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Chesapeake Energy – Ready to Rise

June 02, 2013 | About:

One of the gurus I pay attention to is Bruce Berkowitz who is the manager of Fairholme Funds and famed for his analysis and sticking to his convictions when he feels the facts are on his side, even if his stocks are down substantially from his purchase price. Given the recent disclosure by GuruFocus that Bruce Berkowitz has re-initiated a position in Chesapeake Energy (CHK) in first quarter 2013 and the oil and gas sector being out of favor, I decided to take a look at Chesapeake Energy (CHK).

I) The Record

Shares of Chesapeake Energy (CHK) are down $62 in 2008 to a price of $20 in May 2013. In the same time the price of Henry Hub natural gas price is down from $12/MMBtu to $4/MMBtu. The oversupply of natural gas in North America caused a secular low in price of natural gas to be made in May 2012 of $1.85/MMBtu. The shares of CHK made a low of $13.50 around May 2012.

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II) Business and History

As per the company website:

“Chesapeake Energy Corporation (CHK) is the second-largest producer of natural gas, the 11th largest producer of oil and natural gas liquids and the most active driller of new wells in the U.S. Headquartered in Oklahoma City, the company's operations are focused on discovering and developing unconventional natural gas and oil fields onshore in the U.S. Chesapeake owns leading positions in the Eagle Ford, Utica, Granite Wash, Cleveland, Tonkawa, Mississippi Lime and Niobrara unconventional liquids plays and in the Marcellus, Haynesville/Bossier and Barnett unconventional natural gas shale plays. The company also owns substantial marketing and oilfield services businesses through its subsidiaries Chesapeake Energy Marketing, Inc. and Chesapeake Oilfield Services, L.L.C.​”.

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III) Operations and Competitive Advantages

Information from the company website about operations is as follows:

“Chesapeake Energy Corp (CHK) is headquartered in Oklahoma City and our operations are focused on exploratory and developmental drilling onshore in the U.S. in major plays such as the Eagle Ford, Utica, Granite Wash, Cleveland, Tonkawa, Mississippi Lime and Niobrara unconventional liquids plays and in the Marcellus, Haynesville/Bossier and Barnett unconventional natural gas shale plays. For more detail, take a look at the map above.

Our operating areas are characterized by long-lived natural gas and oil reserves and established production capabilities with abundant growth opportunities. In each of the company’s operating areas, our deep backlog of drilling locations enables us to establish substantial economies of scale in drilling and production operations for more effective drilling and reservoir management practices.”

CHK has grown its reserves substantially over the last decade by taking on significant debt. The strategy going forward seems to involve asset sales to reduce the debt and focus on intelligent capital allocation and increased shareholder return.

Below is select information from the May 2013 investor presentation by the company and the 2012 Annual Report:

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Competitive Advantages:Chesapeake Energy (CHK) is a leveraged bet on long-term natural gas prices (and natural gas liquids) and as such the company does not have many competitive advantages. It is however the second largest producer of natural gas in the U.S., which provides it some scale advantages, and it has some of the best assets in North America.

IV) Balance Sheet and Profitability

Chesapeake Energy Corp (CHK)has a weak balance sheet with a net debt position in excess of $12 billion. For the year of 2012 the company had a loss of $1.46 per share down from EPS of $2.36 in 2011. Below is information from the company 2012 annual report, 2013 first quarter report and 2013 company presentations:

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V) Management

Robert Douglas (Doug) Lawleris currently president and chief executive officer ofChesapeake Energy (CHK).

As per the company website:

“Mr. Robert Douglas (“Doug”) Lawler, 46, Senior Vice President, International and Deepwater Operations at Anadarko Petroleum (NYSE: APC), will join Chesapeake as Chief Executive Officer and a member of the Board of Directors, effective June 17. Mr. Lawler is a petroleum engineer with 25 years of experience in the upstream Exploration and Production industry who has served in increasingly senior leadership roles at Anadarko, the second-largest independent upstream company in the U.S. with a $45 billion market capitalization. He is a proven oil and gas executive with significant expertise in asset development, operations management and engineering as well as experience in corporate and strategic planning.

With Mr. Lawler assuming the CEO position at Chesapeake, the Office of the Chairman will be discontinued and Archie W. Dunham, Steven C. Dixon and Domenic J. Dell’Osso Jr. will continue to serve in their roles as non-executive Chairman of the Board, Executive Vice President of Operations and Geosciences and Chief Operating Officer, and Executive Vice President and Chief Financial Officer, respectively.​​”

I believe Chesapeake Energy is going to work for its shareholders' benefit after Aubrey K. McClendon has retired from the company on April 1, 2013.

Top shareholders as of 31 March 2013 as per Yahoo Finance includes Southeastern Asset Management (13.4%), Carl Icahn (8.96%), Vanguard Group (3.97), State Street Corporation (3.61), Franklin Resources (3.30), Wellington Management Company (2.54), BlackRock (2.28), Fairholme Capital Management (2.01), Brandes Investment Partners (1.81).

VI) Value and Price

CHK is trading in $19 to $22 range as of May 2013. Below is the price history of natural over the last 12 years and history of oil/natural gas ratio.

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There is a high probability that reduction in oversupply in North America and opening up of export to foreign markets can support a natural gas price between $4/MMBtu and $6/MMBtu in the U.S. Under these prices and with reduced debt after asset sales, CHK could have EPS between $2 and $3 after 2014. Thus CHK offers potential for high reward with high risk.

Mritik Capital suggests the due to the volatile nature of natural gas prices, rather than buy CHK shares at current prices it may be better to sell the January 2015 $25 Put for CHK at a premium of $7.00 or above. If the put is assigned, the investor will have an effective share price of $18. which would provide a significant margin of safety. If the put is not assigned then the investor would make a 17.7% annual return, i.e. $700 (per each put) income on a risk amount of $2,500 over the next 19 months.

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VII) Catalysts

1. An increase in natural gas price over the coming years increasing asset valuation and cash flows.

2. Market taking note of the shareholder-friendly management and increasing valuation multiple.

3. Asset sales (and reduced debt) over next 6 to 12 months leading to a better balance sheet leading to increased valuation multiple.

4. Natural gas exports becoming a reality over the next three years would increase valuation and cash flows.

VIII) Specific Risk

1. Natural Gas prices may decline again and stay low for longer duration leading to reduced cash flow and earnings.

2. If asset sales do not pan out over next 12 months the high debt could be unsustainable with reduced cash flows.

3. The vision to export natural gas from the U.S. to export markets does not materialize.

IX) Why Is This Cheap?

1. The price of natural gas is very volatile and there has been a sharp correction (and recent recovery over the last year) of natural gas prices from $12 to $4 (back from low of $1.85 made in May 2012) over the last few years.

2. Oil and gas stocks are currently out of favor.

3. The company has a relatively poor balance sheet.

4. The shareholders of last few years when Aubery McClendon was CEO suffered through poor governance issues.

Disclosure

I have sold January 2015 puts on CHK.

Comments and questions welcome.

Read more:

CHK Investor Relations

Natural Gas Org

Yahoo Finance

US Energy Information Administration

Natural Gas Terminology

Ourfiniteworld

Note:

I have used information from the CHK investor presentations and financials. I have referenced information from Natural Gas Org, Yahoo Finance, U.S. EIA, ourfiniteworld.

About the author:

MritikCapital
Mritik Capital Inc. is a financial advisory firm with focus on identifying quality businesses with durable competitive advantages that are undervalued. Our first goal is to preserve the capital of our clients and look for strategies for enhancing their net worth based on opportunities that present compelling risk adjusted reward.

Please note that investing offers both risks and rewards. Before investing do your own due diligence and consult your financial advisor.

Visit MritikCapital's Website


Rating: 4.4/5 (45 votes)

Comments

kartikey1
Kartikey1 - 1 year ago
Precise and Concise. Great insight. Thank You for great research and analysis.
MritikCapital
MritikCapital - 1 year ago
Hi Kartikey1,

Thanks for reading the article and your comments. I appreciate it.
MritikCapital
MritikCapital - 1 year ago
Possible natural gas 20 year export contract to Europe's E.ON AG.
vgm
Vgm - 1 year ago
Thanks Mritik. Agree with Kartikey. Great piece!

It's probably worth adding that, beyond Berkowitz, CHK has an exceptionally credible shareholder base in Carl Icahn, Southeastern, Mohnish Pabrai, and insider Director Archie Dunham. In addition, a couple of years ago, former Buffett lieutenant Lou Simpson - who at the time was a CHK director - bought 200,000 shares on the open market for around $26/share. (I presume he still holds them)

http://www.forbes.com/sites/energystockchannel/2011/12/20/top-buys-by-directors-simpsons-5-4m-bet-on-chk/
vgm
Vgm - 1 year ago
Southeastern had their investor day April 16. An audio recording is now available on their website.

One investor asked "What happens next with Chesapeake?" Mason Hawkins provides his thoughts on the sale of assets and how the cash proceeds (he estimates $5-7B) might be used to pay down debt and potentially for buybacks since the stock is way below their estimate of intrinsic value. He thinks this could give the company "an investment grade balance sheet", and expects things will look very different in a year's time:

http://www.longleafpartners.com/commentary_news/audio
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Thanks for sharing your thoughts and posting the Southeastern commentary. It is indeed very informative. Having so many intelligent investors being long CHK is indeed interesting. Obviously May 2012 was the best price to invest but there was higher uncertainty in terms of governance and I was unsure if the published earnings statements were reliable so I stayed away. I feel much more confident in the current board and leadership team. Although nobody can predict the commodity price a lot of factors seem to be coming together well for CHK. Let us check back in 3-5 years time on this one and see if our analysis was correct.
swnyc2
Swnyc2 - 1 year ago
Mritik Capital,

Thank you for the nice review of CHK.

There are a number of stocks in this space.

For example, Batbeer2 recently wrote a nice analysis of KWK, which you can find here.

I was wondering if you've considered how any of the other companies such as KWK compare or contrast to CHK?

MritikCapital
MritikCapital - 1 year ago
Hi Swnyc2,

Thanks for your comments and for highlighting the KWK analysis by batbeer2. I will look into this further. I usually like to follow the company at least for a year before I invest. I like the fact that KWK is an owner operated company and as noted in the comments on the article has a position (14% as per Yahoo Finance).
MritikCapital
MritikCapital - 1 year ago
Moodys revises rating outlook for CHK to stable. I suspect with some more asset sales and reduced debt a rating upgrade is viable in a years time.
MritikCapital
MritikCapital - 1 year ago
I am wondering how SandRidge Energy compares with CHK from a valuation perspective. Major shareholders are TPG-Axon, Fairfax Financial, Riverstone Holdings, Carlyle Group and most likely Tom Ward is on his way out. Selling Jan 2015 $5 puts give premium in excess of $1.55. You either get assigned at ~$3.5 or make 19.5% per year return on at risk capital.

There is definite risk here but there is possibility of some catalysts in next few months and even a sale of the company is possible. Although I am not sure who would be eager to buy unless natural gas prices rise.
trinathdasari666
Trinathdasari666 - 1 year ago
Thanks Mritik. Agree with Kartikey. Great piece!
MritikCapital
MritikCapital - 1 year ago
Hi Trinathdasari666,

Thanks for reviewing the article.
vgm
Vgm - 1 year ago
"I am wondering how SandRidge Energy compares with CHK from a valuation perspective."

There's so much negative sentiment around SD that I'd be willing to bet it's significantly undervalued.

Prem Watsa's ownership has always puzzled me, since, from the outside, Ward's behavior seems reprehensible (a la McClendon - Ward and McClendon were at CHK together). It's not like Carl Icahn taking a chunk of CHK to go in as an activist to fix governance. On the contrary - Watsa stated at the recent Fairfax annual that he has complete faith in Ward and that Fairfax would be keen to own any other company that Ward might lead.

Have you looked at Exco? It also has been beaten down and has an impressive cadre of major shareholders - including Wilbur Ross, Howard Marks, Prem Watsa and Chuck Akre. It currently trades just above $8. Wilbur's cost basis is well above that. In 2011 there was an attempted but thwarted management buyout around $21. Like CHK and SD, XCO is suffering from low nat gas pricing.
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Thanks for sharing your thoughts, I very much appreciate it.

My take is that Watsa is investing in Natural Gas with more of a longer term horizon like 10 years. I too am surprised by his praise of Tom Ward although it is difficult to know whether he really believes what he is stating or he is saying this as he owns a lot of shares of SD and Ward is still CEO.

I have been looking at XCO over the last 1 year. I came across it when viewing one of Wilbur Ross's interview a year ago where he admitted to have jumped on it too early. I have very high regard for Howard Marks and Oaktree so I did notice their 17% ownership. There was an opportunity in late Feb 2013 in XCO at prices which I suspect were close to Oaktree's purchase price. I will keep an eye on this over the next year. It is not that easy to have a time horizon of 10 years but I suspect people who can do that can benefit with these contrarian picks.
MritikCapital
MritikCapital - 1 year ago
Malaysian state oil and gas firm Petronas to invest B over 6 years in its Western Canada LNG export project.
MritikCapital
MritikCapital - 1 year ago
As expected at SD Tom Ward gets the boot. CFO James Bennett named CEO and President. Lead independent director Jeffrey Serota will serve as interim non-executive chairman.
MritikCapital
MritikCapital - 1 year ago
Leon Cooperman thoughts on SD during CNBC interview.
MritikCapital
MritikCapital - 1 year ago
Exxon Mobil Corp (XOM) is seeking a license to export 30 million tonnes of liquefied natural gas (LNG) per year to Asian markets from the coast of British Columbia, according to a regulatory filing in Canada.
vgm
Vgm - 1 year ago
Wilbur Ross on nat gas as a paradigm shift in US and elsewhere. Mentions that export licenses beginning to get approval in Washington, and some 14 or so others in line. Nat gas discussion comes at the beginning nd end of this interview - one of the better ones from Bloomberg:

http://www.bloomberg.com/video/ross-says-shale-gas-game-changer-for-u-s-world-JUYjbvo0RCqHGlPAW1spWQ.html
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Thanks for posting the nice interview. Whether North American energy independence is indeed going to be a game changer or whether it ends up being a lot of hype is one of the big questions to ponder. I think the US industries including chemicals will likely benefit a lot and low energy prices and input costs would benefit most manufacturing companies as well.

One question that sticks in my mind is whether uncovering shale resources and tapping them is possible in other areas of the world. If this does happen at a fast pace then potential to profit from natural gas export to Asia could diminish and the opportunity window could be narrow. I hope the governments in North America will act in an agile and responsible manner.
vgm
Vgm - 1 year ago
Hi Mritik,

Thanks for your interesting thoughts. My take is that shale gas will indeed be a game changer in the US - definitely for the chemical industry and manufacturing as you mention, but other areas too, including (heavy) transport. Wilbur is clearly optimistic that the export of nat gas will become a reality and has got himself in position in the shipping of LPG.

Yes, a number of countries are discovering their own shale gas deposits. China purportedly has more than the US, but it's at deeper levels in the earth's crust and may be in smaller pools. The Chinese have little or no experience in fracking and they are setting up JVs with US entities to gain experience. Wilbur has been involved in the auctioning of these JVs thru Exco:

http://m.gurufocus.com/news_read.php?id=191028

http://www.bbc.co.uk/news/world-asia-22023464

In contradistinction, I recall Munger saying that he thought the US was 'nuts' to be exporting its own energy! Buffett seemed to be in agreement.
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Thanks for the info. I am looking at natural gas infrastructure companies like KMI as well since they should benefit from this export potential.
MritikCapital
MritikCapital - 1 year ago
Petronas in talks to sell 10% stake in Canada shale to Indian Oil.
MritikCapital
MritikCapital - 11 months ago
The change a competent and shareholder friendly management can have on a mismanaged company cannot be overstated. Doug Lawler has done an excellent job in cleaning up the company and righting the balance sheet. Although CHK is significantly up from $18 to $27 reversion to mean for Natural Gas prices could provide continued upside for long term shareholders.
vgm
Vgm - 11 months ago
Hi Mritik,

Interesting point about Doug Lawler. I read some comments from a value fund manager recently who made the observation that he thought CHK today is like BAC three or four years ago in needing a CEO who would rationalize the company and its great asset base.

Lawler is doing all the right things in transforming the (terrific) assets Aubrey amassed into a more coherent story - just as you say. The timing of your piece was outstanding. And I agree the prospects are still looking good too. Glad to be an owner.
MritikCapital
MritikCapital - 11 months ago
Hi Vgm,

Its nice that CHK has worked out well for you. Timing was partly luck and the other part we can put down to the odds being skewed to the upside. NatGas price was depressed, balance sheet was in bad shape, prior management was poor and shareholder unfriendly. With Carl Icahn and Long Leaf as investors and change imminent there were a lot of catalysts.

Let us see how things turnout over the next year. I think CHK can buy back shares meaningfully from next year if natural gas prices recover. A part of me wishes that CHK price would haveclanguished for another year under $20!

I also like XCO for the long term and I am optimistic with Oaktree as a major investor.
MritikCapital
MritikCapital - 10 months ago
CHK getting closer to fair value. Leverage to natural gas price gain and possibility of takeover premium cannot be ruled out.
vgm
Vgm - 10 months ago
H Mritik,

Thanks for sharing your thoughts. To me the good times are just beginning for CHK and expect it to go much higher in the next 3-5 years as financial discipline gets embraced and their balance sheet continues to improve. Southeastern certainly have a much higher valuation on it going forward. There was talk of a buyout at $40 which I think is way too low. Can't see Icahn or Mason Hawkins supporting it at that level. I was in below $17 and plan to hold. Good luck.
MritikCapital
MritikCapital - 8 months ago
Hi Vgm, I was hoping for Nat Gas prices to rebound in the winter months and seems to be edging close to $4.5. I suspect $5 will be a psychological level to cross. Any thoughts on XCO at the $5 level. Obviously bad balance sheet and capital raise needed but with tax loss selling out of the way and more clarity likely on the management team and plan going forward I am keeping my eye on it.
vgm
Vgm - 8 months ago
Hi Mritik -- I got nervous with the news coming out of XCO and sold out a couple of months ago. But I bought back in around $5 over the past few days. (May sound like I'm a trader, but not). I think it's a very cheap stock at these prices. Wilbur Ross and Prem Watsa, both large shareholders, have announced that they will backstop the offering, which is needless to say a very positive development.

And in this interview, Wilbur says that his decision to put more money in speaks for itself: http://uk.reuters.com/article/2013/11/25/exco-offering-idUKL2N0JA1UI20131125

I'm not exactly sure what his cost basis is, but I believe it's in the double digits. He's been on the inside now for a few years and the fact that he still has confidence and is ready to add is a huge vote of confidence from such a shrewd investor.

I also now have a position in SD. It's back down around $5 too, and is also cheap I think. Their new management team are making a difference. Leon Cooperman has taken a position and has given his analysis that it's worth $10. Other major holders (some activists) believe it's worth up to $15. Prem Watsa also has a major stake.

The markets have risen alot but arguably there's still value to be found in selected energy names.
MritikCapital
MritikCapital - 8 months ago
Hi Vgm,Thanks for sharing your thoughts. The price of natural gas is rallying as winter is more severe than last year I suspect. Even Gurus can be wrong and can be affected by their own biases. Example is Prem Watsa and BBRY. Lets wait and see how it plays out. I am staying on sidelines on these commodity plays for now.
vgm
Vgm - 8 months ago
Thanks Mritik. I don't disagree about gurus. They're not infallible by any means. But I would add that when a few of them get around the same idea, it gets my attention. That's the case with both SD and XCO (and CHK). Yes, let's see how it plays out. 

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