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Is Chesapeake Energy Making a Mistake Betting on This Marginal Play?

By Arjun Sreekumar - Jul 17, 2014 at 2:24PM

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Chesapeake Energy’s decision to accelerate drilling in the out-of-favor Haynesville shale gas play could actually pay off in the long run.

Chesapeake Energy (CHKA.Q) had made its priorities quite clear. The company aims to deliver profitable and efficient growth from its existing asset base, while balancing its capital expenditures with cash flow from operations and reducing its financial and operational risk and complexity.  

To help achieve these goals, Chesapeake is focusing primarily on its most profitable liquids-rich opportunities, mainly in the Eagle Ford shale, the Anadarko Basin, and the Utica shale. That's why it may have come as a surprise to some when it announced plans to accelerate drilling in the Haynesville shale, a relatively high-cost shale gas play from which several operators have retrenched over the past couple of years because of poor returns.

Is Chesapeake making a mistake by focusing on the Haynesville? Or does it have good reasons to do so?

Source: Chesapeake Energy.

Chesapeake in the Haynesville
The Haynesville, discovered by Chesapeake in 2008, is a shale gas formation located in northern Louisiana and eastern Texas. Despite having sold roughly 9,600 of its net Haynesville acres to EXCO Resources (NYSE: XCO), Chesapeake remains one of the leading operators in the play, with a 387,000 net acreage position that contains estimated net recoverable resources of 10 trillion cubic feet.

While Chesapeake's Haynesville rig count plunged to as low as three rigs in 2012, the company plans to operate between 7-9 drilling rigs in the play this year. The main reason is because the economics of its Haynesville drilling program have improved dramatically over the past few years, thanks to sharp reductions in operating costs and higher natural gas prices.

Dramatic improvements
Through an aggressive transition toward multi-well pad drilling, Chesapeake has driven its Haynesville well costs down from $10.3 million per well two years ago to just $7.5 million per well during the first quarter of this year. At that well cost, the company's unburdened rate of return (ROR), which counts minimum volume commitments and firm transport as sunk costs, easily exceeds 100%, even at a wellhead gas price of $4.00 per Mcf.

And at the current NYMEX gas price of roughly $4.50 per Mcf, the company's unburdened ROR rises to nearly 200% at the current $7.5 million cost per well. Even the burdened ROR at that well cost and gas price is pretty solid, at around 60%. While that's not as good as the company's drilling economics in the northern Marcellus, it's not too far behind and still a massive improvement over 2012.

At any rate, the company has spent a great deal of time and money optimizing its drilling program in the Marcellus. As it does the same in the Haynesville, it sees substantial potential for further cost reductions. Given that Chesapeake's cheapest Haynesville well to date cost just $6.9 million, further improvements in average well costs wouldn't surprise me.

Growing regional demand
In addition to the sharply improved economics of its Haynesville drilling program, there is another very good reason for the company to be drilling in the play -- growing demand from LNG exports and also from regional utilities and petrochemical plants.

So far, the only two projects to have received final approval from US federal regulators -- Cheniere Energy's (LNG 0.81%) Sabine Pass facility and Sempra Energy's (SRE 1.14%) Cameron LNG project -- are both planned for Louisiana. Sabine Pass will have an export capacity of roughly 16 million metric tons of LNG per year, while Cameron LNG's will be 12 million tons of LNG per year.

On top of that, demand from regional utilities and petrochemical plants is forecast to grow by about 1 trillion cubic feet each year over the next decade. Put it all together, and Chesapeake's Haynesville gas production should be in extremely high demand over the next few years.

Investor takeaway
Chesapeake's decision to accelerate drilling activity in the Haynesville shale makes sense given the current commodity price environment, dramatically higher returns, and rapid expected growth in demand from LNG exports, utilities, and petrochemical plants. With a massive inventory of remaining drilling locations and further cost improvements likely, the company's move should pay off in the long run.

Arjun Sreekumar owns shares of Chesapeake Energy. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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