I'm a bit of a reluctant Chesapeake Energy (CHK) shareholder. I fought the urge to buy shares for years, leery of what I thought was a bit of an overly promotional and somewhat risk addicted management team.
This past summer I started buying and have been slowly increasing a position ever since. What finally won me over were the recurring monetizations of pieces of various shale plays that pointed to a combined asset value far in excess of the current enterprise value.
But while I have realized that Chesapeake is undervalued, Mr. Market does not agree. Chesapeake's share price is down close to $20 which means it has gone nowhere for almost 10 years, despite the shale boom the company helped create.
One big and common criticism of Chesapeake is that its business model is too complicated. Multiple joint ventures, royalty trusts and regular asset sales simply make Chesapeake too messy for some investors to bother with. Not surprisingly Chesapeake does not agree with this criticism and tries to address it in the most recent company presentation.
In the presentation Chesapeake notes that while the perception in some circles is that Chesapeake has a complex business model, the reality is that the model is simple. Chesapeake goes on to present its simple business strategy which can be captured in six key points:
1) Chesapeake's geographic footprint is very compact with assets only located onshore in the United States
2) Chesapeake grows reserves and production organically through the drillbit and doesn't have to repeatedly seek out acquisitions in order to grow.
3) Chesapeake has a vertically integrated business model that includes midstream and oilfield services that allows the company to retain full value for shareholders.
4) Chesapeake hedges oil and gas production opportunistically when opportunities present themselves. This hedging has resulted in $8.1 billion of hedging gains since 2006.
5) Chesapeake identifies and develops new leasehold plays, which enables it to acquire leasehold at wholesale prices and then sell off a minority position at retail prices. The portion sold off typically results in zero or negative leasehold cost for the leasehold retained by Chesapeake.
6) Chesapeake recognizes that investors today are "short yield" and therefore Chesapeake is happy to provide yield hungry investors alternatives for which these investors pay considerably more than core E&P investors do. Examples of this include the VPPs, royalty trust and preferred stock deals that Chesapeake has done.
I'm an investor in shares of Chesapeake, so obviously I buy into the company strategy. But I have to say that just because it can be summarized in six points doesn't mean that it is simple.
I like the idea that Chesapeake is taking advantage of yield hungry investors who pay more for pieces of Chesapeake's assets than an energy investor would. But that doesn't have anything to do with a simple business strategy. Even though I'm a shareholder, I couldn't come close to naming all of the legal entities that Chesapeake has created to sell pieces of its massive asset base. Reconciling and consolidating all of these entities must be an accounting nightmare for Chesapeake's Finance group.
And I like the idea that every year Chesapeake leases billions of dollars of land and then recovers all of that cost through joint ventures while still retaining 75% of the leasehold. How can you not like getting millions of acres of land at a net cost of zero? But again, while I like the strategy I wouldn't call it simple.
And this complexity is certainly part of the reason that Chesapeake share price is still only at $20 despite continuous growth in reserves, production and acreage. But the complexity isn't the main reason for the depressed share price. The main factor depressing the share price is extremely simple. It is the price of natural gas. Natural gas prices are horribly low, so it only makes sense that Chesapeake's share price is not doing too well either given that almost all of Chesapeake's production and cash flow is from natural gas
Personally, I'm of the opinion that natural gas prices have to improve. However I'm also of the opinion that I have no idea when that improvement might happen.
As for why natural gas prices have to improve, I'll refer you to the most recent presentation from the well respected CEO of Contango Oil and Gas (MCF) Ken Peak. In this presentation Peak refers to the total cost structure for 41 leading natural gas producers. For these producers, the average cost to produce an mcfe of natural gas is $5.53. At today's natural prices under $3 these companies are losing a lot of money. Over time supply simply has to drop to push prices back up.
At some point I'm likely going to look to purchase a basket of natural gas producers to try and take advantage of the inevitable rebound in prices. The key for me will be making sure I find producers that can survive if I'm far too early in betting on this rebound, because getting the timing exactly right is virtually impossible.