1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Matthew Indyke and Brian Zen
Matthew Indyke and Brian Zen
Articles (23)  | Author's Website |

Inside Chesapeake’s Outlook: Gas and Liquids

September 25, 2012 | About:

Natural gas is drawing attention as a result of its record low prices and its vast potential as a prime energy source in the United States. The use of natural gas, recently, has especially risen for electricity. Weather conditions are having a significant influence on the demand for electricity. As temperatures drop in the winter, demand increases since electricity is required to keep houses warm. Likewise, demand for electricity increases in the summer as the temperature increase creates the need to sustain a cooler indoor climate. As a result of the warmest summer in history, demand for electricity has been at a high, thereby increasing the consumption of natural gas.

Coal, Oil or Natural Gas?

It should be noted that electric utilities have started shifting production of electricity from coal-fired generators, which are environmentally non-friendly, to natural gas-based generation, which has lower emissions. Coal, along with oil, are two of the most popular energy commodities in this economy that power everyday activities like cooking and driving. But their downfall has always been the high level of CO2 emissions polluting our vulnerable atmosphere.So natural gas, naturally, should be the commodity of choice. But to what degree can natural gas be useful many years down the road? Can it replace and eliminate oil? Can it create a lesser need for coal? Questions like these face companies in the business of exploring, producing, and developing natural gas.

Because natural gas uses are limited, the demand is subdued and prices have been decreasing over the last few years. But due to optimism regarding increased demand for electricity, natural gas prices are starting to rebound, as low prices are sparking an increase in demand for the commodity, pushing natural gas prices back up gradually. Many companies are expected to benefit from the rebound in natural gas prices, including Chesapeake Energy Corp (NYSE:CHK), the second-largest producer of natural gas in the United States behind Exxon-Mobil (NYSE:XOM). Most, if not all, companies in the natural gas business are value stocks with 10 to 20 times earnings, 1 to 2 times book value, and an ROA/ROE in the range of 10-25%.

Why Chesapeake Could Be a Value Play

At a 6.56 P/E and 0.89 P/B ratio, Chesapeake looks cheap with limited downside.

Natural gas prices are expected to rise, which could turn Chesapeake from a cheap stock to one of the industry’s richest companies for the foreseeable future.

The company’s focus is increasing on asset development and less on land acquisitions, positioning it to generate more cash and get the best value out of its resources.

Chesapeake dominant in its industry with no direct competition threatening to take away its profits.

Oil vs. Natural Gas

The performance of the natural gas industry is linked to the price of oil, as oil and gas prices derive the level of activity from the exploration and production process involved in extracting natural gas. Because oil is the primary material for major economic activities, our dependence on oil remains high. Natural gas is nothing more than a work-in-progress when it comes to everyday use. This is especially true in our transportation system, where oil reins king as the fuel for the vehicles we drive. There are several new sources of demand that could be added, such as natural gas vehicles, or gas-to-liquid plants, or pipelines to underserved parts of the country that now use oil for heating. But these large investments don’t make sense unless there is a reasonable likelihood that increased natural gas supply will be available for 20 or more years. With the introduction of hydraulic fracturing and horizontal drilling over the last few years, it has become more economically viable for drillers, including Chesapeake to extract and produce shale gas from tight rock formations. This has led to an increase in the supply of natural gas in the region, thus decreasing the price of natural gas initially.

As oil prices rise, though, demand for natural gas will increase since natural gas is a cheaper commodity. That is, if natural gas ever finds a home in energy sources besides electricity. The more uses we find for natural gas, the more its demand will go up, increasing the price. “In terms of the operating environment for Chesapeake, it’s very good right now with the rebound in natural gas prices,” says Scott Carmack, a money manager at Leader Capital Corp. in Portland, Oregon. The determining factor for Chesapeake will be how well it manages the price increases as natural gas develops into a more viable alternative to oil.

More Assets, Less Land

As the best investors will tell you, the best companies to invest in are ones who generate lots of cash that create high returns and the worst companies to put your money in are those whose bottom line is acquiring more companies for the sake of owing more. Chesapeake’s goal is to accumulate revenue-generating assets that help its business operations, not buying excess land for the sake of owning more territory. Chesapeake, in an effort to generate more cash, is focusing more on asset development and less on land acquisitions, something that will sit well with value investors. “The progress on selling assets is making investors more comfortable”, according to Peter Speer, a New York-based analyst at Moody’s.

Chesapeake has pledged to reduce capital expenditures by $6 billion in 2013 andsell up to $14 billion in assets by the end of this year in order to meet its debt obligations. Furthermore, the company is selling off oil and gas assets and increasing its focus on natural gas. The company recently agreed to sell its pipeline interest in Chesapeake Midstream Partners LP to Global Infrastructure Partners and said it would sell some of its Permian Basin oilfield assets in Texas and New Mexico for an undisclosed price. “The demand for oily plays such as the Permian is impacted by oil prices,” said Michael McMahon, managing director of the energy investment team at Pine Brook, a New York-based private- equity firm. “As long as oil is in the mid $80s or higher, there’s still a good profit to be made. There are additional plans in the works to reduce its reliance on natural gas while increasing natural-gas liquid and oil production, as these are much more stable fuels which should ultimately benefit Chesapeake's bottom line. “The company has assets in attractive places for producing natural-gas liquids”, says Travis Hoium of the Motley Fool. Chesapeake, with its revised business structure, is putting itself in a better long-term financial position.

Asset Ownership Limiting Competitions

Industry leaders are difficult to compete against when it comes to natural gas production, which decreases business and investor risks. Chesapeake is regarded as an unquestioned leader in the industry of natural gas production and development thanks to its valuable foundation of assets. The market for natural gas is quickly expanding, which lowers the threat of direct competition and increases Chesapeake Energy's profits.

Chesapeake is one of the very few energy stocks that outperformed the United States Natural Gas Fund (UNG) in the last year. The company has vertically integrated its business and owns substantial midstream, compression, and oilfield services assets. Chesapeake Energy is dedicated to location and acquisition of rights to underground reservoirs or crude and natural gas throughout the US. In 2006, they showed a 9.0 trillion cubic foot reserve. In addition, they boast interest in 34,600 producing wells across the country. Some analysts put Chesapeake's underground reserves at an estimated value of $26 billion. After a land grab of such assets over the last few years, Chesapeake is in an attractive position for producing natural-gas liquids. The company's production of liquids was up 65% in the second quarter and now represents 21% of production.

Due to depressed natural gas prices and excess supply of the commodity, producers, including Chesapeake, are shifting their exploration and drilling toward areas with oil-and-liquid reserves, which offer higher margins than natural gas production. More than 50% of the revenue for the company in 2012 is expected to be generated through the production of oil and liquids. This increased contribution in revenue is not only due to the increased production of oil and liquids but also due to the severe drop in natural gas prices.

McClendongate at Chesapeake

There are, however, existing red flags in Chesapeake that could keep investors away, particularly the conduct of the reportedly greedy CEO Aubrey McClendon, who co-founded Chesapeake in 1989. Chesapeake has been operating under a cloud of legal and governance issues following investigations showing potential conflicts of interest on the part of McClendon as well as the collusion allegations. McClendon was replaced by Archie Dunham, previously Chariman of oil and gas giant ConocoPhillips (NYSE:COP), as the head of the company’s board in June while the U.S. Internal Revenue Service and the Securities & Exchange Commission began investigations on his financial transactions. More than half the board was replaced by Dunham upon stepping into his new role.

The company has been at the center of lawsuits from shareholders since April after it was revealed that McClendon enjoyed perks, and certain business strategies were pursued to his own benefit at the detriment of the company. The CEO often used the company as his personal piggy bank. Doubts over CEO’s fiduciary gene and the dramatic decline in natural-gas prices left Chesapeake investors with the daunting task of deciding whether Chesapeake's assets are worth more than the current market price. McClendon, for instance, used stakes in company wells to secure more than $800 million of personal loans fueled calls for better corporate governance.

Chesapeake Energy is also the subject of a U.S. government investigation over possible criminal antitrust violations related to the purchase and lease of oil and gas properties in Michigan. In June, Reuters reported that Chesapeake plotted with one of its competitors, Canada's Encana Corp (NYSE:ECA), to suppress land prices. Emails between Chesapeake and Encana showed the two companies repeatedly discussed how to avoid bidding against each other in a public land auction in Michigan two years ago. Price-fixing, bid-rigging and market allocations by competitors are illegal in the United States under the Sherman Antitrust Act, and companies can be fined up to $100 million for each offense.

Outlook for Natural Gas and Chesapeake

Chesapeake is not an easy company to analyze. If not for CEO Aubrey McClendon, we wouldn't be scratching our heads over Chesapeake. However, a positive outlook is being maintained on Chesapeake. The rig count for gas projects has decreased, while the rig count for oil projects increased in the first half of 2012. This trend of high growth in rigs for oil projects and declining rig count for gas projects is expected to continue in the second half of 2012, and throughout 2013. These factors should contribute to a rebound in natural gas prices, due to increased demand and decreased supply of natural gas. The price of natural gas, more than anything else, will determine Chesapeake's recovery and how much it will prosper in the long-term future.

Disclosure: One of the authors own shares in CHK.

About the author:

Matthew Indyke and Brian Zen
SUPERINVESTOR.net is an investment research co-op for next-generation super investors, analysts, and advisors.

Visit Matthew Indyke and Brian Zen's Website

Rating: 3.6/5 (9 votes)


Please leave your comment:

Performances of the stocks mentioned by Matthew Indyke and Brian Zen

User Generated Screeners

soho_analogusd project2018
pbarker46Total Payout Yield
DBrizanrota16Jan2018 1143p
DBrizanrota16Jan2018 1118p
DBrizanrota16Jan2018 1114p
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat