Is It Time to Sell Chesapeake Energy?

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Chesapeake Energy (NYSE: CHK  ) , the nation's second largest gas producer, recently reported a strong third quarter, led by strong liquids production growth, reduced expenses, and higher realized gas prices. Yet shares declined by nearly 7% following the company's lower guidance for oil production in the fourth quarter.

Could this mean that it's time to sell Chesapeake Energy? Let's take a closer look.

Production outlook concerns
With Chesapeake's financial health having improved markedly over the past year, investors now appear to be more concerned about the company's production growth outlook. But I think they may have overreacted to comments made by CEO Doug Lawler during the company's third-quarter earnings conference call, in which he suggested that Chesapeake's fourth-quarter oil production would decline by about 9,000 barrels per day sequentially.

In my view, nothing suggests that this anticipated decline in fourth-quarter volumes is a structural or permanent fixture. Instead, it largely reflects the impact of production lost due to the sale of 55,000 net Eagle Ford acres to EXCO Resources (NYSE: XCO  ) in July -- acreage that included 120 wells that were producing roughly 6,100 barrels of oil equivalent per day.

It also reflects the company's plans to reduce its rig count in the region during the fourth quarter to focus on optimizing its drilling program, as well as normalization from third-quarter volumes, which were abnormally high due to accelerated inventory reduction during the second quarter.

Heading into next year, sequential growth should resume, especially if the company is successful in its efforts to optimize its Eagle Ford drilling program through a transition toward pad-based drilling and a stronger focus on well scheduling, which should improve cycle times, minimize down time, and boost rates of return.

Indeed, Chesapeake is now the Eagle Ford's second-largest gross oil producer, and boasts the fastest growth rate in the play, placing it in the company of heavyweights like EOG Resources (NYSE: EOG  ) , which is currently the largest oil producer in the Eagle Ford and boasts the highest oil production growth rate of any large-cap E&P this year, ConocoPhillips (NYSE: COP  ) , which reported a 66% year-over-year increase in Eagle Ford output during the third quarter, and Marathon Oil (NYSE: MRO  ) , which doubled third-quarter Eagle Ford production volumes from a year earlier.

Reasons not to sell Chesapeake
Given the temporary nature of the issues impacting Chesapeake's fourth-quarter oil production, I think the recent sell-off was unwarranted. Over the past year, the company has made huge strides. It's got a new CEO who is focused on financial discipline and profitable growth from the company's existing asset base. Its financial health has improved significantly, though I'll concede that its level of long-term debt still remains uncomfortably high and most of its liquidity consists of undrawn credit revolvers.

Still, the company has aggressively slashed costs, while growing production at double-digit rates and maintaining its asset sale program -- not an easy task. This year, production is poised to grow by 28%-34%, while total capex is projected to fall by more than 50%. Liquids now comprise 27% of total production, up from 21% a year earlier. And the company is finally moving toward a position where it can fund itself through its operating cash flow, which greatly reduces the threat of a dilutive equity offering for shareholders.

Lastly, another big reason not to sell Chesapeake is its huge upside optionality to a long-term rebound in natural gas prices. Though the company is currently focused on liquids-rich opportunities, it has sizable positions in key natural gas shale plays, including the Marcellus, Haynesville/Bossier, and Barnett, which could become much more valuable when gas prices rise.

The bottom line
To answer the question posed at the onset, I don't think it's time to sell Chesapeake yet. While I don't think we'll see the kind of short-term gains that we saw from July to November, when shares surged 35%, I think the company's strong outlook for liquids growth, improving financial position, and gas upside optionality make it an attractive stock to hold over the long term.

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