Chesapeake Energy: Good Summer Buy (CHK)

| About: Chesapeake Energy (CHK)
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I picked up some shares in Chesapeake Energy Preferred (NYSE:CHK) on Thursday at $90 [CHK-D]. Chesapeake, for anyone who doesn't know, is the dominant US natural gas company Though the name conjures up skipjacks, crabs and oysters, they actually work primarily in Oklahoma and thereabouts and are based in Oklahoma City.

So why buy a natural gas company when the price of gas has dropped like a stone from about $15 post-Katrina to about $6 today (I think it blipped just above $6 when inventories were a little lower than expected this morning)?

There are a couple reasons. First of all, the time of year. For those interested in shorter term trading (or just in finding a nice buy-in point) summer is a good time to buy natural gas companies because short-term traders bid them up in the fall when winter demand starts to build and inventories diminish. And more recently, we've been reminded that late summer is prime hurricane season and any damage to Gulf of Mexico rigs or pipelines can also drive prices higher.

And second, longer term, is that natural gas remains one of the most important alternative energy plays out there, both for political reasons in reducing dependence on foreign oil and for environmental reasons in reducing power plant and vehicle emissions.

Hydrogen fuel cells would be lovely to have in all of our cars, but you're much more likely to see expansion of natural gas-fueled city buses and personal cars in the near future because the emission benefit is great and the infrastructure is already in place. And even if hydrogen does become a fuel source for transportation, the cheapest and easiest way to get hydrogen is from natural gas or other hydrocarbons. Natural gas also fuels many of the newer power plants, and I expect before too long we'll reach an equilibrium between the lower emissions profile of natural gas and the expense of clean coal technology that makes both of them competitive for electricity generation. I'm no expert on this, but I don't see usage of natural gas declining in the long term.

Add on to that the other important customers for natural gas: fertilizer manufacturers, chemical and plastics companies and the growing internationalization of the NG market as LNG becomes a big business in Asia.

So why Chesapeake? The simple reason is that they are the dominant producer of natural gas in the US and are not subject to much disaster risk since their fields are well inland in the plains and Appalachia. They also have hedged their production for most of the year at fairly high prices, about 50% above today's cost, so they stand to certainly make solid profits for the year no matter what.

They're also aggressive, leveraged, and focused on growing their business. Evidence of this is the fact that they're taking advantage of this downturn in NG prices to buy up new fields, with the most recent acquisitions bringing in what they estimate are about 500 new drillsites in Texas. Unlike some of the companies I own, this one is certainly not under-covered -- 20 analysts have 2007 estimates up, and they average about the same as 2006's at near $3.50 a share. I think that's probably a little too conservative, but I certainly think a forward PE of 8 looks reasonable. Some interesting articles posted in the last few months on Seeking Alpha have also called attention to CHK's value, with Chad Brand in particular putting up a few good notes that are worth a read. And anyone who watches or listens to Jim Cramer will have heard quite a bit about Chesapeake, I'll leave it up to you to decide whether that's positive or negative.

CHK stock has been beaten up pretty significantly, down about 20% from its highs earlier this year. But since I'm looking at this as a very long term investment and would prefer a little less volatility than this Cramer favorite has been demonstrating, and like the idea of a nice yield in this environment that can help support the price, I decided to go with the convertible preferred stock instead.

The prospectus for the preferred stock provides the details, but at today's price of $90 you're getting a 5% yield that cannot be called unless the conversion reaches 130% of fair value after 2010, you're getting preference over common stockholders in any nightmare scenario of bankruptcy, and you get the right to exchange each preferred for roughly 2.26 shares of CHK common.

Right now, the conversion value of these preferred shares is in the mid $60s, and the price would have to hit about $40 to make conversion worthwhile. I'm confident we'll eventually reach that price. In the meantime, I'm happy not to watch the vicissitudes of the natural gas market and just collect my $4.50 per share each year while I wait for what I expect will be some significant capital gains within a few years. The preferred dividend appears to be eligible for the lower dividend tax rate, too, FYI.

CHK 1-yr chart: