Should Chesapeake Give a Frack About the Cost of New York Land Leases?

Oil

Investors do not seem to like the idea of Chesapeake Energy (NYSE:CHK) walking away from land leases in New York state. Shares were off nearly 3 percent in morning trading Wednesday following a Reuters report that cited sources suggesting that a two-year long legal battle between landowners and Chesapeake could end as early as next week.

Chesapeake is interested in the land — as much as 10,000 acres in Broome County and Tioga County — because it sits on top of the liquids-rich Marcellus shale. The Marcellus shale sits in the Appalachian Basin and extends from southern and western New York through Pennsylvania, and into most of West Virginia. These latter states have been at the heart of the shale gas boom in the United States. Hydraulic fracturing has done nothing short of begin a revolution for domestic oil and gas production by making it economically feasible to access tight oil and shale gas formations.

Because of this, the value of the land that sits on top of the Marcellus shale has increased dramatically over the past several years as oil and gas companies compete for the right to drill. However, New York state put a ban on fracking in 2008 so that studies could be conducted on possible health and environmental impacts. This has prevented Chesapeake from capitalizing on the land it leased in the early and mid-2000s.

Chesapeake entered lease agreements with landowners operating under the assumption that they would be able to drill. Landowners in these deals were given a fixed rate per acre, plus a royalty payment for what was produced from the land. In the early and mid-2000s, with the shale gas boom just getting underway, the cost of land on the Marcellus was not nearly as high as it is now.

The increased value of that land and the state ban on fracking have made the leasing arrangement particularly complicated. Chesapeake has tried to claim force majeure on the land — a move that would let the company hold on to the property past the natural expiration date of the contract without renegotiating the terms — citing the moratorium on fracking. Meanwhile, landowners would like to renegotiate for higher prices.

While part of Chesapeake’s decline on the stock chart Wednesday can be attributed to participation in broader market pessimism, the decision to walk away from the land deals is particularly significant to investors, who could have mixed feelings about the leases. Chesapeake has a long history of aggressively pursuing land rights, and came under a lot of fire recently for paying too much and saddling itself with a tremendous amount of debt.

Chesapeake stock has climbed more than 32 percent since January 28, the day that infamous CEO Aubrey McClendon announced he would step down. The market reaction to his departure has largely been positive. Although he was responsible for much of the innovation and growth at the company — under his guidance, the company became the second-leading producer of natural gas in the U.S. — he he was also mired in damaging financial scandal, and many investors seem glad to wipe their hands of the complication.

Now, new management is focused on reducing costs and capitalizing on the company’s many attractive properties for unconventional gas and oil plays, many of which were acquired thanks to McClendon’s willingness to pay high premiums for prime real estate.

Under new CEO Doug Lawler, Chesapeake Energy is focusing on strengthening its balance sheet — namely, reducing the $12 billion of debt on its books. To do this, the company recently announced that it is selling portions of its Haynesville and Eagle Ford shale fields for a total price of $1 billion.

While the company will lose some production capabilities from the sale, it will not have to take on additional debt to run its operations for the rest of the year. New management is committed to avoiding land sales to fund operations in the future and instead is focusing on creating net positive cash flows by compressing its leasing operations and creating higher-yielding extraction operations.

The issue at hand may not necessarily be just how much the land costs, but whether Chesapeake feels like it can get a reasonable bang for its buck. The legal landscape in the state of New York is by no means certain, the price of natural gas is relatively low, and Chesapeake has a much harder time justifying paying for the land — which is a tiny fraction of its nearly 2.5 million acres of shale in the U.S. — than it used to.

Don’t Miss: BP Cries Fraud in Oil Spill Payouts Once Again.