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, Financial) 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, Financial) 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.
II) Business and History
As per the company website:
“Chesapeake Energy Corporation (CHK, Financial) 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.”‹”.
III) Operations and Competitive Advantages
Information from the company website about operations is as follows:
“Chesapeake Energy Corp (CHK, Financial) 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:
Competitive Advantages:Chesapeake Energy (CHK, Financial) 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, Financial)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:
V) Management
Robert Douglas (Doug) Lawleris currently president and chief executive officer ofChesapeake Energy (CHK, Financial).
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.
[b]
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.
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:
US Energy Information Administration
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.
