More for Less: The Turnaround Story Unfolds

Has Chesapeake Energy really managed to fully turn itself around?

Feb 19, 2014 at 2:49PM

Spending less but producing more: Is it possible? Chesapeake Energy (NYSE:CHK) is going to spend 20% less on capex yet will still grow output by 8% to 10% this year, after adjusting for asset sales. In order to compensate for low natural gas prices (which have risen substantially recently), Chesapeake Energy has been focusing all of its cash on liquids-rich plays.

This is clearly seen in Chesapeake's update and guidance for 2014. After adjusting for asset sales, there will be around 8%-12% oil production growth, 4%-6% dry gas output growth, and a whopping 44%-49% growth in NGL production this year.

Overall, Chesapeake is guiding for 1%-5% oil, 40%-45% NGL, and -2%-zero dry gas output growth. Total liquids production would be up around 14%-18%, while dry gas production would remain relatively flat.

A major plus for Chesapeake Energy has been the abnormally cold winter all across America, which has pushed natural gas prices up to $5 mmBtu due to sharp increases in demand. While Chesapeake is moving away from dry gas plays, it's production mix is still ~70% weighted toward dry gas.This doesn't mean that Chesapeake Energy should stop its major push into liquids production, but it will help Chesapeake generate more cash flow.

New demand helps previous focus
Looking a little farther out, it seems higher natural gas prices are here to stay. Ultra Petroleum (NYSE:UPL) sees LNG export demand hitting 2.6 bcf/d by 2015, which will grow even larger as more LNG export facilities come online.

On top of that, Ultra Petroleum sees an additional 12 bcf/d of demand growth online for 2013-2015 from various sources in the U.S., such as electricity generation (5 bcf/d) and increased industrial demand (1 bcf/d).

Both Chesapeake and Ultra Petroleum are major natural gas producers, even as they shift to more profitable liquids-rich plays. Surging domestic demand, combined with LNG exports to meet the world's voracious appetite for LNG, will prop up U.S. gas prices and will allow Chesapeake Energy and Ultra Petroleum to put that cash to good use.

For Ultra Petroleum, that would mean further developing its Wyoming, Uinta Basin, and Marcellus assets. Just like Chesapeake Energy, Ultra Petroleum has been steadily trying to boost liquids output. Higher natural gas prices will aid Ultra Petroleum's quest in moving into more profitable liquids plays while returning existing assets to profitability.

In Chesapeake's case, higher natural gas prices combined with continued asset sales will help plug its $1 billion funding gap this year. Beyond that, if Chesapeake can become a more profitable company, then it should be able to pay down its debt.

How can you spend less and grow output at the same time?
The answer is simple: cost control and efficiencies. This year, Chesapeake thinks it can reduce production expenses by 10% and G&A expenses by 25%, resulting in substantial savings.

If a producer can use better drilling techniques while creating a more efficient workplace, it can pump out more for less.

Stable ship
For a while, many doubted Chesapeake and weren't sure it would be able to turn itself around. But through asset sales, cost reductions, and a shift to liquids production, Chesapeake might be able to prove the doubters wrong.

Going beyond just 2014, Chesapeake is guiding for long-term production growth of 5% to 9% per debt-adjusted share. While this doesn't factor in asset sales, Chesapeake Energy may have finally found a path to stability.

For years Chesapeake Energy spent reckless amounts of money to acquire and develop as much natural gas acreage as possible. This seemed like a good idea at the time, until U.S. natural gas prices fell to record lows and Chesapeake had little liquids output. 

This led Chesapeake to begin aggressively divesting assets and directing almost all of its capex to liquid-rich plays. Now Chesapeake's liquids production mix is around 29%, with management guiding for that figure to move higher.

Foolish takeaway
Chesapeake still has a long way to go before it can officially be considered a changed company. As long as it keeps divesting non-core assets and keeps growing liquids output, Chesapeake Energy will become cash flow positive. It may take until 2015, or maybe even longer, but Chesapeake thinks it can become a cash-flow-positive company very soon. This is huge and would likely be reflected in Chesapeake's share price. 

Chesapeake has made great strides in growing liquids production while reducing debt through asset sales and getting its spending under control. LNG exports are going to be huge, and Chesapeake is well positioned to service the additional dry gas output needed while also growing margins through liquid-rich plays.

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Callum Turcan has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum. The Motley Fool has the following options: long January 2016 $25 calls on Ultra Petroleum. 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.

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