Chesapeake's Lows Bring Opportunity

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Starting in 2017, modestly higher oil and gas prices and an improvement in the firm's cost structure (driven by regional mix shift and natural reduction in financing obligations) should lead to significant cash flow growth and rapid deleveraging, which in turn should mitigate concerns regarding Chesapeake's long-term viability and bring about a shift in investor sentiment. It doesn't require an overly optimistic set of assumptions--or an exceedingly long period--for Chesapeake to bridge the gap with our $27 fair value estimate.

New Management a Welcome Change With free-spending McClendon gone and an accomplished ex-Anadarko executive now occupying the top spot, change has come quickly to Chesapeake, and we think that's a good thing for investors. Since being installed as CEO in June 2013, Doug Lawler has stressed corporate discipline, with an eye toward repairing the firm's overtaxed balance sheet and its reputation as an imprudent steward of shareholder capital. Early results have been impressive, as the firm has kept spending levels within (or even under) budget, reduced head count, and implemented a competitive capital-allocation process meant to high-grade Chesapeake's assets and shift key metrics toward the top of its peer group.

Chesapeake's portfolio includes more than 9 million net acres of onshore oil and gas assets. The firm holds leading positions in the Barnett, Haynesville/Bossier, Marcellus, Eagle Ford, Powder River Basin, Utica, and Anadarko Basin regions, among others, and continues to move aggressively within its liquids-rich plays as part of an ongoing strategy to diversify away from natural gas. Given impending lease expirations (or a sizable inventory of wells waiting on completion) in a number of its plays, as well as joint venture considerations and takeaway commitments across certain regions, we expect Chesapeake to push its drilling and completion plans hard over the next several quarters in order to hold acreage and bring production on line.

Despite the potential for some fits and starts over the next few years as Chesapeake works through how to best monetize its extensive inventory, we're bullish on the company's ability to increase production and reserves, given the breadth of the firm's oil- and liquids-rich drilling opportunities and the reconfigured board's apparent insistence on spending discipline. The company's recent $5.375 billion sale of gas-oriented assets in the southern Marcellus and eastern Utica align with its objectives to consolidate its portfolio and will help to fund its aggressive development push, in our opinion. We expect Chesapeake's monetizations to primarily be plain-vanilla asset sales going forward.

Acreage Holds Significant Potential The competitive advantage of exploration and production firms largely stems from the quality of their assets. In particular, we consider the rates of return of wells drilled on the company's acreage as well as the number of potential drilling locations remaining. The former depends on the productivity of the well and the cost of drilling and operating it. Hydrocarbon flow rates are primarily a function of the underlying geology, but the company's completion methodology will also have an impact. Typically, more aggressive completion techniques will boost productivity but at a greater cost; management will seek to optimize these variables to maximize return. Other factors influencing the cost of a well include drilling cost, royalty rates, leasehold outlays, production taxes, and lifting expenses.

Few operators are as skilled as Chesapeake at quickly assembling large acreage blocks within emerging plays. Most recently, the company announced plans to exchange nonoperated interests in Wyoming's Powder River Basin with RKI Exploration and Production, which increased its net acreage position and working interest in the play from 322,000 to 388,000 and 38% to 79%, respectively. The firm's tendency to pay top dollar and offer more favorable royalty rates to landowners, however, generally leads to higher break-even points for its resource inventory. In addition, several of Chesapeake's plays--in particular its acreage in the Utica shale, the Anadarko Basin, and the Rocky Mountain region--are still early in their life cycles, with a good amount of uncertainty surrounding their ultimate economic profiles.

Still, we believe Chesapeake's more than 9 million net acres merit a narrow economic moat rating, in large part because of the significant monetization potential they represent. The firm holds acreage in almost every major unconventional resource play in the United States, a number of which we think would be attractive to potential investors (especially now that the unconventional land rush has largely come to a close). We believe Chesapeake will be able to recapture a meaningful portion of its leasehold spend through asset sales. Such transactions would compensate for the firm's propensity to overreach on acreage costs and should help drive continued growth in production and reserves throughout our forecast period.

In the near term, we expect Chesapeake's returns on invested capital to come under some pressure as the firm works to optimize drilling and completion costs and as lower commodity prices pressure margins. Longer term, we think Chesapeake can achieve returns above its cost of capital as oil and gas prices recover.

Low Oil and Gas Prices Biggest Risk Chesapeake's biggest risk is a substantial and prolonged drop in oil and gas prices, which would depress profits, slow development plans, and reduce the value of its properties. Other risks include a disruption in the asset market, which would limit the company's ability to monetize its acreage holdings; execution risk in Chesapeake's emerging plays (in particular the Anadarko Basin, Utica, and Powder River regions); potential midstream bottlenecks, especially in the Utica and Marcellus; and regulatory headwinds that could ultimately eat into profitability.

We believe the company's joint ventures with CNOOC in the Eagle Ford and Niobrara and Total in the Utica Shale, as well as its Fayetteville sale to BHP, confirm Chesapeake's deal-making savvy and the relevance of its acreage to investment partners. We think Chesapeake is likely to execute similar-size asset sales to help realize the value of its vast onshore inventory. Its willingness to take on asset price risk through higher up-front leasehold costs puts the company somewhat at the mercy of its investment partners, however, and in our opinion offsets any advantage of holding large blocks of acreage in emerging plays.

Chesapeake has historically paired its aggressive operating strategy with a similarly aggressive financing strategy. From 2005 to 2013, its capital spending significantly outpaced operating cash flow, resulting in billions of dollars of borrowing and the implementation of several nontraditional financing vehicles to help meet cash shortfalls. The firm has taken a number of steps to improve its financial position during the past several quarters, including the redemption of high-interest-rate financing instruments and several billion dollars of noncore asset sales.

Chesapeake's credit metrics will become increasingly stretched over the next several quarters as earnings decline and cash burn accelerates. In fact, we project covenant violations to occur both this year and next. However, we don't believe these violations will give rise to a near-term liquidity crisis or require additional equity capital to be raised, nor are they likely to imperil Chesapeake's long-term prospects, given the multiple options the company has at its disposal to remedy them, including asset sales, accelerated activity levels, and credit agreement amendments.