Most veterans of the oil and gas industry eventually subscribe to its most common mantra—that its fortunes are cyclical—at least in part because their loyalty requires a sort of zealous optimism that their best days are just ahead.
And if there is a U.S. energy producer that embodies the industry’s ability to rebound, it may be Chesapeake Energy Corp.
Founded almost 40 years ago by the late Aubrey McClendon, Chesapeake was an early mover in horizontal drilling. At the top of its game, the company was operating 175 rigs in Texas, Louisiana, Pennsylvania and Ohio basins.
But Chesapeake was just another gas producer burdened by longtime low gas prices during the 2000s. Along with managing in the dismal commodity market, Chesapeake was bucking beneath the weight of $7 billion in debt in early 2020. And then COVID-19 swept around the world and decimated demand. Finally, Chesapeake capitulated. On June 28, 2020, the company filed for Chapter 11 bankruptcy protection.
That’s all ancient history now.
Chesapeake entered and emerged from bankruptcy intending to wipe out its debt, retool its corporate strategy and refocus its operations on natural gas. Less than two years since the firm regained its stock listing, Chesapeake has done all of that and more.
CEO Nick Dell’Osso spoke with Oil and Gas Investor editor-in-chief Deon Daugherty this summer, detailing the firm’s new, focused financial strategy and laying out exactly what makes Chesapeake “the most compelling investment opportunity in the energy space today.”
Deon Daugherty: Chesapeake has generated more than $1 billion worth of free cash flow by the midpoint of 2022, less than two years after emerging from bankruptcy. Tell us how you’ve accomplished this: Is it new assets, new management or new ideas?
Nick Dell’Osso: It’s really all of the above. What’s great about where we sit today and what is tough about where we sit today is having gone through bankruptcy. We were able to really change the makeup of the company, and we were able to completely remake our cost structure in a way that’s been really important to having a sustainable cash flow profile going forward.
Chesapeake had a history of having a number of contracts and legacy issues that were pretty high cost and obviously a lot of debt but also a lot of transportation contracts that were burdensome. We shed all of that in bankruptcy. And so today we have a really tight cost structure and an improved portfolio of assets as well. We’ve done a lot of work on M&A, as you sort of alluded to in your question, over the last year, and that is yielding some really tremendous benefits as well.
DD: Were you able to renegotiate contracts from the bankruptcy?
ND: During bankruptcy, you can take advantage of the rules that allow you to reject contracts. Basically that opens up a big renegotiation, and so we were able to reduce commitments and renegotiate the commitments that we needed.
DD: That’s a benefit of corporate bankruptcy. What were the challenges?
ND: Well, obviously, the biggest challenge is the decision to go into bankruptcy—the decision to tell all of your stakeholders that they are not going to see the benefits of their planned investment in Chesapeake. And that’s an incredibly difficult decision to make. A horrible decision to make, frankly, and one that we fought for the better part of 10 years. And we had made tremendous progress in avoiding that eventual outcome. Then, with the market fall of the pandemic, we couldn’t escape it.
DD: So all told, it was the pandemic that ushered Chesapeake—and some other E&Ps—into bankruptcy?
ND: The price collapse associated with the pandemic is what got us into bankruptcy.
DD: Since emerging from bankruptcy, Chesapeake has reworked its portfolio significantly. What’s next for the footprint, additional corporate deals or just bolt-ons?
ND: We completed a lot during the past year. We purchased a very large asset in the Haynesville [and] a very large asset in the Marcellus. We also divested a sizable asset in the Powder River that was less competitive in our portfolio. That’s left us now with a portfolio that we’re really happy with.
We have a huge inventory—well more than 10 years of inventory in all of our plays—and a really high-quality inventory on top of that. So we think the combination of depth and quality in our inventory is unmatched, particularly in our gas assets. We have the best gas portfolio in the United States, and so we don’t need to do anything else. From an M&A perspective, we’re pretty content with our portfolio.
That said, we think we’ve created a lot of value through the consolidation that we’ve completed. And if similar opportunities were to arise again in the future, we’d be happy to think about them. We just know that in an environment where prices have gone up so far, so fast, that makes deals that look as attractive as what we’ve completed over the past year much harder.
“When we think about that magnitude of returns relative to the company we are today, it’s incredibly large. We will generate more free cash flow over the next five years than the entirety of our market cap as measured today.”—Nick Dell’Osso, Chesapeake Energy Corp.
DD: Given the no-growth demand from shareholders in recent years, how have they responded to the acquisitions?
ND: Really well, and I think it’s because we’ve had a framework that we refer to as our “guidelines” for the way we’ve thought about acquisitions. We talk about them as non-negotiables and negotiables.
We can’t overpay for an asset. It has to be accretive from a cash flow perspective. It can’t damage the balance sheet; you have to protect your balance sheet. And it has to have an environmental footprint that you can either be proud of on Day One or improve upon very quickly.
If you bring together all of those things, the upshot of all of that is it has to make you better, not just bigger. Accomplishing all of that, I think investors have reacted very well to the concept of consolidation.
We don’t need to go out and have new rank exploration. What we need is efficient development of the resources that have been identified. And when you consolidate assets, you can more efficiently develop those resources, you can rationalize costs and you can improve your capital allocation across a bigger set of assets in a portfolio such that you increase your returns. And that’s really how investors want to make sure that you can grow return. They want you to be able to grow cash and returns to shareholders, but you ought to be able to do that without necessarily growing production in the ways that we have over the past 10 to 15 years.
DD: What is that philosophy done for generating shareholder returns?
ND: We think we have the most compelling return profile. While in the industry today we have a base dividend of $2 a share, we have a variable dividend of 50% of free cash flow beyond that. And then we have a very large buyback program that’s currently set to $2 billion.
When we think about that magnitude of returns relative to the company we are today, it’s incredibly large. We will generate more free cash flow over the next five years than the entirety of our market cap as measured today.
DD: That’s quite a statement. How will you manage to do that?
ND: Well, our stock price is too low. What that means to us is that the market has not fully adopted or recognized that cash that we will generate over the next five years. That could mean that investors don’t believe in the strip, and they don’t believe in commodity prices.
But we think it’s more to do with us being new out of bankruptcy and needing to prove our track record and showcase to investors that what we’re doing is sustainable.
We think that we have a story to tell investors about being, frankly, the most compelling investment opportunity in the energy space right now with the amount of cash that we’re generating and ability to return so much of it to shareholders with a balance sheet that can support that for the long term.
One thing you see from a lot of companies right now is a discussion of a lot of cash flow—giant cash flow numbers—but only a much smaller group is actually returning that cash to shareholders in a large magnitude as well.
DD: When you’re returning high volume cash back to shareholders, how long do you think it will take for them to realize that Chesapeake is back on track and can support these returns long term?
ND: We’ll be impatient about it because we want to provide that uplift in stock price to our investors. And we know that they should be eager to see that as well. But I think it’ll take, you know, a couple of quarters. We’ve done this now for two quarters. We’ve had a variable dividend in place for two quarters. And we’ve surprised at the upside with both of those quarters.
DD: Several companies in the space similarly say their stock is undervalued and yet the sector itself spent the first half of the year outperforming the S&P. How does that reconcile?
ND: We’ve just gotten back to outperforming the S&P really within the last 12 months, but we were such an underperformer in the S&P for so many years.
You can measure the relative valuation in a lot of different ways. One of the easiest ways for our industry, now that we are paying real cash returns to shareholders, is just to look at the yield. And the yield on our stocks is really wide compared to other industries.
You can compare an average oil and gas company yield to other industries and see that it’s higher and so therefore relatively undervalued. And then you can compare Chesapeake to oil and gas stocks and see that we are wider than that as well. That’s where we come back to saying the most compelling investment opportunity in the energy space today.
DD: How has generalist investor sentiment evolved, or are they still in a sort of a wait-and-see pattern?
ND: They’re just starting to come back. We are having some good conversations with some journalists, investors, but they’re cautious. They’re cautious because we live in an environment where as much as prices are very high and seem very sticky and they’re having a big role in inflation today, this is a relatively new phenomenon for an industry that has been living with declining prices for the better part of 10 years on the gas side and five years on the oil side.
I think investors want to see a little bit more stability, and they want to understand the regulatory environment they’re going to be in. We have so much discussion broadly in the general political and media space about the future of oil and gas and what will the policy decisions be to either support or not support affordable, reliable and lower-carbon energy. I think investors want to see that take hold, and they want to see an industry that is doing the things that we’re doing in Chesapeake to be a sustainable part of the energy supply picture.
DD: Energy policy seems pretty tricky. What do you foresee happening in the near term for U.S. energy policy? Is a singular policy possible given the dynamics of the U.S. government, and moreover, is it necessary?
ND: It’s totally necessary. And I think the thing that’s clear to all of us and clear to the whole world over the past year, but especially the last four or five months, is that the world should look broadly. The world needs more energy. And you can see it in the traditional way that we think about rural communities around the globe being starved of energy or not having had energy supply developed where they live.
But now you’re really starting to see it in places where established supply for energy is becoming tight. You see it certainly in Europe as a result of the war and the reduction in Russian supply. But you really also see it in the U.S. at the moment too where we have a robust demand for energy. We have had declining supplies of oil and gas as a result of lack of investment, with low prices then exacerbated by the pandemic. And we have higher prices than we need to have, given the resources that we all know exist.
CHESAPEAKE FOCUSES ON RSG CERTIFICATION
All of the natural gas produced by Chesapeake Energy Inc. in the Haynesville and Marcellus shale basins will be certified as responsibly sourced by year-end, CEO Nick Dell’Osso told Hart Energy in an exclusive interview.
Responsibly sourced gas (RSG) is gaining traction among U.S. producers that want to quantify their emissions reduction efforts for shareholders. And a handful of firms have sprouted in recent years to help them.
Chesapeake achieved certification of its legacy Marcellus operations under the MiQ methane standard and the EO100 Standard for Responsible Energy Development, which cover a broad range of ESG criteria. Companies such as Project Canary offer measurement-based emissions profiles using the monitoring technology that has caught up to the need for leak detection. They provide an external validation that a company’s emissions and overall carbon footprint are as low as possible, Dell’Osso said.
“Our gas portfolio has a very, very low carbon footprint, a very, very low emissions profile,” Dell’Osso said. “But this isn’t just for altruism. [Shareholders] recognize that in order to remain competitive in this industry, we all have to be improving our carbon footprint.”
Chesapeake has already secured the RSG certification for its entire Haynesville and legacy Marcellus operations making it the first producer to certify two major natural gas basins. The firm is now working toward completing the same validation process for the Marcellus assets it acquired from Chief E&D Holdings in March.
Altogether, Chesapeake production of 4.5 Bcf/d will have the RSG certification within the next five months, Dell’Osso said.
“We have thousands of active methane monitoring devices that are constantly sampling the air on our production facilities for 365 days a year, 24 hours a day. You also have to have business practices that support a best-in-class environmental footprint,” Dell’Osso said. “We’ve received the grade “A” MiQ and EO100 certification for responsible energy production from this group for both our Haynesville and the Marcellus assets that we have certified thus far, and we’re really proud of that.”
Following the initial certification, the assessments will continue annually, validated by a third party, to maintain certification status.
“This is not a certificate that you just put on the wall and feel good about,” Dell’Osso said. “You have to be willing to commit to this on an ongoing basis in your operations and have continuous improvement. We’re creating sustainable value for our business while positively impacting the communities where we operate.”
DD: Regarding ESG matters, particularly the environmental matters, there are different schools of thought as to whether the industry can regulate itself or if it needs the government to step in and set standards. What are your thoughts?
ND: Generally, we think well thought out and established standards are good for the industry. We’re proud of our environmental footprint. And we know that we, as an industry, all need to have a strong environmental footprint in order to be a part of the energy policy.
We have an ability to deliver affordable, reliable and lower-carbon energy domestically and internationally and greatly improve the access to energy around the world again as well as domestically. We have to be really serious about our environmental footprint and our commitment to that environmental footprint and a commitment to improving that environmental footprint. If that’s going to continue, if we’re going to be successful in improving the world’s access to energy and achieving all of those goals of it being affordable, reliable and lower carbon, we have to have a really serious commitment.
So, you probably do need some real regulation around that. We have some and the regulation that we have is good. And I think there are things that can be done around really just following what the industry is doing and putting some sort of rules around it that I think would be helpful.
DD: As a company, what can you do to improve the industry’s ESG management?
ND: I’ll stay on [environmental] for the moment. There’s plenty we can do. It is technology. It is how we invest in our assets. It’s going out and making changes in the way our business works. Oftentimes it’s very small changes, but you have to make them thousands of times.
I’ll give you an example. This year we are retrofitting over 19,000 pneumatic devices across our field. That sounds like a really large undertaking. We will be able to do that in a year, and it will cost us less than $25 million to complete that project. So, it is a very logical amount of money to spend, and it will have a big impact on our CO2 and methane emissions.
We will do those things within our business that first and foremost improve upon the emissions profile of our assets. Today, we’ll do those on our own.
This is where regulation, though, can be helpful. We are a large company with ample resources and a real commitment to improve [our] environmental footprint. As you get into smaller companies and private organizations, you probably don’t have the same capitalization or drive to deliver on that commitment. And so if there is a rule in place that actually steps up the requirements for everyone and puts everyone on a level playing field, then that will flow all the way through the supply demand economics and that will give you a better overall product as an industry.
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