3 Oil And Gas Stocks To Buy Now Instead Of Chesapeake

|
Includes: APA, CHK, DVN, LNG, XOM
by: Investment Underground

by Victoria Lee

Chesapeake Energy's (NYSE:CHK) stock has been under attack by the investment community during the last few weeks for the borrowing practices of its CEO, Aubrey K. McClendon. Reuters broke the story of the CEO borrowing money to take advantage of a job "perk", referred to by the Chesapeake Board of Directors as the Founders Program. A lawsuit against the CEO and other members of the Board of Directors has been filed by a group of stockholders over non-disclosure of the loan to the stockholders. This internal turmoil has contributed to the stock price falling 53% from its 52 week high of $36 per share. It is now trading near its 52 week low of $17 per share.

Often these types of breaking stories fade away as fast as the aroma of your morning's coffee, replaced by the latest, just-as-shocking breaking news about some other corporation. In fact, already headlines from some stock analysts are stating "Time to Buy Chesapeake Energy?," and citing the slight rise in natural gas prices as a reason to pick-up the relatively cheap Chesapeake stock.

"Cheap" isn't always a good buy, and this is one news story that shouldn't simply fade away. It's just the last tip of the sinking ship, hit by the iceberg of the company's long run of questionable practices.

Aubrey McClendon has overseen the growth of Chesapeake Oil from a fledgling start-up, to taking its place as the number two natural gas producing company, immediately behind Exxon Mobil (NYSE:XOM), and the fifteenth largest producer of oil and natural gas liquid. Its operations are based in the continental USA, and it has extensive land and lease holdings, with 15.3 million acres under leasehold as of December 31, 2011. Chesapeake was also one of the leaders in developing new oil drilling techniques, which opened up vast deposits of shale as possible sources of natural gas.

Chesapeake's pioneering efforts in new drilling technology have also contributed to the precarious financial position it now finds itself in. This new drilling technology is the primary cause behind the sharply increased supply of natural gas, driving the price down to $2 per 1,000 cubic feet, which is the lowest price point for natural gas in the last ten years.

Problem Number One: Business Strategy & Financial Position

Corporate business strategy is set in what is commonly called "the C-Suite." How and when to acquire assets, if and when to sell assets, general business practices, and financing the business, are all decisions made by the executive management team. Middle management will execute the decisions, but the executive management team makes them.

Chesapeake's strategy to capitalize on the new shale deposits was, in its own words, the "gas shale land grab." Working through a large network of brokers, Chesapeake had a number of ways it ensured it would be the successful leaser, including what Morningstar Reports characterized as a "general willingness to offer more favorable lease terms than its competitors". It used a number of creative techniques to finance this strategy. In fact, all of this spending on capital has exceeded the cash generated from Chesapeake's operations since calendar year 2003. How long can a company go on paying out more in capital expense than it has in actual cash to spend on capital?

Late in calendar year 2011, before the latest issues with its CEO, Chesapeake's financial situation started to unravel. There were mentions of "fire sales," and how much cash could Chesapeake raise by monetizing (selling off) its assets to meet what Citigroup estimates to be a $5.2 billion shortfall for calendar year 2012.

Chesapeake's balance sheet won't support unfavorable events that affect market conditions. With a debt to equity ratio at .59, compared to the median of its peers at .34, it is carrying twice the amount of debt as Exxon Mobil, which has a market value twenty-five times more than Chesapeake's. With a debt load that high, forcing the cash position into a negative value, Chesapeake needs to take drastic action to withstand the record lows in natural gas -- lows that, given the glut of supply on the domestic market, will be around for awhile.

Problem Number Two: Business Practices in the C-Suite

Reuters broke the story on the borrowing practices of CEO McClendon. Basically, he has a job "perk" which allows him to buy 2.5% interest in every well drilled, and he incurs 2.5% of the cost for the well. He financed this perk by borrowing $1.1 billion in personal loans from a lender which also has a big stake in loans to Chesapeake. The conflict of interest is obvious to anyone except, apparently, the Board of Directors at Chesapeake. The man who heads the C-Suite, which makes the acquisition decisions (both to buy and sell), is also responsible for setting the policy on when to drill, when not to drill, what to buy and where to buy it. With this type of job "perk", it can also mean a huge personal gain on those same decisions, depending on what he decides as a company course of action. Obviously, there is no guarantee that the CEO's personal gain and what is best for the stockholders will always be a match.

This is not the first story Reuters has broken about the business practices of Chesapeake. While doing an investigative series on corporate secrecy in the United States, it ran an article on a "shell game" engaged in by Chesapeake, which used a number of "holding companies" (with no assigned assets), to first acquire, and then reject, leaseholds in the State of Michigan. According to the investigation cited in the article, Chesapeake gave out strict instructions to the brokers engaged to acquire the land leases that they were not to mention that the true owner of the holding company was Chesapeake Oil.

This also is not the first time McClendon's practices have been questioned. In calendar year 2008, he was forced to sell millions of shares of Chesapeake stock to cover margin calls. That much stock suddenly put up for sale had the expected affect of dropping the stock price, which then affected all the other shareholders in the company. That was the same year the company reported a $58 million loss, yet the CEO received a large "bonus" payment ($75 million) to participate in none other than the Founders Program. There was also the matter of McClendon having to buy back an antique map collection he sold to Chesapeake for $12.1 million.

Problem Three: Why Invest in Chesapeake?

Whether or not to invest in Chesapeake Oil is a simple question to answer. With a crushing debt, questionable business strategies and a history of practices called into question for lacking ethics, why would you invest in Chesapeake Oil? I wouldn't. The Gas and Energy industry has many, better prospects than Chesapeake.

Apache Oil (NYSE:APA), with a debt to equity ratio lower than the industry standard, APA has interests in both domestic and foreign oil fields. Its portfolio is diversified, it has a good acquisition partner in Mariner Energy, and recently acquired Gulf of Mexico assets from British Petroleum and Devon Energy. With a 52 week high of $134 per share, and a 52 week low of $73 per share, Apache is currently trading at $93 per share. With its strong balance sheet, it's a good, solid buy.

Devon Energy (NYSE:DVN) is another, well-managed company. Unlike Chesapeake, Devon's management anticipated the drop in natural gas prices and started to diversify its riskier assets back in calendar year 2009. Like Chesapeake, it concentrates primarily on domestic, land-based operations, although it has a good sized interest in the sand oil fields in Alberta, Canada. Unlike Chesapeake, it has a debt to equity ratio much closer to the median of its peers, and has a strong cash position to sustain a reasonable rate of expenditure on capital, and to withstand any negative events that may affect the marketplace.

Exxon Mobil is a heavyweight player in the natural gas and oil industry, and would also be a solid investment. It recently raised its dividend by 21% for the thirtieth consecutive year. Currently trading at $87 per share, it's very near its 52 week high of $88 per share, but takes a smaller, per share price swing then its peers over a year's period, with the 52 week low standing at $67 per share.

For a less well-known company, and so a slightly bigger risk, Cheniere Energy (NYSEMKT:LNG) would be a good place to invest. While the price of natural gas is low in the USA, it's much higher in other parts of the world (China, India, Japan, and Korea) where there is a shortage of the gas. Cheniere has an interesting process of freezing the natural gas to 1/600th of its unfrozen volume, and shipping it to the international marketplace. It has an exclusive export license to energy-desperate countries in Asia, and currently has contracts worth $2.5 billion after operational expenses.

Any one of these would be a better place for an investment dollar. When it comes to Chesapeake Energy, it may be best to remember Moody's assigned rating of Ba3 to a recent offering of senior notes by Chesapeake. In the financial world, that is junk bond status.

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