Ah, Chesapeake Energy Corporation (NYSE:CHK). What a story, both good and bad.
Aubrey McClendon and a partner founded the company on $50,000 of borrowed money and ran it up, then down to near bankruptcy, then up again to become the nation's second largest producer of Natural Gas.
In 2005 the future of Natural Gas production looked so dire in the US that liquefied natural gas import facilities were built on all three US coasts to prepare for what was thought to be the inevitable import of LNG. These facilities were never used. Unbelievably, the last I heard, one of those facilities is being converted into an LNG export facility.
On June 2, 2008, CHK peaked at an intraday high of $74. I remember because I owned a bunch of options and stock. I also remember that a day or two either side of June 2, 2008, CHK had a conference call to tell the world about some well results in the Haynesville shale play.
These gas wells have chokes, or restrictions on them. The chokes are measured in 64ths of an inch, so a 64/64ths choke is a wide open, unrestricted choke. The wells around the Barnett shale were producing 8-9mmcf (million cubic feet) of natural gas on 64/64 chokes. These are considered very good wells. Aubrey McClendon told us that the Haynesville shale wells were producing 18+mmcf on an 8/64ths choke! I remember thinking that was an eighth of an inch! it's no more than a pinhole!
On June 2 the NG industry realized that the NG shortage was over. NG was at its peak of $16/mcf and CHK was at its peak stock price of $70/share. Both have been on a steady decline since then. NG bottomed recently at under $2/mcf and CHK went under $10/share. During this decline Mr. McClendon had a margin call on his CHK holdings that apparently cost him $3 billion.
Aubrey McClendon and some others in the E&P industry turned a severe shortage of NG into an incredible glut in three years, saving Americans billions of dollars in the process, but nearly taking his company down as well. Plastics companies are moving back on shore, with good jobs, because NG is so cheap and likely to stay that way. No government involvement in all this, just good old free enterprise at work.
Aubrey McClendon and CHK were good at two things; they almost always knew the direction of future NG prices, but made one enormous mistake back in June of 2008. The company is also very good at estimating and ultimately producing very close to what they claim as unproved resources. They are still good at that.
Today could be the beginning of the mirror image of the debacle that began on June 2, 2008. NG rigs are down to just over 400, electric generating plants are using NG over coal, we might get NG fueled heavy trucks which could cause our importation of crude oil to decline dramatically. The important thing is that NG is $3.52 today. As NG prices rise, the strain on CHK lessens.
This article does the standard job of valuing the proved reserves of CHK at $20 billion net of debt. "Take the difference between $39 billion and $19 billion and you get an implied core shareholders' equity of $20 billion (which, again, excludes potentially billions more in unproved reserves)"
It makes (on purpose) no attempt to value the unproved, undeveloped resources of CHK. The number for these immense unproved undeveloped resource is 348tcf of NG equivalent. That number has appeared on investor presentations (see slide 10) until recently. The total unproved, undeveloped resources is stated in terms of tcf (trillion cubic feet) of NG. Notice that I said resources, only proved reserves can be called "reserves". Equivalent, because most of CHK's resources are NG so they express it in units of NG. If most of CHK's resources were liquids the resources would be expressed in barrels crude oil. 348 tcf represents 17 years of current US NG consumption. One company, 17 years usage of NG. Amazing. At at today's price of $3.52/mcf, that amounts to $1.2 trillion worth of NG. Of course, applying a wellhead price to unproved undeveloped resources is ridiculous. So, lets pick another number to value the NG that CHK thinks they own. How about a dime per mcf? At a dime per mcf the 340tcf of NG would be worth $34 billion or about $53/share (using Yahoo's 640 million shares outstanding). At $.20 per mcf the value goes to over $100/share.
Now, let's check those numbers by converting the NG equivalent to crude oil equivalent. This is reasonable since about 30% of the resource is expected to be liquids. On a BTU basis a tcf of NG is equal to 166 million bbls of crude oil (6000 cf of NG = one barrel of oil). So if we multiply the 348tcf of NG by .166 we would get the equivalent in billions of barrels of crude oil. That gives us about 56 billion barrels of crude oil equivalent. At six billion barrels of consumption per year, it that resource were all oil it would fuel our country for about nine years. Now, what is 56 billion barrels of oil worth that is undeveloped and unproved? Is it worth $1 per barrel?, $5 per barrel? at $1/barrel of unproved, undeveloped crude oil, CHK is worth about $56 billion or $87/share to some major oil company that is running low on friendly resources.
So, the value of CHK's unproved, undeveloped resource is $34 billion in terms of NG or $56 in terms of liquids. Now, remember that well reasoned $20 billion, net of debt value of proved reserves above? That needs to be added to the unproved resource valuation "guess". that give a total value for CHK of either $54 billion ($84/share) or $76 billion ($119/share). Obviously there are a lot of "educated guesses" involved in these valuations and the resource will decline while assets sales continue, but the point I am trying to make is that it is difficult for potential investors to appreciate the absolutely enormous size of the resource base that Aubrey McClendon & company have assembled.
In any case, when the current mess is cleaned up, Chesapeake Energy will be worth multiples of today's share price.
A while back I did this same analysis for Petrohawk. Since they looked like a small version of CHK I thought they could be acquired. They were acquired and at almost the exact share price predicted by this kind of an exercise.
Buy CHK with as much leverage as will still allow you sleep at night. This would include call options in the $30 area for January 2014.