Is Chesapeake Poised for a Major Turnaround?


Embattled natural gas producer Chesapeake Energy reported fourth-quarter earnings that beat Wall Street's estimates, as better-than-expected progress in reducing costs and stronger oil production helped mitigate the impact of low natural gas prices.

With CEO Aubrey McClendon departing on April 1, it appears that the nation's second-largest natural gas producer is finally enforcing the strict financial discipline that so famously eluded it in prior years.

The company's year-end report and earnings conference call illustrated a stark contrast between the Chesapeake that McClendon built from the ground up and nurtured for more than two decades and the company as it exists today.

When McClendon was at the helm, Chesapeake was a company eager to expand aggressively, often by taking on risk that, at times, could be described as excessive. But with his imminent departure and a recently reconstituted board increasingly exerting its authority over the company's decisions, Chesapeake is starting to look like a leaner, more fine-tuned version of its former self, quick to emphasize fiscal discipline and risk management over reckless expansion.

The big question on investors' minds now is: Can Chesapeake stage a successful turnaround, or will prior years' profligacy prove too difficult to surmount?

Earnings recap
For the fourth quarter, Chesapeake reported a profit of $300 million, or $0.39 a share, down 36% from the $472 million, or $0.63 a share, it reported in the year-earlier period.

Adjusted earnings, excluding debt-repurchase costs, hedging impacts, and other items, declined to $0.26 a share from $0.58. Meanwhile, revenue rose 30% to $3.54 billion.

Earnings were boosted primarily by stronger oil production and expense reductions, both noted as top priorities going forward.

During the company's earnings conference call, COO Steve Dixon and CFO Nick Dell'Osso filled in for McClendon, whose absence was palpable. Dell'Osso summed up Chesapeake's new focus succinctly, saying, "We and the board are very focused on our budget."

And, right off the bat, Dixon categorically listed the company's three overarching objectives: 1. improving the production mix by gearing it more toward liquids, 2. reducing per-unit production costs, and 3. achieving targeted capital budget reductions.

Transition toward oil
In the area of ramping up liquids production, Chesapeake's progress has been respectable. Especially considering that it's still the nation's second-largest natural gas producer, its production mix has improved substantially over the course of a year.

At the end of 2012, natural gas accounted for 70% of its reserves, with liquids accounting for the balance. That's much better than reserves as of year-end 2011, when Chesapeake had 83% natural gas and only 17% liquids.

The big driver of liquids production growth was undeniably the Eagle Ford shale of south Texas, which posted a whopping 314% year-over-year production increase. Importantly, the play is weighted heavily toward oil, with Chesapeake's liquids mix consisting of roughly 82% oil and 18% natural gas liquids (NGLs).

Successful cost-cutting measures
As for reducing production costs and other expenses, Chesapeake offered a pleasant surprise to the upside. Drilling expenses fell 34% from the fourth quarter of the previous year, as the company saw substantial reductions in both well costs and spud-to-spud cycle times, which both fell by roughly 30% from the year-earlier quarter.

This year, the company plans on spending $6 billion on drilling, down markedly from $8.7 billion last year. After reducing the number of drilling rigs by half over the past year, it looks like Chesapeake is finally seeing the benefits of capital discipline.

Other expenses declined, too, with general and administrative expenses coming in at $99 million for the quarter, down from $138 million in the year-earlier quarter.

Funding gap remains daunting
Though Chesapeake's improved production mix and its better-than-expected success in slashing costs are promising developments, the company still faces a major financing shortfall and remains burdened by a heavy debt load.

These issues have further been exacerbated by low natural gas prices, which rendered uneconomical nearly a third of Chesapeake's undeveloped reserves in the Haynesville and Barnett shales.

To combat these problems, the company embarked upon a large-scale asset sale program last year, agreeing to sell more than $12 billion worth of oil-field and pipeline assets.

Some of the major assets it parted with included blocks of Permian Basin acreage, which it sold to SWEPI LP, a subsidiary of Royal Dutch Shell , Chevron , and a private Houston-based company. Net proceeds from these transactions totaled around $3.3 billion .

Later in the year, it parted with assets in the Eagle Ford shale, which were scooped up by midstream operator Plains All American . And finally, as the year was drawing to a close, it inked a deal with Access Midstream Partners , which decided to buy a "substantial majority" of Chesapeake's remaining midstream assets for $2.16 billion in cash.

Despite Chesapeake's best efforts, however, it failed to meet its year-end asset sale target of $12 billion. As a result, its funding gap -- the disparity between what it spends and the cash flow it generates -- remains daunting.

According to Chesapeake's own estimates, its funding shortfall for this year is about $4 billion. To plug that gap, the company hopes to generate $4-$7 billion through proceeds from asset sales this year. It recently took care of $1.02 billion of that $4 billion funding gap by selling half of its interest in its Mississippi Lime assets to Chinese oil behemoth Sinopec , though the price it received per acre was disappointingly low.

A new, more disciplined Chesapeake?
As the financial media has repeatedly spotlighted, Chesapeake has been through a rough year. But it looks like the company's revamped strategy, which includes ramping up oil production, reducing expenses, and shoring up its funding gap, is being met with initial success. In coming years, a more disciplined and less risk-loving Chesapeake may yet emerge.

Take its hedging strategy as an example. This year, the company has hedged half its natural gas production at $3.62 per million BTUs, a sharp contrast from the previous year, when it decided to enter 2012 unhedged because it expected natural gas prices to rise. When they didn't, it took substantial losses on its gas production while it scrambled to ramp up liquids production.

But despite encouraging developments, it might be too early to tell whether Chesapeake has truly turned over a new leaf. Even if it has, a host of challenges remain, the most important of which are its sizable funding gap and its long-term debt.

Though its debt has declined from $16 billion as of the end of September to a more manageable $12.3 billion currently, that's still almost $3 billion shy of the $9.5 billion target the company announced in 2011.

While only time will tell what the future holds for this storied natural gas producer, this is one saga worth keeping your eyes glued to even after the abrupt departure of its flamboyant co-founder and CEO.

With or without Aubrey McClendon, Chesapeake will forge ahead. While the aforementioned debt-related challenges continue to cast a dark cloud of uncertainty over the company's future, few would question the superb quality of Chesapeake's remaining oil and gas assets. For many investors, the important question is whether Chesapeake's current share price reflects the true value of its assets. To answer that question and to learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy, and as an added bonus, you'll receive a full year of key updates and expert guidance as news continues to develop.

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Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool has the following options on Chesapeake Energy: long Jan. 2014 $20 calls, long Jan. 2014 $30 calls, and short Jan. 2014 $15 puts. 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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