Chesapeake, Debt and Natural Gas

Perhaps no company prospered more during the early stages of the U.S. shale gas boom than Chesapeake Energy (NYSE: CHK). Its strategy was to aggressively buy drilling rights in relatively unexplored shale fields. This gave Chesapeake a very strong position in dry natural gas shale plays such as the Barnett in Texas and the Haynesville in Louisiana.

This strategy of buying acreage, however, in combination with a decline in natural gas prices from $6 per million BTU in 2010 to less than $2.50 per million BTU today, has left the company with a much heavier debt burden than most of its peers. The debt has been a drag on the stock's performance with it dropping by 25% in the second half of 2011.

The company pledged to reduce its debt by the end of 2012 by $800 million, to $9.5 billion. This is still a very high two-thirds of its market capitalization. More ominously, Chesapeake does not expect to generate enough cash from its operations to fund planned drilling and completion capital expenditures until 2014.

So the company has adopted a two-pronged approach to the problem. It is cutting back on some dry gas drilling activity and it is also disposing of some of its hydrocarbon assets.

Chesapeake recently reported it may sell up to $12 billion in assets as it seeks to plug its funding gap. It said earlier this week it was close to a deal to sell future output from the liquid-rich Granite Wash in the Texas panhandle. The company is also contemplating disposing its entire interest in the Permian Basin region of Texas, an area the company has yet to explore heavily, but thought to be rich in oil and 'wet' gas. Chesapeake would rather be selling some of its dry gas assets, but the price of natural gas is so low right now, there are few if any buyers for such assets.

The company last month also announced a planned 8% cut in gas production and a 67% cut in the number of rigs drilling gas wells. This number will drop from an average of 75 rigs in use in 2011 to only 24 by the second quarter of this year. This is a significant move since Chesapeake is the second largest natural gas producer in the United States. It accounts for 9% of the country's production and contributed a high proportion of the growth in gas production in the last decade.

The good news for Chesapeake is that other companies have joined them in cutting back on gas drilling activities. According to Baker Hughes (NYSE: BHI), the number of rigs drilling for gas in the United States fell for the fifth week in a row to 720 last week. This is the lowest level since October 2009 and down more than 23% from its October 2011 peak of 936. But more cutbacks need to happen for the industry to enjoy a rebound in prices.

The COO of Baker Hughes, Martin Craighead, said he expects the gas rig count to keep falling “until there is a meaningful increase in gas prices”. Most in the natural gas industry believe the 700 level in rigs will be crucial. The belief is that once the rig count is below 700, gas production will begin to fall and prices will stabilize then within a 5-6 month period.

The price of gas is now below the cost of production in some parts of the United States, so it logical to conclude that other large producers such as EOG Resources will follow Chesapeake's lead. Other companies like Canada's Talisman Energy have already sharply cut rig drilling in Pennsylvania's Marcellus Shale region.

Chesapeake and its shareholders must hope that others in the industry will follow them in slashing gas production. Such actions should raise gas prices and lend a little stability to its financial situation. After all, it can't simply keep selling all of its assets until its well of assets runs dry.

This article was originally written for the Motley Fool Blog Network. Be sure to check out my daily articles for the Motley Fool at http://blogs.fool.com/tdalmoe/