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Falling gas prices might burst Chesapeake’s bubble

Chesapeake Energy was a pioneer of the US unconventionals rush, but as gas prices continue to plunge, the firm’s position looks increasingly difficult

It had been a difficult first quarter for Chesapeake Energy, even before the March publication of an excoriating piece on the firm and its chief executive Aubrey McClendon in Rolling Stone magazine.

The article, The Big Fracking Bubble: The Scam Behind the Gas Boom, attempts to debunk McClendon’s spiel that Chesapeake is in the business of providing a cleaner-than-coal fuel that will revive the US economy and free it from reliance on foreign oil. Rather, the magazine argues, hydraulic fracturing (fracking) “is about producing cheap energy [in] the same way the mortgage crisis was about helping realise the dreams of middle-class homeowners”.

Chesapeake’s PR machine accused the article of recycling “the same old debunked theories of a few short-positioned analysts, activist academics and publicity-seeking litigants that have mischaracterised our company and our industry for the past five years”.

Yet Chesapeake, while still a darling of retail investors looking for exposure to the US shale-gas bonanza, is regarded with more suspicion by the institutional investor community, and the firm’s latest earnings results have done little to dispel the notion, articulated by Rolling Stone, that “McClendon’s primary goal is not to solve America’s energy problems, but to build a pipeline directly from your wallet into his”.

On 21 February, Chesapeake reported sharply higher net profits in the fourth quarter of $429 million, or 63 cents per share, compared with $180 million, or 28 cents per share, in the same period a year earlier. For the full year, net income came in at $1.57 billion, down from $1.663 billion in 2010. However, that rise in fourth-quarter profits came largely thanks to a $315 million gain from closing out hedges it had placed on the price of gas in the neighbourhood of $3.70. Without that, Chesapeake’s profit in the quarter was 58 cents per share, missing slightly expectations of a profit of 59 cents per share.

The company has explained its decision to take profits on the gas hedges on McClendon’s belief that gas prices have bottomed. However, since then, prompt month futures have traded as low as the $2.20s and are in the $2.30s (about 37% lower than when the hedges were lifted). As one trader, who manages a proprietary fund in energy derivatives and is shorting the company, noted: “The fact a speculative call was made on this market by management that now has created further risk for the company is not something shareholders should take lightly. After all, it has cost shareholders and will continue to do so until the natural gas supply glut finally subsides.”

The year got off to a rotten start for the US gas industry when the Energy Information Administration (EIA) issued its 2012 Annual Energy Outlook that showed sharp cuts to its estimates on total shale-gas reserves in the US. In 2011, the EIA estimated there were 827 trillion cubic feet (cf) of gas in US shale; that number has now dropped to 482 trillion cf. The EIA cut its estimate for the Marcellus Shale’s gas reserves to 141 trillion cf. While estimates are, by nature, movable feasts, IHS Global Insight says that whatever the exact number, “the downgrade is significant in that it could call into question the prospectivity of US shale plays whose reserves estimates might have been blown out of proportion somewhat by companies seeking investment funds”.

Since 2000, Chesapeake has built the largest inventory of US shale-gas play leasehold with 2.2 million net acres (and a total of 15.8 million net acres for all types of oil and gas). Despite the divestiture of about 2.8 trillion cubic feet of gas equivalent (cfe) of proved reserves, proved reserves in 2011 increased by 1.7 trillion cfe, or 10%, to 18.8 trillion cfe, giving it a reserve replacement ratio of 242% in 2011.

However, its initial strategy of buying up vast tracts of unconventional-gas acreage has left it scrabbling for cash to develop these assets. With gas prices so low and the supply of gas continuing to outstrip demand, Chesapeake has little option but to push to monetise these assets to reduce its debt burden, which at the end of 2011 stood at $10.3 billion, down $2.2 billion from the year-end 2010. McClendon has long endorsed selling assets rather than drilling; during a call with investors in October 2008, he said: “Buying leases for X and selling them for 5X or 10X is a lot more profitable than trying to produce gas at $5 or $6/'000 cf.”

Thus, in an effort to reduce its debt to no more than $9.5 billion by the end of 2012, Chesapeake announced on 13 February that it would sell assets worth $10-$12 billion this year to cover its debt and fund some of its ongoing and planned operations. Chesapeake is prepared to sell part or all of its liquid-rich Permian basin assets.

“The company is faced with tough decisions on asset dispositions in its wetter plays, as dry gas prices have fallen so low that finding a buyer for such assets will prove very difficult,” says IHS Global Insight.

Chesapeake has shut in nearly 500 million cf a day (cf/d) of gas due to low pricing, which is 8% of the company's gas volumes and nearly 1% of the US' total gas production. The company said it was ready to reduce its production by another 500 million cf/d if prices don't strengthen. If it does cut production by 1 billion cf/d, this would reduce revenue by $2.5 million a day at a $2.50 gas price and nearly $1 billion of lost revenue on an annualised basis. The derivatives trader noted: “[It’s] not good when you need cash flow for debt servicing and operations.”

Aside from McClendon's optimism that prices have hit bottom, what are the chances that they will strengthen?

It depends on who you ask. The trader points out that the record supply growth, coupled with a warm winter, is leaving an almost unmanageable surplus of gas in underground storage, which will leave very little room for summer injections before storage is completely full. “The only way to deal with this issue now is through price, which will need to fall far enough to price off at least a few more billion cf/d,” the trader says.

Worryingly, the EIA projects that marketed US gas production will grow by 2.8% (1.8 billion cf/d) in 2012, slower than the 6.6% (4.1 billion cf/d) growth rate in 2011, “but still ostensibly a bad omen for an oversupplied market”, says Raymond Deacon of Brean Murray, Carret & Co.

Others are more optimistic. “Chesapeake says it will decrease total supply growth by nearly 30%, if not by 60%, all on its own through production shut-ins. Conceivably, we now have supply less than demand,” says Thomas P Larsen, of Cross Current Research.

Ultimately, say analysts, the best cure for low prices is … low prices. However, Chesapeake is not in a position to sit out record-low gas prices, which are not expected to pick up significantly before the middle of the decade. With investor pressure mounting, analysts say this is likely to lead to a leaner company emerging this year, which could mean the firm loses its position as the US’ second-biggest gas producer. And that, rather than any articles in Rolling Stone, will be the biggest blow to McClendon’s ego.

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