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By Ishtiaq Ahmed

Chesapeake Energy (NYSE:CHK) produces, explores and markets mainly natural gas in the U.S. The company focuses on unconventional plays, and has large positions in the Eagle Ford, Barnett, Haynesville, and Marcellus Shales. Chesapeake holds over 15 million net acres in its properties. At the end of 2011, the company's proved reserves totaled 18.8 trillion cubic feet equivalent, and a daily production of 3.5 Bcfe. Chesapeake Energy is the second-largest U.S. natural gas producer.

Affects of Falling Natural Gas Prices:

Natural gas futures are currently trading for $3.47, well below its peak of $14 per thousand cubic feet in 2005. The prices touched the ten year lows recently. However the market has recovered slightly and the prices have started going up.

The United States Natural Gas ETF (NYSEARCA:UNG) which invests in natural gas futures has suffered worse. The ETF, which was trading for as high as $500 has slipped to $15 in April. While it returned 50% since its dip in mid-April, the year-to-date return stands at -14%.

The increase in shale gas production caused an enormous near-term oversupply. As a result, prices of natural gas plunged in the U.S. The problem is aggravated due to the leasing system in the U.S. The leasing system obligates lessees to drill quickly or surrender their drilling rights. As a result, the company had to write down almost 24% of its proven gas reserves. The massive write downs were valued in the range of $4 billion to $5 billion. The company stated these reserves in the portfolio are not economically recoverable at present natural gas prices.

However, Chesapeake was not the only loser during the low natural gas price environment. BHP Billiton (NYSE:BHP) also had to write down $2.84 billion off its Fayetteville shale gas business. BHP was forced into the write down after the price of natural gas tumbled to 10-year lows. Additionally, Canadian giant Encana Corporation (NYSE:ECA) shed $1.7 billion in write downs, mainly in its U.S. segment. A few days later, British Petroleum (NYSE:BP) announced it would also take $2.1 billion worth of largely U.S. fracking-related write downs.

Falling natural gas prices forced the companies to decrease the production levels. As a result, the number of shale gas rigs operating in the US has tumbled by 44% in the previous year and currently stand at about 300. Chesapeake is the world's biggest shale gas producer. Nevertheless, the company has followed suit and is currently in the process of cutting its gas drilling activities. Chesapeake will cut the drilling activities by about two-thirds and decrease production by approximately 7%. This will be the first decline for Chesapeake in 23 years.

The Future is Bright:

Chesapeake is aggressively changing its fracking resources from gas to oil, which will not suffer the same decline in prices due to the export infrastructure. The company will also benefit as decreasing gas production pushes up prices. Shale gas now accounts for about 23% of U.S. production, making up for the decreased supply from the conventional wells. Gas is now abundant in the United States, and the country is contemplating new port facilities to chill and liquefy gas to export it by tanker overseas.

The prospect of exporting natural gas looks good. There are many opportunities in Asia and Europe. With Chesapeake being the second largest natural gas producer in the U.S., the company will surely benefit from gas exports. Another key customer, the U.S. chemical industry, relies on natural gas as a feedstock. The chemical industry was fleeing offshore due to high prices only a decade ago. However, now it is considering new factories in the heart of shale country. In addition, a large number of energy producers have shifted to natural gas to exploit the low prices. As a result of increased demand and decreased supply, the prices of natural gas will pick up and provide healthy revenues for Chesapeake.

Peers Comparison:

Chesapeake peers include Devon Energy Corp (NYSE:DVN) and EOG Resources (NYSE:EOG).

CHK

EOG

DVN

P/E

7.20

21.40

10.10

P/B

0.90

2.20

1.10

P/S

1.30

2.60

2.20

EPS Growth

35.60%

-25.00%

N/A

Operating Margin

23.70%

22.00%

33.00%

Net Margin

17.30%

12.10%

21.70%

ROE TTM

16.20%

10.90%

11.10%

Debt to Equity

1.00

0.40

0.40

Source: Morningstar.com

The comparison shows that the stock is trading at a discount compared to its peers based on multiples. In addition, the company offers attractive margins. However, the debt to equity ratio for Chesapeake is higher than its peers.

EOG Resources performed relatively better than both Chesapeake and Devon. The stock returned 37% in the last 12 months. While I think the stock is expensive based on trailing and forward P/E ratios, UBS and Howard Weil do not agree with me. UBS has a target price of $120, whereas Howard Weil has a target price of $125.

Devon Energy is also attractively priced. The stock is trading with a trailing P/E ratio of 10.1. It also pays a yield of 1.3%. The company recently announced that it will consolidate "its U.S. personnel into a single operations group centrally located at the company's corporate headquarters in Oklahoma City." Consequently the company is expected transfer its Houston office to Oklahoma. I think that is a good move for cost reduction in the light of increasing competition in the field.

Summary:

Chesapeake has suffered from declining natural gas prices recently. However, the recovering natural gas prices will augment the earnings of the company and lift the stock. At the moment, Chesapeake stock is trading at a discount. It has very attractive fundamental ratios. As the comparison shows, the stock is trading at a significant discount compared to its peers. The shale plays have given a new life to the natural gas industry in the U.S. as well as the rest of the world. Chesapeake is positioned nicely to take advantage of this opportunity. I believe the company will generate impressive earnings and prove to be a shrewd investment.

Source: Chesapeake: Primed For A Rebound