Chesapeake Energy Delivering Production Growth with Less Spending

Chesapeake Energy  (NYSE: CHK  ) , America's second largest natural gas producer, is on a mission to improve capital efficiency through a narrower focus on the company's higher return projects. The company's recent announcements of asset sales, strong oil output, and strong production growth have eased some near-term liquidity and operational concerns. Moreover, the new major cost-cutting initiatives should help management improve the balance sheet further.

Capital and operating efficiency
Capital efficiency was one of the most important themes of the oil sector in 2013. Chesapeake managed to cut its capital spending by half in 2013 to $7.2 billion from $14.1 billion in 2012. The company is expected to reduce capital spending further in 2014 to approximately $5.76 billion. The company significantly improved its capital efficiency, cash costs, and margins in 2013 and the trend is expected to continue in 2014 as well. On the other hand, the company's larger competitors, including integrated majors ExxonMobil (NYSE: XOM  ) , Chevron, and Royal Dutch Shell, are struggling to justify rising project costs in the wake of declining volumes.

Going forward, part of Chesapeake's new discipline will be to keep E&D capital spending within operating cash flow. The company has already reduced its drilling activity to 55-65 rigs, compared to an average of 71 rigs last year. The company, despite being one of the pioneers of the North American shale revolution, has a lot of room to improve operating efficiency. There is plenty of opportunity for the company to both reduce drilling cycle times and improve well productivity. Chesapeake's new management plans to continue to pursue an aggressive restructuring and cost reduction program while realizing significant efficiency improvements throughout its core regions.

Production volumes expected to increase
Chesapeake's capital efficiency program is underappreciated by the market. Despite significant cuts in capital spending, Chesapeake's organic production is expected to grow by 8%-10% in 2014. Caution on the part of investors is understandable, as many of them question whether the company can increase or maintain its production while cutting its drilling activity. The company is actually well positioned to increase production despite a reduction in drilling activities. The emerging Utica play along with the Eagle Ford and Marcellus shale plays will largely drive growth, with the product mix transitioning from ~25%/75% to ~37%/63% liquids/gas in 2020, absent any major asset sales.

Improving balance sheet
Chesapeake doesn't plan to issue equity in the near-term, nor should the company need to. The company should be able to close the funding gap with the recently completed sale of its Chaparral Energy ownership stake for $215 million and the sale of midstream compression assets for $520 million to Access Midstream Partners and Exterran Partners. The company should be able to reduce its financial complexity further in the next two years by trimming its extensive asset base. However, the company is under no financial pressure to sell its assets at discounted prices. The next important catalyst for the company is the planned sale or spinoff of its oilfield services business and potential other non-core E&P asset sales, including real estate holdings.

Valuation
Chesapeake is currently trading at discount compared to its peers. I believe that investors are underappreciating the company's strong capital efficiency program and growth profile. Chesapeake has the ability to cut it costs significantly while grow production at the same time. Chesapeake is trading at a forward price/earnings ratio of 11.9, compared to 16.7 for Anadarko Petroleum and 12.5 for ExxonMobil. Moreover, Chesapeake has a price/book ratio of 1.3, compared to Anadarko's 2.2 and ExxonMobil's 2.4. Finally, the company has a price/cash flow ratio of 3.7, compared to 5.5 for Anadarko and 9.5 for ExxonMobil.

Bottom line
Chesapeake Energy's production growth is expected to accelerate with a significantly better capital efficiency program. The company's extensive resource growth should drive solid organic growth for the next several years. In 2014 alone, the company is expected to grow its organic production by 8%-10%. In the past, the company mostly spent its capital on either acquisitions or drilling to hold acreage, which led to far less efficient operations than most of Chesapeake's peers. However, the company's new management is bringing a lot of financial discipline to the capital budgeting process along with improvements in drilling efficiencies. As a result, the company is quickly catching up to its peers.

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