We previously analyzed and evaluated how Chesapeake Energy (CHK) has gone from being a shooting star of the energy business to requiring significant asset sales in order to shore up its balance sheet. We were also amazed at how Aubrey McClendon has gone from being the wiz kid of the energy business to being an embattled CEO who had to give up his Executive Chairmanship. We're hoping that the recent bad patch for Chesapeake has humbled Aubrey enough so he won't be trying to win the title of the world's most reckless billionaire of all time. Chesapeake Energy was facing enough headwinds with the decline in natural gas prices and needs its CEO to get his head in together, rather than acting like an overgrown man-child. At least its asset sales helped to contribute net income and cash flows to offset declining operating income and increased CapEx. Now that natural gas prices have bounced off the sub $2/MCF levels achieved in April 2012, we believe that will give Chesapeake a chance to catch its breath and help it stabilize its revenues excluding the impact of volatile derivative gains and losses.
CHK Natural Gas: Despite its efforts to shift its production from natural gas to oil, Chesapeake is still dependent on natural gas production with regards to its total production. The good news is that CHK increased its natural gas production by 48BCF (18.9%) in Q3 2012 versus prior year levels. Another bit of good news is that natural gas production increased by 10% on a linked quarter basis and natural gas now only accounts for 39% of its Q3 2012 revenue, down from 40% in Q2 2012, 48% in Q1 2012 and 72% in Q2 2011. The bad news is that this shift was due primarily to the decline in natural gas prices year-over-year.
Because hydraulic fracturing has changed the paradigm for natural gas production, supply and even demand, we don't expect natural gas prices to snap back immediately to the $5/MCF levels CHK enjoyed last year in Q2 2012, let alone the $10.79/MCF peak in July 2008. We were surprised that CHK's average natural gas revenue/MCF is still under $2 considering that natural gas prices have increased from less than $2/MCF in April to $3.80/MCF as of November 16th. While the number of natural gas rigs has declined by 51% year-over-year according to Baker Hughes, the amount of natural gas in underground storage in the Lower 48 states has increased by 0.6% according to the EIA on a year-over-year basis and by 4.5% versus the 2007-2011 5 year average.
CHK Oil: We were happy to see that CHK was able to increase its oil production by 96% in Q3 2012 versus prior year levels. We thought it was impressive that CHK had increased its oil production in Q2 2012 by 22% on a linked quarter basis and we were even more impressed that CHK increased by 23% in Q3 2012 versus Q2 2012 levels. CHK's oil revenues declined by 21.5% as revenue increased from oil sales were offset by sharply reduced derivatives gains in Q3 2012 versus the prior year period. Despite the increased oil production by Chesapeake and other oil and gas companies, Chesapeake was able to enjoy a slight boost in the price per barrel for oil in Q3 2012 ($88.07) versus Q3 2011 levels ($84.18). CHK's strength in its oil production operations helped ensure that at least the company would see a slight increase in its Q3 2012 oil, gas and liquids revenues of 1.5% versus Q3 2011 levels if we exclude the impact of volatile derivative gains and losses. Because of the intractably high price of crude oil in the energy markets, CHK's crude oil and natural gas liquids now collectively account for 61% of CHK's revenue and 63% of its unhedged revenue. CHK would have eked out $121M in operating income for Q3 2012 had it not suffered a $3.3B fixed asset impairment in the quarter.
CHK Financial Summary: While CHK may look like a bargain because its stock price is 90% of its book value, we believe that investors can't overlook the headwinds facing the company. In the third quarter of 2012, it generated a $2B loss thanks to a $3.3B pre-tax asset impairment charge. CHK's adjusted operating income excluding derivatives gains and impairment charges in Q3 2012 was $148M versus $508M in Q3 2011. We previously thought that CHK's outlook on natural gas for 2013 was excessively optimistic. CHK estimated natural gas would reach $3.75/MCF. Despite the fact that monthly natural gas production has shown 30 straight months of year-over-year increases in natural gas production and despite monthly natural gas production increasing on a year-over-year basis in 68 out of the last 74 months as measured by the EIA, natural gas prices have almost doubled from the sub $2/MCF prices realized in April 2012. We also think that oil and gas prices are pretty high when we consider that the US is in an economic slowdown, Europe is in a sclerotic death spiral, emerging markets are seeing growth decelerate, hydro-fracking has changed the natural gas production paradigm and even oilman T. Boone Pickens has been vocal against proposals to export natural gas. Also, we are concerned that CHK is only expecting to generate a maximum cash surplus of $0-$750M in 2013 even with reduced CapEx ($13B in 2012 versus $7B in 2013) and $4.5-$5B of asset sales.
NOTEABLE HOLDERS OF CHESAPEAKE
Equity Holders: Dan Loeb of Third Point Capital opened a new $5M convertible bond position in CHK during Q2 2012. Third Point has $5M in CHK's 2.25%, 12/1/38 Convertible bond issue. Southeastern Asset Management is CHK's largest shareholder with 89.7 M shares of Aubrey's Baby, including 27.4M in its flagship Longleaf Partners mutual fund. Carl Icahn is the second largest stakeholder with 50.1M shares. Other notable equity holders include Brandes Investment Partners (13.5M shares), the Hartford Capital Appreciation Fund (5.8M shares) and Mohnish Pabrai (3M shares).
Debt Holders: The Four Star Bronze Rated Franklin Income Series Fund has $780M worth of CHK's debt and is CHK's largest individual lender. Franklin Income Series has $642M in Long-Term debt (5 years or more) and $138M in Short-Term debt (Less than 5 Years). Other notable lenders include the Four Star Bronze Rated PIMCO High Yield Fund ($105M), the Four Star Gold Rated Fidelity High Income Fund and the Four Star Rated Franklin High Income Fund.
In conclusion, we are warming up to taking a position in CHK, especially since it has declined by over 15% since we initiated coverage on it. We remain cautious because although CHK is expected to reduce its 2013 capital expenditure levels by nearly $6B versus 2012 estimated CapEx levels - the company is only expecting to generate a maximum cash surplus of $0-$750M in 2013. Furthermore, this surplus is due primarily to asset sales and other transactions rather than free cash flows from business operations. For those interested in getting exposure to Chesapeake and its affiliated companies, we would suggest investors consider one of Chesapeake's oil royalty trust spin-offs. Our firm published a report in May about Chesapeake Granite Washington Trust (CHKR). As of right now, we still like CHKR better than CHK because we don't have to worry about if the company can generate sufficient cash flows from asset sales plus we are enjoying an ample, annualized per share dividend of $2.52, which represents 13.25% based on the November 23rd market price of $19.01.
Source: Morningstar Direct
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the article’s recommendation. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.