage of its overall business that it is not terribly significant. The same applies to major producers BP (NYSE: BP) and Royal Dutch Shell (RDS.A). The third largest domestically based gas company is Anadarko Petroleum (NYSE: APC), which drills not just in America, but in Africa and Asia as well. It staggered last year from a $4 billion settlement from its role in the Gulf Oil Disaster. But it faces now another multi-billion dollar hit from a matter with Tronox (NYSE: TROX). Tronox has the EPA's support in the claim that Anadarko is responsible for over 2000 polluted sites. And Tronox also seeks $10 billion in damages. Anadarko has reserved a little over $500 million for the matter, though that is likely not nearly enough.
In its second quarter, Anadarko realized gas prices were too low to allow it to profitably drill at its Powder River facility in Wyoming, so it took a large impairment write down on the project of a pretax $978 million. This led to a GAAP loss of $380 million, or $0.76 per share. Absent one-time factors, the quarter was profitable at $424 million, or $0.85 per share. To me, the Tronox matter overshadows everything else right now. Therefore, I cannot give serious consideration to Anadarko stock until the direction of that litigation is known.
StockCroc1 has no positions in the stocks mentioned above. The Motley Fool has the following options: 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, and long JAN 2014 $30.00 calls on Chesapeake Energy. 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.If you have questions about this post or the Fool’s blog network, click here for information.
