Falling Oil Knife Means Stick A Fork In Chesapeake

Jun.21.12 | About: Chesapeake Energy (CHK)

Chesapeake Energy (NYSE:CHK) has done what, in ordinary times, could have put a line under its financial problems and ethical concerns. It made former ConocoPhilips head Archie Dunham its board chairman, replacing founder Aubrey McClendon. The move was part of a board shake-out that removed McClendon loyalists. Also, it hinted at a coming deal with China's Sinopec that could be worth several billion dollars.

Trouble is, with West Texas Intermediate on short-term contracts now pricing in under $80, it may be impossible to get the company out of its nosedive. Chesapeake is carrying an estimated $12 billion in debt and needs $7.6 billion over the next six months to cover its drilling costs.

Our IncomeHunter rates CHK a buy at $18 based on its selling a pipeline business for $4 billion and rights to 300,000 acres in Ohio for another $4 billion. But its cash crunch is already starting to bite and the company had to lay off 70 employees in the Barnett Shale field just this week.

Even when an exploration company is working on a cash basis, it's automatically leveraged to the changing prices of commodities. Its asset value is based on the proven reserves is has under production plus the estimated reserves it can reasonably be expected to extract under leases. A falling commodity price cuts the value of all these assets.

When the company started nosediving last year, Chesapeake blamed its problem on falling natural gas prices and announced plans to expand production on land that was "liquids rich." Well, gas prices are now up almost 20% since the winter, but those liquids are now worth about 20% less.

The job of Dunham and the new board is to figure out the company's real obligations, to untangle the financial engineering of founder McClendon, and to match assets to those obligations to reach a real value for the company. This would most likely be followed by a sale.

So the price of CHK today is based on your estimate of its final break-up value. Your time horizon for getting to that value also seems to be narrowing, based on the money it needs to maintain operations in the short term.

Unless you think the price of oil is about to spike upward, this is not a trend that looks good.

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