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Chesapeake Energy Called the Market's Bluff

by: Horacio Marquez September 02, 2008 | about stocks: CHK    

Horacio Marquez

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To say that trading energy stocks has been difficult in recent months is a major understatement. When you see that even an industry giant like Chesapeake Energy Corp. (CHK) lost money in its hedging activities, you know that trading activity during the last quarter was extremely wild.

At Friday’s closing price of $48.40, Chesapeake Energy shares are down 35% from their 12-month high of $74. But the cause is clear.

Considering crude oil shot up from about $100 per barrel to $135 per barrel a few months ago - and natural gas skyrocketed from $10 per billion cubic feet (bcf) to $13.50 per billion cubic feet at the same time, prompting all sorts of investigations into speculative activities by the Commodity Futures Trading Commission, and in turn prompting calls for Congress to make it harder for financial investors to buy energy futures - it’s no surprise to see that almost every energy producer that prudently hedges part of its production against price drops had losses in the quarter.

Most analysts - myself included - are asking: “If we would have started drilling in the Continental Shelf and other such places a while ago, would this have ever happened? Probably not.” But it did. When the market supply-demand equation gets tight for any critical resource, prices have a way of getting totally out of hand.  And lack of flexibility in supply is always to be blamed. In this case, it seems as if Chesapeake Energy was caught badly on the “wrong” side of the trade. Or was it?

As Chesapeake was selling natural gas futures, and as those futures were climbing exponentially, the company was taking what looked to be huge mark-to-market losses. But natural gas prices peaked shortly after June 30 and have collapsed with the demand destruction that has prompted a quick reversal in investor positions from “long” to “short.”

This brought prices down to their strong support levels of around $8 per bcf.  These much lower levels were pretty stable for all of 2006 and 2007. So it turns out that Chesapeake was actually prudent in its strategy of taking advantage of high natural gas prices while it had the chance to do so. And its chief executive officer was confident enough that he was willing to take the heat over lackluster quarterly earnings for this huge temporary mark-to market hit and was not squeezed into closing these “losing positions” and realizing the loss. He took the bad mark-to-market hit at the quarter’s end and all the heat that this implied.

But do not let this quarterly loss fool you. In fact, the staggering $1.6 billion loss had, by July 25, reversed and moved up the value of Chesapeake hedges by a gorgeous $4.7 billion. CEO Aubrey K. McClendon and his team had seen what was coming and masterfully called the market’s bluff.
With Chesapeake’s staggering reported loss for the quarter and with natural gas prices now down to pre-bubble levels, the “fluff” in the stock has been removed.

Are the shares now worth a shot? You bet.

Not only is natural gas a key part of the energy solution for this energy-starved country, but Chesapeake’s long-term strategy is to tap into a very clean form of energy that is abundant in the U.S. market and to lead production in North America. Natural gas and oil sales almost doubled from a year earlier to about $2.2 billion, showing an operating gain of $479 million, which beat Wall Street estimates by a penny. What’s more, at these prices, you are already seeing strong incentives to switch some energy generation away from coal, whose prices have remained stronger, to natural gas-fired plants.

And Chesapeake is growing its reserves at about a 20% to 21% annual clip thanks to its expanding production in The Barnet, Haynesville Fayetteville and Marcellus Shale areas. This is the key to future share price growth. The shale production revolution, enabled by newer and cheaper drilling technologies and current prices of natural gas, is changing the industry, allowing for sustained reserve growth. And that will help satisfy the ever-expanding demand.

So you are buying Chesapeake at levels that now reflect the much lower prices we are seeing today in natural gas - but at a time when we are heading into the heating season, and are counting on continued reserve growth from their shale strategy to keep growing the bottom line. What about the volatility in earnings due to hedges? It is just loud market “noise” that proved that the company really knows the market and that has provided you with this great buying opportunity.

Suggested action: BUY shares of Chesapeake Energy Corp.

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This article has 31 comments:

  •  
    Sep 02 03:45 AM
    Don't do it! CHK just finished it's first primary downtrend leg. This is secondary reaction (look at the really low volume on the rally) which is bearish.

    Look at a 3-year chart...notice the parabolic uptrend? Just wait until it hits the 30's or you'll be investing dead money. You should read my article on bear markets: (seekingalpha.com/artic...). It applies to individual securities as well.
    Reply
  •  
    Sep 02 04:57 AM
    I got your dead money! Right here! Chesapeake knows gas, how to get it and how to market it. Parabolic this!
    Reply
  •  
    Sep 02 06:25 AM
    CHK can get it out.
    CHK can market it.
    Can they make a profit based upon the nutty costs they incur in doing it?
    They have paid some monsterous lease bonuses.
    They will also be paying abut double the rig costs for drilling as they have to get this stuff done before the leases expire.
    High gas prices and the lust for rapid development may kill the earnings.
    Reply
  •  
    Sep 02 07:30 AM
    Aubrey McClendon is the Eric Clapton of energy. Great LT hold in a strong structural market. Buy on weakness.
    Reply
  •  
    Sep 02 07:55 AM
    Chesapeake Energy is too risky for me. And the dividend is too low too.

    Also, I see oil and NG prices headed lower too.

    Go to:

    www.stopoilspeculation.../

    to see what I mean.
    Reply
  •  
    Sep 02 07:58 AM
    PS

    Read the article 10 ways to invest in Utah , above. The comment on NG pricing in Utah is very interesting.

    Oil and NG is political.

    OBAMA / BIDEN 08
    Reply
  •  
    Sep 02 08:06 AM
    There are some bulls here for Cheasapeake but also many bears. On the balance of available evidence, I favour the bears; not time yet for long momentum players. Let's observe carefully.
    Reply
  •  
    Sep 02 08:06 AM
    No dividends worth mentioning on the horizon. So, buy HGT and enjoy the cash along with the gas play.
    Reply
  •  
    Sep 02 08:25 AM
    Weekly TA has it right -next target is $40.
    Reply
  •  
    Sep 02 08:44 AM
    First, the author needs to get a grip on his "CHK lost money on their hedges" conclusion. That is so much bull cr*p. These are paper losses on marked-to-market...a nuance of stupid financial accounting. They did not lose money on the hedges. Repeat after me: no losses. They only gave up the option to make MORE money, they didn't lose money. The financial accounting lala land (as opposed to cash accounting and cashflow) show it as a loss but they didn't.

    Second: jjason, if you want anyone to take you seriously as an investor, you need to drop the Obama/Biden crap. That just shows you don't have a clue and are drawn to empty promises. I'll take that comment back if you can list for me 2 accomplishments that Obama is responsible for. Actual things he has done that has resulted in anything! And don't bring that "hope" and "change" baloney. Tell me about a bill he passed. Tell me about a program he administered, led, or showed any EXECUTIVE MANAGEMENT experience. Without that, your opinion is forever tainted as it shows you can be led by the nose with nothing but an empty suit and some cute words.

    Third: CHK is a long term play and a great one. Don't be misled...gas prices will be stuck in a range of $6-10. They can't go much lower as it will result in the stoppage of drilling and an abrupt drop in supply. When they go too high, storage gets full and price drops. At those prices, CHK will make huge money, regardless of the costs alluded to by a few posters. CHK is spending roughly $2-3/mmcf to find and develop the gas. They are getting paid $6-10/mmcf. Hmmm, sounds like a good deal. A huge percentage of their gas costs $1/mmcf to produce. Yeah, looks like a bad business deal!

    And, BP has bought in to 25% of one of their big plays. I can tell you that Aubrey got lots of leverage in that deal because everyone wants in on his plays/acreage so he is able to negotiate really sweet deals. Look at the Plains deal...Plains paid $1.7 billion for 30-40% and then will also pay all of CHK's drilling costs for the first $1.5 billion. But CHK retains their production revenue for their share. Now that's leverage!

    If it goes to $40, buy a boat load.
    Reply
  •  
    Sep 02 09:16 AM
    The industry has just valued two of CHK's holdings, Haynesville and Fayettesville at $24B...look at PXP and BP purchases of a percentage of those assets - PXP $3.3B for 20% of Haynesville, BP $1.9B for 25% of Fayettesville...

    That leaves the Barnett and Marcellus and various other holdings at around $4B...No way!

    Market has undervalued CHK. They are selling dollar bills at 60 cents.

    Buy while you still can get it at these prices...don't have to wait - it might not get to $40...

    After all, in March A.M. promised 5 non-conventional oil plays in 4 states that will yield a minimum of 1B barrels of oil to CHK...and that';s not in anyone's calculation of CHK value so far...
    Reply
  •  
    Sep 02 09:19 AM
    Compare a chart of Nat Gas for the last five years and the stocks of CHK and EOG. The positive correlation is very high, so no matter how good or bad these hedging gains or losses are, share prices are still going to resemble what is going on with gas prices.
    Reply
  •  
    Sep 02 09:45 AM
    Mmarrkk: I'd like to hear about John McCain's executive management experience. And please don't include the fact that he was an officer in the Navy until 1981. Anyone who has been in the military knows that experience there does not translate to experience in the business world. And his 30+ years in the Congress/Senate isn't executive in nature --- its legislative. I'm not crazy about Obama, but I do get tired of everyone questioning his "executive experience" without doing the same for McCain. They're both in the same boat in my opinion.
    Reply
  •  
    Sep 02 10:31 AM
    The real problem for CHK and others like her is the use of water in the fracturing process. The amounts are huge and already a water shortage is developing in Denison County Texas, heart of the Barnett Shale,for 2010 and that comes from the local water commiisioners who have been, obviously, pro drilling and pro development.

    This problem will come to the forefront regardless of who is President. The drillers will have to go back to gel packs which will raise the cost substantially. This should reduce supply which will drive up prices.
    The water issue is worsening and it can no longer be overlooked as well as waste water disposal which is just as serious.
    I own tar sands and Bakken shale stocks who also have their pollution problems but this specific issue will come down harder on the investor.
    I predict fratracide warfare amongst the Dems. will be fun to watch.
    Reply
  •  
    Sep 02 10:38 AM
    Steve: the gel frac's still take water and they aren't effective. I believe there is an innovative solution to the water issue that is coming in the not so distant future. Won't solve all the problems but will enable the continued drilling/fracing of wells in many places. For the places that don't want to go after the gas, then their utility bills will have to go up as any cut back in drilling for the shale gas will directly result in skyrocketing nat gas prices. These wells decline rapidly when drilling stops.
    Reply
  •  
    Sep 02 04:06 PM
    I missed the part where the author talked about the election. Keep your election comments to an election board!
    Reply
  •  
    Sep 02 04:26 PM
    Assuming NG is a good long term investment, what's to distinguish CHK from other NG producers? Bigger is not necessarily better.
    Reply
  •  
    Sep 02 04:40 PM
    The correct price of NG is $10 per thousand cu. ft. not billion cu. ft. One thousand cu. ft. (Mcf) has a heating value of one million Btu so another way to quote the price is $10 per million Btu.
    Reply
  •  
    Sep 02 05:02 PM
    Is all of this bickering legal? I love CHK, but Audry stole our basketball team and I want to factor that in. Any ideas. I mean this board is a nut house so anything could happen. Zooey.
    Reply
  •  
    Sep 02 05:23 PM
    Come on Guys this is NOT a political forum
    Reply
  •  
    Sep 02 07:03 PM
    CHK should be a fair portion of the foundation of your investment empire. Looking out years from now, you will wish you had bought more at these prices.
    Reply
  •  
    Sep 02 07:54 PM
    i noticed that a lot of articles' comment sections turned into political debates...there needs to be some moderation of comments.
    Reply
  •  
    Sep 02 08:01 PM
    Any opinions out there on XTO? Is it as good as CHK?
    XTO is also in a stock price downward path. Any buy entry points? Again, how does it stack up to CHK?
    Reply
  •  
    Sep 02 08:51 PM
    Investing is about timing!...or the time value of money!

    What good is it to invest in CHK (for example) if it is dead money for 3 years, than doubles in the next 5?...which means it took 8 years to double! Chances are, it is very likely you or I would tire of it and sell at no gain in less than those first 3 years.

    Give me a stock that will grow by about 15% per year.

    Most of us don't need 'home runs'; we need good sleep-at-night steady performers. (If you don't believe me--just look the turnover in your portfolio!)
    Reply
  •  
    Sep 02 08:52 PM
    p.s. No one here is going to change their opinion of BO or JM because of some comment they read here...please keep this to CHK (or XTO).
    Reply
  •  
    Sep 02 10:19 PM
    I am a little concerned about CHK's leverage. It was interesting that Simpson (XTO) referred to "hype artists in our industry." I suspect he was referring to McClendon (CHK) who does sound a little that way at times with his $200+ share of reserves talk. Nat gas has to be a huge part of our transition energy solution and we are going to be using a lot of it. It is clean and we have it. CHK is not a bad choice <45 and I would look to add to my modest position at that price. As for politics - I am sick of it already. We will drill and RIG will benefit. $80 oil won't hurt their earnings.
    Reply
  •  
    Sep 02 11:56 PM
    People don't think that nat gas can go down because the companies will simply shut in the wells. However, they don't understand the economics of the producers. Producers used to get less than $1 for gas not so long ago. In fact, when I worked in the nat gas industry there was once where producers were paying people to take gas from them in the spot market because of a quirk in the pipeline system (but only for a few days).

    Producers, once they've sunk millions and billions into the production, have to flow the gas. At that point their variable costs are minimal and their fixed costs are huge. They will flow and take whatever price they can get. They'll keep flooding the market with gas until it is well below where people think it can go to. Even drilling is semi-variable in cost since compared to the overhead of other costs including debt, many companies will be forced to spend the money to drill to bring on gas at even ridiculously low prices because they need to service the debt.

    Otherwise what's their alternative? Not pay the interest on the debt? Sit on the assets? Sell the assets at low prices because in a low nat gas price environment no one will pay up?

    So BP's purchase of a stake in CHK is something for bulls to hang their hat on. Well Shell bought out Duvernay Oil right at the top of the market after several wobbly pops during Calgary Stampede. The big guys don't know what they're doing anymore than the little ones - or maybe less so.

    The producers are boxing themselves into a corner again just like they've done many times before. Boom = bust.
    Reply
  •  
    Sep 03 09:25 AM
    Howsie: you are partly right on gas pricing. In the actual market, gas is priced in the $/mmBTU and 1 MCF has ROUGHLY the same value of 1 mmBTU. However, note that I said ROUGHLY as gas quality and heating value vary from place to place and well to well. There are many producing wells that have gas heating contents of 1200 mBTU per SCF (or 1.2 mmBTU per MCF). So be careful.

    XTO: a good company and part of what I would call "foundational&quo... nat gas stocks, along with CHK, Devon and EOG. If I could only have 4, that's the 4 I'd take. Devon, XTO and EOG have a bit more oil in their portfolio whereas CHK is virtually 100% gas. Devon also has deepwater GOM exposure. If you told me I could only have one, I'd probably take EOG as they are good, organic growth company.

    CHK's leverage: I actually look at CHK's leverage as a huge positive. They have leased hundreds of thousands of acres in some of the best plays going in North America. Its like owning 25% of New York City before it was developed (someone say $24 worth of beads...?). Now they are working deals to get other companies to pay for a huge portion of the drilling costs, yet CHK gets the revenue. This is one slick model!

    Production: One of the previous posters talked about the cost to produce and why the companies won't shut in production after investing so much. What you are missing is the type of wells currently being drilled. These shale wells come on at very high rates but decline very rapidly. So, when prices decline, the companies just stop drilling new wells, reduce their capital burn and then the production starts to fall. Then storage gets reduced, then prices ramp back up and they start drilling again. And the smart companies like CHK also use hedges wisely. When prices are high, they lock in hedges/floors to guarantee prices above $9/10/mmBTU. As production goes up, prices drop to the $6/7 range but CHK keeps getting $9/10. And while prices are down in that $6/7 range, they go out and reset some of these hedges, lower their costs, and wait for the cycle to go back up again! Its actually a pretty good deal.

    And, you've got a CEO willing to invest $40+ Million of his own money in the company. Not stock options, warrants, etc.....but real live stock purchases!

    And to the whiner about "his" basketball team being "stolen" by Aubrey, can you say "out-bid" and "out-negotiated&q... Aubrey used the free market to go and flat out school your weak West Coast butts. People on the East and West Coasts have such an "entitlement"... attitude. Maybe that's why they vote heavily Demoncratic and the rest of the country...the REAL PEOPLE...vote Repub's. Ooops, slipped the politics.

    But you can watch your team...I'm sorry...Aubrey's team...on television. Pay Per View, of course!!
    Reply
  •  
    Sep 04 02:33 PM
    I beleive that the price of natural gas is $10.35/m mbtu, /not billion cu.ft.
    Reply
  •  
    Sep 07 10:41 PM
    A number of oil field service companies and suppliers will not do business with CHK because the are very slow pay and difficult to deal with. I will not invest in a company that makes its supplies wait for their money.
    Reply
  •  
    Sep 29 11:17 AM
    looks like I got YOUR dead money. lol

    CHK will hit $30. I wasn't f-ing around...
    Reply
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