Chesapeake: A Top Energy Play

Chesapeake Energy (CHK) has risen more than 20% since the end of January and hit an all-time high. CHK shares have been driven mostly by the rally in natural gas prices and strength in the energy sector. Short interest has been increasing, as some investors are betting on a pullback, yet the CEO has been taking the other side of the trade buying more shares. Natural gas is on an upward trend and may find a higher sustained price range. In follow up to my earlier writings on CHK: CHK- Earnings and CHK- Smart Money, here are some other bullish points.

Natural Gas Price Momentum

Natural Gas prices have been on a tear recently. There has been an increased, longer-term bullishness on the commodity. One reason stems from bloated storage levels that are being worked off. Current levels are about 5% higher than the 5-year average, down from levels that were nearly 35% above 5-year average. Gas has a difficult time moving higher when excess supply exists.

Demand should strengthen as well. Natural Gas is a clean energy, and there has been no shortage of “green” dialog recently. This heightens the pressure for utilizing the clean resource in place of dirty fuels when feasible. Coal energy is a target. Investment bankers are expressing reluctance to engage in bond deals for new coal power plants. Bankers express apprehension about future legislation on carbon emissions that could financially penalize power plants. The fear is that revenues that go towards paying down the bonds would be diverted to paying for carbon credits or some type of pollution permit. (see WSJ article) Five coal powered projects in Florida have already died in the last year, forcing utilities to shift to gas.

Crude oil generates 6 times as much energy than an equal amount of natural gas. This implies that natural gas should trade at 1/6 the price of oil, and historically this has somewhat been the case. Currently, the ratio is almost double. With crude at inflation-adjusted all-time highs, there should be a push towards exploring the use of natural gas since it’s relatively cheap. For applications where natural gas substitution is possible, stronger efforts will be made to use the cheaper alternative. Crude has shown no signs of backing down, and likely will only go higher.
Certainly this will be the case in the long-run as accelerating demand continues to outstrip decelerating supply. Natural gas is cheaper, produced domestically and abundant.

Natural gas has been stuck in the $6 to $8 range the past two years, but the CEO believes a multi-year trend is emerging that will result in natural gas prices in the $8 to $10 range. Futures prices support McClendon. Generally, NG prices pull back during the summer months when demand drops, and storage withdrawals switch to injections. However, the future curve depicts higher gas prices all the way out to March 2009. Not only does this suggest higher prices in the future, it also benefits CHK now since it’s an active hedger.

CHK applies more coverage than most its peers, reducing sensitivity to the commodity. While this can cap gains to the upside, it limits downside exposure that could destroy a producer. I think it’s a very smart move. Management is placing certainty on an uncertain variable. Natural gas prices are set by the market, and CHK has no control as price-taker. While many companies rely on volatility as a source of profits, CHK focuses on aspects it can control, such as its competitive advantage it drilling.

Increasing Production and Higher Cash Flow

In the last several years, Chesapeake went on an acquisition binge. The company snatched up land at favorable prices during a time when natural gas prices were falling. CHK funded a significant amount of this land expansion with the use of debt and preferred instruments that eventually convert into equity. This has resulted in the share count to almost double over the past five years. Since then, net income has increased five-fold, yet EPS has only doubled. The dilution has caused frustration for some investors.

However, share dilution is not always negative, as the term often has a negative connotation. As long as the capital raised from the dilution creates more value than the amount of value diluted, then it’s a positive move. For example, if EPS is $1, but a share issuance doubles share count and reduces EPS to .50, then value will be enhanced when the proceeds generate new $1 EPS, increasing total EPS to $1.50. Dilution caused the outstanding shares to double, yet investors are better off because EPS increased 50%.

Chesapeake has completed its land acquisition phase and is now focusing on development of those reserves. Production will increase, and in a pro-rata basis, capital needs should be reduced. Increased production will generate higher levels of cash flow further reducing needs for external capital. CHK has also announced its intentions of using asset sales as a source of funds, and not accessing the public capital markets. Not only will this drastically slow the rising pace of the share count, but enhance value though the asset dispositions.

Reserves that have little or no future upside for CHK can be sold at almost 2x the level as implied by CHK’s share price. Going forward, CHK will capitalize on the assets that came at the expense of diluting the equity and produce returns justifying those actions. This should quell apprehension among investors and remove any overhang in the stock price that may have arisen from it.

CEO Continues to Buy Stock

Chesapeake’s CEO, Aubrey McClendon, is no stranger when it comes to insider buying. McClendon has been buying aggressively recently, purchasing 600K shares in the last week of February even while CHK shares are hitting all-time highs. Back in January, McClendon picked up more than 500K shares around $36.

Barron’s reported last week that since July 2003, McClendon has bought 254 million in stock at an average price of $28.61. He has been an astute investor as well: data from Thompson Financial indicates that CHK shares have increased 40% in the 6 months following McClendon’s 61 prior buying occasions. He is halfway there on the January buys.

The CEO thinks shares are poised to keep moving up, and he has a track record of being right. It’s often a good idea to follow the smart money. We, as investors, will never have as much information and tools to analyze CHK as McClendon, thus his investment opinion will always be more qualified and informed. Opposed to a gradual rise, CHK’s share price increases in spurts, followed by longer periods of sideways movement. It appears CHK is embarking on its next leg up to a new trading range.

Short Interest Continues to Increase

Chesapeake’s short interest has increased for the past two periods, which has proved to be a poor bet as the share price has risen. I wouldn’t bet against CHK. Certainly not for the long-term, as I am very sure CHK will go much higher. In the short-run, I can’t be so sure. A pull-back is highly possible, and obviously that is what the shorts are betting on.

However, the energy sector is exhibiting strength in a very weak market and economy. There are fundamental and technical factors supporting CHK shares. The strong momentum could continue to drive CHK higher. In addition, the increased number of shorts could add pressure if momentum continues, further contributing to higher share prices from a short-squeeze. Hence, in my opinion, the short interest is positive since it represents future share demand, and is not a result of fundamental problem with the company of sector.

Disclosure: Disclosure: long CHK.

Comments

[beegdawg007]

There are near term problems with natural gas. First realize that NG is used in the U.S. for two primary purposes. Heating homes and, as a fuel source for some cleaner power plants.

First heating homes... the problem here is the current very low rate of new home construction, now the lowest in a decade, means new customers for natural gas are signing up at a much lower level now then in the past few years. Growth for that portion of the market is stagnant right now. That may change in a few years, but for now, there is very little GROWTH comming from the residential side of that market.

Power generation... Here much is made of how dirty coal is vs. NG. That is true. However, in the U.S. a BTU from Coal costs 1/5th as much as does a BTU from NG. And, contrary to what some would have us believe, new coal powered electric plants are still being approved and built in the U.S. Second, in regards to power generation, NG has a new competitor. If a plant is going to be built and powered by NG (not coal), wind power is now cost competitive and cleaner. This is why Mr. Oil himself, T-Boon Pickens, is now building the largest U.S. wind powerer plant in West Texas. This is a 2 gigawatt monster which derives energy from 600 large wind turbines. This plant, when completed will supply electricity to 200,000 homes. And, this is but one of dozens of Wind Projects being constructed in the U.S. right now.

The other issue with NG is that supply is not at all in jeopardy. Inventories may be comming down, but all that needs to happen is for the spigget to be cranked up on the pipeline to resupply the storage. During the past few years, new NG wells were drilled at an enormously high rate, and this is still going on. AS a result, it is very unlikely that we will see a shortage of supply of NG in the near term. I am not predicting a crash in NG prices, but I see no reason to expect much of an upside either. To me, it appears as though the demand/supply curve is really in limbo for now. Now coal... that's a completely different story, but one to be told some other time. And then there is solar... the fastest growing industry in the world right now!!

[ErnieMontague]

I agree with beegdawg's analysis. NG will always be a hugely important energy source, however, it does not replace oil. Most oil is used for gasoline production, with the remaining half of the barrel going to bunker oil, aromatics, asphalt, kerosene etc. . NG does not replace any of these.

Nonetheless, it will remain a hugely important source of energy for decades. Solar needs a footprint 100 times what it is now to make ANY impact on oil usage.

Chesapeake was a bargain at $28. At current prices it is a questionable investment.

[JLeo]

Thanks for the article & the comments. I was under the impression that natural gas usage was going up due to several factors other than being pegged to oil and cost compared (BTU) to coal and that is because oil sands production is increasing (?) for oil, also increases in fertilizer damand, a component for some plastic material production reqirements that are going up due to developing markets (BRIC), etc. Please comment.

[beegdawg007]

U.S. natural gas is not yet being exported, at least not in any significant amount, simply because there is a shortage of the special kind of ships needed to transport NG. However, when there are enough of those ships, U.S. NG prices might actually decline because there are many sources of NG in the world which are much cheaper than the NG being produced in the U.S. We are actually likely to become an importer of NG.

[Mmarrkk]

beegdawg: I have to disagree with your last comment regarding US nat gas export. US nat gas is not being exported because we are SHORT! We actually IMPORT nat gas from Canada and from the Middle East via LNG. And LNG import rates will be increasing over the next couple of years as 2 very large projects are coming on that have the gas contracted to US re-gas plants. So, why would a shortage in LNG tankers be the problem for us EXPORTING?

Right now, supply is growing through drilling. And demand is growing, but a bit slower. So, what happens if supply outstrips demand? We do not have the facilities within the continental US to export gas. They just don't exist. So, we would cut back on Canadian imports and LNG imports. But, over time, the greenies in this country will drive additional increases in nat gas consumption over other fuels due to its clean properties. Near term I think there will be some price weakness but long term prices are headed into the 10-11 range.

[T Muller]

I think there is some resistance to LNG imports. The US does receive small amounts of LNG imports, but there are significant security issues. From my understanding, much of the off-loading occurs offshore.

If a LNG tanker exploded in harbor, the destruction would reach far in-land. Thus, there are worries of LNG tankers being terrorist targets.

I would think if LNG shipments really caught on, there would be additional costs incurred for the security aspects would would add to LNG prices. I think drilling will be the answer for the near future.

[whidbey]

I took profits recently. Maybe in again in the fall, if there is a fall.

[swimjames]

Wind power plants are not as simple as they sound since they need a very complex transmission line grid to work, which takes time and serious capital, and they also need a backup as power outages would occur when there isn't enough wind (backup would use gas and/or coal powered plants). To solve the lack of wind, the wind turbines would have to be built offshore, in the ocean where there is ample wind, but there has been resistance to that (view from shore front and danger to birds). Denmark has been a big user of wind power, but the high tax rate structure is there to support the costs, whereas the US is not in a position to add a significant amount of wind power anytime soon, as the cost is too prohibitive. The argument of cost and time can also be used for nuclear power, so that leaves gas, imported/domestic, and coal which is cheap and plentiful, but highly pollutive. In recent articles about China and Australia/New Zealand, it is abundantly clear that gas is the preferred energy source and is used more and more and the eyes of the world are now upon the USA which I expect will be using more gas despite a limited supply, which for the long term spells higher prices for gas. In the meantime, construction & engineering firms such as Fluor Corp, Jacobs Engineering and Foster Wheeler have been raking in the bucks for scrubbers to clean the coal from coal plants and also for building nuclear plants around the world (including China), which is the cleanest energy source around. From what I understand emission credit trading can be quite profitable for the clean energy companies , which is in theory the best incentive for companies to plan cleaner alternatives for the future. The question that remains is if the government continues to regulate how much utilities charge customers for heat/electricity, will the government subsidize the extra costs associated with cleaner power or create tax incentives that favor green non-pollutive energy? My guess is that coal will be around for a while... (immediate evidence is the rise in coal prices and rise in railroad share prices).

[swimjames]

lots of evidence for opposition to coal fired power plants:
12:17 AM 3/22/08
The Wall Street Journal Interactive Edition
Kansas Governor Vetoes Power-Plant Plan
Kansas Gov. Kathleen Sebelius vetoed a bill aiming to remove a roadblock to the building of two coal-fired power plants in southwest Kansas.

[TurleyMuller]

swimjames-
thanks for the update. I think it is significant if states are opposed to coal plants. We know the bankers had been but localities preferred coal because it's cheaper for their constituents. However, it's a worthy development if they are now preferring cleaner energy. I think all this "green" dialogue has resulted in many believing saving the environment is worth it even if it involves slightly higher costs. Yet, if carbon credits and emission fines are strictly implemented then cleaner fuels such as NG may actually be I than dirty energy sources.

[swimjames]

just went to see a lecture in Princeton University of a highly respected and reputable 'green energy' scientist who informed us all of all the new wind projects in the USA (huge growth so far, and much more growth potential to come). good co for that is VESTAS. Also, gas according to IEA is being depleted in USA (fields are getting older, and new ones are hard to find), so alternative energy will have to step in big time to fill in gaps as the demand for gas keeps rising - that is inevitable!

[swimjames]

recent BW article: While wind has reached maturity, there are research efforts in Denmark aimed at developing smaller wind turbines that can operate at lower wind speeds and cooler temperatures. That could lead to equipment that can derive two to three times as much energy per acre of land as larger turbines.