Chesapeake Energy (CHK) has been in the process of transitioning from a pure-play natural gas company to a more diversified oil and gas company, as the price of natural gas has been on a downward trend for a couple of years and is currently in the cellar at around $3 per MMBtu. As a result of low natural gas prices, the company has been struggling to make a profit, but the price of oil has remained at the $100 level for the last year or so, so the company is in the process of transitioning to producing more profitable oil. Chesapeake plans to have completed the transition from a pure-play natural gas company to an oil and gas company by the end of 2013. Chesapeake expects the price of natural gas to recover in the future, but until it does, the company plans on focusing on the oil segment of the business.
As noted in Chesapeake's Q1 2012 earnings call held on May 2, 2012, the company has gone from producing 30,000 barrels of liquid per day at the end of 2009 to producing 114,000 barrels of liquid per day. The company estimates future oil production at 150,000 barrels per day in 2013, 200,000 barrels per day in 2014 and 250,000 barrels per day in 2015.
The transition from a natural gas company to an oil and gas company has been rocky, as the company has been quickly ramping up oil drilling rigs, while slowly ramping down gas drilling rigs. The ramping/un-ramping process has created a cash flow burn for the company, as the company reported an Earnings-per-Share (EPS) of $0.18 in Q1, which was considerably below the expected EPS of $0.29.
Also contributing to the low EPS results were non-cash losses associated with equity investments in Frac Tech and Chaparral, as well as a Marcellus impact fee passed by the state of Pennsylvania, which was assessed, retroactively on all operators.
Chesapeake expects to be cash flow positive in years 2014 and beyond and has no plans of expanding its operations outside of the U.S., as the company is going to take advantage of its very high-quality asset base located in the U.S. The company's strategy going forward is to transition Chesapeake from an aggressive identifier/leasehold acquirer into a very high-quality manufacturing company focused on achieving exceptional returns on capital on assets already owned. Additionally, in an effort to shore up its balance sheet, Chesapeake has been selling some assets and has taken out a term loan for $4 billion with Goldman Sachs Bank USA (GS) and Jefferies Group (JEF).
The company's stock price has dropped significantly over the last year as a result of the pummeling of natural gas prices as shown below:
At this point, the stock price appears to have put in a bottom and is transitioning to a bullish sentiment.
With the low price for clean burning natural gas, companies such as United Parcel Service (UPS) and FedEx (FDX) have been transitioning their truck fleet to operate on natural gas instead of diesel. The conversion of trucks to natural gas, combined with the natural gas industry's pullback in activity will eventually result in a recovery in the price of natural gas, which could be very lucrative for Chesapeake. The long-term prospects for Chesapeake look bright, however, in the short term, the company has a lot of work to do in order to transition to an oil and gas company and to make good on its plans to convert to a high-quality manufacturing company.
With Chesapeake's upcoming Q2 2012 earnings release scheduled for August 7, 2012, an investor might consider protecting an investment in the company, just in case the company has some bad news to report. A protective strategy to consider is a protected covered call or collar, as the strategy provides positioning for a potential profit, even if the stock price remains unchanged, while protecting against a large drop in stock price. The protective covered call may be entered by selling a call option against a stock and using some of the proceeds to purchase a protective put option for protection or "insurance."
Using PowerOptions tools, a variety of protected covered call positions are available as shown below:
The top position looks attractive as it has a potential return of 2.3% (47% annualized) with a maximum potential loss of 7.4%, so even if the stock price plummets to zero, the maximum loss which can be sustained is 7.4%. The specific call option to sell is the 2012 Aug 19 at $0.87 and the put option to purchase is the 2012 Aug 17 at $0.45.
Protected Covered Call/Collar Trade
- CHK stock (existing or purchased)
- Sell CHK 2012 Aug 19 Call at $0.87
- Buy CHK 2012 Aug 17 Put at $0.45
A profit/loss graph for one contract of the Chesapeake protected covered call is shown below:
As a bonus, if the price of the stock is greater than the $19 strike price of the call option at expiration, the position will return 3.5% (71% annualized). Additionally, for a stock price below the $17 strike price of the put option, the value of the protected covered call remains unchanged. And, if the price of the stock increased to around $21, the position can most likely be rolled in order to realize additional potential return.
As an alternative to the protected covered call, an investor might consider a married put strategy for the company. The married put strategy provides for unlimited upside while providing for limited downside. The married put may be entered by purchasing a protective put option against the stock. In order to reduce the insurance cost per day, the put option is selected far out-in-time.
Using PowerOptions, a variety of married put positions are available for Chesapeake for January of 2013 as shown below:
The married put using the 2013 Jan 21 put option looks attractive with a maximum potential loss of 8.5%. However, when considering expected dividend payments during the holding time, the maximum potential loss is reduced to 7.7%. The specific put option to purchase is the 2013 Jan 21 at $4.20.
Married Put Trade
- CHK stock (existing or purchased)
- Buy CHK 2013 Jan 31 Put at $4.20
A profit/loss graph for one contract of the Chesapeake married put, including dividend payments, is shown below:
If the price of the stock increases to above the $21 strike price of the put option, then income methods as described by RadioActiveTrading.com may be applied in order to receive income and reduce risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.