2023-05-10 09:31:00 ET
Summary
- Natural gas spot prices have declined steeply, which has impacted producers like Chesapeake Energy.
- Despite the short-term setback, drillers remain optimistic about the future and believe that a rebound awaits in 2024. This is backed by slowing production growth rates and strong demand.
- Chesapeake is making progress toward being LNG-ready and connecting its production to international markets and pricing.
- The company has a healthy balance sheet and conservative hedges. It responded to lower prices by adjusting production.
- While demand risks remain persistent, CHK shares remain significantly undervalued.
Introduction
Natural gas isn't doing so well. While the futures curve remains in steep contango, spot prices have come down crashing, from almost $10 per MMBtu in 2020 to currently less than $2.30.
TradingView (Henry Hub)
Caused by a mix of weather and economic demand headwinds, this has pressured producers like Chesapeake Energy ( CHK ) , one of America's largest natural gas producers. Its shares are down 25% from their 52-week high and down 16% year-to-date.
Nonetheless, the company's stock continues to receive good price targets, which is related to the fact that natural gas remains severely oversold.
In this article, I will share my thoughts on the matter and explain why I believe that CHK is significantly undervalued.
So, let's get to it!
Drillers Are Bullish On Natural Gas
As reported by Bloomberg the other day, US shale-gas drillers are optimistic about the future, believing that the recent drop in natural gas prices will be short lived and that a rebound awaits in 2024. Companies such as EQT Corp. ( EQT ) and Southwestern Energy Co. ( SWN ) have reassured investors that natural gas supply and demand fundamentals remain structurally bullish despite prices having fallen by more than half this year.
The rise of natural gas to 14-year highs in 2022 supported producers, driving a surge in utility bills while providing them with unprecedented cash flows. The same applied to oil producers.
Wall Street Journal
Hence, this year's drop, following a mild winter and recession fears, has led traders and producers to speculate whether the market's exuberance has come to an end or just taken a pause. Needless to say, whoever can correctly answer this question can make a lot of money!
Going back to the Bloomberg article I just mentioned, the message from suppliers is that production growth in the US is quickly slowing down as shale explorers cut down on drilling activity. While natural gas supply growth is in a much better space than oil supply, we see that production growth has slowed significantly since last year.
Energy Information Administration
The data below shows data from the Appalachia region, the biggest natural gas region in the United States, covering the Marcellus and Utica basins. As we can see, new-well gas production per rig is down significantly. Production from new wells is barely offsetting the decline from lower legacy production.
In its latest energy outlook, the EIA updated its production outlook for natural gas. According to the EIA (emphasis added):
We forecast slight declines in U.S. natural gas production in April and May because of pipeline maintenance in West Texas and the Northeast, with U.S. production averaging 100.6 Bcf/d in our forecast for the remainder of 2023. In our forecast, U.S. natural gas production averages 100.9 Bcf/d for 2023, 3% more than in 2022 .
The chart that goes with this data shows that the production surge of the past few years seems to be over.
Energy Information Administration
Hence, the supply glut, which is currently weighing on prices, should shrink into next year as new export capacity is set to considerably boost demand for heating and power-generation fuel from Europe and elsewhere.
The bullish view on 2024 is reflected in producers' hedge books. According to Bloomberg, Antero Resources ( AR ) recently said it paid about $200 million to unwind contracts aimed at protecting it against lower gas prices next year as the company seeks to be fully exposed to the commodity upside.
So, What About Chesapeake?
Chesapeake's first quarter was good. The company reported $1.87 in adjusted EPS, which beat estimates by $0.21.
In 1Q23, the company produced 4.1 billion cubic feet of equivalent per day. 49% of this was produced in the Marcellus basin. 38% came from the Haynesville basin. The Eagle Ford accounted for 13% of production, where the company still owns natural gas assets after selling most of its oil assets.
Chesapeake Energy
Chesapeake generated $350 million of free cash flow, about $240 million when adjusted for the aforementioned asset sales. This translated to a total dividend of $1.18 per share for the quarter, and the company has returned more than $250 million to shareholders with its buyback program.
As the overview below shows, CHK maintains a policy of distributing 50% of its post-base dividend as a special dividend.
Chesapeake Energy (Author Annotations)
If we annualize the $1.18 dividend, we get a 6.1% yield .
Chesapeake also is making progress on its path to being LNG-ready and connecting its production to international markets and pricing, with its Gunvor agreement providing up to 2 million tons of LNG per annum indexed to JKM (Asian-based LNG prices), an important first step for Chesapeake.
Reuters
As reported by Reuters , Chesapeake signed a 15-year agreement to supply up to 2 million tonnes per year of US liquefied natural gas to a unit of Swiss commodity trader Gunvor Group Ltd. This deal was made as US LNG exporters are experiencing increased demand due to Europe's sanctions on Russia over its invasion of Ukraine, which put pressure on the already-tight global natural gas market.
The agreement entails selecting a US LNG export plant to liquefy Chesapeake's gas and deliver the LNG to Gunvor, with a scheduled start date in 2027.
On a side note, I just wrote an article on LNG, which might be interesting for readers interested in LNG fundamentals.
With that said, the company's capex was slightly ahead of expectations due to very strong execution from its drilling and completion teams. It drilled three of the five fastest all-time footage per day wells in the geologically complex southern portion of its Haynesville acreage position, averaging 690 feet per day in the quarter on this acreage, which is 30% faster than its closest offset operator. Additionally, the company has deployed continuous pumping wellhead technology that enabled its teams to pump a record 36 consecutive hours on a Haynesville frac.
However, production is expected to decline as producers are more cautious in this environment. Total natural gas production is not expected to exceed 3.5 billion cf/d.
Chesapeake Energy
According to the company :
[...] our capital came in on the low end of guidance as we dropped a rig in the Haynesville and a frac crew in both the Haynesville and Marcellus . Based on the midpoints of our 2Q guidance, we expect D&C capital to decline approximately 10% and natural gas production from the Marcellus and Haynesville to decline approximately 5% quarter-over-quarter. This decline was part of our plan for the year which is why we reiterated our full year capital and production guidance today.
Furthermore, the company's balance sheet has improved with the closing of the aforementioned Eagle Ford sales for $2.8 billion. As of April 30, the company had $1.2 billion of cash on hand and more than $3 billion of available liquidity. The company's credit rating was upgraded to BB+, and it has only $500 million in maturities until 2027.
Chesapeake Energy
With regard to production and pricing, the company believes that the contango in the curve for 2024 is constructive, and if predicted activity reductions come through, 2024 should follow the contango, making it more constructive than this year.
Note that contango is a situation where the futures price of a commodity is higher than the spot price. While spot prices are roughly $2.25 per MMBtu, January 2024 prices are $3.80.
Chesapeake Energy
For the remainder of this year, CHK has at least 55%of its production hedged. The company also is using production growth as a tool to control volumes. According to the company, if prices are weak during the summer, they can choose to hold off on turning wells in line. However, having the activity completed, they can rely on the contango of the curve to make those decisions positive from a net-present value standpoint. Chesapeake is pleased with the way they are set up from an activity perspective, and they want to maintain their production capacity for 2024.
Given these valuations, I stick to what I wrote in February .
Chesapeake Energy Corporation is trading at 7x [note: 8x due to lower natural gas prices] 2023E EPS, which I believe is undervalued. The current stock price is $80 [current: $78]. The average target is $127 [current: $108].
[...] I believe that as natural gas prices rebound in the quarters ahead, the company has room to rise back to $110, followed by way more upside if my long-term commodity outlook turns out to be correct.
That said, investors need to be aware of the stock's high volatility. Do not buy any energy exposure without being aware of the risks. As bullish as I am, recession fears might keep CHK from breaking out until economic demand bottoms.
Takeaway
The recent drop in natural gas prices has affected Chesapeake Energy's share price, which is down 25% from its 52-week high and 16% year-to-date. However, US shale-gas drillers like EQT Corp. and Southwestern Energy are optimistic about the future, believing that the recent drop in prices will be short-lived and that a rebound awaits in 2024.
Production growth in the US is quickly slowing down as shale explorers cut down on drilling activity. Chesapeake Energy, one of the largest natural gas producers in the US, is making progress on its path to being LNG-ready and connecting its production to international markets and pricing.
Moreover, the company is flexible in its capex, finally enjoying a healthy balance sheet and hedged to withstand the current (likely temporary) low-price environment.
I remain a long-term CHK bull and believe that shares remain significantly undervalued.
For further details see:
Chesapeake Energy Looks Significantly Undervalued