Where Chesapeake Energy Corporation Sees Opportunity in 2014

2013 was a truly transformational year for Chesapeake Energy (NYSE: CHK  ) , as the nation's second-largest producer of natural gas made commendable progress in reigning in spending and delivering profitable and efficient growth from its existing asset base. As it aims to continue improving its financial health and boosting production, let's take a closer look at where the company sees opportunity in 2014.

Chesapeake's plans for 2014
In 2014, Chesapeake expects to spend $5.2-$5.6 billion, down 20% from the midpoint of the company's 2013 capital expenditures guidance. Despite this sharp reduction in spending, however, it expects to deliver 8%-10% year-over-year production growth this year after adjusting for 2013 asset sales and 2%-4% production growth on an absolute basis.

Once again, the largest portion of Chesapeake's 2014 E&P capex, about 35%, will go toward the Eagle Ford shale -- the company's key driver of oil production growth -- while the rest will be divided up between the Midcontinent (20%), the Utica shale (15%), and the northern Marcellus shale (10%).

Eagle Ford
In the third quarter, Chesapeake's net production from the Eagle Ford surged 82% year over year to average roughly 95,000 barrels of oil equivalent (boe) per day. At the same time, the company's spud-to-spud cycle times in the Eagle Ford have fallen from 29 days in 2011 to 18 currently, while well costs have plunged from $10.1 million per well in 2011 to $6.9 million, thanks largely to an aggressive shift toward pad drilling.

Other operators have also sharply reduced their well costs through greater use of pad drilling, including Continental Resources (NYSE: CLR  ) , Kodiak Oil & Gas (NYSE: KOG  ) , EOG Resources (NYSE: EOG  ) , and Hess (NYSE: HES  ) . Continental now spends around $8 million per well in the Bakken, down from an average of $9.2 million in 2012, while Kodiak has slashed its Bakken well costs to $9.7 million-$10.2 million per well, down from roughly $11 million per well in 2012.

Similarly, EOG is now spending about $5.8 million per Eagle Ford well, down from $9.1 million in 2009, while Hess has brought its Bakken well costs down from $9 million per well in the fourth quarter of 2012 to around $7.6 million currently. Greater use of pad drilling was the main driver behind all these companies' sharp reductions in well costs.

Anadarko, Utica, and Marcellus
The next biggest portion of Chesapeake's 2014 E&P capital budget -- about 20% -- will be devoted to Midcontinent drilling, which encompasses the Mississippian Lime, Cleveland, Tonkawa, Granite Wash, Hogshooter, and other plays in the Greater Anadarko Basin. Third-quarter production from these plays averaged 109,000 boe per day, up 12% year over year, though down 14% sequentially largely because of the sale of producing assets in the Mississippi Lime.

Next, Chesapeake expects to allocate roughly 15% of this year's E&P capital budget to the Utica shale and 10% to the northern Marcellus shale. The Utica will be crucial is helping the company meet its target of 44%-49% natural gas liquids production growth, while the Marcellus will be the biggest contributor to expected gas production growth of 4%-6%.  

Northern Marcellus production averaged 825 million cubic feet of natural gas equivalent (mmcfe) per day in the third quarter, up 53% year over year, while Utica production averaged approximately 164 mmcfe per day, up 91% year over year. Crucially, both plays will benefit tremendously from the improvement in gas processing and pipeline takeaway capacity this year. Lastly, the remaining 20% of Chesapeake's E&P capex will be divided up between the Haynesville shale, the PRB Niobrara, the southern Marcellus, and the Barnett shale.

The bottom line
As you can see, Chesapeake's oil production growth this year will be led mainly by the Eagle Ford and Greater Anadarko Basin plays, while dry gas and gas liquids growth will be fueled by the northern Marcellus and Utica shale, respectively. Over the past year, the company has made solid progress in delivering on its two main objectives -- funding the majority of its capital program with operating cash flow and improving its financial position by reducing debt.

Despite this progress, however, I see limited upside for shares of Chesapeake this year -- especially after the phenomenal 60% surge last year -- as the markets digest the implications of the company's weaker-than-expected production forecast. Longer term, though, I think the company remains a buy, given its improving fundamentals and tremendous upside optionality to a recovery in natural gas prices.

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