2 Reasons Why Chesapeake Energy Will Continue Its Solid Run in 2014

Last year, Chesapeake Energy (CHK +0.00%) emerged leaner and fitter. Moreover, by borrowing a page from successful natural gas-turned oil producer Devon Energy and increasing liquids production, the reshuffled management at Chesapeake Energy brought back the much-needed investor confidence. Not surprisingly, the markets rewarded Chesapeake's stock with a handsome 60% return in 2013.

Source: Company website.

So where do we stand?
But was this rally just a flash in the pan? Or does it signal the beginning of some solid growth that investors could safely look forward to? By delving deeper, we should be able to get a clearer picture about what's in store for Chesapeake in 2014 and beyond.

It seems that the causes behind the recovery so far are backed by some solid fundamentals. A liquids-driven production growth brought about by operational efficiency and financial discipline is at the root of the outstanding turnaround for the Oklahoma-based Chesapeake. Let's dive deeper:

A way back to financial discipline
One of the biggest changes that occurred in 2013 was a massive reduction in capital spending. Total capital expenditure for 2013 was 48% lower year on year at $6.9 billion. The main focus was on core exploration and production activities while simultaneously shedding assets that didn't fit into the company's long-term plans. With such a strategy, management could balance capital spending with cash flow from operations. That's more like cutting the coat according to the cloth, and it definitely makes long-term business sense.

In the first nine months of 2013, cash flow from operations stood at $3.5 billion, a solid 80% growth from the same period the year before. While it seems unlikely for cash flows to overtake capital costs for 2013, the signs are hugely encouraging. CEO Doug Lawler has made clear that management is categorically looking toward minimizing the gap between the two metrics.

The divestitures netted $3.7 billion in the first nine months of 2013 with another $500 million expected in additional sales in the fourth quarter. Additionally, the exploration and production workforce was trimmed by 20%.

On the downside, there are few things that need to be taken care of. Reducing financial leverage is a key concern. Current debt-to-equity ratio at 70% isn't exactly enviable. Moreover, some of the noncore asset sales and transactions are pretty complex deals that have the potential to affect the company for some time. Specifically, prices of Chesapeake Granite Wash Trust (CHKR +0.05%) have tanked more than 40% in the last 12 months as wells in the Colony Granite Wash field are producing less oil and gas than forecasted.

Operational efficiency
The lower capital costs were driven by a reduction in well costs and a 40% reduction in rig count year over year. In the unconventional shale plays of Utica, Eagle Ford and Northern Marcellus, the company is gradually shifting to pad drilling while reducing the percentage of wells drilled using single-well pads. The following chart captures Chesapeake's progress:

Source: Investor presentation.

Not surprisingly, net production volumes grew. Chesapeake currently drills 75% of its wells from multi-pad wells. Its foray into liquids production is commendable. Operated rig count has dropped to a historic low of little more than 50, a massive drop from 175 in the fourth quarter of 2011. In all this, total production grew 2% year over year.

Increasing liquids production: A worthy result
For 2013, a whopping 86% of the drilling and completion capital budget had been allocated to liquids production. The Eagle Ford is Chesapeake's best bet to increase oil production with management looking to ramp up rig count to 15 this year from 10 last year.

In an ironic twist, natural gas prices have recovered significantly thanks to an unexpected cold weather fueled by the polar vortex. This should definitely boost the company's bottom line for the immediate future as natural gas still commands more than 70% of total production.

Foolish takeaway
Chesapeake's new management has painstakingly been undoing the wrongs done in the past. It has also been laying a solid foundation for future growth. Investors may do well to watch out for this company, whose world-class assets should now be a blessing rather than a curse.