The Numbers Are Finally Catching Up With Chesapeake Energy

| About: Chesapeake Energy (CHK)

Chesapeake Energy Corp. (NYSE:CHK) is a large US oil and gas acquisition, exploration, development and production company. It started as primarily a natural gas E & P company. It bet heavily on the natural gas industry. When the bottom fell out of the natural gas market, a seriously in debt CHK had to change its strategy to emphasize oil development. Aubrey McClendon et al came up with the strategy of buying huge leaseholdings in new unconventional oil fields early. CHK would then do a small amount of development to prove the new field was an economic success. Then CHK would sell a part of its interest in the field to pay for the entire cost of all of CHK's leases on the field plus some development costs. This strategy has been a great success, and it is probably the only thing that kept CHK out of bankruptcy when natural gas prices fell to historical lows (less than $2 per MMBtu) in Q2 2012. Even so, CHK needed emergency loans to see it through that time.

As part of this strategy CHK was the discoverer of the Haynesville, Utica, Powder River Niobrara, Tonkawa, and Mississippi Lime. It was one of the early developers in many more fields. This has made the CHK strategy work. It has allowed CHK to retain 15.1 million net acres of leaseholdings, while still selling or agreeing to sell approximately $12B in leaseholdings in FY2012 (and many more billions in the preceding years). Some have tried to say that CHK has been failing by selling off parts or all of its holdings in great fields. However, the opposite is true.

At the end of 2012, CHK claimed it had $4B in liquidity. Soon those $12B in 2012 deals will be completed. Plus CHK plans to sell another $5B-$7B in 2013. CHK asserts that these last sales should finally put it below $9.5B in debt by the end of 2013. At that point CHK will likely have more than $5B per year in operating cash flow. That sounds like a company that deserves an investment grade bond rating. Such a rating will be a huge acknowledgement of success for CHK. CHK should achieve that milestone by the end of 2013 (or shortly after it reports year end results for FY2013).

CHK is in the final stages of a dramatic move from a major natural gas producer to a major oil producer (and a much better credit risk). If you are a CPA the numbers for this move add up. CHK has 15.1 million net acres of lease holdings. It has 21.3 Tcfe of proved reserves (or about 3.67 billion Boe). It has 4.1 bcfe/d of production (or 706,897 boepd). FY2012 liquids production was up approximately 52% vs. FY2011 results. Oil production was up approximately 80% and NGLs production was up about 19%. For FY2013, CHK forecasts production to increase by at least 25% (21% for oil and 43% for NGLs). CHK is actually targeting a 29% increase in liquids production for FY2013. CHK's oil production alone was approximately 98,000 Bopd in Q3 2012. In Q3 2012 CHK produced an average of approximately 143,000 bpd in liquids alone. If you propose another +10% sequential growth in Q4 2013, you get to production of approximately 157,000 bpd in liquids. I note that sales of leaseholdings could negatively affect this number. Still from that figure it is a virtual certainty that CHK will best its proposed average figure of 170,000 bpd of liquids production in FY2013. In fact CHK's proposed 29% growth in FY2013 liquids production yields an average production figure of 180,000 bpd in liquids for the full year (using the 157,000 bpd of liquids figure as a starting point). CHK is quickly becoming a force to be reckoned with in US liquids production. On top of that production from the Utica and the Niobrara should ramp up much more quickly in 2013 as more midstream resources come online.

For FY2012 liquids are expected to be about 20% of total production and about 57% of total revenues. In FY2013 liquids are expected to be more than 25% of total production and about 55% of total revenues. Keep in mind that natural gas prices are expected to be higher in 2013. This is the behavior of a top company. In fact the charts bear this out. CHK has been the top percentage US liquids production grower over the last three years (Q3 2010 - Q3 2012) and the second fastest grower over the same period in absolute terms. The following chart shows how it compares to its peers.

The above should not really be surprising for a company that can brag that it has the #1 or #2 position in 10 of its leading plays. CHK is still second only to Exxon Mobil (NYSE:XOM) in natural gas production and reserves in the US. However, in the last few years it has grown from almost no oil production to the 11th largest oil producer in the US, and that position is only likely to get stronger in the near future. CHK has gone from using 110 rigs for natural gas development as of January 1, 2010, to using 9 rigs as of December 21, 2012. CHK has gone from using 15 rigs for oil/liquids development on January 1, 2010, to using 85 rigs on December 21, 2012. CHK is emphasizing oil/liquids development, and the production numbers are showing it.

Not only has CHK upped its oil production, but natural gas prices have risen, and they may go higher. This winter has been a normal to moderately colder winter. Electricity generation is using more natural gas. Public transit systems are converting from diesel to "cleaner and cheaper" natural gas, etc. The surplus in natural gas of 2012, mostly due to the warmer than normal winter that year, has already been reduced to 348 bcf above the 5 year average from 900 bcf (as of February 14, 2013). CHK believes the remaining surplus will soon disappear, and a deficit situation will instead start to present itself. This should be a boon for natural gas prices (see chart below).

Natural gas prices have already risen significantly from their nadir in Q2 2012, but they may have farther to rise. Such an eventuality would be a huge boon to CHK. CHK states that every $0.10 in higher natural gas prices will mean $100 million in added EBITDA. This says that earnings in Q4 2012 should be considerably higher than in Q3 2012 due to higher natural gas prices and to increased oil and NGLs production. In fact, if the EIA's latest predictions for residential use prices of natural gas are to be believed, natural gas prices should continue to rise throughout 1H of 2012 (see chart below).

In sum CHK's production growth is among the best. Its US leaseholdings, even after its large sales, are still huge. It trades at a price/book ratio of only 1.07. When you consider that its book value is grossly underestimated, you really begin to see what a bargain CHK is. I saw a Motley Fool article recently that estimated Hess (NYSE:HES) was worth far more as a broken up company. In other words the Motley Fool was proposing spinoffs and/or sell offs in order to harvest value. The same could be said of CHK, The difference is that CHK has been making huge strides in harvesting its own value by producing more oil. Once the industry recognizes this (and sees that there are no huge debt problems), CHK's stock will be off to the races. The stock price could easily double within two years. This would be a very nice profit.

The two year chart of CHK provides some technical direction for this trade.

The slow stochastic sub chart shows that CHK is neither overbought nor oversold. The main chart indicates that CHK has bottomed recently. CHK now appears to be in the initial stages of a new uptrend. The fundamentals back up this uptrend. The FPE of 17.02 seems low if anything for a company that is expected by analysts to grow EPS by 152.10% in 2013. The guidance from CHK when it reports on Thursday February 21, 2013, almost has to be good. There should be no new huge losses due to a lower 12-month rolling average natural gas price. It could be slightly lower (I haven't checked exactly), but it will be vary slightly. Plus higher natural gas prices will start to replace lower ones in the twelve month rolling average in Q1-Q3 2013 (and possibly Q4). This might cause write ups. CHK will soon be rid of the very low hedges it bought in panic for Q4 2012. It should be able to realize significantly higher prices for natural gas in Q1 and beyond. In other words the guidance should be good.

When a highly traded stock with a short interest of 13.50% of the float gets good news on earnings, the HFT/momentum traders normally cause a short squeeze. I would look for a nice pop on earnings, if only on the improved guidance.

Longer term CHK is a stock most investors will want to own. It is a value play that has attracted such market savants as billionaires Carl Icahn and Mason Hawkins. They will tend to ensure that CHK does harvest value for shareholders. CHK pays a good dividend of 1.7%. This has an excellent chance of being raised in 2013 or early 2014 as CHK pays down significantly on its debt (and its oil production expands significantly). Everything is a risk, but CHK is one of the better ones. For longer term investors, averaging in around a possible overall market downturn and a possible recession in 2013 is a good idea. Still it would appear you don't want to wait too long to buy this stock.

NOTE: Some of the fundamental financial information is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.