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3 Key Trends Weighing On Chesapeake Energy's Valuation

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Chesapeake Energy is going through a rough patch currently. The company’s stock price has declined by almost 64% over the past 12 months, primarily because of the trends in commodity prices that it has little control over. However, based on our current valuation model, the company’s stock price seems to be trading at a discount of about 20% to its estimated fair value. Below, we take a look at the 3 key trends weighing on its valuation currently and how they are expected to play out in the long term.

See Our Complete Analysis For Chesapeake Energy

  • Lower Natural Gas Prices: Natural gas makes up almost 73.2% of Chesapeake’s total net hydrocarbon production, all of which comes from the U.S. Therefore, the company’s stock price is highly sensitive to the variations in spot Henry Hub natural gas prices, which have been depressed this year because of higher storage inventories. According to the latest Natural Gas Weekly Update by the U.S. Energy Information Administration , underground natural gas storage inventories in the U.S. are currently 42.9% higher than last year, and by our estimates, spot Henry Hub natural gas prices have been almost 42.5% lower year-on-year so far. However, based on the projected demand and supply growth, we expect natural gas prices in the U.S. to move higher from current levels in the long run. We therefore currently forecast Chesapeake’s average natural gas price realization to increase from around $1.5 per thousand cubic feet (mcf) this year to around $2.5 per mcf by 2021, assuming the marketing price differential to the Henry Hub declines from around $1.8 per mcf this year to around $1.5 per mcf in 2021.

  • Lower Liquids Prices: Although liquids (crude oil and natural gas liquids) make up just around 26.8% of Chesapeake’s total net hydrocarbon production, they contribute more than 63% to its total value by our estimates, because of higher profitability. However, liquids production will not be as lucrative for the company under the current commodity price environment. The front-month NYMEX crude oil futures contract has fallen by more than 43% over the past 12 months due to a combination of the slowest growth in demand for oil products last year, since the 2008-2009 recession, and a robust growth in supply from Non-OPEC sources, primarily the U.S. In addition, natural gas liquids prices in the U.S. have been severely depressed this year because of oversupply. According to the EIA, the natural gas plant liquids composite price at Mont Belvieu has declined by almost 52.5% over the past 12 months. When dry natural gas prices in the U.S. fell precipitously in 2012, Chesapeake and most of its peers increased their focus on crude oil and wet gas production to boost their profitability. However, with all commodity prices down sharply this year, we expect the company’s exploration and production (E&P) margins to decline significantly in the short term and increase gradually to around 78.2% by 2021.

  • Slower Production Growth: In view of the changed commodity price environment, Chesapeake has announced that it will spend around $3.5 to $4 billion in gross capital expenditures this year, about 45% less than what it did last year. Lower capital expenditures mean lower investment in future production growth. Therefore, while lower capital spending will improve its free cash flows to the firm, we believe it will also slow down the company's short to medium-term production growth. For example, last year, Chesapeake's liquids production grew by almost 21% y-o-y, but we expect it to decline by around 16% this year, followed by a 4.5% average annual growth beyond that. The steep production decline this year is expected mostly because of the asset sales that the company completed last year. However, even after adjusting for divestments, the company’s net hydrocarbon production is expected to grow by just around 2% y-o-y this year, well below the 4.3% CAGR growth it registered between 2012 and 2014.

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