Faced with persistently low natural gas prices over the past few years, Chesapeake Energy (OTC:CHKA.Q), the nation's second-largest natural gas producer, has made impressive strides in boosting its production of oil and natural gas liquids, which are more profitable than dry gas.
But the company recently said that its crude oil production growth will slow dramatically this year -- an announcement that clearly disappointed investors, judging by the immediate negative impact on Chesapeake's share price. But is the guidance really that big of a deal?
Chesapeake's oil production growth to slow
Over the past few years, Chesapeake has made commendable progress in becoming a more liquids-focused producer, ramping up activity in liquids-rich plays such as the Eagle Ford and Utica shale and curtailing drilling in less economical gas plays such as the Haynesville and Barnett shales. Largely as a result of this shift, the company delivered 32% year-over-year growth in oil production in 2013.
That pace of growth puts it squarely among some of the fastest-growing midmajor liquids producers in the country, including EOG Resources (NYSE:EOG), Apache (NASDAQ:APA), and Anadarko (NYSE:APC). EOG's enviable acreage position in the Eagle Ford helped the company deliver 40% year-over-year growth in oil production last year. Similarly, Apache's operations in the Permian Basin helped boost its North American liquids production by 34%, while Anadarko's stronghold in Colorado's Wattenberg shale and the Eagle Ford fueled 25% year-over-year growth in its domestic oil production.
But unlike these companies, Chesapeake's impressive streak of oil production growth won't continue into 2014. During its fourth-quarter earnings conference call, Chesapeake management forecast a sharp decline in the pace of its crude oil production growth this year, down to a paltry 1%-5%, due largely to the impact of 2013 asset sales.
Context is key
Though oil is Chesapeake's highest-margin product, the sharp expected decline in oil production growth must be viewed in the proper context. First, Chesapeake has unloaded more than $11 billion in assets over the past two years and plans to sell an additional $1 billion this year. Though the company characterized these assets as "non-core," many of them were producing properties in liquids-rich plays such as the Permian Basin and the Mississippi Lime. Therefore, their loss will obviously take a toll on oil production.
Second, Chesapeake still expects strong year-over-year growth in natural gas liquids, or NGL, production of roughly 40%-45%, driven largely by Ohio's Utica shale. While NGLs aren't as profitable as crude oil, the company still earns a competitive return from their production. In the fourth quarter, Chesapeake received $31.76 per barrel of NGLs, compared to average unit costs of $19.35 per barrel.
Finally, Chesapeake's reduced oil production growth outlook has to be viewed against the backdrop of sharply reduced spending and improving capital efficiency. The company has slashed its capital budget from $13.4 billion in 2012 to just $6.7 billion last year and expects spending to decline by an additional 20% this year to an estimated $5.4 billion.
Yet despite its plans to cut $0.7 billion from its drilling budget and operate 10 fewer rigs this year, Chesapeake still expects to deliver 2014 company-wide production growth of 2%-4% on an absolute basis and 8%-10% adjusted for asset sales, highlighting marked improvements in capital efficiency. Capital efficiency should improve further this year, as the company targets 97% multiwell pad drilling utilization in the Eagle Ford -- its key driver of oil production growth -- which should shave $0.5 million off average well costs, reduce spud-to-spud cycle times to just 14 days, and boost returns.
While sharply lower oil production growth will certainly weigh on Chesapeake's earnings and cash flow this year, investors should recognize that the deteriorating outlook comes amid sharply reduced spending and significantly improved capital efficiency. While I expect Chesapeake shares to remain pressured by oil production concerns in the near term, I believe the company's longer-term outlook remains promising thanks to an improving balance sheet, reduced funding and liquidity concerns, and tremendous upside optionality to a rebound in natural gas prices.