As if Chesapeake (CHK) did not have enough problems on its hands because of the depressed natural gas prices, the actions of its CEO, Aubrey McClendon, who had to step down as Executive Chairman, have contributed significantly to its problems. It has gone from being one of the stars of the energy business to an embattled company which is resorting to asset sales in order to strengthen its financial position. McClendon has played a significant role in founding and building up the company, but his seeming recklessness as well as his disregard for good corporate governance have damaged the reputation of the company and created a stigma around its name.
Despite an attempt to switch focus from natural gas to oil and gas liquids, the company is still highly dependent on the natural gas business. The company has increased natural gas production and this is offset the lower prices to some extent. Moreover, natural gas only accounts for about 40% of its revenues in the second quarter compared to 48 % in the preceding quarter and 72% in the same quarter of the previous year. Unfortunately, these declines were primarily due to the decline in prices from the last year. It is extremely unlikely that natural gas prices will recover in the near future. But the good news is that oil production was up 88 % from the previous year's production levels and up almost 22% over the first quarter. Oil and natural gas liquids now account for around 60% of revenues. Prices for oil and natural gas liquids continue to be strong and are expected to stay that way.
Chesapeake reported net income of $929 million in the second quarter against $467 million for the same quarter of the previous year. But virtually all the net income came not from operations but was made up of $490 million of unrealized gains on derivative contracts and $584 million in gains from asset sales. The adjusted net income only works out to $3 million. The company is going to have major problems in generating cash flows from operations even though capital expenditure is expected to reduce from $13 billion in 2012 to $7 billion in 2013 and asset sales are expected to bring in another $5 billion or so.
Consequently, the company faces a large funding gap of about $16 billion which it must scramble to cover. The gap has caused primarily by aggressive spending in an attempt to diversify the portfolio from gas to oil and gas liquids. The estimated capital expenditure for 2012 is around $12 billion and their income after expenses for the year is only expected to be around $2.5 billion. This would create the funding gap of around $10 billion and the company is planning to complete asset sales of approximately $13 billion to $14 billion to cover this gap and this should be sufficient in normal circumstances. Management is going to be under severe pressure and I can only hope that the adverse conditions do not influenced their ability to take the right decisions about price and the assets that they are going to sell.
Because of the importance of the asset sales to the company, it is necessary to examine the progress in this direction in greater detail. For the first half of 2012, asset sales worth $4.7 billion were accomplished. These included the sale of 10 year VPP (volumetric production payment) for hydrocarbon producing assets in the Anadarko Basin Granite Wash play and preferred shares of its subsidiary, CHK Cleveland Tonkawa, as well as a royalty interest in the Tonkawa and Cleveland plays. The largest of these disposals was the sale of its general partner and common interests in Access Midstream Partners (ACMP) to Global Infrastructure Partners (GIP) for $2 billion. It announced that it has signed a Purchase and Sales Agreement (PSA) for properties in the Midland Basin area of the Permian Basin with affiliates of EnerVest Limited. Chesapeake is also currently negotiating with GIP for the sale of most of its remaining midstream asset. $7 billion of asset sales are expected to be completed in the third quarter of 2012 and, if this target is reached, the funding gap for the year will be covered.
There is some speculation about the possibility of Chinese investment in Chesapeake, especially from its one-time partner Sinopec. Sinopec is interested in shale gas extraction technology and has many partnerships in the US but will probably not operate fields by itself. The largest investment that it has made is a $2.5 billion joint-venture with Devon Energy (DVN) for a 33% stake in the fields covered by the deal. Sinopec is unlikely to be interested in operating Chesapeake's large Permian Basin holdings by itself. Moreover, the Permian Basin holdings are rich in oil and what the Chinese are looking for is technology for gas. But, a couple of deals suggest that the Chinese strategy may be changing. Hess (HES) recently established a joint venture with PetroChina to develop the Satanghu Malang Trough which is one of China's many possible shale oil reserves. The deal is unusual because regulations in China prevent local refiners from making a profit. China is also looking outside the United States going by Cnooc Ltd making an all cash offer of $15.1 billion for the Canadian energy producer Nexen (NXY).
Chesapeake may look cheap at the current price of around $19 because of the price decline caused by its problems, but it would hardly qualify as a desirable investment. I cannot classify it as a growth stock because of the uncertain outlook in the short term. I cannot call it an income stock either because of the current yield of around 1.7% and the fact that the problems and the funding gap could affect the dividend. All in all, you are better off not touching the stock at the present time. If you already have an existing holding, I recommend that you continue to hold in the hope that the company overcomes its current problems.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.