Once a darling in the energy industry, Chesapeake Energy (NYSE: CHK) hasn't been able to recover since the financial crisis. More recently, the company seems to have hit another rough patch. Even as one of the premier oil and gas companies, the recent decline in commodity prices caused the stock to tumble by almost 50% year to date.
Despite industry headwinds, management seems to be confident about the company's future. Yet investors seem to expressing their concerns by dumping the stock. So, who should you believe? To answer this question, we'll need to examine the reason behind the poor performance and the steps that Chesapeake is taking to prepare itself for the future.
As with many other producers, Chesapeake had a horrendous first quarter in 2015 when compared to Q1 2014. Of course, the single biggest factor affecting the performance was commodity prices. The Western Texas Intermediate hovered around $100/bbl in 2014, more than double its low in 2015. Similarly, natural gas tumbled 35%.
Commodity fluctuations are an extrinsic factor inherent in all upstream companies and Chesapeake does try cope with commodity volatility using hedges. Looking at when commodities were worst hit, the fourth quarter of 2014 and the first quarter of 2015, derivative payments contributed $496 million of cash flow to the company. To put it into perspective, Q1 2015's operating cash flow was $423 million while cash from derivatives amounted to $408 million, meaning that the hedges contributed to a substantial portion of Chesapeake's cash flow.
Evidently, the hedges did a very good job during the commodity downturn. However, the long-run profitability of the company will always be linked to the performance of crude and natural gas. What could distinguish Chesapeake from other producers is management's strategy going forward and the efficiency of Chesapeake's operation.
The company most recently went through a shake-up in 2013. Founder Aubrey McClendon resigned in January and was eventually replaced by the current CEO, Doug Lawler, and three other top executives departed as well. The new management has been shifting focus to the higher-margin crude production and managing the high debt load the company incurred prior.
Thus far, management has been diligently carrying out their tasks. Production did indeed shift toward oil, and the debt load is being prudently monitored. Chesapeake now has substantial liquidity resources and should have no problem repaying debt in the next couple of years. At the end of the first quarter, the company had $6.9 billion in immediate cash availability versus $5.5 billion in debt obligations within the next five years. As expected, liquids production increased in 2013 by 27%.
These things may seem trivial, but being able to trust management's guidance is no small thing.
The company's operation is highly efficient. For example, in a recent presentation, the management stated that Chesapeake's drilling activity is 40% more efficient than its competitors in Utica.
Considering that the Utica Shale is one of the more difficult areas to develop, this really reflects on the quality of the company's operation. A quicker turnaround would provide a meaningful advantage to Chesapeake in terms of volume, so Chesapeake is poised to take advantage if commodities move higher. Without an efficient operation, producers cannot fully realize the potential gains even if opportunity presents itself. With oil rebounding from its low in the first quarter, Chesapeake has the capacity to increase production and capture higher margins.
Even the best producer cannot prosper if it cannot survive a trough in the commodity cycle. Given the current environment, Chesapeake is correctly managing costs. In March, the company announced plans to decrease capital expenditure and lower rig counts. While this may lower the potential production in the short term, the cash saved up-front can be quickly deployed when commodity prices completely recover and will allow the company to capture higher gains.
A Foolish conclusion
The company is being managed well during a stressful time for the industry. The folks in charge stick to their plans, and you shouldn't expect any surprises. With an efficient operation, Chesapeake is staying well prepared for a recovery by carefully conserving capital and cutting costs. At an opportune time, the company should be able to quickly ramp up production and become more profitable.