Chesapeake Energy: Doubled Value, But Hedge Still Suffered

| About: Chesapeake Energy (CHK)

Summary

Chesapeake's stock didn't appreciate despite neutral or improved commodity prices.

Futures prices rose for both oil and natural gas, adding losses to the overall position.

Higher commodity prices will add billions of dollars of value assuming that spot prices will converge to current futures prices.

We are ultimately relying on the market to be efficient enough to recognize Chesapeake's upside.

Energy prices have fluctuated wildly since I talked about Chesapeake's (NYSE:CHK) fundamental hedges two weeks ago (see my previous article, "Prepare for $2 Gas and $40 Oil"). Oil (NYSEARCA:USO) sunk to as low as $45.83/bbl before recovering some of the losses. The opposite occurred with natural gas (NYSEARCA:UNG), with the August contract flying to $2.998/mmbtu before dropping to the current price of $2.800/mmbtu.

Oil

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Natural Gas

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It was this uncertainty in commodity prices that we tried to hedge away by selling oil and gas futures. What's unique about this hedge is that it utilized the company's fundamentals instead of the correlation between assets. By estimating the company's annual production and assigning a value multiple, we can estimate the amount of value that each dollar increase (decrease) in commodity prices will add (subtract). We can then attempt to offset this gain or loss by selling enough futures contracts so that they match the company's underlying production.

The rationale behind the hedges is explained in more detail in my previous article, which is linked to above.

Hedging In Action

Unfortunately the hedge hasn't done very well. Although the stock price didn't move much since June 24, the futures did.

Even though the changes in spot commodity prices were either neutral (oil) or beneficial (natural gas) for Chesapeake, investors did not react accordingly as shares did not appreciate. Meanwhile, the June 2017 contracts increased for both oil and natural gas, rising by $0.75 and $0.095, respectively. Marking the entire position to market, we would have achieved the following result:

Source: Author's calculations

Depending on which hedge we chose, we would have suffered varying degrees of losses. Perhaps the "high hedge" is a misnomer, as the higher number of contracts (3x than is necessary) makes the position more of a speculation, but I digress. The medium hedge, which was set up to mimic the fluctuation of Chesapeake's intrinsic value, resulted in a $0.90/share loss or an extra 21% loss based on the initial stock price of $4.37.

Does this mean that the hedge failed? No. This mismatch in market value was highlighted as one of the key risks of cross hedging. There is no guarantee that gains and losses will be offset in a timely manner.

Because the futures have not expired yet, the above losses are merely paper losses. If we look at the improvement in intrinsic value, the rise of natural gas from $2.641/mmbtu to $3.086/mmbtu created $2.46 billion of value alone based on a 5x multiple. Adding the appreciation of oil from $47.69/bbl to $51.85/bbl, the total value created was $3.2 billion, or $4.37/share. So theoretically, Chesapeake's value doubled. What's the catch? The above calculation implies that the future spot prices of oil and gas (i.e. when we are in May 2017) will converge to the current prices of the respective futures. Should the above occur, it is assumed that Chesapeake will be able to sell production at current futures prices for periods after June 2016. This is the basis of value creation, as the company was originally selling production at the lower spot prices ($47.69/bbl for oil and $2.641/mmbtu for gas).

Other Considerations

It's important to understand that the hedge is based on fundamentals and not the mathematical correlation between the assets. Because the hedge adequately covers the estimated annual production, there is no need to rebalance as long as future production does not differ significantly from the underlying commodities backing the futures.

This fundamental hedge is no different from value investing in principle, in that we are betting that the market will be efficient enough to recognize the upside if the value drivers (oil and gas prices) are in place. Even though there is no guarantee of success, by establishing this hedge, we no longer have to diligently monitor the day to day commodity fluctuations, since any downside will be adequately covered by the hedges (see model in my previous article, linked to above). In exchange, we face the possibility of losing money even if we are right should the market fail to recognize Chesapeake's value under improved commodity prices.

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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.