Chesapeake Energy: Value is the Gas in the Ground

Production hedging for commodity producers should be about enabling a company to fund its value-added activity, which is exploring, developing and exploiting assets. Lots of ink has been spilled about how Chesapeake Energy's (CHK) earnings per share fell in Q1 2007 (as compared to Q1 2006) due to mark-to-market hedge losses. I think these comments miss the point.

As a current CHK investor (both my clients and I own CHK), if management can find and bring to market an mcf of gas for $4-5 and sell it forward (hedge it) for $8-10/mcf, it would seem only prudent to do so for some percentage of their production to ensure they will have the cash flow to support further similarly-profitable development. Why should running a E&P (exploration & production) company be any different from running an oil refinery or an ethanol plant, where plant owners know exactly how much it costs to convert oil-to-gasoline (crack spread) or corn-to-ethanol (crush spread) and so long as the input commodity and the output commodity prices can be fixed beforehand, minimum budget targets can be met?

Furthermore, there's great optionality for CHK and other hedging producers. When natural gas prices fell last summer, CHK reduced gas production slightly, helping to support gas prices, and also closed some previous hedges, locking in gains. In the 1990's, when aluminum prices were below production costs, I believe Alcoa (AA) bought a boatload of aluminum futures prior to announcing a production cutback, making a fair bit of money on the trade, which helped to offset some of the operating losses.

I like to think of the mark-to-market balances, or value of the hedges, as a balance sheet item, which happens to rise/fall in value inversely with the commodity price. Typically, and correctly in my mind, the stock should react much more to the movements in gas prices, rather than the change in mark-to-market hedge value as the preponderance of company value is the gas in the ground.

Disclosure: Author has a long position in CHK

CHK 1-yr chart

Comments

[Mmarrkk:]

Excellent analysis. The emphasis on mark-to-market "losses" is ridiculous. The GAAP accounting of these instruments is flawed at best. Only in this contorted world does an investment that is making you a big profit get counted as a "loss"

2007 May 08 09:17 AM

[Mmarrkk:]

Full disclosure: I R AN ENGINEER, not an accountant

2007 May 08 09:18 AM

[Monica Verma:]

I agree with you that CHK is a great one to own. In fact, I'd say that now is the best time for an investor to get in. 1) yes it looks like a manufacturing company since it hedges a majority of expected production; but the company is still in the phases of delineating exactly how much gas it has and that number is growing every quarter
2) it is the largest driller in the US and just beginning to realize that it needs to seriously ramp up production to increase cashflows to fund capex and to really just deliver on its promise of reserves
3) it is an expert deep driller meaning it has positions in and can effectively drill the BIG wells; a company that can target wells with >5 Bcfe of reserves behind it at a fairly good cost is one to invest in
4) management just said it was open to an MLP for midstream assets, rigs/services or its mature Appalachia assets. this is perfect for a company the size of CHK b/c it has a huge inventory to drop down into the MLP for years to come.

I believe that investors are simply tired of the company not ramping its production up quickly enough and therefore assign a discount.

2007 May 08 10:28 AM

[Zman:]

Is any institution conerned about the non-cash charge? It's valued cash flow, not earnings anyway.

As far as CHK goes, much of the Street is sorely underestimateing the asset here. Producing > a Bcfgpd gross from the Barnett with 300 wells spud to date. With 8 to 12x that many prospects left. It's not like their slacking off else either. They replaced 400% of 1Q production so their reserve life is expanding rapidly but they don't get the multiple of an EOG. Why is that? After their numbers I wrote:

* 1Q Production of 154 Bcfe beat guidance range of 150 to 152.5 Bcfe.

* Production growth of 14-18% expected for 2007. No change from previous. (but they hinted guidanced will be increased on the conf call)

* LOE increased a little but not bad. 1Q07 $0.93/Mcfe vs $0.87/Mcfe in 1Q06. Guidance was $0.85 to $0.95 so this is a little high considering they topped the production number. They’re looking for $0.90 to $1.00 going forward. Still,

2007 May 08 08:05 PM