One of the more interesting firms I follow is Chesapeake Energy Corp. (NYSE:CHK). With management forecasting neutral cash flow next year and the potential for significant asset sales to help make this happen, a lot of activity could take place at any given moment with the company. Given some recent developments provided by the firm, not to mention some changes in the market itself, I figured it would be interesting to dig into the numbers and give my thoughts on why, despite some improvements that have been partially offset by a bit of bad weather-related news, Chesapeake is still a questionable prospect.
Setting the ground rules
In a press release issued a few days ago, the management team at Chesapeake revised its guidance for this year. According to management, the effects of Hurricane Harvey have been painful for the firm from an operational standpoint and, instead of springing the news on shareholders when it releases its third-quarter financial results, it elected to soften the blow by letting shareholders in on what has transpired now.
*Taken from Chesapeake
As you can see in the image above, there are a lot of items that have been typed out in bold. Each thing you see in bold is a revision compared to the guidance provided by management back in August. For instance, at the midpoint (which I’ll be using for all categories), production this year is slated to be around 196.5 million boe (barrels of oil equivalent). Though this is a lot of oil, natural gas, and natural gas liquids (mostly natural gas), it does represent a decrease of 4.75 million boe compared to what Chesapeake had previously forecasted.
Some expense items, too, have changed. Production expenses, for instance, had been forecasted to average $2.60 per boe for the year. However, that number has been moved higher to $2.85 per boe. This may not seem material, but it is. Every $0.05 change per boe, at current production forecasts, implies a change in cash flow of $9.83 million for the year. Fortunately, though, not everything worsened. Cash-based general and administrative costs have been decreased from $1.25 per boe to $1.20 per boe. More significantly, we have the issue of differentials. Natural gas differentials have been trimmed down from $2.10 per boe to $1.95 per boe while oil differentials have plummeted from $1.15 per barrel down to just $0.70 per barrel. These developments are certainly positive, but the fact that output will be the same while capex is expected to remain flat at $2.10 billion is a bit scary.
In addition to relying on these numbers (though I’ve calculated my own effective interest expense), I am going to assume that current energy prices remain intact, on average, for this year and beyond. The last time I performed an analysis of Chesapeake’s cash flow, natural gas prices were at $2.937 per Mcf. They have moved down a little but, at $2.924 per Mcf, the difference isn’t that significant. Oil, on the other hand, has moved up considerably. At the time of the publication of my last piece, oil prices stood at $47.74 per barrel. As of the time of this writing, prices are at $52.22 per barrel. That’s an increase of 9.4%.
One final note. I have not included the revenue from its compression and other activities in this analysis. Instead, I have included management’s guidance on what that loss will be for this year and then I trusted that it is correct in forecasting neutrality for it in 2018. I assumed the same neutrality for 2019 as well.
Cash flow is looking better… but still bad
Now that we have the ground rules set, I think it’s time to take a look at the cash flow prospects (or, rather, lack thereof) offered by Chesapeake. In the table below, you can see my own calculation of the company’s free cash flow. Based on the numbers, this year does not look that good at all. In fact, if my estimates are right, Chesapeake should see a net outflow this year of a whopping $839.34 million.
*Created by Author
Some of you may think that this doesn’t square up because, absent any impairments or other similar items, it’s probable that Chesapeake will earn a net profit this year. That is true and it’s also true that the firm could have generated significant cash flow, but that’s where the weakest part of the company comes into play. You see, just in order to keep output approximately flat year over year, management will need to allocate $2.1 billion toward capex. Now, to be fair, the firm did state that its fourth-quarter production should be much higher than first-quarter production (with oil output up 40% during this time frame), and it is likely that this will help out next year. In my own model, I’m assuming a 10% growth rate in output per year, but we’ll need to wait and see from management if this is realistic.
Thanks to higher production, as well as different hedging effects and lower amounts due for preferred distributions (it had an accrual it paid out earlier this year), the picture next year should be better, but still not great. According to my calculations, investors should expect the company to generate negative cash flow in 2018 of $521.25 million. As hedging effects wear off, this will worsen, using my underlying assumptions and assuming that management does not complete a significant asset sale, to $631.64 million.
While these numbers are bad, they aren’t as bad as when oil prices were lower. As you can see in the table below, this year, next year, and 2019 are all meaningfully better, even with the lower production and some higher costs, than I had anticipated the last time I wrote about Chesapeake. This is encouraging, but the same harsh reality exists: either management has to cut costs/spending further, energy prices have to continue rising, or some mix of the two. Otherwise, the debt picture facing the producer will worsen with no end in sight.
*Created by Author
Based on the data provided, I believe that, while the picture facing Chesapeake has gotten better compared to the last time I ran the numbers, the situation is still quite scary. Obviously, if management can do something significant, then these fears could be mitigated or erased entirely, but it would require a very large asset sale in order to reduce debt, some major cost-cutting, or for the energy space to improve materially. I know that Chesapeake is primarily a natural gas producer, but my own belief is that if it moves away from that space to focus more on oil, its numbers would probably end up better at the end of the day.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.