Chesapeake Energy Getting Oilier – Asset Sales Expected to Top $4 Billion by Year-End 2014

Chesapeake Energy Corporation (ticker: CHK) is the second-largest producer of natural gas and the 11th largest producer of oil and natural gas liquids in the U.S. Headquartered in Oklahoma City, the company’s operations are focused on discovering and developing its large and geographically diverse resource base of unconventional natural gas and oil assets onshore in the U.S. The company also owns substantial marketing, compression and oilfield services businesses.

Recent Financial Results

Chesapeake announced results for Q3’13 on November 6, 2013. In comparison to Q3’12, adjusted EBITDA increased 29% to $1.325 billion and operating cash flow increased 22% to $1.368 billion. For the same period, adjusted net income per share rose $0.43 in comparison to $0.10 from the prior year’s quarter. Net daily oil production equaled 123 MBOPD, up 23% from Q3’12. CHK slightly scaled back on its capital expenditure and expects its full-year 2013 costs to total $5.7 billion and $6.05 billion, a decrease of $300 million (approximately 5%).

Due to continued Eagle Ford success, CHK raised its total 2013 oil production guidance by 2 MMBO to range between 40 MMBO and 42 MMBO for the year. If successful, this would equate to a 28% to 34% increase year over year.

Culture Change Results in Substantial Asset Sales

Chesapeake has completed asset sales of $3.6 billion in 2013 and expects to sell an additional $600 million in Q4’13, all outside of what CHK deems its core areas. Other asset sales may close in the first half of 2014.

In a conference call following the release, CHK said its balance sheet consists of too much debt and reducing the number is a strategic goal for the company. Previous company standards are holding acreage by production has been significant yet not efficient. CHK realizes production growth from multi-well pad drilling and hopes to involve 100% of its rigs in the process, while the number has been in the 75% range for the past two years. Additional information on play development and right-sizing the company will be addressed in CHK’s 2014 guidance, which is expected to be released in early 2014.

Proceeds have resulted in $5.2 billion of liquidity consisting of $4 billion from an undrawn corporate revolver, approximately $215 million of availability on its oil field services revolver and approximately $1 billion of unrestricted cash. CHK’s liquidity position improved by approximately $430 million compared to Q2’13, and by approximately $840 million from Q4’12. Long term debt net of cash declined to $11.7 billion from $12.4 billion at Q2’13. CHK said it sees no need to issue equity.

*based on expected 14% decrease

Operational Update

The Eagle Ford Shale is CHK’s primary oil play where they operated an average of 13 rigs in Q3’13. Production averaged 95 MBOEPD (68% oil) and 100 gross wells were connected to sales. CHK currently has 788 net producing wells with 117 waiting on completion. CHK noted production stages are shortening due to familiarity with the play and improved cycle times and planning.

Utica Shale net production averaged roughly 164 MMcfe/d, an increase of 91% from the previous quarter. Currently 377 wells have been drilled with 208 wells waiting on various stages of completion. CHK said they are aiming to improve their geologic program in the area and are “pulling back” to conduct more studies and increase their confidence on the operational side.

The Greater Anadarko Basin consists of five plays and is CHK’s most heavily-operated project. Quarterly production averaged 109 MBOEPD through 22 operated rigs, a 14% increase from Q3’12. However, production decreased 12% from the previous quarter due to the sale of 22.2 MBOEPD in the Mississippian Lime. Roughly 45% of production in the region accounts for natural gas. Currently 123 wells are in the Basin with 44 waiting on completion.

The 100% natural gas-producing Northern Marcellus Shale provided 825 MMcfe/d for a 6% increase on its Q2’13 numbers. Five rigs operated in the area and 128 wells are awaiting completion. Production is expected to rise in Q4’13 due to new capacity expansion projects and CHK has contracted for approximately 33% of the 1.4 Bcfe/d of new pipeline capacity.

Southern Marcellus Shale production in the wet-gas region amounted to 275 MMcfe/d for a 33% increase from Q2’13. Approximately 13% of the company’s southern Marcellus production was oil, 17% was NGL and 70% was natural gas. Three operated rigs connected 52 gross wells in the quarter and 62 wells are in the process of completion.

Research Commentary

Oil & Gas 360® compiled a few paragraphs from research analysts who wrote on Chesapeake following the announcement. OAG360 suggests that you contact the analyst and/or salesperson to receive a complete copy of the report. Please read the important disclosures at the end of this note.

Bank of America Merrill Lynch – 11.6.13

3Q13 clean EPS of $0.43 beats consensus

Chesapeake’s clean 3Q13 EPS of $0.43 beat consensus of $0.42 (BofA ML $0.46). Oil production was strong – up 23% year over year at 120,000 bpd and continues to drive higher cash flow growth relative to the pace of top line growth. Liquids now account for 27% of total production, up from 21% in 3Q12. At first glance, strong oil volumes were offset by higher DD&A and interest charge. Production for the quarter came in at 674 boepd, 2% lower sequentially and in line with expectations; however total production fell 2% yoy with the entire decline concentrated in natural gas. Notably oil guidance has been pushed up, capex is falling, opex is trending lower and disposals are back on the table. CHK’s investment case is evolving towards a recovery play, which we expect to accelerate in 2014.

Oil Guidance moves higher: CHK has now raised full year oil guidance by 28-34% to 40-42 Mbbls driven by strong results out of the Eagle Ford. The company continues to deliver on its promise of lower operating and capital expected costs. FY drilling and completion guidance is now expected to be $5.5-5.8 bn vs $5.7-$6.0bn previously; helped by a lower operated rig count with plans to run 59 rigs in the fourth quarter vs 67 in the 3Q13. Leasehold acquisition guidance is also down to $200-$250mm from $300-$350 mm previously. Additionally, production expenses for the year are expected to average $0.80-$085/Mcfe vs. 0.85-0.90 / mcfe previously – however this looks like the start of a process that has internally targeted ~50%% improvement in unit costs.

Anticipates closing ~$600mm of asset sales in 4Q13: To date, CHK has completed $3.6bn of asset sales and it anticipates closing an additional $600mm in 4Q13 with negligible associated impact on production. This brings net disposals to date to the bottom end of its target range FY target of $4 – $7bn. However management continues to pursue other potential sales, with progress expected in 1H14. Critically, CHK retains ample liquidity to avoid any ‘distressed’ valuations.

Strong results in the Eagle Ford and the Utica: Eagle Ford production increased by 12% sequentially to 95 Mboe/d during the quarter. Utica production jumped to 164 MMcfe/d from 85 MMcfe/d. The company brought on 63 Utica wells during the quarter that had an average rate of 6.6 MMcfe/d – in line with the average rate of the 42 wells brought online during the second quarter. In the Marcellus, the company did grow volumes despite even takeaway constraints (+6% in its core Northern area).

Maintaining Buy rating: Our long standing view on CHK has been anchored on its transition from gas to liquids. However this has evolved to a restructuring play where we expect cost improvement to offset headwinds from lower gas prices.

UBS Investment Research – 11.6.13

3Q EPS in line but production beats on higher than expected oil production

Clean 3Q EPS/CFPS of $0.43/$1.33 was in line with UBSe $0.43/$1.28 & consensus’ $0.43. 3Q highlights: 2% YoY decline (+8% YoY and +5% QoQ adjusted for asset sales) in production to 4.04 Bcfed (1% above our estimate and 2% above consensus), 18% YoY rise in price realizations (in line), and 9% YoY decline in per-unit costs (1% below UBSe). Notably, 4% QoQ oil production growth to 120 MBbld (UBSe 108 MBbld) was driven by Eagle Ford volumes which rose ~11% QoQ and 82% YoY.

Lowers 2013 capex outlook, but production guidance raises growth concerns. CHK lowered its 2013 E&D capex target to $5.5-$5.8bn from $5.7-$6bn prior as 3Q was below budget and it will run 8 fewer rigs in 4Q & complete 14% fewer wells QoQ. CHK raised 2013 oil production guidance by 2 MMBbls to 40-42 MMBbls, but guidance implies a 10 MBoed QoQ decline in oil production (from reduced activity and asset sales). In addition to a 1.5 MMBbl cut In NGL guidance and lower gas guidance, the midpoint of full year production guidance is essentially unchanged at 3.99 Bcfed (+3% YoY growth, including the impact of $3.6bn in asset sales YTD). We’ve adjusted our 2013-14 CFPS estimates to $5.15 and $5.75 from $5.05 and $5.85, respectively.

Guidance highlights underlying investor concerns

The implied QoQ decline in 4Q oil production highlights concerns about CHK’s ability to deliver oil growth next year given reduced drilling activity. In addition, wider natgas differential guidance may get worse in 2014 given CHK’s large NE Marcellus production base. While the cut in capex and LOE guidance are positive, CHK’s premium valuation will struggle to be maintained if it cannot deliver attractive liquids growth, and CHK will not provide that 2014 guidance until early next year. We model companywide growth of 4% (consensus is +1%), led by NGLs (+30%) and oil (+12.5%).

Valuation: large >2 turn premium on EV/DACF

Our PT of $27 assumes 6.7x normalized 2014E DACF (vs. its historical average of 7.4x).

Stifel Note – 11.6.13

Investment summary. This morning before the open, CHK reported a CFPS beat, further improved its 2013 guidance in terms of oil production/capex/opex and indicated positive 2014 organic production growth, which is better than what most investors are expecting. As a result, this morning’s release is a positive, but given CHK’s valuation relative to other large cap names, which do not have the same balance sheet constraints and have more focused assets in top tier plays, we maintain our Hold rating.

Earnings recap – CF beat. CHK reported a solid CF beat with 3Q13 CFPS/EPS of $1.79/$0.43 versus our estimates of $1.75/$0.46 and the Street consensus of $1.59/$0.43. The beat was driven by higher-than- expected production, which came in about 1% higher than our forecast, and lower per unit LOE costs, which were 11% below our estimates. Overall, production fell about 1% Q/Q to 4,071 mmcfe/d, as a 2% Q/Q decline in gas volumes offset a 7% Q/Q increase in liquids volumes.

Positive 2013 guidance changes. The midpoint of production guidance is largely unchanged, but the oil production forecast was increased by 5%, and capex guidance is coming down by 6%. Opex/G&A guidance are also down, showing further capital discipline, a focus on capex efficiency, and cost controls materializing.

2014 outlook. While CHK is still working through its strategic review and has not yet provided guidance, the company did mention that it should deliver organic production growth next year, driven by Eagle Ford and Utica/Marcellus volumes. Consensus expectations were for flat production growth, so as a result, this morning’s commentary may cause a slightly improved outlook for 2014.

Wells Fargo Securities – 11.6.13

CHK Q3 First Look–Positive. Production beat us by 3.5% on the quarter, driven by crude volumes, and full year crude guidance increased. 2014 capex indicated lower than 2013 (which was decreased $300MM this am) – to our knowledge first time that has been publicly stated but need more color on details (lower E&D or other, which was expected to be down). Mgmt also indicated this would generate organic growth–seems likely positive. Adjusted Q3 EPS of $0.43 versus our $0.40 and the Street’s $0.42 estimate. Prod’n beat by 3.5%, LOE lower than expected, and marketing margins better, offset by price realizations.

Operations. Eagle Ford: growth continues to ramp, up 11% sequentially, or 10 Mboe/d, despite selling 6 Mboe/d effective 7/31. Backlog down significantly, 117 vs. 168, but could be asset sale. Anadarko Basin: 109 Mboe/d, down 17 Mboe/d after selling 22.2 Mboe/d. Utica: 164 MMcfe/d, up 91% sequentially. Brought on 63 wells during Q3, with average peak well for those on 1st production at 6.6 MMcfe/d. Marcellus: production up 6% q/q in Northern, and up 33% sequentially in Southern. CHK has contracted around 450 MMcfe/d of the new capacity which is expected in Q4 2013.

Guidance. 2013 production essentially flat, although crude increased 2 million boe (Eagle Ford), or 5%, while NGL decreased by 1.5 MM boe (Utica ethane rejection and Utica slower production ramp on 3rd party processing downtime) and natural gas reduced by 5 Bcfe. 2013 D&C capex guided to $5.5-5.8BN from prior $5.7-6.0BN, while net acquisitions of unproved properties guided down by $100MM to a $225MM midpoint. No other meaningful changes. Q4 capex midpoint at $1.45 B at midpoint after E&D at $1.2B in Q3. Based on prior Q2 commentary, we expect company to reduce rig count another 6 rigs in its core plays. Back of the envelope, looks closer to $5 billion E&D range for 2014.

Conference Call Summary. In general, not much new information from the conference call, although we did get more clarity on Q4 down-tick in oil prod’n. Despite bringing up FY oil prod’n guidance after a strong Q3 in the Eagle Ford, the midpoint of Q4 guidance suggests a sequential downtick in oil volume; flat prod’n puts us in the high end of guidance. Looking at the numbers, the 95 Mboe/d EF prod’n was net of 6.3 Mboe/d sold on 7/31/13, which will impact Q4 by ~4.2 Mboe/d. According to management, the remaining downtick in volumes is primarily related to the Eagle Ford. Company cited “inventory acceleration reduction” and we note the company took its EF backlog down by 51 wells in the quarter, so some of that “flush” production rolling off. Management also cited infrastructure and weather as impacting Q4, which in theory is temporary, and that it was reducing its rig count in Q4. Didn’t provide a level for the rig count, although we note in its Q2 release is stated Eagle Ford rig count would exit the year at 10 rigs (versus 13 in Q3 and 15 in Q2). Management noted that the slowdown in EF volumes would be temporary and it would return to sequential growth in 2014, although judging by the market reaction, the Street looks skeptical. Commentary could also be management padding the numbers somewhat. We would also note the rig count has been dropping dramatically in the Anadarko Basin, from 26 rigs in Q2 to 22 and likely headed lower into year end. While only 34% oil, still represents 37,000 boe/d in the quarter and a slowdown there could eliminate some additional crude volumes that have helped in prior quarters.

2014 In Focus. Also significant discussion around capex and 2014 production. On capex, management commented that total capex should be lower y/y in 2014 vs. 2013, with total capex in 2013 at ~$6.9BN. However it refrained from breaking down the components. Company had previously indicated that the $1BN spent on “other” capex could be cut in half. Not much room to move on $225MM of lease acquisition capex. So assuming “other” is down $500MM and lease acquisition flat, means E&D could be anywhere south of $6.2BN (E&D at $5.65 billion in 2013). For what it’s worth, we are currently modeling $5.5BN in 2014. On the growth front, in the press release management indicated that it expected “organic” growth in 2014 vs. 2013, meaning production growth after adjusting for asset sales. During Q&A, would not give any color on whether it expects total growth to be up as well, or just organic growth. And it does matter in the case of CHK – for instance in Q3 2013, production was down 2% from Q3 2012 and down nominally from Q2, but after adjusting for asset sales, volumes are up 8% YOY and 5% sequentially. We are currently modeling 1% absolute growth (no adjustment for asset sales) in 2014, versus the Street at ~flat, but are in the process of scrubbing our numbers. FY2014 guidance likely coming early next year.

Share Reaction. Market obviously reacting negative on the release, which judging by our incoming phone calls and emails, are concerns about Q4 production and what that implies for 2014. Could of course be shorts doubling down and creating additional pressure. Regarding our rating, while we missed the trade earlier this year, we remain on the sidelines. On a multiple basis, CHK is trading at 6.1x on 2014E EV/EBITDAX, a multiple which could rise as Street trues up 2014 production targets. For lower multiples, we would look to Outperform-rated APC ($92.18) at 5.5x and EOG ($177.35) at 5.3x — we prefer those names to CHK.

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