Just in Time - Chesapeake Counters Gas-Price Nadir With Output Slash, Innovative Inventory Build

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Monday, 03/04/2024 Published by: Tom Biracree

Faced with sustained sub-$2/MMBtu natural gas prices and dim prospects for significant gas-demand growth until sometime next year, a number of major gas-focused E&Ps have been tapping the brakes on production and trimming their planned 2024 capex. But one company — Chesapeake Energy, slated to become the U.S.’s largest gas producer thanks to a recently announced acquisition — has taken a more dramatic step, implementing a novel strategy that will slash production by 25% but leave the E&P ready to quickly ramp up its output as soon as demand and prices warrant. In today’s RBN blog, we’ll review the 2024 guidance of the major U.S. gas producers and delve into the analysis of Chesapeake’s unusual approach. 

Natural gas prices have declined severely over the past two or three weeks, and a few days ago (February 20) the March contract settled at $1.576/MMBtu. In nominal dollars, that was the lowest front-month price since the summer of 2020, but in real, inflation-adjusted terms it was the lowest price of the 21^st century. The primary culprits are record-high production, which reached 106 Bcf/d in December 2023, combined with one of the mildest winters since the 1950s in many major U.S. heating markets. As a result, gas-storage levels are now more than 25% higher than the five-year average.

Lower natural gas prices are having a predictable impact on gas producer profits and cash flows. Although a couple of smaller producers have yet to report Q4 2023 results, the seven large gas-focused E&Ps that we monitor reported year-end pre-tax operating income and operating cash flows down 86% and 67%, respectively, from Q4 2022. Although their remarkable focus on investment discipline and operational efficiency have allowed producers to stay in the black, the continuing decline in natural gas prices in Q1 2024 threatens further erosion in profitability — and in the cash-flow generation that funds the modest shareholder returns some companies in the gas-focused peer group have managed to sustain. 

With the gas market currently oversupplied, one potential solution available to some producers would be to rein in investment and production. However, there are a couple of complications to that strategy. For smaller producers who need to make payroll, scaling back operations may be impractical. For larger producers, strategic capital allocation decisions are complicated by the anticipated dramatic gas-demand growth in 2025-28, driven by an expected 12-Bcf/d increase in gas demand from LNG export projects under construction, growth in pipeline exports to Mexico, and increasing industrial and power-generation demand. Conference call comments over the past few weeks indicate that corporate managements have been weighing the short-term benefits of cutting investment to reduce output with the longer-term issues of retaining the ability to reverse course and boost output when gas demand, and then presumably prices, jumps in the future.

The results, as reflected in the 2024 guidance issued to date, generally reflect a cautious approach. As shown in Figure 1 below, eight gas-weighted producers are guiding, on average, to a 13% reduction in capital investment (from $9.6 billion in 2023 to $8.3 billion in 2024) and flat output at 1.4 trillion cubic feet of natural gas equivalent (Tcfe). Note that the chart excludes major producer Southwestern Energy, which has not released guidance because of its pending acquisition by Chesapeake Energy (stock ticker CHK). 

The importance of that $11.5 billion acquisition is magnified because Chesapeake’s 2024 guidance reflects what you might call the boldest, most coherent strategy to mitigate the impact of current low natural gas prices with the ability to quickly reverse course when gas demand increases. The company announced a 31% decrease in drilling & completion (D&C) capital spending, from $1.74 billion to $1.2 billion. It also said it will eliminate a rig in both the Marcellus (from four to three) and Haynesville (from five to four) and cut frac crews from two to one in both plays. The result will be about a 25% decrease in total 2024 production, from more than 3.6 billion cubic feet of natural gas equivalent per day (Bcfe/d) last year to less than 2.7 Bcfe/d this year.

Chesapeake’s capex reduction is less than the 37% cutback announced by Haynesville producer Comstock Resources (CRK) and roughly matches the 30% haircut revealed by Antero Resources (AR). However, both Comstock and Antero have guided to flat 2024 output. The reason for the dichotomy is an innovative Chesapeake strategy that is reminiscent of a widely employed manufacturing production strategy known as “Just in Time.” This approach, created in Japan in the early 1970s, closely coordinates the flow of raw materials and equipment with customer orders to cut costs by reducing the time between receiving inventory and meeting customer demand. But gas wells are not cars or consumer appliances. The obvious problem in translating this strategy to oil and gas production is the dramatic difference in time between receiving inventory and factory production, sometimes days or even hours, and the weeks to months-long process of planning, spudding, completing and turning a well in line — aka TIL, the industry term for initiating production.

The closest the E&P industry has come to inventory management is a reserve of drilled but uncompleted wells (DUCs — see DUC, DUC, Produce! for a deeper dive on DUCs). While well completions can be delayed for a variety of reasons, such as bad weather, funding issues, temporary infrastructure constraints or difficulty in securing qualified completion crews, they can also result from affirmative decisions to defer the completion and TIL process because of low prices or poor market conditions. According to Energy Information Administration (EIA) data, the DUC inventory for major shale basins built to a high of about 8,900 wells in mid-2020 (shown in Figure 2 below), exacerbated by falling commodity prices in the second half of 2019. Early on in that phase, in the blog Got That Swing, we likened DUC inventory to storage that could be called upon based on price signals. But the number of DUCs since 2020 has subsequently been plunging, at first as a response to rebounding commodity prices and then, more recently as the industry turned to the alternative strategy of TIL-ing these wells, first to maintain production with lower capital investment, then to more quickly grow output as commodity prices soared. The DUC inventory reached a 10-year low of 4,386 in January 2024.

 Rebuilding the DUC inventory is a logical approach after the bottoming of gas prices; however, Chesapeake’s recently announced strategy substantially shortens the time and slashes the expenditures needed to respond to a sudden demand increase. The company announced that its 2024 capital allocation plan involves building a substantial inventory of “deferred TILs” — namely, wells that have been drilled and completed up to the final step of turning them in line. [Turn-in-line is another way to say turn-to-sales, which differs from and happens after completing a well, which refers to the final steps of preparing the well for production, like fracking and installing the production valve.] As shown in Figure 2, Chesapeake expects an inventory of 80 deferred TILs by year-end 2024 (orange bar to far right) and has indicated that those wells can be activated to quickly add up to 1 Bcf/d of gas production at a cost of less than $50 million. It will also modestly boost its DUC inventory to 35 wells (blue bar to far right) that can be activated for approximately $175 million. This strategy should allow Chesapeake to quickly respond to price signals to better balance its supply with demand.

Chesapeake’s announcement of the substantial cut in output and its “Just in Time”-focused plan to rapidly ramp up production to meet demand changes certainly shocked U.S. gas and equity markets. U.S. natural gas futures soared to the best one-day gain in more than a year and a half on the day after the company’s announcement. Investor enthusiasm was reflected in an 8% gain in Chesapeake’s stock price, while other gas-focused equities — EQT, Comstock, Antero, Range Resources, Southwestern Energy, and Coterra Energy — surged by 6% to 10%.

Of course, one U.S. company can’t bring domestic gas markets back into balance. The impact on other gas equities was based on the analysis that Chesapeake’s bold move at least marks a bottom for gas prices and the expectation that the other producers with the wherewithal to temper production could follow suit. Chesapeake will almost certainly implement this strategy for the assets of Southwestern Energy after the expected midyear completion of its acquisition of the company, which reported 2023 production of 4.6 Bcfe/d, including 3.9 Bcf/d of natural gas. While Southwestern did not hold an analyst call or release 2024 guidance with its 2023 results because of the pending deal, its first-half capital allocation and drilling plans are likely to be influenced by the guidance of its acquirer. The combined company will take over from EQT as the largest U.S. gas producer, which will magnify the impact of its strategy on future gas markets.

EQT, the current top gas producer, is the rare company that has guided to approximately 11% increases in capex and production, which are both driven by the 2023 completion of its $5.2 billion acquisition of Tug Hill. EQT said in its conference call that its 2024 plan, which includes $200 million to $300 million of strategic growth capex above its maintenance capex, was made with “some flexibility to curtail volumes should natural gas prices remain weak.” In response to an analyst’s question, CEO Toby Rice said that EQT could decide to defer some planned TILs depending on the 2025 outlook.

Range Resources (RRC), which guided to relatively flat spending and production, outlined a plan that most directly reflected Chesapeake’s approach. The company said it was keeping the same level of drilling rigs and frac crews to “maintain operational efficiencies and provide flexibility for 2025 and beyond.” It also said its program increases its year-end inventory of “drilled and/or completed lateral footage” to provide flexibility to meet demand in future years.

Three other major producers released plans focused primarily on significant spending cuts. Coterra Energy (CTRA), which gained significant oil-weighted assets in the Permian and Anadarko basins with its acquisition of Cimarex Energy, announced a modest 4% reduction in total capex. However, that reflects a 55% reduction in investment in its core Marcellus Shale assets, which is offset by a boost in oil-weighted capex. The E&P’s resulting 6% decline in gas production will be more than offset by a gain in liquids output. Fellow Appalachian producer Antero Resources cut its 2024 investment by approximately 30%. Partially because of increased operational efficiencies, the company expects only a modest production decline as it awaits market developments in 2025.

Higher costs in the Haynesville resulted in negative Q4 2023 free cash flow for Comstock Resources. As a result, the company suspended its dividend and guided to a 37% capex reduction that included the release of two of its current seven rigs. The pain was also reflected in reports that large private Haynesville producer Aethon Energy suspended drilling in December 2023 on its drilling joint venture with mineral/royalties firm Black Stone Minerals.

In upcoming blogs, we will report in detail on the 2023 financial results and cash allocation for all the major U.S. E&Ps, including the gas-focused producers. We will also cover 2023 capital budgets and strategies across our universe, including any cascading impacts of Chesapeake’s announcement.

For those interested in how the U.S. natural gas market works, we’ll be diving into the nuances of pipeline analysis and modelling in our upcoming NATGAS Master Class on April 10th. This event provides a unique opportunity to gain a comprehensive understanding of these crucial topics and explore their practical applications through insightful presentations, interactive exercises, and discussion. Click here for more information and to register.