Don't Ignore This Company's Goals

02/28/2014 10:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The recent earnings report numbers from this leading drilling company are only disappointing to those who refuse to consider the company's goals and progress towards said goals, writes MoneyShow's Jim Jubak, who prefers to look at the big picture instead.

The nagging worries about the sustainability of the US energy boom, built around producing oil and natural gas from shale, seem to have found a temporary (at least) home in the shares of Chesapeake Energy (CHK) after the company reported fourth quarter earnings after the close the day before yesterday, on February 26. (Chesapeake Energy is a member of my Jubak's Picks portfolio.)

Earnings of 27 cents a share were 12 cents a share below the Wall Street consensus. (Adjusted EBITDA—earnings before interest, taxes, depreciation, and amortization—climbed 4% year over year.) Revenue rose by 28.3% year over year to $4.54 billion versus the $4.4 billion analyst projection. Daily production averaged 665,000 barrels of oil equivalent. That's an increase of 2% from the fourth quarter of 2012 and a drop of 1% from the third quarter of 2012. Average daily production for the quarter broke down this way: 111,300 barrels of oil, 63,700 barrels of natural gas liquids, and 2.9 billion cubic feet of natural gas.

Those results are a disappointment only if you ignore the company's goals and the progress toward them these numbers represent. (The shares finished up 1.13% yesterday.) After digging itself a deep, deep financial hole, as it emphasized growing leased acreage over production, the company has turned around its finances through a series of asset sales. In the post earnings release conference call, Chesapeake said it no longer needs to sell assets to survive or to fund capital spending programs. The company said it is still pursuing a sale or spin-off of its oilfield services unit—Chesapeake is unusual among oil and natural gas exploration and production companies in that it owns its own drilling rigs rather than leasing them from an service company. But that is now a question of how best to deploy capital rather than a required fire sale.

All that represents good progress toward the company's goals of profitably, exploiting the huge reserves that the company does control. At the end of December, Chesapeake's proved reserves came to 2.7 billion barrels of oil equivalent. That's a 2% increase from the end of 2012.

What set off some alarms, however, was an increase in costs that reduced operating cash flow per barrel of oil equivalent to $16.26 for the quarter, from $18.88 in the fourth quarter of 2012. Much of that was a result of costs that Chesapeake incurred as it reduced the size of its operations in order to ultimately increase its return on capital. But in the short run, that $120 million to end a lease obligation in Fort Worth, and the $154 million in restructuring, and employee termination costs, hurt earnings and cash flow.

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Those numbers are understandable in the context of what Chesapeake needs to do to right-size itself after focusing on adding acreage, but those results feed into worries about the US shale boom that are bubbling not so far below the surface.

Those worries focus on the rising costs of that boom. Output from oil and natural gas wells drilled in shale falls faster than production from conventional wells. While I'd take any average with a ton of salt, since shale geologies vary so much within even a single field, on average, the output of an oil well drilled in shale drops by 60% to 70% in the first year, according to Drillinginfo.com. In traditional wells, in contrast, output drops by 55% in the first two years.

The fix for this problem has been to drill more wells, either in new areas, or in between existing wells. That's expensive and it raises the breakeven price for producing a barrel of oil from US shales to $60 to $80, according to the International Energy Agency. (In contrast, Citigroup estimates the breakeven cost of oil in Iraq is about $20 a barrel—assuming nobody blows up your pipeline or shoots your workers, of course.) This hasn't been an issue when oil was $100 a barrel and headed higher, but now that many analysts are predicting that oil prices will head lower in 2014, costs in the US boom are becoming a big deal.

Here's where that pesky variable shale geology bites analysts again. The cost of a well can vary wildly depending on the complexity of the geology (and the efficiency of the drilling company). Chesapeake will spend a projected $6.4 million a well in its Eagle Ford operations in 2014. Its drilling costs in the Haynesville shale formation, in contrast, are projected at $7.9 million to $8.3 million in 2014. That's a 23% to 30% cost difference. (Other companies are reporting costs as high as $13 million a well.)

Going forward, one metric to watch is how quickly producers in US shales can reduce the cost of a well. Chesapeake has cut the cost of an Eagle Ford well to a projected $6.4 million in 2014, from $10.11 million in 2011, $8.1 million in 2012, and $6.9 million in 2013. In the Haynesville formation, the reduction hasn't been nearly as large, as costs per well are projected to drop to $7.9 million to $8.3 million from $10.3 million in 2010. (The experience of US shale producers in reducing drilling costs is a major competitive advantage as the shale boom moves to new regions, such as Mexico.)

As of February 27, I'm leaving my target price for Chesapeake Energy at $33 a share, but stretching out the schedule until December 2014.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of Chesapeake Energy as of the end of December. For a full list of the stocks in the fund see the fund's portfolio here.

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