Even though oil prices climbed back up again and so did shares of Chesapeake Energy (NYSE:CHK) in the past several days, the company's stock is still down by nearly 30% year to date. And the latest news is that the rating agency Standard & Poor's downgraded CHK's credit rating from B to CCC+ with a negative outlook. This downgrade comes at a time of downward revisions in the assumptions of oil and natural gas prices for 2016 and 2017. Given the low price of the shares, is the current valuation of Chesapeake too low compared to other oil producers? How do changes in the assumptions about oil and natural gas prices impact the valuation of CHK?
The drop in oil and natural gas prices hit all oil producers hard. Many companies are in the process of scaling down production, improving cost structure, slashing capex, deleveraging and extending maturities, and selling non-core assets. But, given the current market conditions, how does CHK measure up to its peers? To make this comparison, let's consider the EV/EBITDA ratio.
Source: Yahoo Finance and Aswath Damodaran's site.
I have also included the debt-to-equity ratio to compare the debt burden of these oil producers. As you can see, even though CHK's EV/EBITDA is low, it isn't the lowest; that "title" belongs to Devon Energy (NYSE:DVN). And it's no surprise to see that CHK's debt burden is the highest even relative to the oil industry -- an issue I have discussed in the past. This is a key concern in times of low oil and natural gas prices. The company is addressing its high debt level, but it will still weigh on the stock.
As Yogi Berra once said: "It's tough to make predictions, especially about the future." This is especially true about the oil market -- perhaps even more so nowadays than it was in previous years. In any case, the direction of oil and natural gas prices will impact the valuation of CHK. So what's the current outlook for oil? According to the EIA's recent monthly outlook, the price of oil is expected to trade, on average, at $40 in 2016 and $50 in 2017. Natural gas is expected to reach $2.65 this year and $3.22 next year. Chesapeake's annual EBITDA for 2015 is expected to be $2.17 billion, of which oil and NGL will account for roughly 60% -- the rest will come from natural gas.
So if we assume, for the sake of simplicity, all things remain equal, including no change in this ratio or in production (I know, it's a crude assumption especially if the company sells assets and becomes more efficient), and we insert the expected oil and natural gas prices for 2016 (as listed above), then the EV/EBITDA climbs to 6.55. Obviously, other oil companies' ratios would have also risen, had we made the same calculations for their EV/EBITDA. But this goes to show that at least in terms of EV/EBITDA, CHK's valuation isn't too low. And if oil prices do remain below $40 throughout 2016, the stock price is likely to reach new lows.
The following table examines the assumptions being made with regard to oil and natural gas prices (again, assuming all other things are equal) and their impact on CHK's EV/EBITDA.
Source: Author's calculations.
On average, the ratio falls by around 6% for every $5 increase in oil prices. And the ratio declines by 4% for every $0.25 gain in the price of natural gas. So if you think that oil prices will be, on average, only $30 and natural gas prices $2.5, then the current EV/EBITDA is actually much higher at 8.2. This could imply that even the current CHK valuation is too high.
This mental exercise was made to examine the assumptions of oil and natural gas prices and their impact on the valuation of CHK. It didn't account for what Chesapeake will do next. The company is likely to make decisions that will change its trajectory, including selling assets, cutting spending, etc. Nevertheless, the current valuation isn't too low compared to its peers and given the high debt burden it has on its balance sheet. If oil prices wind up much lower than they were in 2015, the current valuation could even be a bit inflated. So even though CHK lost 30% of its value, it might face additional sell-offs if oil prices remain low. (For more, please see "Will Oil Continue Its Tumble?")
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.