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Cory Renauer, Cory Renauer (10 clicks)
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Chesapeake Energy Corporation (CHK) was downgraded recently by analysts Stifel Nicolaus and RBC Capital. Reasons for the downgrades and lowered price targets include a downward trend for natural gas prices and recent difficulties selling off assets. Although I agree with the assessment that share prices of Chesapeake will remain depressed for the short to intermediate term, I think this is an excellent opportunity to scoop up shares of a stock poised to make large gains from rising global demand for natural gas.

Domestic natural gas prices are rebounding after frighteningly low prices seen in April largely due to producers like Exxon Mobil (XOM) and Chesapeake lowering the number of natural gas rigs in operation. In response to a weak domestic market for dry gas, producers have lowered their dry gas rig counts and shifting their focus to liquids and oil until prices rebound.

Chesapeake's cash flow problems not as serious as they seem

Chesapeake's cash flow is a concern for analysts. Share prices were rebounding off their lows seen earlier this year on hopes that the company would be able to sell off assets to pay down debts. Although they have had some success, there are signs that it won't be enough. At the end of last year, the French energy giant Total purchased a 25% ownership stake in Chesapeake's Ohio Utica Shale leases for $2.3 billion. This May, Total spent another $2 billion on leases in Ohio, and was expected to buy a lot more. Unfortunately for Chesapeake's balance sheet, Total has decided to stop acquiring more US shale until prices rebound.

Chesapeake's Q2 2012 debt ratio, as calculated by total liabilities/total assets, was 0.584, down slightly from 0.586 in Q1 2012. For the past few years their annual debt ratio has hovered between 0.62 in 2009 and 0.59 in 2010. Although they are financing most of their assets through debt they have been careful not to take on dangerous levels of debt.

Their debt ratio alone doesn't tell the whole story related to Chesapeake's sound financial management in an ever fluctuating sector. See a much more detailed analysis of Chesapeake's financials here. Chesapeake's sound financial management is one of the main reasons I recommend buying and holding this stock for the long term.

Company Name (ticker)

Q2 2012 Debt Ratio

Debt Ratio 2011

Debt Ratio 2010

Debt Ratio 2009

Chesapeake

0.58

0.57

0.59

0.59

SandRidge Energy, Inc. (SD)

0.69

0.74

0.71

1.07

Devon Energy Corporation (DVN)

0.49

0.47

0.42

0.48

Chesapeake chairman puts his money where his mouth is

Another bullish signal that leads me to believe that Chesapeake shares are a buy at less than $19 is the recent insider buying by the non-executive chairman Archie Dunham. The former ConocoPhillips (COP) CEO was brought onboard to clean up the mess made by Aubrey McClendon, and has since accumulated 326,000 shares. His latest insider purchases were made just last week at an average price of $20 on the open market.

Foreign demand for natural gas on the rise

Outside of the US demand for natural gas is rising, yet the ability of US companies to export gas is seriously lagging. My long term bet on Chesapeake hinges on America's ability to rapidly switch from an importer to an exporter of natural gas. Last week I wrote about Cheniere Energy's (LNG) efforts to ramp up their natural gas exports to meet rising demand in Asia.

The glut of natural gas due to wildly successful advanced extraction techniques in the United States is something that China, and many others, would like to would like to duplicate. If the US can't modify its existing LNG import terminals for export, companies like Chesapeake could lose their opportunity to take advantage of huge differences in natural gas prices between the US and Northeast Asia.

I believe that exporting gas from the US will remain profitable for many years to come, but right now demand in Asia is sky high. Northeast Asian demand will certainly relax over the next few years as China's Sinopec allows foreign firms to develop their shale gas resources. The faster export facilities are up and running, the better.

Electricity generation from natural gas to provide a much needed buffer

Rising electricity generation from natural gas should provide a sort of buffer to keep natural gas prices from making wild swings. Coal fired power plants that are fitted for natural gas can easily revert back to coal when it becomes more economical to do so. When natural gas prices are too high, plants can be expected to revert back to coal, reducing natural gas demand. Conversely, when natural gas prices drop, power plants should be encouraged to use it in place of coal, increasing demand. We will still see gas prices rise and fall in response to unexpected weather patterns and fears of storage overflow, but I expect less dramatic spikes and dips in the future.

Natural gas vehicle usage on the rise in the US

The most bullish signal for my long term Chesapeake Energy recommendation are promising signs that the United States might finally be warming to the idea of using compressed natural gas as vehicle fuel. Natural gas vehicles are on the roads in the US, but heavy oil subsidies and an immature CNG distribution network mean it will be many years before Americans can take advantage of the savings enjoyed by drivers across North and Southeast Asia.

Unfortunately for US consumers, Honda is the only automaker currently offering gasoline/CNG vehicles in the US. The CNG Civic is also a whopping $5,600 more than the standard model. From experience I can say that a CNG tank can be added to a gasoline powered passenger car for less than $500, but I doubt we will see mechanics offering that service for those prices in the US. Still, the most popular vehicles, by sales, are also the least expensive to operate. Adding a natural gas option to passenger vehicles isn't difficult or necessarily expensive and should make them much cheaper to operate than popular hybrids.

While, I honestly don't expect much progress on the passenger vehicle front, I do think there will be rising demand for natural gas in the United States from delivery vehicles. Cummins (CMI) and Westport Innovations (WPRT) are cooperating to produce natural gas engines to be used mainly in trucks, and also in locomotives. Currently a family of four can expect a yearly savings of less than a thousand dollars by driving a CNG Civic. A trucking company, on the other hand, has a lot more to gain by switching their fleet from diesel to natural gas.

While Cummins and Westport put the engines on the road, Clean Energy Fuels Corp. (CLNE) continues to build the necessary network of CNG fuelling stations. According to Pike Research's Smart Transportation estimates, there will be 123,600 natural gas vehicles on US roads by the end of 2012. Clean Energy fuels is rapidly building stations to accommodate all of them.

Summary

There is no doubt that difficult times are ahead for Chesapeake, but I feel that they can hold on to their place as the world's number two producer of natural gas until conditions improve. I expect domestic demand to steadily rise due to expanding vehicle use and electricity production. I also expect steadily rising exports of natural gas from the US to areas with higher demand. Chesapeake Energy currently offers a dividend yield of 1.9%, which I expect to collect and reinvest many times as I hold on to this stock for several years.

Source: Chesapeake Downgrades Are An Entry Opportunity