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Is Chesapeake Energy Corporation’s NGL Strategy Sound?

The decision of Chesapeake Energy (NYSE: CHK  ) to increase its production of natural gas liquids raises the question of whether this is the right move for the company, and how will this play impact its bottom line. Also, what are the main opportunities and challenges this move entails? Let's tackle these issues.

Growing business 
Chesapeake Energy expects to grow its NGL production by 63% to 68% during this year. In the first quarter, its output grew by 55%, year over year. Further, the NGL operation expanded by a faster pace than Chesapeake Energy's oil or natural gas production during the first quarter. This year, NGL will account for 13% of the company's total output; back in 2013, it accounted for only 9%, and back in 2012 it was 7%. Most of Chesapeake Energy's NGL production comes from its Mid-Continent, Eagle Ford shale, and Utica Shale operations.

The company's decision to increase its NGL operations is part of the growing NGL business in the U.S. According to the U.S Energy Information Administration, volume of liquids (including NGL and methane) extracted from wet natural gas wells grew at an average of 7% per year between 2008 and 2013. Other oil and gas producers such as Anadarko Petroleum (NYSE: APC  ) and Marathon Oil (NYSE: MRO  ) have also expanded their NGL operations in the past year and are expected to keep doing so in the near term. But the growing supply of NGL may have a negative impact on its price in the coming years. 

High NGL prices -- will they last?
NGL is mostly comprised of ethane and propane. These two commodities' prices are affected by the cold weather. The harsh winter in the U.S. drove higher the prices of ethane and propane, which led to an increase in the price of NGL in previous months. Moreover, the prices of NGL are considered correlated with crude oil prices. In the past several years, this relation with oil gave NGL prices a premium over natural gas. 

The current price of NGL is still elevated at around $40 per barrel, which is 14% higher than last year. Since the harsh winter conditions have subsided in the past several weeks, the demand for these commodities are likely to come down, which could pressure down the price of NGL. Moreover, in the coming years, the EIA estimates the rise in liquids production will have a negative impact on the prices of ethane and propane, which will also bring down NGL prices. Nonetheless, for now, the current elevated prices of oil are likely to keep NGL prices higher than last year's levels.   

High margins on NGL
Due the premium NGL prices have over natural gas prices (as stated above), this premium also suggests NGL may offer higher profit margins for Chesapeake Energy compared to natural gas. Thus, the company could improve its profitability in the coming years as its NGL production takes a bigger role out of its total output. 

Chesapeake Energy is making the right move by expanding its NGL production. Nonetheless, the potential decline in prices of NGL could reduce its appeal and thus make this move less profitable in the coming years. 

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Lior Cohen

Lior has been a contributor for the Fool since 2012. His main interests are in commodities, and energy and materials companies.You can follow him on Twitter to stay up to date with his industry analysis. @tradingnrg

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