Chesapeake is a Natural Pick in Natural Gas

I really like Chesapeake Energy Corp (CHK), the producer of natural gas, the heating fuel used by most folks in the US and for many electric power plants. Chesapeake is a newer player in the commodities industry. It went public in 1993, then almost sank in 1997-8. But its leaders, CEO Aubrey McClendon and COO Tom Ward (now retired) saved the ship, rerouting its path and turning it into the largest natural gas producer in the US.

Most of its drilling is concentrated in areas in Arkansas, Texas, Oklahoma and Kansas, allowing it great economies of scale. Chesapeake has also been aggressively acquiring new companies in the area (a massive $8 billion worth since 2002), causing its output to rise at an average pace of 37% in the last 3 years.

In 2005, it bought Columbia Natural Resources, a $2.2 billion reserve outside of its usual map: an area from New York to Ohio to Kentucky and West VA. A massive purchase like this relies on natural gas prices to remain high to pay off. I feel that a much safer strategy would have been to continue producing gas from their reserves in the south, rather than banking on the potential hiding under costly land. That said, it could pay off in spades. Time will tell.

But management and financials are rock solid on this company. Wisely, Chesapeake has hedged a substantial portion of their natural gas production. In 2006, for example, CHK hedged 80% of their gas production at $9.45 per thousand square feet. So when gas is selling on the market for less (right now, analysts are predicting that 2006 natural gas prices to average at about $7.51 per thousand cubic feet on the spot market this year, and currently spot prices have fallen down to just under $5 range), Chesapeake is earning greatly more than its competitors.

Commodity stocks like Chesapeake tend to be valued in direct proportion to the price of natural gas, which doesn’t always take into account factors like hedges. Given its hedging program (more than 70% of its production through 2008 is hedged), you are currently getting more value than the analysts’ estimations may indicate with Chesapeake.

Type of stock: A commodities stock in the natural gas industry, Chesapeake is making impressive gains, and has smart management and strong financials. While the recent large acquisition of Columbia Natural Resources is a big risk, CHK’s aggressive hedging program mitigates some of the risk.

Price target: Currently trading in the $28 range, CHK is near its year low, having been at a high of $40.20 in the last 52 weeks. I think it is a great value at this price and would grab it now. While all commodities are risky, I am betting it is going to continue its impressive growth in the next several years.

CHK 1-yr Chart

Comment on this article

Comments

[Sidney Will...:]

I live in Oklahoma, and have watched CHK as a neighbor and investor. It is an aggressive company. It's headquarters looks like a major University campus with building after building, a literal business campus. These guys are looking for oil and gas, and are determined to find it. Your article has merit. My attention to CHK was brought to my attention by my late father, and I wish I had bought it when he originally described it to me. Part of one's port should be CHK. Sidney Williams MD

2006 Sep 24 09:30 PM

[CrossProfit_:]

Chesapeake (CHK) has a dividend yield of 0.8%. The only way to profit from this stock is to buy low and sell at a high. Due to the nature of the commodity market, volatility is the name of the game. It is true that if you held the stock long enough you would be indexing your money to the price of natural gas. If that is what you want, we think there are better ways to index without the added risk of tying yourself down to one company. We are NOT saying that CHK is a bad company. On the contrary, it is a well managed company.

We take issue with two points in your article and agree with the rest. First, the 52 week high is technically $40.20 going back to September 2005. However this was a spike that did not last long. A careful study of CHK reveals that using $38.50 as a ‘high’ guide would yield a more accurate analysis (in our opinion). Second, CHK hedged very well in 2006. The profits from these activities ARE factored in by your and our colleagues. The problems begin in 2007 where CHK should have hedged sooner and better. At least that is the picture for now. Who knows, maybe CHK is counting on a winter spike in natural gas and will teach us a lesson or two.

In conclusion the average reader wants to know whether or not to buy in at 30, 28 or 26. The answer is simple. Natural gas is highly volatile; such is the nature of the beast. Oil is like a tamed house pet in comparison. Such being the case CHK is likely to visit 38.50 again within the next 12 months. It may not hit 26 and you might miss the boat so 28 looks pretty good. [CrossProfit evaluation line: CHK EOL = 08/07 38.80].

Disclosure: This comment was written by a CrossProfit analyst and does reflect the opinion of CrossProfit.com. AOL and Hilary Kramer are not affiliated with CrossProfit.
www.crossprofit.com

2006 Sep 25 02:30 AM

[Mmarrkk:]

One counterpoint to your 2007 hedge comment: do you know that CHK has 72% of its 2007 gas hedged at $9.88 and 57% of its 2008 gas hedged at $9.37??? I'd say that Aubrey has done a real nice job of hedging and taking volatilityin as a good friend!! I'm not sure how you can support your statement that they should have "hedged sooner and better" and "At least that is the picture for now.".

You are right: natural gas i highly volatile but CHK's strategy for 2006 and 2007 and a good portion of 2008 is to lock in a fairly high price and to use lower prices as an opportunity to buy up others who fear the volatility you refer to.

2006 Oct 06 07:56 AM

[CrossProfit_:]

Mark-

“Sooner and better” is a hindsight statement in relation to both price and percentage opportunities that were seized and executed to perfection in 2006. 2007 and 2008 are below 2006 percentages as CHK was probably waiting for a better price that didn’t materialize. Not to be taken as criticism, more like Monday morning quarterbacking… and NO, we couldn’t do better ourselves… however if 2007 was hedged at 85% at 9.88 they could shut down 15% of production for the rest of the year!

“At least that is the picture for now” means that we still don’t see a better price than 9.88 for 2007, but maybe we are wrong and leaving 28% open for a better price might turn out to be the correct play for 2007. All we are saying is that we don’t see it happening, yet at the same time we’re being cautious because CHK (a.k.a. Aubrey) knows this market better than most.

COP’s BR acquisition makes it impossible for COP to shut down so maybe CHK should have realized that COP was going to inevitably cause an oversupply…didn’t think of this at the time either.

2007 Jan 14 12:19 PM

[mega trade:]

good comments.

2006 Sep 29 11:18 AM

[Lissa Tucker:]

I prefer PVX -- Provident Energy Trust (Canadian Trust). You get a 15% tax credit back.
This stock has done very well for me over the three-year duration. I foresee natural gas
further increasing in the S-T as well...in light of CAs landmark passage of the emissions legislation.
(Hopefully, the rest of the country will follow suit....)

2006 Sep 30 11:47 PM

[Lissa Tucker:]

Recent Forbes article on Canadian Trusts/PVX:


www.forbes.com/2006/10...

2006 Oct 14 05:09 PM