Chesapeake's Not Choking

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Apparently, natural gas prices collapsed in the third quarter. You'd hardly know it from Chesapeake Energy's (NYSE: CHK) quarterly results.

Natural gas price realizations -- industry jargon for the effective sales price -- came in at $8.02/mcfe (per thousand cubic feet) for the third quarter. That's down 2% from the June quarter. Production levels were also roughly the same, resulting in operating cash flow of $1.4 billion, compared to $1.44 billion previously.

Confused? Well, the secret sauce is called a swap. Swaps and collars are derivatives employed by E&Ps to hedge their cash flow in case commodities suddenly crash. Practically everyone, from Anadarko Petroleum (NYSE: APC) to Williams Companies (NYSE: WMB), utilizes at least a moderate amount of hedges. Only firms with the most underleveraged balance sheets, such as Occidental Petroleum (NYSE: OXY), are able to largely go without. Those price realizations I mentioned before include the effect of cash-settled derivatives.

The giveaway that something went sour in the quarter is the mark-to-market gain of over $2.8 billion on unrealized hedges -- the ones that are still being carried on the books. This non-cash gain pumped up Chesapeake's net income figure, which, as a result, is pretty much useless for analytical purposes. This is why we generally pay closer attention to cash flow rather than earnings in E&P land.

So hedges are one thing protecting Chesapeake's caboose. Monetization is another maneuver available to muddle through this morose period. In the third quarter, the company completed about $7.5 billion transactions, from BP's (NYSE: BP) Woodford Shale purchase to Plains Exploration & Production's (NYSE: PXP) Haynesville Shale farm-in. Chesapeake is looking to execute more deals in the near term and, so far, sounds confident in its ability to close on them.

These monetizations might smack of deleveraging desperation were they not so darn lucrative. Through the first nine months of this year, Chesapeake sold undeveloped leasehold for $3.6 billion. That's nearly five times the firm's cost basis. There's something to be said for the long-term cash stream that a drilling program provides, but as with respectable ATP Oil & Gas (Nasdaq: ATPG), I see nothing subpar about converting some of that future value into cash today -- especially when credit is tight and you've got as deep a development pipeline as Chesapeake does.