There are not many instances when a stock delivers 200% returns within one month. Chesapeake Energy (CHK, Financial) was trading at $1.59 on Feb. 12; the stock is higher by 229% at $5.23.
At $1.59, there was speculation of bankruptcy and sentiments that were as bearish as possible. These kinds of returns come in such a scenario, and the fact that Seadrill (SDRL, Financial) surged by 121% in a single trading session supports that point.
In the last few months, I have continued to recommend energy stocks as valuations are cheap, and these valuations will be impossible to find when oil witnesses sustained recovery. I maintain that view, and investors should consider small exposure to beaten-down stocks.
However, the point is whether Chesapeake Energy is worth buying after 229% upside. It is important to note here that Chesapeake Energy is still down by 63% in the last year; if oil market fundamentals improve along with the company’s fundamentals, the upside can still be significant from current levels.
The first point I want to mention is that Chesapeake Energy clearly stated on Feb. 8 that the company has no plans to pursue bankruptcy. The company can navigate the crisis if the next few months are good for oil and if the company can manage a few asset sales at decent valuations.
Oil has trended higher recently on hopes of a production freeze by oil-producing countries. The offsetting factor is global economic slowdown. However, dollar weakness due to sluggish economic growth can take oil higher as well.
Coming to company-specific factors, Chesapeake Energy is targeting $500 million to $1 billion in asset divestiture in 2016, and the company’s planned capital expenditure for the year is in the range of $1.3 billion to $1.8 billion. Therefore, investments will be covered through divestment and operating cash flows, and debt can be expected to remain at the same level or decline during the year.
While the company’s capital expenditure is planned above $1 billion, production is likely to remain flat (adjusted for asset sales). But flat production should not be a concern as long as the balance sheet metrics keep improving.
Considering the fact that Chesapeake has hedged more than 590 billion cubic feet of its projected 2016 natural gas production at approximately $2.84 per mcf and more than 19 million barrels of its projected 2016 oil production at approximately $47.79 per barrel, decent cash flows are likely if oil continues to trend higher.
Therefore, the key consideration is whether oil sustains its current rally. If oil retreats to $30 per barrel, that will be cause for concern. Chesapeake Energy has quality assets; if oil were trading around $45 to $50 per barrel, the stock could potentially double from these levels. This does not imply that investors consider a big plunge in the stock. I remain cautiously optimistic.
Investors can still consider some exposure to Chesapeake Energy on correction. Since the stock has surged over 200% within one month, it will not be a surprise if there is a 20% correction from these levels. Investors also need to keep a close watch on global economic activity as it might have a crucial role in determining the direction of oil prices in the next three to six months.
Disclosure: No positions in the stock.
