Chesapeake Stays Neutral

We maintain our long-term Neutral recommendation on the second largest natural gas producer in the U.S. − Chesapeake Energy Corporation (CHK - Analyst Report).

The company’s better-than-expected third quarter results with higher production and its keenness on deploying more funds toward liquids remain partially tempered by the weak ongoing natural gas price scenario.

The Oklahoma-based natural gas giant reported better-than-expected third quarter earnings on 24.4% year-over-year growth in production. Chesapeake also slightly upped its full-year 2012 production guidance encouraged by higher-than-expected liquids volumes but left the 2013 production guidance unchanged.

Given the downtrend in natural gas prices, the company intends to allocate the majority of its capital to drill liquids-rich plays in the near future. The spending will be primarily targeted toward Eagle Ford Shale, Utica Shale, Mississippi Lime, Granite Wash, Cleveland, Tonkawa, Niobrara, Bone Spring, Avalon, Wolfcamp and Wolfberry.

Chesapeake increased its drilling capital expenditure guidance for 2012 by $500 million to $8,750 million. Most importantly, the company’s efforts seem to produce desirable results, as reflected by a 96% year-over-year increase in the average daily oil production during the third quarter.

With the biggest inventory of unconventional resource potential than probably any other domestic independent, Chesapeake boasts a leading position among the top unconventional liquids-rich plays, comprising Eagle Ford, Utica, Granite Wash, Cleveland, Tonkawa, Mississippi Lime and Niobrara as well as in the Marcellus, Haynesville/Bossier and Barnett natural gas shale plays.

The company also remains focused on its asset monetization initiatives as it is trying hard to minimize capital expenditure and devolve as much as $14.0 billion worth of assets in 2012 and an additional $4 billion to $5 billion in 2013.

However, these positives are negated by the low gas price environment that has shattered the company’s financial strength. Since natural gas accounted for about 79% of Chesapeake’s third quarter production, results are particularly vulnerable to fluctuations in the natural gas market. The embattled Chesapeake is trying hard to minimize capital expenditure through its divestiture program.

Chesapeake also exhibits a weak financial profile with huge debt balance. At the end of the third quarter, the debt balance stood at $15.8 billion, representing a debt-to-capitalization ratio of 47.1%.

Hence, given the weak natural gas price scenario, we believe that the stock will perform in line with the group. Chesapeake − the largest U.S. natural gas producer after ExxonMobil Corporation (XOM - Analyst Report) − holds a Zacks #3 Rank, which is equivalent to a Hold rating for a period of one to three months.