Chesapeake (CHK) is the second-largest producer of natural gas in the United States after ExxonMobil (XOM). Thanks to an aggressive land campaign over the last five years, the company boasts the largest inventory of natural-gas shale play leaseholds in the country (2.5 million net acres).

With gas prices forecast to remain in the doldrums for the short- to medium-term, Chesapeake has launched a two-pronged strategy to tackle the low margin environment. While investing heavily on projects intended to stimulate domestic natural gas demand, the company has also been moving rapidly to increase higher-margin liquids production.

Natural gas production represents 75% of the Trefis stock price valuation for Chesapeake.

See full Trefis analysis for Chesapeake

Soaring natural gas production outstrips demand

Technological developments have resulted in a dramatic boom in the U.S. shale gas industry over the last decade. Shale gas production increased from a base of near zero at the turn of the century to 4.4 trillion cubic feet in 2010. Growth has been soaring, with annual average increases of 17% from 2000 to 2006, and 48% from 2006 until 2010.

Rapid expansion in shale drilling activity across the nation has driven the 3.3% annual average increase in total U.S. natural gas production over the last five years, despite declining production from conventional resources. Meanwhile domestic consumption of natural gas during the same period only increased on average by 1% per year.

With demand failing to keep up with increasing supply, natural gas prices in the U.S. have slumped from over $13 per million British thermal units in 2008 to below $4 as of November 2011. With such low prices in the domestic market, pure dry natural gas drilling has become an extremely low-margin activity and even unprofitable for higher cost operators.

Rapidly increasing liquids production

In the face of low gas prices, Chesapeake is continuing its huge growth in production (13% year-on-year increase as of Sept. 30), but seeking to alter the production mix. With natural gas liquids tracking crude oil prices, Chesapeake has aggressively sought to position itself as a leading presence in liquid-rich shale plays over the last three years. The company now claims a leading position in 12 of the best 15 liquid-rich shale plays in the country.

Oil and natural gas liquids represented 17% of Chesapeake's total production in the third quarter, up from only 10% in the prior year. Actual oil and liquids production for the nine months to September 2011 reached 21.9 million barrels - a 71% increase year-on-year.

The company intends to continue to increase liquids production, with the proportion of drilling and completion capital expenditure allocated to liquids development increasing to 50% in 2011 and to 75% in 2012. Management is forecasting an average daily liquids production of 250,000 barrels by 2015, which is a 212% increase on present day production levels.

In pursuit of higher margins, Chesapeake is altering its production mix rapidly. The Trefis stock price valuation of $35.02 assumes the company increases total annual liquids production to 29.4 million barrels by 2015. There could be significant upside if management delivers on its stated strategy and delivers faster growth in this sector.

You can drag the trend lines in the modifiable charts above to see the impact of increasing liquids production on the estimated stock price valuation.

This article was submitted as part of our Trefis Contributors program and may not reflect the views of Trefis analysts.