There is little doubt that Chesapeake is putting on the brakes in terms of capex spending, due to their debt position (and related credit market conditions), but more importantly because the supply of natural gas is growing at a faster pace than demand at the moment. This is a very wise reaction. Proactive management.

In fact, just today they came out with another report reconfirming this. From Dow Jones today:

• HOUSTON (Dow Jones)–Chesapeake Energy Corp. (CHK) said Wednesday that natural gas prices will be range bound between $7 to $9 a million British thermal units for a “few years,” resulting in a diminished rig count.
• In a presentation posted on its Web site, the Oklahoma City-based natural gas producer said the industry needs prices between $9 and $10/MMBtu to support the number of rigs drilling for natural gas.
• Chesapeake predicted that the credit crunch will reduce the number of rigs and bring balance to the natural gas markets faster than lower gas prices.
• The company said that proposed rules by the U.S. Securities and Exchange Commission on recognizing reserves could lead to Chesapeake’s proved reserves exceeding 20 trillion cubic feet by 2009.
• Those proposals would change how oil and gas companies report their resources. Reserves are among the most important assets for oil and gas companies, and current SEC rules limit companies to reporting only proved reserves from conventional sources, an approach that excludes oil shale, tar sands and other potentially rich sources of oil and gas.
• The U.S. consumed about 23 trillion cubic feet of natural gas in 2007, according to the U.S. Energy Information Administration.
• -By Jason Womack, Dow Jones Newswires; 713-547-9201; jason.womack@dowjones.com

This is a bit of a problem. It suggest that the rapid development of unconventional gas fields through new technologies (hydro-fracturing and horizontal drilling), in which Chesapeake is in the forefront off, might have created the seeds of its own destruction. Actually, we don’t think it will be that bad, and that warrants some explaining.

Demand factors:

The problem with demand for gas is that it is very price inelastic in the short-run, because natural gas needs facilities and infrastructure to be able to be useful to end consumers. Here are a couple of factors that are in play that could gradually ramp-up demand in the longer run though:

1. Electricity generation. Natural gas is way cleaner than any other combustible, and it is also considerably cheaper than oil. The investments for gas burning electricity power stations is relatively modest, hence these are in demand just on price, but there is more than price alone
2. With so much new gas being exploited in the US, there is the geo-political element of energy independence coming into play. It seems like a winning proposition, domestic energy supplies that are cleaner and cheaper, reducing dependence on foreign oil (Chavez, the Middle East, do we need to say more..), improving the US balance of payments in the process..
3. Environment. With a new president, this might get a little more currency. Natural gas has advantages here, it emits half the CO2 of coal, contains low levels of nitrogen and sulphur dioxide and near zero levels of mercury or particulate emissions
4. Boone Pickens plan. We’ve written about it before, it involves making much more use of domestic natural gas, especially in transport. For sure, there are opportunities there, and an additional advantage is that cars driven on natural (compressed) gas relief city air especially of dangerous particles (a Dutch study found that living close to a major highway is as dangerous as smoking, cutting life expectancy with a whopping 7 years, mainly due to small particles emitted by diesel engines). However, this will not happen anytime soon either (at least not on the scale to rev up gas demand in earnest. There is a whole lot of infrastructure needed before more consumers will switch to compressed gas as a fluel (apart from having to do non-trivial engineering on their cars)
5. Export. With gas prices twice (or more) those of US prices in most other parts of the world (Asia, Europe, Middle East), this seems to be an attractive possibility. However, to do that, a host of very expensive infrastructure has to be build (multi-billion dollar LNG facilities, export terminals, etc.) which need years to complete. This won’t arrive any time soon.

Supply factors to consider:

1. Most of the new gas coming on-line is so called unconventional gas, like the big new shale gas fields (Haynesville, Fayetteville, Barnett, Marcellus). Unconventional in the sense that conventional vertical drilling alone doesn’t release the gas, new production methods have to be used (water fracturing, horizontal drilling) which make it more expensive.
2. More expensive it may be, but those new drilling methods seem to have provided something of a breakthrough. According to the EIA, natural gas production is up by 8.8% in the first half of 2008 while the growth in the number of wells is tapering off, suggesting increasing well productivity
3. However, gas prices have come down steeply since July. At today’s wellhead prices (which are seisonally the softest in Sept. and Oct. according to the recent business update from Chesapeake), it’s not a good proposition, which is one reason why Chesapeake is reducing it’s drilling program (and even has shut in some wells). Although they are the first to announce this, they expect others to follow.
4. So supply is a little bit more elastic than demand, when prices go to the $7-8 per Mcf level, it provides incentives to reduce some supply and reduce some exploration, setting us up for higher prices in the future, but with a considerable lag. Chesapeake expects prices in the $7-9 range to persist for a couple of years, which is not good news.
5. Conventional gas production (both onshore and offshore) are declining rapidly though, which sets the US up for higher gas prices, as these conventional sources are considerably cheaper
6. The jury is still out on whether unconventional gas, as plentiful as it may seem, can make up for this. Despite all the technological advances, wells in unconventional sources produce much less gas, and deplete much more rapidly compared to those in conventional sources. This means capex spending needs to be much higher, many more wells need to be drilled and replaced at a much faster rate. The economics of unconventional gas is not nearly as good as those of conventional gas.

So, despite it’s undeniable potential, a complex bevvy of forces is hobbling the rapid development of unconventional gas. We still think that has been (more than) priced in Chesapeake’s share price though, especially after another brutal day today..

It might look gloomy now, but gas prices are at their seisonal lows, and when others will follow Chesapeake’s lead in dealing with the situation by curtailing drilling, gas prices could very well recover (especially when the US economy starts to improve).

Chesapeake remains very favourably placed, in our view.