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Summary

  • Improving Fundamentals make it a buy.
  • Opportunity to exploit the booming NGL market.
  • Healthy product mix will decrease the volatility in the revenues.

Chesapeake (NYSE:CHK) was the pick of the energy companies during the last year as the stock recorded the highest gain among its peers. The stock went up by more than 63% during the last year while its peers such as ConocoPhillips (NYSE:COP), Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) gained 19%, 14% and 13%, respectively. Some structural changes, stronger natural gas prices, sale of non-productive assets and shift in the product mix contributed towards the strong performance of the company. As a result, the stock recorded stellar performance and beat the sector by over 40%. Going forward, I believe the company is well positioned to grow and we will see substantial increase in the stock price over the next few months.

The Changes in the Product Mix will Decrease the Volatility

As I mentioned above, the company has been focusing on changing its product mix - too much focus on the natural gas resulted in a disaster for Chesapeake and the company has taken steps to decrease its dependence on natural gas and increase the proportion of oil and liquids in the total production. According to the 10-K filing of 2013, the company has increased its NGL production by roughly 17% during the last year and decreased its natural gas sales by about 3%. Aside from this, the company has increased its oil production by more than 32%. Since oil has a more stable demand than gas, this will lead to stable revenues in the future and save the company from the seasonal ups and downs of natural gas to some extent.

Benefit from the NGLs

Natural gas liquids have historically followed crude prices; as a result, increasing the proportion of natural gas liquids will further decrease the volatility for the company. Furthermore, the price for natural gas liquids have been on an upward trend and the global demand for NGL remains strong, which will support the price going forward. As the demand for NGL has been rising, the companies have increased the production. NGLs are a group of hydrocarbons (ethane, propane, butanes, and pentanes) that are often found alongside dry natural gas (methane). The companies that have rich natural gas assets also gain NGLs from these assets. Chesapeake being one of the biggest players in the natural gas assets is set to benefit from this increased demand for NGL. The prices for NGLs have been rising mainly due to the increase in demand for Propane (a component of NGLs).

The U.S. demand is derived by 14 million households and 80% of the farms, which use NGL. In addition, the cold weather acted as a catalyst in this increase in demand. As a result, NGL suppliers are not only capitalizing on the opportunity of overseas demand but also enjoying the increased prices in the domestic market.

Chesapeake is well positioned to benefit from this NGL power play due to its strong backing of reserves. As reported in the 10-K filing of 2013, the company had proved and developed NGL reserves of 177mmbbl, which equals to 8.5 times of what the company produced in 2013. Aside from that, the company has further 122mmbbl of proved but undeveloped reserves, which equals to 6 times its production of 2013. Chesapeake is likely to increase its NGL production this year to capitalize on this opportunity. The production increased by 16% in 2013. With this growth in production, the current reserves could be enough through 2018 without having to incur any further costs in capital expenditure. Including the undeveloped assets, the reserves could cover the production up till 2020 but the company will have to spend on capital expenditure.

The company will have to look for further assets and cannot sit on these reserves. However, having this much volumes in developed reserves would allow the company to capitalize on the opportunities NGL offers. As I mentioned above, NGLs follow crude oil and I believe crude prices will remain strong, which should allow the company to minimize volatility and get better revenues.

Improving Fundamentals

Fundamentals of the company have improved dramatically over the last three years. First of all, the operating income - the company had operating losses of about $1.7 billion at the end of 2012, which has turned into operating profit of over $2 billion by the end of the last year. It is a major swing for the company and shows the efficiency of its cost cutting and product mix measures. At the moment, operating margin of the company is just under 12%. As a result of impressive operating results, the company was able to turn net loss of about $770 million into net profit of $724 million during the last year.

At the moment, net margin of the company stands at 2.7%. Both of these measures are still behind the industry averages of about 19% and 8%, respectively - however, it shows how far the company has come over the last twelve months. If we compare the rise in the stock price with the improvement in the margins; I believe the rise is justified. The current P/E ratio of 35 makes it look expensive compared to the industry average of 32, but the forward P/E of about 12 is extremely attractive for the stock, in my opinion. I believe the growth in the stock price will continue as we will see further improvement in the fundamentals. As a result, we will see a healthy rise in the stock price over the next few months.

Conclusion

The stockholders were not too happy as the company announced its outlook for 2014. However, it was heading in the right direction as I discussed in my previous article. I remain optimistic about the prospects of Chesapeake as I believe the company is heading in the right direction. It will prove to be a very good investment in the long term and I believe shareholders can gain considerably by holding onto the stocks for 2-3 years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. IAEResearch is not a registered investment advisor or broker/dealer. This article was written by an analyst at IAEResearch and represents his/her personal opinion about the companies mentioned in the article. The article is for informational purposes only and it should not be taken as an investment advice. Investors are encouraged to conduct their own due diligence before making an investment decision. I am not receiving any compensation (other than from Seeking Alpha) for this article, and have no relationship with the companies mentioned in the article.

Source: Chesapeake Set To Grow