Chesapeake Energy: Sell For Tail Risk

| About: Chesapeake Energy (CHK)

Summary

Position sizing is very important for risk control.

As risk increases, you may want to trim Chesapeake despite a higher upside.

Debt is now a valid concern because bond holders are "in the money."

Chesapeake's future is brighter, but it won't matter if it can't meet short-term liquidity needs.

Given the current situation, Chesapeake is safe. However, I believe that the tail risk is significant enough for investors to consider reducing the position.

Last week was relatively quiet for the energy sector. S&P's E&P ETF (NYSEARCA:XOP) fell slightly by 0.57% whereas Chesapeake's (NYSE:CHK) stock rose by 2%. Given that the stock can swing 15% in either direction in a single day, I would treat Chesapeake's slight outperformance as noise. As always, I believe that investors' focus should be on Chesapeake's fundamentals rather than the stock's day to day fluctuations; but if you are very concerned about the short-term, understanding the drivers behind the price action can't hurt (read Expect Regular Heavy Sell-offs). Other than the consideration of fundamentals and short-term price movements, many investors often overlook a third factor: position sizing.

As I've discussed in several updates for the V20 Portfolio, you can have a million good ideas, but ultimately your portfolio's return will be determined by how much money you invest in each of them. In determining a stock's allocation, one must not only consider the upside, but the tail risk as well. If the tail risk is significant, the position must be reduced. This is what we have to worry about with Chesapeake.

Typically speaking, as the fundamentals of a company improve, the stock becomes more attractive. Chesapeake's upside also increases as fundamentals get better. After all, the company does make more money at higher commodity prices. However, I believe the stock has become more risky due to surging commodity prices. When commodities were trading at multi-year lows, a bankruptcy would have yielded disastrous results for junior debt holders due to a maneuver pull by the management back in late 2015 (read Chesapeake's Stroke Of Genius).

However, the tables have been slowly turning. As both natural gas and oil have rebounded, debt holders are becoming more comfortable with Chesapeake's future prospects. In Q1, EBT adjusted for impairments and other one-time expenses was -$127 million. For every $1/bbl increase in crude, the company can rake in around $9 million of additional cash flow. Considering that crude is now trading near the $50/bbl level, which is $17 higher than the Q1 average of $33/bbl, debt holders are now comfortably in the money, since the extra cash flow will be more than sufficient to service their debt.

This sounds benign on the surface, I mean what company wouldn't want their lenders to be confident about its future prospects? Unfortunately, this also means that debt holders will become more willing to push the company into bankruptcy if Chesapeake can't come up with the cash.

Theoretically speaking, a brighter future leads to better access to the credit market for refinancing. However, lenders' appetite for energy related debt still remains low, hence Chesapeake can't completely rely on the credit market to refinance, even if its outlook has dramatically improved. Given the above, it's not surprising to see that the management has executed multiple debt for equity swaps over the past couple of months in a bid to fend off near-term maturities.

Where does this leave us? It's strange to think about, but I believe that despite higher energy prices, Chesapeake's investors should reduce their positions in the stock, for the simple reason that liquidity risk is slowly creeping back. In my last article, I talked about how Chesapeake should generate more than enough cash flow from operations and asset sales to fend off any liquidity event in the near-term. However, this does not change the fact that if something does go wrong (i.e. tail risk), such as a failure to sell assets or a short-term dip in energy prices, the potential for loss is significant.

Click the "Follow" button beside my name on the top of the page to be updated with my latest insights. To learn more about the V20 Portfolio (+40% in 2015), whose goal is to compound capital at 20% over the long term, I encourage you to read the introduction to my investment process. Premium subscribers get full access to the V20 Portfolio. Track the portfolio through the latest update, here.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.