by Mark Hanson, CFA (Morningstar Analyst)
Chesapeake Energy CHK announced Tuesday a definitive agreement to sell the majority of its remaining midstream assets to Access Midstream Partners ACMP (formerly Chesapeake Midstream Partners) for $2.16 billion. The transaction is expected to close later this month. Chesapeake had announced a letter of intent for these assets in the third quarter. The company expects to sell an additional $425 million of midstream properties in the first part of next year, bringing the total proceeds for all of its midstream assets to $4.9 billion. Assuming the Access deal closes this month, Chesapeake will have sold just under $11 billion in assets in 2012. Other near-term monetizations to keep an eye out for include the sale of the company's D-J Basin and noncore Eagle Ford acreage as well as a joint venture across its Mississippian leasehold. Our fair value estimate remains at $26 per share.Chesapeake is among the most aggressive operators in the U.S. E&P space, able to quickly build dominant positions in emerging plays through its vast network of land brokers and a general willingness to offer more favorable lease terms than its competitors. While this approach has helped Chesapeake amass a portfolio that comprises almost every leading unconventional play in the U.S., it has also led to ongoing questions about the sustainability of the firm's business model, given its propensity to outspend available cash flow. 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 going forward, given management's knack for creatively financing its operations and the relevance (that is, the attractiveness to third-party investors) of its current leasehold positions.
Chesapeake's portfolio includes more than 15 million net acres of onshore oil and gas assets. The firm holds leading positions in the Barnett, Haynesville/Bossier, Marcellus, Eagle Ford, Niobrara, Permian, Utica, and Anadarko Basin regions, among others, and continues to build its presence in 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, 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, especially in the Haynesville and Barnett regions. There is generally less urgency in Chesapeake's Marcellus, Eagle Ford, Utica, and Granite Wash acreage, although we expect joint venture considerations and takeaway commitments to drive drilling activity in these regions to a certain extent.
Chesapeake's "land rush" strategy has led to charges that the firm marginalizes the economics in its plays, given its willingness to accord higher royalties and pay top dollar for leases. The company would counter that it is locking up once-in-a-lifetime assets and would point to subsequent transactions that validate its above-market cost basis. We concede that Chesapeake appears skilled at securing large blocks of land within emerging plays--a combination of its "land machine" and technical skill--and find it hard to argue with the prices that have been paid by third parties for portions of its acreage. That said, Chesapeake's approach has at times led to serious problems for the firm, as in 2008, when a steep drop in natural gas prices forced the company to sell assets and raise external capital to help shore up its balance sheet. To Chesapeake's credit, the financing methods it put in place at that time--most notably volumetric production payments, or VPPs, and a handful of joint ventures--have helped the company stay afloat longer than most thought possible and served as an essential financing tool for the firm as it expands its operations. Nevertheless, we believe these financial maneuvers--in particular JVs--have benefited Chesapeake to the detriment of the broader E&P industry, in large part through carries that help support uneconomic drilling meant to achieve HBP status.
Based on the success it has had with such structures, we expect Chesapeake to continue utilizing JVs and VPPs going forward. The firm has entered into seven JVs and 10 VPPs since late 2007, generating total proceeds of approximately $23 billion ($2.1 billion of which remains to be earned over the next several years in the form of drilling carries). Chesapeake's key JV partnerships include Statoil STO in the Marcellus, Total TOT in the Barnett and Utica, and CNOOC Ltd. CEO in the Eagle Ford and Niobrara.
Chesapeake is more vertically integrated than most large producers. The firm takes an active stance on costs by investing directly in its service providers: Chesapeake holds interests in the fifth-largest rig contractor, the fourth-largest hydraulic fracturing company, and the second-largest compression business in the U.S. and also operates its own core sample testing center. We highlight the potential for takeaway bottlenecks in some of the firm's newer plays--particularly the Haynesville, Marcellus, and Eagle Ford regions.
In short, despite Chesapeake's past missteps and some ongoing uncertainty as to how the firm best realizes the potential of its inventory, we expect additional JVs, VPPs, and trust offerings to help fund drilling activity across the firm's 15 million net acres, leading to growth in production and reserves throughout our forecast period.
Valuation
We are lowering our fair value estimate for Chesapeake from $27 to $26 after incorporating the firm's most recent results and management's latest guidance and updating our midcycle natural gas price assumption, from $6.50 per mcf to $5.40 per mcf. Excluding any impact from our updated midcycle price, our estimate would have increased by $4, to $31 per share. Our new fair value estimate implies a forward 2013 enterprise value/EBITDAX multiple of 6.8 times, and is based on our five-year discounted cash flow model and an assessment of trading multiples, comparable transactions, and longer-term resource potential.
We project average daily net production of 3.9 Bcfe in 2012, 4.2 Bcfe in 2013, and 4.6 Bcfe in 2014, representing a 12% compound annual growth rate over 2011 levels. Chesapeake remains one of the most active drillers in the U.S. E&P industry, with approximately 100 operated rigs across its acreage. The firm's push to achieve HBP status in certain plays, along with JV partnership obligations and minimum takeaway commitments, should continue to fuel high levels of drilling activity over the next few years, funded in part through Chesapeake's approximately $2.1 billion in remaining drilling carries. We expect the firm's Eagle Ford and Anadarko Basin acreage to drive most of its production growth throughout our forecast period. Within the Anadarko Basin, we forecast net production of 909 mmcfe/d in 2012, 1,247 mcfe/d in 2013, and 1,538 mmcfe/d in 2014. Across Chesapeake's Eagle Ford acreage, we forecast net production growing from 277 mmcfe/d in 2012 to 577 mmcfe/d by 2014.Driven by production growth and an ongoing shift toward liquids, we forecast EBITDA of $3.2 billion in 2012, $5.3 billion in 2013, and $6.3 billion in 2014.
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; a shrinking universe of potential JV partners with which to transact going forward; execution risk within Chesapeake's emerging plays (in particular the Haynesville, Marcellus, Eagle Ford, Anadarko Basin, Utica, and Niobrara regions); potential midstream bottlenecks, especially within the Marcellus and Eagle Ford; and regulatory headwinds that could ultimately eat into profitability.
Management & Stewardship
Chesapeake is led by CEO Aubrey McClendon, who, up until his announced ouster from the role earlier this year, also served as chairman for the past 23 years. McClendon maintains a fairly visible and controversial presence in the E&P space, in part through his role as a de facto spokesman for the U.S. natural gas industry as well as his highly promotional approach to Chesapeake's business dealings.
Chesapeake has generally exhibited poor stewardship of shareholder capital over time. The firm has roughly doubled its share count since 2005 thanks to subpar operating performance, an overstretched balance sheet, and the need to continually bridge the gap between cash flow and capital expenditures. Investors have suffered as a result, with Chesapeake's shares badly lagging those of its peer group over the past several years and returns well below our estimated cost of capital for the last three years.
Despite this, Chesapeake's top officers routinely collect some of the biggest compensation packages in the E&P industry. The firm's decision to award McClendon $75 million in incentive pay in late 2008 was especially controversial and viewed by many as nothing more than a make-whole for McClendon in the wake of a margin call that forced him to liquidate substantially all his Chesapeake stock holdings.
We think the now infamous founder well participation program wasn't necessarily a bad idea and in theory should have aligned McClendon's interests with those of the company. The big issue we have with the FWPP was that it allowed McClendon to borrow to fund his obligations under the program. Doing so enabled him to effectively short-circuit the alignment of interests this program was intended to promote. It also created a potential conflict once McClendon borrowed from some of the same institutions that had relationships with Chesapeake on a corporate level.
Overview
Financial Health:
Chesapeake has historically paired its aggressive operating strategy with a similarly aggressive financing strategy. From 2005 to 2011, the firm's capital spending significantly outpaced operating cash flow, resulting in net borrowing of more than $10 billion and the implementation of several nontraditional financing vehicles to help meet cash shortfalls. During this time, Chesapeake's debt/capital ratio averaged 45%, with average debt/proven reserves and debt/EBITDAX ratios of $0.89 per mcfe and 2.6 times, respectively. The firm has taken a number of steps to improve its financial position during the last several quarters, including the redemption of close to $3 billion in senior notes and the issuance of more than $3 billion in preferred securities.
We expect Chesapeake to continue its strategy of funding investment activity through a combination of operating cash flow, VPPs, JV transactions, asset sales, trust offerings, and debt financing through 2014, with free cash flow becoming positive by late 2015. We forecast an average debt/capital ratio of 49% through 2015, with the firm's debt/proven reserves and debt/EBITDAX ratios remaining elevated as well. We estimate the firm's outstanding obligations for its VPPs will be $1.2 billion by year-end 2015. (Note that none of the preceding credit metrics incorporates Chesapeake's ongoing VPP obligations.)
Profile:
Chesapeake Energy, based in Oklahoma City, explores for, produces, and markets primarily natural gas within the U.S. The firm focuses on unconventional plays, with large positions in the Barnett, Eagle Ford, Haynesville, and Marcellus Shales, as well as leaseholds in a number of liquids-rich basins. Chesapeake controls more than 15 million net acres across its properties. At year-end 2011, the firm's proved reserves totaled 18.8 trillion cubic feet equivalent, with daily production of 3.5 Bcfe. Natural gas made up 85% of proved reserves.
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