Every four years, voters and investors alike are bombarded with unrealistic promises and lofty goals for the energy sector. In the past decade or so, alternative energy options have become the sexy topic on which Washington's hopeful have chosen to strut. Recent controversy has driven down the per-share price of Chesapeake Energy (CHK) by nearly 25% and created a significant buying opportunity heading into the fall. While the source of this controversy, and potentially of the decline, is not to be simply overlooked, the potential impact for the world's second-largest producer of natural gas, second only to Exxon Mobil (XOM), is dramatic. Natural gas prices seem to have settled to recent-term lows, and when coupled with the attention the industry will get in the campaign, investors may have a rare opportunity to capitalize on a particularly attractive entry point.
A 2008-Style Decline
The last time the company saw a decline as severe as the current plunge was in 2008. One of the reasons for the decline is blurred lines between company business and the personal finances of Chief Executive Officer, Aubrey McClendon. McClendon has reportedly been adding oil fields to his personal holdings at an extremely high rate, while simultaneously taking the company down the same road. While this may seem like a good thing to the uninitiated - after all, shouldn't a CEO believe in the moves he or she is making sufficiently to risk their own personal capital? - it presents a problem for investors because it can be viewed as a practice called front-running. In front-running, an investor buys ahead of a major institutional purchase with the hope that the large infusion of cash from the institution will both drive the price higher and signal to the general market that the investment is sound. Additionally, Mr. McClendon has used some of his stakes in the company to finance personal loans upon which he has defaulted. The entanglement between Mr. McClendon's business responsibilities and his personal affairs is a negative for the company.
When this type of conflict is detected by the general market, in addition to having the potential of sparking an investigation by regulators, it calls into question both the stability and judgment of the company's management. The judgment issue is obvious, forcing investors to reevaluate all of the company's major decision. The stability issue is driven by the fact that one becomes uncertain as to whether a major management change is forthcoming. A new CEO will often want to "shake things up," so when the top job at a major corporation is under a cloud of uncertainty, the whole company suffers.
The result for Chesapeake has been a dramatic decline in the share price. The stock that traded as high as $25.56 per share in mid-March dropped below $17.50 in recent weeks. While this is driven in part by the events discussed above, there has been general weakness in the natural gas markets. Using United States Natural Gas (UNG), the natural gas exchange-traded-fund as a proxy, natural gas prices are at long-term lows. Likewise, using the front month contract on the futures side, natural gas recently dipped below $2 for the first time in several years. This weakness is unlikely to persist over the long run, making any entry at these levels attractive. The advantage of buying natural gas stocks is that there is no expiration concern, as there would be when buying futures contracts.
Natural Gas and the Political Landscape
While it is not uncommon for the leaders of natural gas companies to assert their intention of bringing political pressure to bear to advance the cause of natural gas as an alternative energy, in an election year, this claim has more teeth. U.S. dependence on foreign oil sources has been a long standing political hot potato and this election should be no different, particularly given what some consider the scant differences between the candidates. In an election that may prove a choice between "anything but four more years of this" and "is this really that different from the other guy?" the role of energy will likely be a topic that the candidates struggle to own. The true question is whether the political wrangling will be a positive influence on the stock price. What is important to keep in mind is that the perceived impact of any political positioning will be as powerful prior to the election as any actual impact.
Chesapeake's Peers
When considering an investment in any given stock, placing the company within the proper context is a critical step. Therefore, in order to properly consider Chesapeake, one should also consider Anadarko Petroleum (APC), BP, ConocoPhillips (COP) and Exxon Mobil. On a valuation basis, using price-to-earnings as a metric Chesapeake trades at a multiple of 7.7 relative to 5.2 for BP, 8 for Conoco and 10.3 for Exxon Mobil. Anadarko has no P/E given its negative earnings. When the efficiency of these companies is considered, Chesapeake becomes even more appealing. The company has an operating margin of 21.8% relative to 17.9% for Anadarko, 8.3% for BP, 9.9% for Conoco and 12.5% for Exxon Mobil.
Additionally, it is important to place the impact of natural gas into context for each of these companies. While Exxon Mobil, as a diversified energy company, has more exposure to natural gas than Chesapeake, the others are more petroleum-centric. What this means is that Chesapeake will be most deeply impacted by a change in natural gas prices. In addition, while the recent controversy at Chesapeake is not trivial, ultimately it should resolve itself, making the sell-off an ideal entry point. It is important for an investor to be aware of the potential turbulence that may still lie ahead for the company, although it should prove to be a solid investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
