Chesapeake Energy (IL/A): Cash flow from hedging gains important, but long term gas price still matters - Goldman Sachs - May 02, 2006
Chesapeake Energy (IL/A) is in a unique position of being among the greatest beneficiaries versus its peers from low natural gas prices while longer-term returns and growth depend on sustainably higher natural gas prices. CHK's hedges are expected to add $650 million in gains this year and invested mainly in additional drilling and further acreage acquisitions. In the medium-to-longer term, higher natural gas prices increase the potential for recoverable resource and greater returns from these investments. CHK's peers have shown initial signs of success in CHK's three key emerging resource areas -- Haley (APC), Fayetteville Shale (SWN) and Woodford/Caney Shale (NFX) -- and we believe pressure will rise towards yearend for CHK to show similar to better results. For now, we see better opportunities in XTO Energy (OP/A) given its trifecta of higher growth, returns, and free cash flow.
KEY COMPANY SPECIFIC CATALYSTS
(1) Growth in the Barnett Shale. Chesapeake currently has 80,000 net acres in the Barnett Shale (with a high quality Johnson County position) and plans to increase the rig count to 20 by year-end 2006. The Barnett was the highlight of 1Q 2006 production growth, with current production at about 110 MMcf/d versus an estimated 90 MMcf/d in 4Q 2005. Johnson County has been the site of recent wells with very high initial production rates by Chesapeake, EOG Resources and others. We expect Barnett production to rise to about 140 MMcf/d by yearend. On the conference call, management indicated its bid on Chief Oil and Gas was not that close to the winning bid by Devon Energy (IL/A). While this is a rare high-profile Barnett asset not won by Chesapeake or XTO, we continue to expect Chesapeake to look to expand its Barnett position. Separately in East Texas, Chesapeake is planning to drill its first Deep Bossier well on its 125,000 net acres this summer.
(2) Favorable service leverage and commodity price hedging. Chesapeake is the most active independent E&P on the oil services front and has undergone a significant rig building program that has hedged the company from rising day rates. Owning rigs (and with the company's recent acquisition of Martex Drilling having rigs leased to customers) almost entirely eliminates the risk of rig delays seen by Chesapeake's peers. Management indicated that in the Fayetteville Shale, it could accelerate drilling the current 2006 plan for 30-100 wells if desired. We believe Chespeake stands to benefit much more versus its peers from favorable natural gas hedges -- it has currently hedged 78% of its natural gas for the remainder of 2006 at an average price of $9.32 per MMBtu versus our annual natural gas forecast of $7.97 per MMBtu; this should translate to total 2006 hedging gains of $650 million versus a loss of $305 million in 2005. Additionally, Chesapeake hedged an additional 18% of 2008 production and has locked in a $9.22 per MMBtu on 36% of estimated 2008 gas production.
(3) Ability to improve production growth and efficiency in Appalachia. Chesapeake's $2.2 billion acquisition of Columbia Natural Resources in 2005 placed the potential for more aggressive spending and growth in Appalachia squarely in the limelight. Chesapeake is playing a leadership role by increasing to 10-12 rigs from 4 over the course of this year. Most current production comes from shallower plays, but Chesapeake is planning several seismic tests this year and has started developing ideas for deeper shale plays. Given the high level of fragementation in Appalachia and the potential benefits from economies of scale, we believe Chesapeake is opportunisitically looking for ways to consolidate this area. Acquisitions like these may hurt Chesapeake's returns in the short-term but could prove accretive to returns in the future if the company can be successful in showing growth without a major cost creep. Chesapeake's average Appalachian realized natural gas price in 1Q 2006 was $11.50 per Mcf, a function of differentials and Appalachian gas' high BTU content. Not unexpectedly, management indicated production growth should be modest over the next two years, so we do not expect any near-term evidence that could boost Street expectations. Chesapeake is rightly beginning the process of attempting to raise worker productivity in part by providing a greater incentive compensation structure.
(4) Drilling results versus peers from Woodford Shale, Fayetteville Shale and Haley Deep plays. Thus far, Chesapeake has not been as excited about some of its emerging plays as other operators. In the Woodford Shale, Chesapeake, which has an interest in the majority of wells drilled by Newfield Exploration (OP/A), is cautious on drilling costs (though management's tone in its cautiousness has softened) but will drill its first horizontal well this year. In the Fayetteville Shale, about 200,000 of Chesapeake's 1 million acres are within the recangular area being actively drilled by Southwestern Energy (OP/A), though admittedly the remaining acreage, mostly to the east, is higher risk. Increased drilling in outerlying acreage through yearend should add some data on both well costs (Southwestern has seen higher rates that seemingly more than offset higher completion costs from the use of slickwater fracture stimulation) and estimated ultimate recovery from Chesapeake's acreage. In the Haley Deep play in West Texas, Chesapeake has seemingly seen more volatile production results versus Anadarko.
Given that Anadarko seems to be showing success in Haley, Southwestern in Fayetteville and Newfield in the Woodford, we see rising pressure for Chesapeake to show success towards yearend. Reasons why successful wells may not have been announced are some function of:
(1) unwillingness by management to discuss positive results while acreage is still being acquired;
(2) potentially inferior acreage position versus its peers; and
(3) potentially inferior fracture stimulation technology versus its peers.
We believe Street consensus is that management is purposefully talking down these plays while erstwhile acquiring acreage; if that is not true there is the potential for Chesapeake shares to underperform.
VALUATION
Chesapeake is currently valued at 4.7x 2006E EV/debt-adjusted cash flow versus the large-cap North American gas E&P average of 6.0x. We believe the discount stems from Chesapeake's below-peer average ROCE of 14% (19% for other E&Ps) and if it can prove to investors its ability to generate significant free cash flow and improve returns from its unproved properties, it can close this valuation gap. We see 21% upside to a $38 traditional peak value.
ADJUSTED EPS HIGHER THAN OUR ESTIMATE ON NON-E&P REVENUES, REALIZED PRICES
Chesapeake reported adjusted 1Q 2006 EPS of $1.07, higher than our estimate of $1.00 and First Call consensus estimate of $0.98. Other revenues, comprised of marketing and service operations, was higher than expected at $28 million. Chesapeake's gas production, at the bottom end of guidance, was 1.35 Bcf/d, lower than our estimate of 1.43 Bcf/d. Natural gas prices of $9.61 per Mcf were lower than our estimate of $9.50 per Mcf. Total costs were generally in-line. Operating cash flow was $1.05 billion versus our estimate of $1.02 billion and net debt-to-tangible capital is now at 46%.
UPDATED ESTIMATES
We are updating our 2Q, 3Q, 4Q, and full-year 2006-2007 EPS estimates on higher costs, lower production, and minor other company adjustments. Our new estimates are $0.71 ($0.74 previously), $0.77 ($0.82 previously), $0.91 ($0.96 previously), $3.46 ($3.51 previously), and $4.15 ($4.20 previously) respectively. We are also updating our 2008-2010 (normalized) EPS estimate to $2.74 ($1.93 previously), $1.36 ($1.30 previously), and $1.41 ($1.37 previously) respectively.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti. |
