How Chesapeake Is Playing the Natural Gas Rally

Prices for natural gas – a commodity that has traded at a discount to crude oil on an energy-equivalent basis over the past few years – are finally on the rise.

Last week, natural gas prices ended the day above $4 per million BTUs for the first time since September 2011. The rally was fueled by strong heating demand, bolstered by chilly temperatures across major U.S. metropolitan areas that have lingered for longer than expected.

Let's take a look at how the nation's second-largest natural gas producer – Chesapeake Energy (NYSE:CHK) – is playing the recent surge in gas prices.

Chesapeake's response to the natural gas rally
On Monday, Steve Dixon – Chesapeake's chief operating officer who is currently serving as the company's acting chief executive until a permanent replacement can be found for Aubrey McClendon – announced that the company is capitalizing on the recent rally in natural gas prices by locking in highly favorable prices for this year and next's gas production.

Dixon told analysts that Chesapeake has begun hedging its gas production for 2014 at prices significantly above $4 per Mcf. However, despite the surge in gas prices, Chesapeake won't be ramping up operations in its gassier plays.  

In contrast, some other major gas producers recently resumed gas drilling, due to its improved profitability. For instance, Encana (NYSE:ECA) announced in February that it is resuming drilling in the Haynesville Shale because it expects the play to deliver "solid returns" at current natural gas prices.

Encana's announcement highlights a drastic departure from gas producers' standard operating procedure over the past year and a half, when most scaled back heavily on gas drilling due to its poor economics. Virtually no gas wells are profitable at prices under $3 per Mcf.

Liquids focus to continue
Dixon stated that Chesapeake would instead continue with its stated goal of maximizing oil production. For the year, the company hopes to grow liquids production 27%, which would make liquids more than a quarter of its total production mix by the end of the year. The Eagle Ford play in Texas, where Chesapeake commands 485,000 net acres, will be the main driver of the company's planned liquids growth.  

Though Chesapeake plans on waiting until gas prices recover further before it starts drilling new wells in its gassier holdings, the surge in gas prices is certainly a boon for a company that has faced its fair share of unpleasant surprises over the past year and a half. Chesapeake's shares took a beating last year after scandalous allegations against its CEO surfaced in April.

Unfortunately, though, the near-term financial impact of higher gas prices will be relatively minor since the company has already hedged almost three-quarters of its expected revenue for the year, as part of its plan to enforce stricter fiscal discipline – a practice often neglected under McClendon's reign.

A more disciplined Chesapeake?
Chesapeake's more conservative stance on hedging also comes as a sharp departure from its hedging practices in late 2011. Based upon management's bullish outlook for natural gas prices, the company decided to enter 2012 "naked," meaning it didn't hedge any of its natural gas production for the year. The bet turned out to be a bad one, costing Chesapeake dearly and exacerbating its already unstable debt situation.

But with McClendon gone and a new CEO set to take over, it appears that Chesapeake may be turning over a new leaf. The company has reported substantial progress in reducing costs over the past year, especially in the Eagle Ford, where a substantial chunk of its operations are currently focused.

The company reported that well costs in the Eagle Ford are currently averaging about $7 million, down from $9 million initially. Thanks to these and other major efficiency gains, Dixon foresees Chesapeake's expenses to come in on or under budget this year.  

Looking ahead, Chesapeake will forge ahead with its asset sale strategy; it plans to raise $4 bilion-$7 billion in proceeds. Of that amount, Dixon said that $1.5 billion has already been taken care of, including the recent $1 billion joint venture with Chinese oil giant Sinopec.