4 Reasons To Be Bullish on Chesapeake Energy

Here are four main reasons for my bullish stance on CHK:

1) Chesapeake is the largest independent domestic natural gas producer.

This is beneficial for several reasons. It has a very large, diversified asset base from which to grow production and reserves. When you are such a big player and have extensive experience drilling in different areas of the country, it gives you an advantage that should lead to very high success rates with future drilling programs. Also, it means Chesapeake would be an ideal acquisition target for one of the big oil giants at some point in the future, if and when management decides to consider an exit strategy.

2) Industry leading production and reserve growth.

Indeed, the numbers back up the points made above. Chesapeake's organic production and reserve replacement rates are among the highest in the large cap natural gas sector (they might be the highest, but I do not have data in front of me to prove that, so I will include the "among" qualifier). In 2007, CHK increased gas production by 24% over 2006 levels and the company's reserve replacement rate was a staggering 369%. Company guidance for 2008 is for 21% gas production growth, followed by another 13% in 2009.I think you will be hard-pressed to find large natural gas producers that are posting organic growth rates much higher than that (clearly small firms can have large growth rates due to a small starting base). As a result of past growth and the expected continuation of it for the foreseeable future, I feel Chesapeake's fundamental outlook is as strong as, if not stronger than, the competition.

3) Extensive Hedging Program.

Chesapeake has the most extensive gas hedging program in the industry. The company has 70% of 2008 gas production hedged, as well as 33% of 2009 production. I like the hedging program because it reduces the commodity price risk the company faces, so its earnings stream is very predictable. The gas market is very volatile, and as a result, Chesapeake doesn't get hurt too badly when prices fall, but when markets are strong (or weather patterns cause temporarily sharp increases in prices) the company steps in and increases its hedges to lock in high prices that might not be realized otherwise.

4) Superior Management, Insider Buying.

CEO Aubrey McClendon has been one of the most aggressive insider buyers of his company's stock that I know of. Given his superb track record of producing strong financial results, this is not surprising. McClendon has long been singing the praises of his company's stock, but unlike most executives who do so, he has been putting his money where his mouth is (and he's been right). He is the largest individual shareholder in the company he co-founded.

In 2008 alone he has purchased more than 1.63 million shares of CHK on the open market at prices between 35 and 46 per share. That is ~$70 million of his own money! Investors should feel comfortable that they are investing right alongside him. Plus, with such a large stake in the company, you can bet that when he wants to retire, the company will be up for sale to maximize shareholder value.

A reader mentioned Devon Energy (DVN) and San Juan Basin Royalty Trust (SJT) as other, potentially more attractive natural gas plays. I am actually a big fan of Devon. However, it's not really a pure play on natural gas (they are 50/50 between gas and oil). If you are looking for a well balanced domestic energy exploration and production company, I agree DVN should be near the top of your list.

Royalty trusts are interesting plays, given their high yields, but they tend to be less geographically diversified and have less financial flexibility. SJT, for instance, focuses on New Mexico, so its asset base is not diversified and it is much smaller than Chesapeake.

Also, while the high dividends of trusts are attractive, it really does not allow company management to be flexible in how it grows the business. When you pay out most of your income out as a dividend, you don't have much capital available to grow faster organically or make acquisitions. Rather, you are forced to sell debt to raise money, which isn't always an ideal funding mechanism (like now when credit markets are shaky).

Those are my thoughts on Chesapeake. Although I am a big fan of the company, there are definitely plenty of very good energy companies from which to choose from.

Full Disclosure: Long shares of CHK at the time of writing.

Comments

[Encore]

Please review the make-up of income royalities. I believe growth by any means is not possible. Only Canadian royality trusts are able to grow by exploration or acquiring other assets. I believe US trusts are different. Please confirm.

[term]

That is substantially correct. US trusts can continue to drill on their own land but can not add to their land holdings. In the case of SJT, I think the article is a bit misleading: it receives royalties from ConocoPhilips (owner of Burlington Resources) to distribute and does not actually have its own company management or plans to expand its business. (I think it technically has just one employee).

[Elliot Miller]

Encore is correct. US royalty trusts are essentially liquidating entities, unlike Canadian trusts, which grow and add reserves.

[Rick L]

Chad,

Good analysis on Chesapeake. I have been a holder and ocassional buyer since '06 and remain bullish on the stock despite the recent appreciation. Two more positives to consider here with CHK:

Management has pledged to begin harvesting assets now (less focus on acquistions) without using capital markets. No more share offerings!

Also, natural gas is gaining traction (pricing +$8) because it is barely over the 5 year average of supply due to a normal/cold winter and less LNG imports. Thus, according to Chesapeake's March Investor Presentation, the company projects the NAV (net asset value) per share with $8 NG is $74.04. Quite some upside here if a major decides to add to its reserves.

Lastly, because the company has been getting a lot of publicity lately I would expect increased volatility so trading around a position might be more difficult yet more profitable. Either way thanks for the piece Chad. Good work!

[who noze]

u make a strong case w// chesapeake any opinion on talisman energy[tlm]

[p2pvoice]

I am also very curious to learn about the pros and cons of Canadian Royalty Trusts. When I look at one such as PGH with great fundamentals up trending "stock" with 14% dividend, I ask myself: Is it too good to be true?

Seeking others' wisdom,
Kanti Purohit

[p2pvoice]

I am also very curious to learn about the pros and cons of Canadian Royalty Trusts. When I look at one such as PGH with great fundamentals up trending "stock" with 14% dividend, I ask myself: Is it too good to be true?

Seeking others' wisdom,
Kanti Purohit

[p2pvoice]

Chad:

It appears that your #3 reason "Extensive Hedging Program" doesn't seem to hold for CHK. When natural gas - along with all commodities - fell on Mar 19/20, CHK fell right with it - reaching a low of 42.15 on 3/20 (-5.76 from the close of 3/18) before recovering to close at 44.29; but still -3.62 from 3/18 close. I should also note that the broad rose significantly on 3/20!

I would very much welcome your interpretation of this movement.

Thanks.