Chesapeake Energy (CHK) and the Utica Shale

Fixed some typos, replaces the earlier version from last night.

After building a huge position in the Utica shale over the last year (to the initial consternation of shareholders), Chesapeake finally announced a monetization deal in this Eastern Ohio play on November 3rd. Rather than selling 25-35% of their Utica position in the form of a joint venture - as Chesapeake had done in five previous shale plays and as the market was expecting - Chesapeake announced two smaller transactions. Chesapeake placed their "wet gas" Utica acreage (like the Eagle Ford shale, the Utica has a "dry gas", "wet gas" and oil window) into a non-recourse subsidiary called CHK Utica LLC. They sold $1.25 billion of 7% perpetual (callable at a 10% IRR to the buyer) preferred shares in this subsidiary, which also receive a 3% royalty on the first 1,500 wells drilled in this area. Chesapeake also signed a letter of intent to sell 25% of this same "wet gas" acreage for $2.14 billion in a traditional joint venture with an "undisclosed major international energy company". CHK shares traded up overnight on this announcement of a "$3.4 billion monetization", but traded off the next day on disappointment that only $500 million of the total $1.25 billion preferred issue had been sold and that the joint venture was only in the letter of intent stage.

Since then CHK Director Lou Simpson (of Geico fame) purchased 100,000 shares at $26.69, CHK closed the rest of the of the preferred issue, receiving an additional $750 million, and the stock has continued trading down to $23.72 per share. The stock is off 18% since the November 3rd announcement and is trading roughly where it was one year ago before the Utica was discovered, leased up and partially monetized. Clearly the market is disappointed in the size and structure of this transaction as well as the fact that the joint venture has not been closed and the partner not named. Chesapeake has never failed to close a deal or turn a letter of intent into a deal before, but the market is clearly concerned given CHK's large capex plans for 2012 which will exceed free cash flow. The company has publicly and privately said that they have not and will not consider abandoning their plans to reduce net debt in 2012 (as part of their 30/25 plan) and this has added to the uncertainty surrounding their 2012 funding.

There are two possible explanations here. That market has apparently decided that Chesapeake was unable to get a bigger deal done in the Utica (or one at all so far), may come up short in funding their huge discretionary capex plans in 2012, and is stubbornly refusing to give up on their debt reduction plans - all of which suggest a cash crunch. An interesting corollary of the market's view is that the rest of CHK's Utica shale is likely worthless. This is interesting for a number of reasons, not the least of which is that the majority of Chesapeake's other 725,000 Utica acres not included in the above deal (they have 1.375 million total acres in the play) are in the oil window to the West. Not only does CHK continue to lease and take out drilling permits in the oil window, but so does Exxon, Devon and Anadarko along with smaller companies.

A quick word on valuation: the already announced transactions only concern "CHK Utica LLC" which is in the wet gas window. Assuming the joint venture closes, the unnamed energy company: will have paid a discounted price of $1.95 billion (discounting the future drilling carries at 10%) for 25% of this portion of the play. This recoups Chesapeake’s entire cost in the play and implies a retained value of almost $6 billion dollars or about $9 per share. This ignores the non-recourse preferred shares and assumes the rest of the Utica is worthless. Considering the other companies involved and that activity is ramping up I think this is a baseline value.

There haven't been any well results out of the oil window yet and so it makes sense why CHK would be unable or unwilling to do a joint venture in that part of the play yet. CHK's junior partner in the Utica is Enervest and their publicly traded MLP EV Energy Partners (EVEP). Enervest/EVEP had a lot of land in Eastern Ohio prior to the discovery of the Utica so CHK partnered with them. As part of EVEP's deal with Chesapeake, the larger company shares all information with them. John Walker, EVEP's well respected CEO made some interesting comments at a Wells Fargo conference last week that I think have big implications for CHK:

"We are pleased to be a partner with CHK, I think you’ll find out more later this month about who the JV partner is and more about the terms of the deal. $15,000 an acre, I think, is a base price. We think the price is gonna get much better in the oil window."

This is significant because Walker has seen all of CHK's information from the oil window and is participating with Chesapeake in a number of wells being drilled there currently. His company, EVEP, is planning to open a data room on their oil window Utica acreage in Q2 of next year to either sell the acreage or do an asset swap. For this reason, I don't think he has any reason to be promotional - by the time his company does anything with their acreage everyone will know what the oil window is worth. Walker clearly is very confident from what he has seen and would rather wait for well results (which he is privy to), than sell into the current hype and already high prices.

The market is saying the oil window is worthless, that CHK has a 2012 funding problem, and that they are stubborn and reckless to hold onto their debt reduction plans. Might Chesapeake have an ace up their sleeve? From Walker's comments it sounds like acreage in the oil window could be worth more than the $13,700 per acre in present value that CHK and EVEP received for the acreage they sold in the wet gas window. This would mean another $9+ billion in value to CHK (~$15 per share) and potentially billions more in cash in the door in 2012 from a new Utica joint venture.

A quick note about the pending joint venture. The French oil major, Total, previously bought into Chesapeake's Barnett shale in Texas. Total publicly said that they want to buy into the Utica shale and both CHK and TOT will not deny (nor confirm) that Total is the joint venture partner. Interestingly, CHK did deny that Reliance was the joint venture partner. Also, in Chesapeake's latest 10Q it was disclosed that Total is accelerating next year's drilling carry payments to CHK (at a 10% discount) for the Barnett shale and allowing them to lower the amount of rigs they must keep active there. Basically, rather than pay for most of Chesapeake's drilling in the Barnett next year, Total handed them $500 million in cash in October and told them they didn't need to drill as much. This is good business on Total's part because gas prices are low, but it is also very helpful to CHK and puts less stress on the company to do a premature deal in the oil window of the Utica. If Total is not the joint venture partner in the wet gas window (and I think contemplating a deal in the oil window when there is more information on it) the company is sure making a lot of statements to suggest it is them for some unknown reason.

I think the logical conclusion from all of this is that not only will the "Utica joint venture" close, but that it will turn out to be the first Utica joint venture for CHK. Either way, just closing this first deal (expected by the end of December) will have created $9 per share of value for CHK. From where I'm standing, there is a lot of circumstantial evidence that there is another $15 per share in value to be had in the oil window.