In the summer of 2010 I looked at Chesapeake Energy (CHK) on a daily basis while the stock traded in the low $20s but didn’t pull the trigger. As the stock price rose to the low $30s over the next several months I kicked myself repeatedly for missing out on an opportunity.
Then in July of 2011 Chesapeake, at the time trading in the low $30s announced the following:
“Having achieved successful results from recent drilling activities in eastern Ohio, Chesapeake is announcing the discovery of a major new liquids-rich play in the Utica Shale. Based on its proprietary geoscientific, petrophysical and engineering research during the past two years and the results of six horizontal and nine vertical wells it has drilled, Chesapeake believes that its industry-leading 1.25 million net leasehold acres in the Utica Shale play could be worth $15-20 billion in increased value to the company. Chesapeake’s dataset on the Utica Shale includes approximately 2,000 well logs, full-suite petrophysical data on approximately 200 wells, 3,200 feet of proprietary core samples from nine wells and production results from three wells. As a result of its analysis, the company believes the Utica Shale will be characterized by a western oil phase, a central wet gas phase and an eastern dry gas phase and is likely most analogous, but economically superior to, the Eagle Ford Shale in South Texas. “
I thought that was pretty big news. $15 to $20 billion is roughly $25 per Chesapeake share. Since this Utica shale property alone is likely worth $25 per share, I figured that my chances of ever getting into Chesapeake under $30 again were long gone.
Right now Chesapeake is trading right around $25. Chesapeake announced the addition of a $25 per share property and since then the stock price has actually gone down.
I’ve now got my chance to get in under $25 and I’m taking it. I’ve been buying and will continue buying while Chesapeake sells for less than $25 per share.
What Is Mr. Market’s Problem?
The overall stock market since the Utica shale announcement has been weak so that has hurt Chesapeake’s share price. But the weakness with Chesapeake’s shares is also very company specific.
I think the issue is very simple. Chesapeake continually outspends its incoming cash flow acquiring land in new emerging resource plays. Chesapeake uses various methods of alternative financing (joint ventures, VPPs) to do this. Mr. Market doesn’t like this continued spending and punishes Chesapeake’s stock price.
Mr. Market wants to see Chesapeake stop spending money on new properties and focus on developing the assets the company already has while living within its cash flows and shoring up the balance sheet.
Consider where the cash Chesapeake is going to spend in 2012 is going to come from (see page 6):
- Operating Cash Flow $6 billion
- Yet to be determined Joint Ventures $1 billion
- COS IPO, Frac Tech sale and Chaparral sale $3 billion
- VPPs, royalty trusts and financial JVs $2 billion
- Midstream drop downs $1 billion
That is $13 billion of cash that Chesapeake is going to require to meet its capital expenditure and debt reduction plans, and only $6 billion of that is coming from operating cash flow.
The stock market hates uncertainty, and the majority of Chesapeake’s spending is coming from sources that fall into the “yet to be completed” category. In other words Chesapeake is telling investors to “trust them” and that they have this financing under control.
When Will Mr. Market Finally Believe?
I used to share the same concerns about Chesapeake outspending operating cash flow every year. But I got over them.
How? I watched Chesapeake promise a series of Joint Venture deals and then execute them exactly as advertised. By my count here are the deals Chesapeake has completed over the past few years:
1) Haynesville Joint Venture with Plains Exploration (PXP) – The timing on this one was extremely fortunate occurring as natural gas prices were over $10 immediately before the world fell apart in June 2008. Chesapeake sold 20% of its Haynesville acreage to Plains for $3.16 billion. That implied that the acreage retained by Chesapeake was worth $13.2 billion.
2) Marcellus Joint Venture with Statoil (STO) – At a time when deals couldn’t get done, Chesapeake got a deal done. In November 2008 Statoil paid $2.1 billion for a 32.5% interest in Chesapeake’s Marcellus shale acreage. The implied value of the retained acreage for Chesapeake was $7 billion. The price received certainly reflected the market conditions of November 2008, but at the time Chesapeake needed to strengthen its financial position.
3) Barnett Shale Joint Venture with Total (TOT) – It is almost like Chesapeake is trying to learn new languages, this time teaming up with a French company. For $2.25 billion Total got a 25% interest in Chesapeake’s Barnett shale properties, which implied that the retained value was $6.8 billion.
4) Eagle Ford Joint Venture with CNOOC (CEO) – Chesapeake put its Eagle Ford acreage position together with blinding speed in 2010. In November 2010 CNOOC bought a 33% interest in the land for $2.2 billion implying that Chesapeake retained a land position worth $4.4 billion.
5) Niobrara Joint Venture with CNOOC – Same partner, different property. This time the Niobrara where CNOOC purchased a 33% interest for $1.3 billion implying that the retained value is $2.6 billion to Chesapeake.
All of these Joint Ventures did two things for me. One, it gave management credibility in my eyes as they have repeatedly delivered these deals as promised. And two, it made very clear just how valuable all of this land is.
Chesapeake has repeatedly amassed leading land positions in highly valuable resource plays and then recovered 100% of the cash Chesapeake invested (while still retaining 75% ownership of the play) by bringing in Joint Venture partners.
Spend a billion dollars for a million acres. Then sell 25% of the acreage for a billion dollars. Keep 75% of the acreage at a net cost of zero.
And the stock market is punishing the stock price because Chesapeake plans to continue to spend money locking down land.
It borders on the absurd. Chesapeake has a net cost of zero on millions acres of land worth billions of dollars. Yet the stock market wants Chesapeake to stop doing this.
Not me. I say spend away boys. I am fully aware that the undervaluation of Chesapeake’s shares can last for years, but at some point the true value of all of this acreage has to be realized.