Why Is Chesapeake Interested in This Unloved Gas Play?

Due to a prolonged period of depressed natural gas prices, Chesapeake Energy (NYSE: CHK  ) , the nation's second largest natural gas producer, has aggressively shifted its focus away from dry gas drilling and toward liquids-rich opportunities.

But during the company's conference call to discuss its 2014 outlook and capital program, CEO Doug Lawler noted that Chesapeake will ramp up activity in the Haynesville gas play of northern Louisiana and eastern Texas this year. Let's take a closer look at the reasoning behind the company's decision.

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Chesapeake's plans for the Haynesville
Chesapeake maintains an industry-leading position in the core of the Haynesville, a vast shale gas formation located in the North Louisiana Salt Basin in northern Louisiana and eastern Texas. Even after the sale of operated and non-operated interests in roughly 9,600 net Haynesville acres to EXCO Resources (NYSE: XCO  ) in July of last year, the company still boasts 570,000 gross acres that have already been delineated and are held by production.

This year, Chesapeake expects to operate an average of seven to nine drilling rigs in the Haynesville, up from an average of four rigs during 2013 and just three rigs at the end of 2012. Basically, as gas prices recently surged to above $5 per MMBtu for the first time in a few years, Chesapeake's gas wells in the Haynesville shale stand to become a whole lot more profitable.

According to a company presentation, Chesapeake's Haynesville wells that cost $7.9 million to drill and complete earn a 69%rate of return (ROR) at a wellhead gas price of $4.50 per MMBtu. Still, I was a bit surprised by the company's decision, especially considering the fact that it can generate significantly higher rates of returns from another gas play -- the Marcellus north -- where wells that cost $7 million to drill and complete earn a whopping 197% ROR with the same gas price.

When questioned regarding the company's decision to accelerate Haynesville activity when its Marcellus north wells are generating much stronger returns, CEO Doug Lawler explained that Chesapeake has made major strides in cutting costs and improving efficiency in the Haynesville, making it a "much more competitive investment for the company" and an area with "significant growth potential."

Efficiency gains and volume commitments
Thanks to 100% pad drilling utilization and other efficiency gains, Chesapeake expects to spend just $7.9 million per Haynesville well this year, as compared to $10.3 million per well just a couple of years ago. Still, despite these cost reductions, the fact remains that Chesapeake can earn almost three times the rate of return in the Marcellus North than it can in the Haynesville.

This is where another consideration factors in -- the company's minimum volume commitments with midstream providers in the Haynesville. In December 2012, Chesapeake's wholly owned midstream subsidiary, CMD, sold its wholly owned subsidiary, CMO, which held a majority of Chesapeake's midstream business, to Access Midstream Partners, L.P. (NYSE: ACMP  ) for $2.16 billion in cash.

As part of the agreement, Access Midstream agreed to perform certain gas gathering and related services for the company in exchange for a number of commitments, one of which was annual minimum volume commitments and a fixed fee per mmbtu of natural gas gathered from the Haynesville. When these minimum volume commitments are considered, Chesapeake's Haynesville drilling program is expected to generate a 100% rate of return, with expected cost efficiencies of 20% to 25% boosting returns even further.  

Lastly, Lawler also mentioned in the company's fourth-quarter earnings conference call that Haynesville investment makes sense from a strategic viewpoint because it provides the company with optionality to market its natural gas from the Gulf Coast, where a flurry of LNG infrastructure projects are currently in the works.

Chesapeake's other opportunities
While I was initially perplexed by Chesapeake's decision, Lawler's reasoning is convincing. At any rate, Chesapeake plans to devote just 10% of its 2014 capital budget toward Haynesville drilling. The largest portion of its capital budget -- about 35% -- will go toward the Eagle Ford, which should help fuel 8%-12% oil production growth after adjusting for asset sales, while the third largest portion -- about 15% -- has been earmarked for the Utica shale, which should help drive 44%-49% natural gas liquids production growth.

Chesapeake isn't the only company benefiting from the record oil and natural gas production that's revolutionizing the United States' energy position. That's why the Motley Fool is offering a comprehensive look at three energy companies set to soar during this transformation in the energy industry. To find out which three companies are spreading their wings, check out the special free report, "3 Stocks for the American Energy Bonanza." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free.


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