Chesapeake: When Gas Prices Will Recover

Chesapeake Energy Corp. (CHK), the (former?) darling of the natural gas industry, has had a rough quarter. CEO Aubrey McClendon had to sell his 33 million shares in the company to meet margin calls. Resultant share dumping and declining natural gas prices have sent stocks from around $50 at the end of September to $14.50 at Tuesday’s close.

Executives are emphatic that there is no reason for worry. Cash is at $1 billion and expected to double by year’s end. The company sold assets and continues to market others to raise cash, executives say. Although reporting a share offering to raise liquidity on Thanksgiving eve was ill-timed and disastrous for shares.

Chesapeake has hedged gas prices and maintains that natural gas is America’s future. Peak oil has arrived, says McClendon, and natural gas is mostly produced in North America. So far, Chesapeake has not really made cuts and investors seem worried over whether that business model can be sustained for long in this environment.

What analysts and investors seem to be looking for on Chesapeake’s earnings call is some kind of certainty: That the company will survive, that gas prices will rise, that the market will rebound. Nobody has a crystal ball, but McClendon’s response and technical analysis in the last paragraph below should be of interest to natural gas investors.

From Chesapeake’s Q308 Business Update Call:

Q: I think you guys are definitely at the forefront of doing some really good financial deals. But I think the problem certainly I have is when I look at your cap ex versus your operating cash flow, over the next couple years you have to perpetually sell this amount of assets in order to fund your program or your program has to get cut back. So that’s kind of where I’m at. I don’t understand how you’re going to do this year in and year out when we’re already looking at your asset sales that you’re doing already.

A: Embedded in your question is the presumption that assets can’t be sold. Tens of billions of dollars are sold every year in this industry. I’m surprised that you find it hard to believe that there is not a ready market for the type and quality of assets that we have. We’ll make more money selling leaseholds than we ever will drilling wells. Again as I told you before that by the time this year is over we will have monetized an amount of assets that will exceed $10 billion. If you include the carries with that and have made an 80% profit margin on that, going forward I think absolutely I want the challenge and I want the organization to have the challenge to be able to find $1 billion of assets a year, $1.5 billion of assets a year.

There’s some presumption in your question that we have no capability of throttling back our business. We’ve already cut back $4.7 billion of expected cap ex just in the last month. If gas prices go to $5, if they go $4, if they go to $3, we’ll cut back. We are completely capable of laying [inaudible] and we will do that. We are completely capable of driving down a lease price. We’re completely capable of saying no to a lease.

Every time we lose money on hedges you tend to make money for the next six to eight quarters and then you get a chance to do it all over again. Remember we lose money when there’s a gas price spike so that happened in the first and second quarter of this year. We lost money on hedges. We’re going to make money in the second half of ’08 and in ’09 and probably ’10.

Comments

[stockdoc06:]

The key is the knockout swaps. They got rid of most of them for 2009, but still have lots of knockouts in 2010. A sustained pullback in gas prices to the <$6 level leaves 2010 effectively unhedged. Kind of defeats the purpose of hedging if you leave yourself exposed on the downside.

2008 Dec 10 08:44 AM

[long_on_oil:]

If we as investors in CHK can not believe or trust the management then we need to sell our shares and move on. Personally, I am not a Kool Aid drinker but neither do I fully understand everything McClendon does. I do place a lot of faith and trust in him so I personally will not sell any of my shares.
As an investor you need to ask yourself a couple questions. When is the best time to drill for reserves, when the price is down and drilling rigs are available and cheap or when the price is high and you have to pay out the nose to get one?
If he needs to sell more shares in order to get money to explore, then lets let him. If CHK wants to sell newly discovered reserves in order to find more, then lets do it. We have to place our confidence in McClendon.

2008 Dec 10 08:59 AM

[User 283977:]

I think trusting McClendon is a mistake… In their recent call transcript, McClendon took umbrage with Joe Allman - J.P. Morgan Securities who apparently had, in the past, referred to CHK management as a bunch of "drunken sailors". You know what, on thinking about it, that is close to the perception I have about CHK management… I think McClendon is more like a buccaneer than a CEO. I don't care that he lost all of his own CHK shares by playing the market, but I do care that he acts like a buccaneer as CEO of a company I owned stock in. For example here is how he explained the disaster of that recent stock offering made late in the day before Thanksgiving…

"Another set of questions has arisen surrounding the universal shelf
and other stock pilings we made the day before Thanksgiving. In retrospect these filings were a mistake and we greatly underestimated how the market would react. I apologize for that and ask your forgiveness for it"

The timing of that move provides a sneaky impression. Second, the associated filing said the offering was necessary to increase liquidity. Yet later in the same call transcript, McClendon says they have plenty of liquidity without the universal shelf offering.

McClendon: "Late last week I noticed we had $1.5 billion of cash on hand and we are still managing to have between $2 billion and $2.5 billion of cash by year end"

It sounds like he was surprised that they had plenty of liquidity on hand. However, given the way he tosses numbers around, he is clearly quite familiar with the companies cash position.

So what was that universal shelf offering about? Lets see, he lost all his CHK stock playing the market, now he comes out with a major stock offering when CHK stock is priced low… perhaps gambling that the stock holders are not going to get upset and sell…

Well this is one former CHK stock owner that got upset and sold. I don't think McClendon and his board understand the concept of Company / Share Holders Trust. McClendon appears to be more like an old style oil well drilling wild cat kind of guy. A real entrepreneur used to running his company his way. He sounds like a fun guy, but now he is CEO of a PUBLIC company, and he is playing with other peoples money. Of course, the real problem here is CHKs board of directors that are not exerting sufficient control over a mercurial CEO.

2008 Dec 10 10:55 AM

[Scammr:]

Any CEO that loses 94% of his holdings in the span of 3 days cause he got greedy and bought a ton on margin should be questioned about his ability to manage a significant company. The guy is definitely smart. I'm questioning whether he is an "addict." I don't want to own stock in a company that is run by an "addict."

2008 Dec 10 01:42 PM

[BrotherMaynard:]

Other famous ideologues - Bernie Ebbers, John Mackey, Jeff Skilling...all lived in a perpetual state of denial. The reason why everybody likes them so much is simultaneously why they shouldn't be liked and their stocks should be avoided.

2008 Dec 10 01:45 PM

[Alamo:]

After carefully reading the CHK Conference call for Q3 '08, I came away satisfied that Chesapeake management has a handle on future developments whether or not, natural gas prices rise or fall. Considering that these comments were made in a highly uncertain economic climate Aubrey McClendon's team has hedged major percentages of 2009 and 2010 reserves at attractive prices. (75% in '09, 50% in'10)

Those hedges should be entirely sufficient to carry CHK profitably forward during the economic uncertainty going forward. Bottom line is the uncontrovertible fact that Aubrey McClendon has acquired very valuable undeveloped reserves and negotiated deals with companies that wanted a percentage of access to those properties. With the hefty cost involved in developing gas reserves I think it makes perfectly good business sense in sharing those costs while retaining half (or more) of the production when it does come on line.

The trick is "being firstest with the mostest", and when it comes to American unconventional natural gas reserves Chesapeake is at the top of their game. CHK and McClendon didn't become the top natural gas producer in the US by being stupid.

2008 Dec 10 04:02 PM

[long_on_oil:]

There is a huge difference between being a great CEO and a great investor. That is why McClendon lost his shirt by purchasing his own stock on margin. Warren Buffet is a great investor but even he admits he is short on the CEO side. That is why he buys companies with great management and leaves them alone. I have been enlightened by the posts after my first post today. That is why I love Seeking Alpha, there are more investment smart people on this site than any other I am aware of. Keep up the good posts.

2008 Dec 10 05:00 PM

[In_search_o...:]

Is there a reason they should get rid of the knockout swaps for 2010 this early without a better understanding of what 2010 NG prices are likely to be? If supply and demand come into balance and enough rigs get laid down, then NG prices could be such that they want to keep the knockout swaps. They only got rid of all their 2009 knockout swaps over the last couple months. If they need to do the same for 2010, they have shown that they have both the time and willingness to do so.

On Dec 10 08:44 AM stockdoc06 wrote:

> The key is the knockout swaps. They got rid of most of them for 2009,
> but still have lots of knockouts in 2010. A sustained pullback in
> gas prices to the <$6 level leaves 2010 effectively unhedged. Kind
> of defeats the purpose of hedging if you leave yourself exposed on
> the downside.

2008 Dec 10 11:49 PM

[weiwentg:]

It does sound to me like Aubrey has a handle on his company's financial situation and his hedge book. However, what worries me is that he seems to assume he can sell assets in every environment. He managed recent large sales to BP and Norsk Hydro in a very difficult environment, but that's not a reason to assume he can keep doing that. Remember what Charles Prince said about how Citi was still dancing?

The comment about Aubrey being a buccaneer really did it for me. The guy is hyper-aggressive. I happen to think he has a high chance of making it big. That said, there's downside risk in that if natural gas gets under, say, $4 for an extended period, I can see a situation in which he drives the company into the ground (meaning it needs a highly dilutive capital injection or files bankruptcy). Sub $4 natural gas is a bit of a doomsday scenario, but you can never tell what commodity prices will do.

2008 Dec 11 09:17 AM

[BrotherMaynard:]

Great rationale, weiwentg. this site needs more of this sober analysis. commodities are a completely random variable. all a conservative investor can do is buy a business that can thrive no matter what the price -- Be it $2nat gas or $12 nat gas. CHK used to be able to do that until their capital structure recently became prohibitave. This is, again, where mcclendon's ideologue-mentatlity ("nat gas will never go to $2") has seriously jeoprodized its long-term prospects. Yes they have lots of valuable real-estate...but this is precisely the worst time in history to attempt large-scale, premium-inclusive, monetization of large assets. I'd throw Rio Tinto in this bin, too.


On Dec 11 09:17 AM weiwentg wrote:

> It does sound to me like Aubrey has a handle on his company's financial
> situation and his hedge book. However, what worries me is that he
> seems to assume he can sell assets in every environment. He managed
> recent large sales to BP and Norsk Hydro in a very difficult environment,
> but that's not a reason to assume he can keep doing that. Remember
> what Charles Prince said about how Citi was still dancing?
>
> The comment about Aubrey being a buccaneer really did it for me.
> The guy is hyper-aggressive. I happen to think he has a high chance
> of making it big. That said, there's downside risk in that if natural
> gas gets under, say, $4 for an extended period, I can see a situation
> in which he drives the company into the ground (meaning it needs
> a highly dilutive capital injection or files bankruptcy). Sub $4
> natural gas is a bit of a doomsday scenario, but you can never tell
> what commodity prices will do.

2008 Dec 11 12:08 PM

[Mmarrkk:]

Maynard and weiwentg: explain how CHK gets to the point of liquidation or dilution again? As I see it, if prices continue on down (which I've stated is very hard to justify over an extended period of time due to the fundamentals), CHK has the option to continue to cut back on their drilling/acquisition budget. It truly is that simple; just live within your means and cashflow. Now, if they continue to cut their drilling costs, they will lose some of their undeveloped leases but that can really be managed by savvy landmen using 640-acre units and a single well in each. A huge portion of their acreage is held-by-production (HBP) which means they don't have to drill the wells anytime soon. the other result of cutting capital is that their production increases will be slowed down. So instead of growing production 20-25% per year, they may have to live with 5% per year. Again, not a liquidation scenario.

They have the choice to either spend the money or not. If they want to spend the money in low price environments, they will have to issue stock which will be dilutive. But they DON'T HAVE TO DO THAT. They just stop drilling! Their average cost to maintain current production is below $1/mcf without drilling.

As for the $2 nat gas scenario, at that price level everyone in NA will stop drilling nat gas wells. You will see a rapid decline in supply, the likes of which we haven't seen in many years. Supply will drop well below a depression-like market and prices will rise. Alternatively, LNG will be attracted into the market at higher prices than $2 as the cost to operate the LNG liquifaction, transport and re-gas system is higher than that. For these reasons, prices at $2 won't last long. I believe prices below $4 won't last long. So all Aubrey has to do is be patient and continue to cut back on his drilling budget, accept very low growth (GROWTH none the less) and wait.

As for me, I'd love a $2 nat gas environ. I'd be out scooping up assets left and right at firesale prices!

2008 Dec 12 10:54 AM

[Mmarrkk:]

Forgot to add this: At $2 nat gas, virtually all of the gas produced in the Rockies would be selling for pennies as the basis differentials are huge due to lack of capacity in pipelines. So what would happen if 1/2 the gas in the Rockies were just shut in?? Think that might have an impact on prices??

2008 Dec 12 10:56 AM

[BrotherMaynard:]

"Barclays: US gas needs to go below $4 to balance oversupplied market"

www.platts.com/Natural...

2008 Dec 12 08:50 PM