THE BOOM AND BUST OF PRODUCER DISCIPLINE

In this issue of our weekly Hyperion research report we want to focus on just one E&P company, Chesapeake Energy, what Hyperion data reveals about their change in strategy and what this could mean for the industry as a whole.

The Boom and Bust

Cracks are beginning to show in the still new industry mantra of producer discipline. Evidence of a changing narrative is in our view shielded by the existence of a frac crew ceiling. But, when examined at the operator level it becomes clear that certain producers are beginning to test if Wall Street is ready to stomach a return to growth. After the pandemic energy bust yielded history's first ever negative oil settlements, Chesapeake, like so many of its peers, promised investors their days of aggressive debt-fueled growth were behind them and that the company would live within its cash flows and pay down debt. Their Q1’21 earnings call, delivered with oil prices around $60, reassured analysts that even as the company looked for a new CEO, their commitment to discipline remained strong. “Second most common question [to the change in CEO] is, is this a change in strategy? The answer is absolutely not. There is no change from the post-emergent strategy. We’re focused on free cash flow, capital discipline, and returning cash to shareholders” One new CEO later the message remained the same; In the Q3’21 call, delivered with oil now around $80, the new CEO reaffirmed the company's strategy. “We're focused on executing the strategy we've articulated over the last eight months. Behind our disciplined capital allocation approach and continued focus on our cost structure, we intend to increase free cash flow, enhance our scale and return significant cash to shareholders.”

The Story Starts to Change

By Q1’22 WTI had topped $110 and Henry Hub was over $8. Comments from the CEO began to hint that the strategy of returning cash to shareholders had changed. “The war in Ukraine is horrible on every level, and we’re eager to see an end of the invasion. We’re also eager to help ensure the citizens of Europe and by extension, the rest of the world are not left without adequate energy resources should Russian supply to continued or either even further interruptions.” Later, during the Q&A session, an analyst asked about how the company planned to allocate capital, would it be used to pay down debt? Without specifying how capital would be spent the CEO answered that it would not be used to pay debt. “On the debt reduction side, we have a little bit outstanding on our revolver today, following the Chief transaction, we’ll probably let that go back to zero. That’ll happen in the normal course as we go through the year. But we don’t really have a priority for debt reduction beyond that. And I would call that, just it’ll just happen as it happens. There’s no urgency necessarily to achieving that by any certain date.”

What will Chesapeake spend capital on? The company does not say. A ‘disciplined’ producer would follow the mantra of living within cash flows and paying down debt. We believe Chesapeake has broken from this strategy and is instead using capital to grow their count of frac crews. Investors are unlikely to realize this yet as Chesapeake does not provide a frac crew forecast. Hyperion data shows a clear change in frac crew trend from flat at 5 crews to a rapid expansion to 10 crews immediately following the Q1’22 comments. We expect this change in strategy will become more explicit to investors come Chesapeake’s Q2’22 earnings release which is scheduled for 8/2. If investors do not punish this new direction it will be safe to say that producer discipline is officially dead.

Does it Matter?

From a macro perspective what does it matter if producers want to grow when a ceiling on frac crews prevents them from doing so? In the near term it probably doesn't matter. But in the longer term the end of producer discipline means there is one less barrier to production growth should the frac crew ceiling disappear.