Chesapeake Energy: Back from the Dead

To say that it has been a rough third quarter for Chesapeake Energy Corp. (CHK) would be the understatement of the year. Shares of the largest natural gas company in the United States have fallen from an intra-day peak of $74.00 all the way down to a measly $9.84. Rumors, all of which ended up being false, had speculators predicting that the natural gas giant would default. Credit default swap spreads on Chesapeake that default in a one year period have risen to a high of 1200 basis points in September (essentially giving a 12% chance to Chesapeake’s ultimate defaulting). Fear caused the stock price to plummet, but that is exactly what CEO Aubrey McClendon has erased with his most recent press conference that was held on Monday, December 8th.

Last Monday, Aubrey McClendon and the rest of Chesapeake’s board held a press conference to calm investors and the markets alike and to give full transparency. You would think that the finances of an energy company would be relatively simple, compared to many of the new complex financial instruments that we have seen used in the financial world. However, Chesapeake managed to get wrapped up in the disaster that is currently unfolding. Their fall from the top was fueled by liquidity problems, the same problems that plagued many of the financial firms that no longer exist. Luckily for shareholders, Aubrey and the rest of the world took drastic and fast action to make sure that long-term shareholder value would be preserved.

The root of the problem was in Chesapeake’s capital expenditure program. Aubrey McClendon saw the massive upside in his leases as natural gas rose from $7 per Mcfe (1000 cubic feet equivalent) all the way to $13.60 per Mcfe and decided to leverage the company in order to begin production from as many wells as possible as soon as possible. This strategy would have worked to perfection if we were not headed into one of the two worst financial crises in the history of the United States, but unfortunately that is the case.

Natural gas prices falling to around $5.5 per Mcfe destroyed the short-term high hopes of Aubrey and almost caused irrecoverable damage to the company. Chesapeake was planning on financing capital expenditures at levels that would be beyond their free cash flow. This type of financing employs a degree of leverage that can only be sustainable for short periods of time, and under particularly favorable circumstances. Before this financial crisis started, Chesapeake would have had the ability to do this… but when lending came to a halt Chesapeake was forced to scale back their drilling expansion. This, in turn, led to much lower near term earnings as their production growth is now going to be much less than previously estimated. Now, instead of growing earnings at rates of 10-20% in 2009 and 15-25% in 2010, Chesapeake’s earnings will be growing at rates closer to 5-10% in 2009 and 10-15% in 2010.

The good news is that now Chesapeake has become financially stable through a number of transactions as well as cuts in their capital expenditure program. Highlighting some of the key points from the conference call, you can see how much more stable the company is than it was even a few short months ago.

• Chesapeake currently has $1.5B in cash, and they will have between $2B and $2.5B in cash by year end
• Cash balance will be built to ~$4B by the end of 2010 through monetizing assets
• Chesapeake’s new capital expenditures program is free cash flow neutral to positive, in other words they will not be employing heavy amounts of leverage to grow organically
• Over the last 5 months Chesapeake was able to sell $12B in assets for a $9B gain
• In order to stabilize future cash flows, Chesapeake was able to hedge 76% of production at $8.20 in 2009 and 50% of production at $9.50 in 2010. These prices are substantially above the current NYMEX natural gas price of $5.83
• Chesapeake will be adding 2.5 TCFE of reserves to their balance sheet in 2009, more than any other publicly traded company in the world, at a cost of only $1.20 per Mcfe
• Aubrey McClendon has estimated assets valued at $25B-$30B in proved reserves, at least $25B-$30B in undeveloped leaseholds, and another $5B in non-core assets
• Chesapeake was trading at a ridiculous 1.4x cash flow (not free cash flow, just cash flow) at the time of the call

As you can see, these points above are evidence of a company that seems to no longer have a liquidity issue. The other great news is that Chesapeake is heavily hedged through the next two years and low short-term commodity prices will not be a problem. As long as commodity prices make a rebound before 2011, Chesapeake should have no long term problem. Aubrey McClendon also mentioned that Chesapeake is going to operate under the assumption of $50.00 average crude oil and $5.00 average natural gas spot prices for 2009. He also mentioned that the company could even operate at natural gas prices as low as $4.00 per Mcfe. While this is extremely unlikely, it goes to show how far management has gone to make sure that the company stays very liquid even during the worst of times. Chesapeake has estimated that the breakeven price for North American natural gas production is somewhere right below the $6.00 level, so any sustained move by natural gas below these levels will eventually cause some firms to begin to operate at a loss and will over time shut in production. This, over the long run, would be extremely bullish for natural gas spot prices.

Obviously the ride down has not been too enjoyable, but if you are in for the long haul this could be a great entry point for Chesapeake. The risks to the company are now much more transparent and priced into the common stock, so the only large variable that remains is the extent of the upside. Even I was fooled, as you can see from an article I wrote all the way back in July posted here. This type of optimism could surround the company in the future, but in the current global economic crisis this seems unlikely for at minimum the next 12 months. That being said, a complete financial disaster would be horrible for the company, but it would be horrible for more than just Chesapeake.

- Charles W. Petredis

Disclosure: The mutual fund the author manages, the author’s family, and the author are all long CHK.

Comments

[User 283977:]

One of the key issues with CHK is McClendon. McClendon is a gambler. He lost all of his CHK holdings on a single play, a decisive action. Another decisive action was the companies surprise universal shelf offering made late in the day before Thanksgiving, which resulted in a substantial sell off by many CHK stock holders who were concerned with the effects of such an offering on the stocks valuation. McClendon said they misread the negative effects such an offering would have on the market.

McClendon misread the odds on a gamble he made with other peoples money. McClendon is kind of like a buccaneer. He is the kind of guy that can make you very rich or totally destitute on a single throw of the dice.

So irrespective of those numbers, there is the McClendon factor to consider. I like the way this guy thinks. But at the same time, he seems to all too frequently shoot himself in the foot.

I would like to hear more of what McClendon thinks about CHKs position against various possible scenarios that could occur in 2009.

2008 Dec 17 03:50 PM

[Jonathan Swift:]

This commentary reads like almost hysterical "wishing upon a star." One gets the impression that it is desperate self-serving promotion, especially from the author's "Disclosure: The mutual fund the author manages, the author’s family, and the author are all long CHK." I can imagine the embarrassment the author faces at family gatherings having talked his family into a major losing financial proposition.

2008 Dec 17 03:57 PM

[wobatus:]

Lunn's comments I have read almost verbatim in response to another note, and only make the point that Aubrey is aggreesive (although here the market has forced him to conserve), and swift's comments do not address the actual arguments made. CHK is obviously well-positioned to ride this out and ultimately prosper. Sure, if natty goes to $4 or below and stays there, chk has issues.

Oh, disclosure: Long CHK. Hey swifty, where's your disclosure? :)

2008 Dec 17 05:14 PM

[BadCompany:]

If you have access to a 20 year chart for CHK, you'll notice the same pump and dump took place in the late 90s.

2008 Dec 17 06:01 PM

[Jonathan Swift:]

Wobatis:

In answer to your question about my disclosure, I'm embarrassed to say that I also have been long CHK... maybe longer than you and Petredis, but I'm finding it more difficult to believe in Aubrey McLendon's leadership as these CHK missteps are increasingly disclosed. I tend to agree with Lunn's observations above.

2008 Dec 17 06:24 PM

[maz:]

BadCompany,

Your comment makes absolutely no sense whatsoever - in a pump & dump scheme the CEO would surely have benefited from selling a vast number of shares in the $60 & $70 range. Instead he sold none & eventually had 95% of his shares taken in a margin call.

Also anyone that invests in energy could tell you that what you are looking at in the charts is another period with very low short term O&G prices.

The share price will follow short term NG prices just as every other natty out there. The value of the assets is not determined by short term prices.

2008 Dec 17 07:04 PM

[JWD:]

Aubrey just personally paid $1.6 billion to gain some experience. Given that price I imagine he has learned something.

2008 Dec 17 07:27 PM

[bfras921:]

Credit default swap spreads on Chesapeake that default in a one year period have risen to a high of 1200 basis points in September (essentially giving a 12% chance to Chesapeake’s ultimate defaulting).

how do you conclude that

you have no clue... imho

2008 Dec 17 08:35 PM

[bfras921:]

CHK is well positioned for the future.

1. No debt is due for 5 years.
2. Chk has had no problem finding JV partners, the most recent deal was 3.4 billion for 32 % of the marcelus, sold 20 % of hanynes ville for 3.2 b
3. CHK cap ex will not exceed cash flow.
4. CHK is the most heavily hedge E&P company out there
5. will generate 2 b in cash flow next 2 years, annually
6. once year end tax selling is finished , chk will sprint to 25 , imho
7. with every ep laying down rigs, there will be a shortfasll in ng in 9 months and prices will soar to 10 or more

2008 Dec 17 08:42 PM

[scfranklin94:]

Nat gas is probably going into the low $5s or mid $4/MMBtu territory in Q1. Too much production is coming online and demand is down. It will probably recover to $6 by next winter as low new production doesn't offset the decline curve in existing wells. So I would wait to buy CHK until Feb-Apr; wait for media stories of "NG at five year lows", etc.

2008 Dec 18 11:20 AM

[scfranklin94:]

No way NG 'sprints' to $10 next winter; these shale plays are too prolific. I can see gas drifting up to $7 or $8 over the next few years, but every time it does, shale production will be ramped up and prices will retreat.

2008 Dec 18 11:25 AM

[BrotherMaynard:]

that would be great if someone elaborated on their debt covenants and when/if they can be triggered at lower ebitda/debt ratios and figure out what nat gas prices would be consistent with those ratios. If you can't do that, don't touch this stock.

No positions

2008 Dec 18 12:21 PM

[applesauce:]

The hedging was brilliant, I would not be suprised that Nat gas as part of Obamas plan will rise above $ 12 in 2010 and ChK may combine with COP or another major.

2008 Dec 18 01:37 PM

[marmaton2:]

The conventional high pressure plays are depleting and most of the large Independants have been distracted by these unconventional dry gas plays which are good and plenty, but not near the quality volumes produced innitially as say a deep Anadarko or Unita resevoirs, i.p's.of 20+Mcfd which produce many Bcf of rich gas quick. True Chesapeake sells a Bcf every other day in north Texas, it just isn't the same gas, a gas which carries all that other 'good' stuff. So we are replacing apples with oranges. $5 is alot for straight dry methane! Where the sleeper lies is with all that acreage tied up with marginal production in say Northern Oklahoma, and Texas. When anything happens anywhere, oil will go up, possibly high. He holds many a 640 tract with a stripper well. That is Mc Clendon's true ace.

Feb 16 08:10 AM