Chesapeake Energy has been in the news a lot, lately, concerning both the significant challenges it faces in financing its ambitious development program, and its high-profile CEO, who was recently forced to relinquish his role as Chairman. The company's stock is trading for half its value one year ago and less than a fourth of its 2008 peak. Chesapeake is the second-largest producer of natural gas in the US after ExxonMobil, and probably the company most associated with the shale gas revolution, yet it is struggling. I wouldn't be surprised if skeptics regarded the firm's travails as a warning that the transformative potential of shale gas for the US has been oversold. However, in evaluating that concern it's important to distinguish among the physical resource, the economics of the industry, and the unusual business model of this one company. Investors and policy makers may not share the same perspective on these issues.
Start with this key fact: If Chesapeake is in trouble, it isn't because the gas resource isn't there or can't be exploited profitably at a reasonable gas price. We'll come back to that. Fundamentally, Chesapeake is on the wrong side of a historic divergence between US crude oil and natural gas prices, and it is playing catch-up to get on the right side of that spread. This is the downside of natural gas that is trading for the equivalent of $15 per barrel when the global crude oil price--and the price of the most valuable US crude--is still over $100 per barrel. That relationship is great for US energy consumers but lousy for US gas producers. It's particularly difficult for Chesapeake, because the company has embarked on a strategy of reducing its focus on natural gas and increasing its production of liquids--crude oil and natural gas byproducts like pentane, butane and propane. That shift requires significant new investments at a time when the cash flow from its core gas properties has fallen off, despite steadily increasing output. It also doesn't help that Cheseapeake began this strategic shift later than competitors like EOG Resources.
Chesapeake's problems are further complicated by its business model, which has focused on finding and proving resources and then selling them down to fund the next big project. Consider transactions such as last year's sales of one-third interests in Chesapeake's Eagle Ford and Niobara shale holdings to China-based CNOOC for around $1.6 B plus a substantial share of development costs. This isn't your father's gas company. But with natural gas prices so low--even a year out they're still only equivalent to $20/bbl--its existing portfolio of gas assets is worth less to potential buyers. Other companies such as BHP that have bought shale assets in the last couple of years are reportedly considering write-downs. As a result of these market conditions, Chesapeake is apparently looking at a variety of new funding opportunities, including selling interests in oil-bearing properties and pre-selling production streams.
I don't have an opinion on whether they'll navigate these rapids successfully or not. I'm not in the business of providing investment advice to my readers, nor do I have any financial interest in Chesapeake. My interest here is in the implications of Chesapeake's dilemma for the larger US energy situation. The current low natural gas prices are clearly putting a lot of stress on independent producers, including the majority that have much simpler business models than Chesapeake's, based on acquiring leases, producing gas, and generating revenues that exceed their costs. If low prices persist, then a lot of producers could be in deep trouble, and some of them won't make it. That's the risk they took. However, the more salient question is what all that means for US natural gas production, which last year broke the production record set in 1973, when we produced 60% more crude oil than today. Could an industry shakeout lead to lower US natural gas production?
One indicator is that drilling for gas has already slowed significantly. According to Energy Information Agency statistics, the number of exploration and development wells targeting gas is down sharply, while those pursuing more valuable oil are up. Sometime soon that switch should be reflected in output trends, though because of the higher productivity of shale gas wells actual gas production may not decline before demand picks up. In its latest investor presentation Chesapeake forecasted producing nearly as much gas in 2013 as last year, despite its big shift to liquids.
As odd as it may sound, the future trajectory of US gas production likely depends on a race between potential supply and potential demand, both of which are enormous. The oil & gas industry hasn't seen the likes of this since the 1980s, and perhaps not since the early 20th century. Today's shale gas output is just scratching the surface of a new resource conservatively estimated at 482 trillion cubic feet (TCF), or 96 times 2010's shale gas output of 5 TCF. Meanwhile, gas is already eating coal's lunch in the utility sector, reducing the latter's share of electricity generation by about 6 percent of the market in the first two months of this year, compared to 2011. The opportunity in transportation is even larger, though clearly more difficult to exploit, because of infrastructure and fleet investments. Chesapeake seems to understand this, given the money it's investing in market development, on both advocacy and specific projects to turn gas into transportation fuels or use it directly in cars and trucks.
If natural gas could be stored and shipped as easily as oil, the current oversupply wouldn't be a problem, nor would domestic producers be forced to pace their expansions to match the growth of demand or exports. However, gas producers have always had to develop major new resources in tandem with markets, with that discipline often enforced by price, as we are seeing today. Time will tell whether Chesapeake expanded too rapidly, or like so many others merely missed the warning signs of the recession and financial crisis that hobbled demand growth at just the wrong time for them. Yet no matter how their story turns out, the fate of US shale gas is not dependent on the fortunes of a single company, and there will be plenty of larger, better-capitalized players waiting to snap up the assets of any first-generation shale gas producers that don't make it. That's because no matter how challenging today's low prices are for producers, the prices that prevailed just a year or two ago were adequate to support the growth of both production and new demand.
