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Less than a year ago, amid the commodities and credit market collapse, some investors were seriously stressing about the solvency of Chesapeake Energy (NYSE: CHK ) . The stock briefly dipped below $10 on massive volumes in early December, which prompted management to hold a conference call to reassure investors that the company wasn't crumbling.
Following that call, I decided that a five-bagger (i.e., a fivefold rise in the share price) was more likely than a Chesapeake bankruptcy. So far, so good -- the shares closed the day of the shareholder update at $13.86, so the stock has only about another 140% to go.
2009 turned out fine
Following the late 2008 crisis of confidence, we saw Chesapeake stop worrying and learn to love low gas prices, chuck more production, and keep growth in check. That was the first half of 2009. More recently, Chesapeake has stopped holding back, for reasons outlined here.
No matter what happens to natural gas prices from here to the end of the year, 2009 is really a closed book, thanks to Chesapeake's hedges. The company will generate around $3.7 billion in operating cash flow, whether gas prices remain weak, or double next week. It's 2010 and beyond that investors need to concern themselves with today.
Having held its annual analyst day last week, the company has given us plenty to chew on. With nearly 200 slides in the deck, the mega-presentation might strike you as overwhelming, but I'll try and tease out a few key themes.
It's all about the Big Four (plus one)
All year, Chesapeake has been building up its theme of the "shale haves" versus the "shale have-nots." The company argues that a big bifurcation in the industry cost curve is coming, with rock-bottom finding costs accruing to the former group for decades to come. Meanwhile, costs for the have-nots will not only remain high, but rise as these players drill increased density (or "infill") and rate acceleration wells in existing fields rather than new discoveries.
Chesapeake is the No. 1 player in this country's two largest "Big Four" shale plays -- the Haynesville and the Marcellus. The company trails only Southwestern Energy (NYSE: SWN ) in the Fayetteville, and is second to Devon Energy (NYSE: DVN ) in the Barnett. You might accuse Chesapeake of "talking its book" here, but keep in mind that the company has an extensive background in, and continuing significant exposure to, conventional natural gas plays. Chesapeake's nonshale, nonwash rig count has dropped from 74 rigs to just seven. That's dictated by economics, not a pet theory. Also consider that even the few low-cost nonshale players like Ultra Petroleum (NYSE: UPL ) are making serious moves on plays like the Marcellus.
Beyond the shale
What's this wash business? That's the "plus one" alluded to above. Shale rock doesn't have an exclusive grip on the low end of the cost curve. By drilling horizontally into various granite wash formations in the midcontinent area, Chesapeake has unlocked some hugely profitable plays.
In the Colony Granite Wash, for example, the company estimates a per-well present value, discounted at 10%, of about $11 million, compared to a drill and complete cost of just $6.25 million. Chesapeake is understandably very active in what it's dubbed the Greater Granite Wash play, with Cimarex Energy (NYSE: XEC ) rating a distant second in terms of horizontal wells drilled.
Unfortunately, these wash plays don't appear to be as laterally extensive as the big shale plays. Chesapeake, the largest leaseholder in the Greater Granite Wash, has just 360,000 net acres, compared to half a million acres in the Haynesville and nearly 1.5 million in the Marcellus. Still, with more than 350 net risked locations in the Colony Wash alone, and given the present value estimate above, this position is very material to the company.
Adding it up
In 2010, Chesapeake is looking at production of 2.65 billion cubic feet of gas per day (a 9% increase) and reserve growth of 23%. The company expects operating cash flow of $4.4 billion to $5.1 billion, which would put the company's forward price-to-cash flow multiple at about 3.6 to 4.2. That's quite cheap given the top-shelf resource base here, though the company looks a bit less so when you factor in its net debt level, which will exit 2009 at a projected $12.5 billion.
The company's cash flow projection is based on 2010 oil prices of $80 (not terribly critical, given the 8% contribution of oil and liquids to the production mix) and natural gas prices of $6.50-$7.50/mcf. If liquidity was the most divisive issue last year, divergent views on natural gas prices are probably separating Chesapeake bulls and bears today.
I'm not going to go into the company's justification of its gas price expectations -- which are largely mirrored by EOG Resources (NYSE: EOG ) and XTO Energy (NYSE: XTO ) -- but you should know that Chesapeake's hedge book is structured for a substantial rebound in 2010, with just 22% of volumes hedged. Make sure you're at least halfway comfortable with this positioning if you're hitching your fortunes to this (or any largely unhedged) operator.