Chesapeake Energy Further Increases Liquids Focus

Yesterday, Chesapeake Energy (NYS: CHK) spurred a rally among natural gas producers when it announced its updated 2012 operating plan in response to low natural gas prices. The highlights included:

  • Plans to reduce the operated dry gas drilling rig count to 24, down from an average of 75 from 2011.

  • Dry gas drilling capex, net of drilling carries, is expected to fall 70% from 2011 to $0.9 billion.

  • Plans to curtail 0.5 billion cubic feet per day of production immediately, with the possibility of further cutting up to 1 Bcf per day if necessary.

  • Undeveloped leasehold spending targeted at $1.4 billion in 2012, down from $3.4 billion in 2011 and $5.8 billion in 2010.

Chesapeake had already allocated the majority of its drilling capex toward liquids before this announcement, but I'm still happy to see the further increase in liquids allocation. Even though the spot price of natural gas has been going nowhere but down, many producers have enjoyed the benefits of their hedged production. However, I have seen very few companies with natural gas hedges for 2013 that are more attractive than what they have for 2012. With the protection of attractive hedges rolling off, I doubt many companies will be able to turn a profit with gas at $3 or below.

Continuing the plan
The big story here for investors interested in Chesapeake might actually be the decrease in leasehold spending. The target of $1.4 billion on undeveloped leases is down almost 60% from last year's number and rightfully allocates the lion's share of this year's capital expenditures toward drilling and completing wells on acreage targeting oil and NGLs.

Given the company's two-year plan aimed at reducing debt and increasing production, the higher allocation toward drilling helps both objectives. The company already has a massive inventory of drilling locations, so a renewed focus on increased production and not on acreage additions is a good goal to have.

With the disparity between oil and gas sitting around 40-to-1, I don't see any reason to direct precious drilling capital toward natural gas until the price rises significantly -- a minimum of $5 or $6 per million cubic feet. It's hard to show attractive returns on gas relative to oil when there's such a huge price disparity. Hopefully, Chesapeake continues this aggressive shift toward liquids and does not look back. I don't see why it wouldn't, since it makes no sense to redeploy a rig from a liquids-rich area unless gas offers a much better payoff at that time.

Foolish bottom line
It's nice to see the second-largest natural gas producer in the U.S. act rationally and curtail its production in the face of horrible spot prices. While Chesapeake accounts for almost 9% of U.S. natural gas production, this move still won't make a large impact unless others follow along. Other top-five U.S. producers such as ExxonMobil, Anadarko, Devon, and EnCana must also make a similar shift. Going forward, it'll be interesting to see if these companies follow Chesapeake's lead and shift more aggressively toward liquids than already planned.

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At the time thisarticle was published Paul Chi is an analyst on the Fool's Alpha and Duke Street services. You can follow him on Twitter to stay up-to-date on his latest market commentary. Paul and Matt Argersinger co-manage the Street Fighter portfolio, where they look for cheap, unloved stocks with home run potential. Paul owns shares of Chesapeake Energy. The Motley Fool owns shares of Devon Energy. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. 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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