With Chesapeake Energy's (CHK) shaky 2012, it's time to take a deep look at the oil and gas company, a look at the company's strengths, weaknesses, opportunities and threats. After digging through these, I believe there is still inherent value in the company.
Strengths & Opportunities
Growth. Since 3Q 2010 through 3Q 2012, Chesapeake has grown its production by 93,000 boe/d (190%). These growth rates put the company as one of the top 2 growth stories in the U.S. during that time period. CHK has the assets and experience to continue this growth. Also, as of end of 3Q 2012, CHK has already surpassed its stated goal of 135,000 bpd of liquids by averaging 143,000 bpd during the 3rd quarter.
CapEx. Chesapeake projects CapEx reduction of 35% going forward, but that doesn't translate to reduced production growth. Instead, the reduction points towards a focus on oil (liquids) well development and a limited number of gas wells. Also, drilling improvements and technologies such as pad drilling (multiple wells, one pad) will allow it to operate more efficiently. CapEx is expected to be mostly, if not completely, funded by operating cash flow.
Liquids focus. Chesapeake, as a percentage of total production, has grown its liquids (oil and natural gas liquids) production from 8% in 2008 to a projected 25% in 2013. Also, liquids currently make up over 50% of its realized revenue.
The market. Activist investors, Carl Icahn and Mason Hawkins, have grown positions in the company, 8.9% and 13.5%, respectively, and now control a substantial portion of Chesapeake's Board of Directors. These two investors have a tremendous track record of creating value. Additions - Along with several new Board members, Chesapeake added Archie Dunham, former Chairman of ConocoPhillips (COP). He is a valuable addition with great experience to lead the search for a new CEO upon McClendon's retirement in April 2013 and help guide the company thereafter.
Weaknesses & Threats
Natural gas. Natural gas still represents 75-80% of CHK's production. While there is tremendous upside should there be any increase in natural gas prices, natural gas is still heavy in supply and a warmer than expected winter ('12-'13) has not helped demand. There are lots of conversations and some legislation around developing more use for natural gas in transportation and other manufacturing methods (cleaner energy), but this is still an uncertainty and would require government subsidies to get them off the ground.
Debt. Chesapeake has a stated goal of reducing its total debt to $9.5B (currently $16.5B) by the end of 2013. This is expected to be accomplished by continuing its asset divestiture program, but it will take tremendous efforts to reach this goal.
Asset write-downs. Due to SEC reserves being based upon rolling 12 month averages, we expect to see some reductions in reserves due to certain resources being uneconomic at recent prices. As long as the natural gas market maintains current pricing, these reserves will be back on the books by end of FY13.
Structure. While Chesapeake appears to be a solid value play for a potential supermajor to swoop in and acquire the company, Chesapeake has a highly complex legal and operating structure with seven joint ventures, 10 volumetric production payments to fulfill, $3B in preferred equity, and $2.4B in non-controlling assets. There is a lot for the new board and future CEO to clean up.
The Board has made some quick and critical improvements to the structure in which management's new compensation structure (no more Founder's Well Participation Program!) is based upon return on capital, efficiency gains, and hitting budgets (as opposed to a strictly growth oriented plan). Giving management the proper direction and finding a new CEO will be great catalysts for the continued turnaround and growth.
Chesapeake has executed on the milestones and initiatives set forth by management over the last couple years. It has aggressively reduced debt through asset divestitures and has shifted its production focus from natural gas to liquids (8% in 2008 to 25% in 2012/13). This builds credibility and proves this company has the ability to continue the transition and growth.
The company appears to be trading at a discount to Net Asset Value and Equity Book Value due to the tumultuous natural gas market and the recent issues with management and corporate governance. The transition from gas to liquids, reduction of debt, and a stabilizing natural gas market will help close that gap in the near future.
The natural gas market has a bullish outlook as potential for demand outside of home energy use, has the potential to make a big impact on Chesapeake's bottom line. The company has stated that a $0.10/Mcf increase in NYMEX natural gas prices would increase its EBITDA by ~$100 million and shareholder value by ~$1.00 per fully diluted share.
Recommendation. Chesapeake appears to be a buy. The natural gas market is stable with a bullish outlook (still 75-80% of its production), its transition to liquids has been quick and effective (currently over 50% of realized revenue), the new leadership (Board + new CEO) will be able to realize the value of its tremendous asset base, and its production growth story since 3Q10 (+93,000 boe/d) is a clear sign that this company knows how to get oil and gas out of the assets it has. Recent positions taken by the activist shareholders Icahn and Hawkins are a good lead to follow as Chesapeake's story unfolds over the next two years.