Chesapeake Energy: Naked Risk Management

EconMatters's picture


By EconMatters


As discussed in our previous post, Chesapeake Energy is one natural gas producer taken the road less traveled by entering 2012 with none of its gas volumes hedged, betting that gas prices would rise.  Exiting the positions was profitable, but could prove to be short-sighted and misguided by over-confidence as it essentially left the company fully exposed to the languishing commodity price, while aggravating its already tight liquidity ratios (both current and quick ratios stood at 0.4x as of Dec. 31, 2011).  In contrast, other natural gas companies, like Encana, Linn Energy, Venoco and Range Resources  have hedged at least 75% of their 2012 production.


Henry Hub natural gas price has tanked 48% to a 10-year low in the past twelve months closing at $2.11 per mcf as of Monday, April 9.  Record production from new shale plays aided by new technology such as horizontal drilling and hydraulic fracturing ("fracking"), a sluggish U.S. economy, and a much-warmer-than-normal winter have all conspired to depress the the price the natural gas since 2009.


Chart Source:, April 9. 2012



The situation could get even worse this year.


The latest data from EIA showed that working gas in storage rose by 42 billion cubic feet (Bcf) to 2,479 Bcf as of Friday, March 30, 2012 hitting an all time high for March month for the week ended March 30, 2012.  This is 56% higher than last year at this time, and 60% or 934 Bcf above the 5-year average of 1,545 Bcf (see chart below).



NOAA announced that March 2012 is already the warmest March on record for the contiguous United States, a record that dates back to 1895 (See Map Below).  A warm winter does not necessarily guarantee a very hot summer, which is one way to burn off some of the gas inventory glut.


Analysts at Barclays estimate the average cost of drilling for domestic natural gas is roughly $4, but may be as low as $2.50 or so in easier-to-drill plays like the Marcellus Shale in the Appalachian region.  That suggests  almost all the new drilling of unconventional plays are under-water at the current Henry Hub price level.


Producers are feeling the pain.  Companies including ConocoPhillips, Chesapeake Energy, Encana, Ultra Petroleum, Talisman Energy have shut in production and/or cut their 2012 capital budget.  However, these planned curtailments most likely will not be enough to balance out the massively over-supplied market.


In its March 2012 Short-term Energy Outlook, EIA now expects inventory levels at the end of October in both 2012 and 2013 will set new record highs as well.  At this rate, some analysts are projecting storage capacity could be close to max out by October of this year.  In an extreme case, with no storage space available, some produced natural gas may get dumped on the spot market, and we could see natural gasbreaking below the $2 mark this year.


Chart Source: Yahoo Finance, April 9, 2012



In this challenging commodity price environment, producers with the better risk and portfolio management skill would likely weather the storm better than peers, while companies like Chesapeake Energy may have to bite its time as well as bullet.  Chesapeake Energy stocks have dropped about 37% in the past 12 months vs. +4.07% of S&P 500 in the same period (see chart above).


Further ReadingNatural Gas: Will The Recent Rally Change The Bear Course?


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banksterhater's picture

They think by pouring $$$$ into LOBBYING, they'll get an artificial Gov mandate to sell NG, approvals/subsidies for export terminals, then they can say we need unbridled fracking to keep up. All A CORRUPT AGENDA, like everything in FraudUSA. Meanwhile they don't give a RAT'S ASS ABOUT WATER FOR LIVING BEINGS. Clear evidence of methane/chemicals/earthquakes is result of fracking and they know it.

ebworthen's picture

Simon Hobbs on CNBC mentioning Chesapeake down 2.14% today.

Now that natural gas is so low, people clamoring to convert trucks and cars over to it.

Gee, wonder what that would do to the price?  Do we want the cost of heating our homes to go up 200% for the sake of cars and trucks?

Please, keep nat gas cheap so I can afford to stay warm in the Winter.

Quinvarius's picture

Chesapeake should not be allowed to hedge.  They are almost bankrupt.  If they hedge, they put counterparty risk into the nat gas market.

Thisson's picture

What are you talking about?  The commodities market acts through a clearinghouse mechanism, so there is no counterparty risk.

John Self's picture

The futures makret acts through a clearinghouse, but the swaps market doesn't yet.  It depends how they'd look to hedge.

In any case, though, the suggestion that they shouldn't be allowed to hedge is ridiculous.  An effective hedge could keep them from going bankrupt.  And any potential counterparty should be able to make its own risk management decisions to collateralize its positions.

overmedicatedundersexed's picture

economic data is beyond obsurd..nat gas at historic lows, oil refineries closing on USA east coast with historic high prices on gas and #2 oil..yet appl at historic highs..UE at historic highs - housing DOA with inflation in things you need sky high..(yet the market ignores it all).

I cannot take any advice on what to do with my $$..if they can close refineries at historic high prices they can do anything to PM's stocks bonds..this economy is right out of the x files..beware the guys tell us what we should do they are out to save themselves at your expense.

devo's picture

CHK trades below book value.

Isn't buying low/selling high the model? Not sure why ZH is so bearish on NG. Great opportunity.

Bicycle Repairman's picture

Some believe that NG is headed still lower.

whatsinaname's picture

The new energy policy is being built around NG ?

Stuck on Zero's picture

The solution to low NG prices has been around for forty years: conversion to liquid fuels.  Long ago Houston Natural Gas built large systems to convert natural gas to methanol.  It is quite an efficient process and methanol can be used directly in your gas tank.  At least one enterprising company is looking at tiny converters that will sit in your garage and convert natural gas to methanol for filling your car at home.  No road taxes and the by-product is heat for household use. 

Bicycle Repairman's picture

Localized solutions to energy problems will never be permitted.

donsluck's picture

Incorrect, they are widely available in the form of solar and bio-diesel.

Downtoolong's picture

I’m taking a contra view on this one. I think Chesapeake energy is making more of a statement about eliminating Wall Street control over their business than it is about taking on more risk. Many energy companies are gradually coming to realize that hedging in the paper markets doesn’t provide nearly as much risk avoidance as Wall Street sells it. It can go terribly wrong. There was a large bio diesel plant start up in 2008 that tried to hedge its initial production with oil futures. The plant startup was delayed by three months causing the hedge and physical production to be out of sync. This happened right during the oil price shock which left the cash strapped company with a huge new capital requirement and sizable loss on the forward futures roll. They lost $50 million and almost went bankrupt before they produced their first gallon of diesel fuel. It was all because of their hedge. They were  squeezed in the markets while trying to work through their problems by the same Wall  Street firms who put them into the original hedge and then supposedly helped them get out of it. It was hostage risk management at its finest. A great deal of the price increase in oil that we saw peak in 2008 was due to people getting squeezed on the short side of the futures market by Wall Street firms.    

One thing to recognize about the kind of risk we’re dealing with here is that it’s very different from something like life insurance risk. Unlike an average human lifespan which tends to remain constant and can be easily measured with statistics, there is no natural average oil or natural gas price which markets ultimately converge on. That means the risk can only be passed around. It can’t be totally eliminated through scale and diversification. What Wall Street has mastered over the years is the technique of charging companies to take risk from them with one hand, and then immediately dump the risk back on their shoulders in another form with the other hand, without them even being aware of it. A lot of companies are waking up to this fact and questioning; where is the fun in that?

ArmchairRevolutionary's picture

I agree with you on this. Over time, hedging will be more costly. It may make you look good one year and then down the next.  Had we had the worst winter on record, everyone would be saying they made a really smart move. Over time though, they will likely be better off.

swissaustrian's picture

They're hedging according to their investor presentation. They even brag about their hedging gains.

Anyway, the best US NG stock is SWN, but it's overvalued right now.

Carl Spackler's picture

You mean it was the best...until the mutiple corrects. Then it can be the best again.


LawsofPhysics's picture

All energy sources moving forward will be just fine.  The world has to use them, period, regardless of any slowdowns in the western eCONomies.  Look for China to "liberate" resource rich countries around the world soon.

covert's picture

the lack of the freedom of enterprize will do it everytime.


Bicycle Repairman's picture

"Look for China to "liberate" resource rich countries around the world soon."

By what means will China liberate these countries?

LawsofPhysics's picture

SImple, China is already buying most of them.  Time to get out from under that rock.

Bicycle Repairman's picture

Oh.  They're buying them.  They're not using covert means to subjugate them or "shock and awe".

CEOoftheSOFA's picture

If storage is at an all time high, that's a real problem. The winter of '84 was warm like this one. The gas transmission companies shut in our gas wells for 6 months per year for 3 years. Gas prices were depressed until the early '90's.

duo's picture

My crystal ball sees an NBA team going up for sale in OKC.

hardcleareye's picture

Processing and transportation cost of LNG is a BITCH!!!!

Hmmm I wonder if we could use it here in our vechs?<sarc>

devo's picture

They should just export surplus.

Call me crazy, but I like natural gas and view this as a good buying opportunity. Energy this cheap will not stay cheap very long. Demand will follow in this instance.

Nassim's picture

What you export now, will need to be reimported in a few short years at a very much higher price.

Flakmeister's picture

Ummm.. you do know that the US still imports NG on a net basis....

Yogaman's picture

There isn't yet the means to export much Natural Gas..... seems to be a major oversight by the producers.  

navy62802's picture

Is liquefied natural gas (LNG) effective? I've seen plenty of big LNG tanker ships on the high seas.

bugs_'s picture

catastrophes waiting to happen.