Chesapeake Energy Appears Very Well Positioned

For the first time in a long time, natural gas may have a time to run. When looking at oil, it has bullish technicals, but it is starting to look a little toppy in the current market environment. The refiners are absolutely getting crushed with the possibility of recession going forward and even more troubling, the price of oil is killing the crack spread.

Natural gas looks extremely bullish as the price doesn't currently reflect its value. Granted, it is generally valued off of oil and oil is linked to the dollar in its current trade, which isn't the same for natural gas as its price is more regional than international in nature. Natural gas is a highly volatile commodity and should be traded carefully, but there are other ways to do it within companies that have a large exposure to it.

Natural gas trades at around $10 and oil at roughly $110. I know these numbers are not exact but it makes it easier to figure what the true value should be. The average over time has been a six to one ratio with oil. Oil is inflated because of the devalued dollar, but if you check, even with a massive pullback in the dollar natural gas is still undervalued. Oil would have to trade for $60 a barrel for this to occur. If oil was to bottom at $80 it would still leave natural gas investors with a 33% gain.

There are several reasons I would invest in Chesapeake Energy (CHK). First, the volatility of natural gas is not for everyone, even with the possibility of it going higher. Second, it is the number one independent producer of natural gas (third including the conglomerates). It is the number one driller in the United States with 254 rigs. It has consistently beaten the market with its hedging strategies, with 2006 and 2007 gains in the billions of dollars. Year over year it has increased production, 34% and last year 23%. Estimates have increases at 21% and 14% the next two years.

Percentagewise it had growth in production and reserves better than any large cap competitor last year. It has over 10,000 prospective, unproven reserve locations that could have potential. It has a large inventory of seismographic technologies to help locate and isolate possible natural gas potential.

Estimates for 2008 have EBITDA at $57 billion (see Q1 conference call transcript). Free cash flow should increase to $5.3, with net income at $1.8 billion for this year. If you would have bought this stock 15 years ago, you would have increased your position 32 times over that period.

2007 proved to be a spectacular year for CHK. It posted $2.1 billion in revenues. It had an adjusted EBITDA of $1.4 billion, $1.3 billion in operating cash flow and $466 million in adjusted net income, giving its shareholders $.93 per share in common earnings. This was all done with a 369% reserve replacement rate.

When we look at the company from a growth standpoint, it seems to have a better outlook than many of its competitors, especially the oil conglomerates. As oil companies are having a tough time not losing production growth, CHK has huge increases in demand for natural gas. For 2006 and 2007 production grew 23% per year. In 2008 it is looking at over 20%; this with higher prices could mean substantial earnings. Its 11tcfe of proven reserves will increase by 33% in two years. Its inventory of proven drilling locations is logged for the next ten years with three times more proven reserves than unproven. In the past five years the EPS has grown from $.17 to $2.62. The stock was up 35% alone last year.

Back in 2000, CHK made several huge purchases with the oil and gas industry. The reason was that they predicted the large rise in both commodities coming, and timed it perfectly (or just got lucky), either way the company rewarded its shareholders handsomely. Many of its purchases were in areas that had difficult assets to access and thus now are affordable through newer technologies and increased price for the commodity. Now CHK is essentially moving to a drilling approach as opposed to acquisition, but selling areas at huge increases if the opportunity presents itself.

The best may lie ahead for CHK as it has huge areas to create revenue. It has a huge base to drill and as the price of the commodity increases it may be a good time to get in while others are focusing on oil. There will be a major conversion from coal to natural gas in the near future and that upside will probably be more for gas than oil. This is a safe and great play within the energy markets.

Comments

[drmalaka]

Note that CHK will not benefit as much as one would think becuase of rising nat gas prices as the company hedges a lot of its production. The CEO was interviewed recently and he mentioned how he owns too much of the company to be beholden to changes in gas prices.

In the same interview he talked about his recent purchases of the stock (a massive amount I believe and I think he mentioned he had 31 million shares, not sure if this is correct or includes options). He said flat out in the interview that he thinks the stock has a double. This is not the type of comment a competent CEO makes off the cuff. I assume the SEC would not be to happy if he were selling and pumping the stock on the way up. That is a true believer and I can not imagine anyone else who has more info about how this company will do.

[DutchMark]

Although a good overview in itself, it contains a few annoying errors. EBITDA for 2008 will not be $57B. (I wish!) Maybe you missed a decimal point in there somewhere? Also, the statement that proven reserves are three times the size of unproven reserves seems to have things backwards.

[User 189732]

I have had CHK for several years and added to it once or twice. I only wish I would have added more and still may do so.

Aubrey has been spot on far more often than not and he is buying shares with his own money. I think that's millions of reasons to join him.

[BradA]

Aubrey has purchased about $111 million of CHK in the past 9 months at an average of $45--I doubt he would put more money in unless he had tremendous confidence in the company's potential.

[ChandlerLutz]

Great article...Drmalaka, do you have a link to that interview?

[drdonrs]

I have been a stockholder for several years. In the last month I added to my holdings. This is an exceptional company, with exceptional management who put their money where their mouth is. Natural gas will have its ups and downs but always seems to have higher highs and higher lows. This, together with my XTO holdings is making me a happy camper.

[warelf]

Dutchmark is spot on - annoying errors. The article is pretty flip and doesn't consider any downside - good for cheerleaders who wish their stock would go up

Let's have some better analysis for a lead off article

[warelf]

Dutchmark is right - annoying errors + the article is little better than cheerleading and very light on analysis and detail

McLendon bought shares, was right in the past & is probably right in the future doesn't pass for analysis

For example: Hedging doesn't always add to shareholder value & will be a significant negative for 2008. 3 or 4 years ago this was also true but overall they do end up on the + side. CHK HAS to hedge because they can not risk low NG prices because of high debt and cash committed to capex. Unlike companies like Cimarex which are cleaning up now because they are largely unhedged

It probably will double if NG stays in the $8 to $10 range but remember that it is a commodity & can just as easily fall back. Currently a very large facility is shut down in the Gulf and this is affecting NG prices which are virtually always down in the May shoulder season - this is an anomaly.

This company has HUGE potential with he Fayetteville & Haynesville shale areas but pull costs are not known & likely to rise + they need high NG prices to be economic.

It pays not to fall in love - even with Aubrey :-)

[warelf]

PS I own CHK shares

[DaveinHackensack]

I asked this in another thread about Chesapeake, but have any of you looked at this (mainly) natural gas royalty trust, TIRTZ.OB? About 85% of its revenue comes from nat gas, with the rest from oil. Very thinly-traded, since it has such a low market cap and trades OTC, but the yield is currently over 10%.

[DrGamimeno]

Fortune magazine states you should hold onto the oil stocks for at least one year and a half to two. It is going up and will continue to go up. I just bought $10,000 of chk and I usually only invest $2000 to at most $3000 in stock as opposed to mutuals in the oil industry. To address some natural gas questions, they usually follow the oil prices as you know. Brad A.-Who is Aubrey? So aRE YOU SAYING THROW IT ALL IN THE POT? Please advise..What do you guys think of Cotton? What else are you guys looking at? I am looking at consumer good retail like CVS as well, but dont see the profits like I anticipated.

[crimfunk]

<Brad A.-Who is Aubrey?>

Better find out before investing 10k. The interview was on Fast money.

[whidbey]

The article is a little glib, but what should trouble the most is the assumed substitution of gas for coal. It is not that easy to do. Some big coal fired plants are duel fuel, but most are not, and even where they are capable of using either, most do not have contracts for firm supply in place. I think a dual strategy that holds both COAL and GAS is to be preferred over either alone. I like CHK but I do wish Aubrey would learn to stop stealing NBA teams.

[morganman]

With the rate of reserve growth, this stock should really rip higher, and make us all wealthy, at least those of us who own a decent amount of the stock. Just follow Aubrey's lead, or are you stupid and blind. He can lead you to the gas, but can't make you buy!

[Ozarker]

With compressed natural gas being available almost everywhere, at a price roughly a third of gasoline, I don't know why it wouldn't be the vehicle fuel of the future. It also burns cleaner than any other fuel that has an infrastructure already in place. If that transformation takes place, then the sky's the limit!

[do]

I do not own CHK but would consider the option chain. Is summer the time to profitably enter a natural gas call option due to historical seasonal variation in price?

[investorslive]

That will be a good short soon - it needs to correct a bit so it can stabilize and head higher... (not long term short)

I will cover it shortly
www.investorslive.com/.../

[Raider2]

CHK and Aubrey are highlighted in the 12May2008 issue of Fortune Mag.see it online . Believe this is moderately good for the stock.Natural gas is a clean fuel answer to the U.S energy prob. ,as well as wind,solar ,geo-thermal and perhaps nuclear.

[MichaelFilloon(legmaker)]

I would just like to appolagize for the mistakes in the article, first one, but it will get better. Check the chart though, my call is up 35% since the call and I believe it is going higher. With reference to hedging, with a company of this growth it is a good idea to hedge. The growth of production will more than satisfy investors in the coming future. Plus check the natural gas chart, even if there is a pull back in oil, natural gas still looks good on valuation with that commodity.
As a long term holder in this stock, I was happy to here the CEO's interview on Fast Money speaking of hedging. He has bought a ton of shares and looks to continue to do so. I am long all year on this stock and will continue to do so. Thanks again everyone.

[User 206965]

I like chk but I love UPL better.

[Mmarrkk]

Somewhere up the thread someone mentioned that the hedges hurt shareholders. Only due to the convoluted accounting rules do hedges reduce Net Income. In the real world, not the hairy fairy world of financial accounting, hedges do not "hurt" net income. They might reduce the opportunity to make MORE money,though. For instance, if I have hedges at $8 and gas is selling for $10, financial mumbo jumbo makes this look like I LOST $2 on my balance sheet. In fact, I only loss the opportunity to make an addition $2. Hedges provide a known return on investment but they do take off a bit of the upside! But they certainly don't hurt value.