Chesapeake's Dip Is A Buying Signal

| About: Chesapeake Energy (CHK)
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CHK shares have dropped of late as oil prices have retreated post the Brexit, but this is a buying opportunity for investors.

Natural gas prices have rallied remarkably of late on the back of higher consumption, which has led to lower-than-expected inventory growth and this trend will continue going forward.

CHK will benefit from stronger natural gas prices as a hot summer season will be succeeded by a colder winter due to the La Nina effect, leading to higher demand.

The strength of natural gas exports from the U.S. is leading to a drop in oversupply, while more coal plant retirements will also act as a tailwind for CHK.

Chesapeake Energy (NYSE:CHK) has had a bad start in July as the stock fell over 6% on Tuesday, shaving off the double-digit gains that the shares had recorded in the past month. The decline in Chesapeake shares was a result of a broad sell-off in the energy industry that was driven by economic uncertainty post the Brexit and the anticipation of weakness in Chinese data. The economic concerns have weighed on oil prices, and the impact is clearly seen on Chesapeake shares as they have dropped post the Brexit vote.

However, I think that Chesapeake Energy is on track to deliver an improved performance going forward as the price of natural gas has picked up impressive pace of late.

The natural gas price rally is good news for Chesapeake

As shown in the chart below, the price of natural gas has made an impressive comeback over the past month and a half:

Source: Bloomberg

As shown above, natural gas prices have rallied from less than $2.00/MMBtu toward the end of May to almost $2.80/MMBtu. This impressive rally in natural gas prices is a result of an increasing consumption of the commodity, which is leading to either a drop in inventories or a less-than-expected growth in inventory.

For instance, according to the last available report, natural gas inventories in the U.S. for the last reported week increased by 37 Bcf, which was lower than the estimated rise of 48 Bcf. More importantly, the rise in natural gas inventory for the week was way lower than the rise of 62 Bcf seen in the preceding week.

The reason why natural gas inventory is increasing at a lesser-than-expected pace is because of a rise in consumption by the electricity sector. For instance, in the first quarter of 2016, electricity generation from natural gas was 32%, while coal had accounted for 29%. Therefore, higher demand for natural gas in electricity generation has been a tailwind for prices, and this will lead to an improved financial performance at Chesapeake, especially as the company is reducing its cost base by deploying longer laterals.

More importantly, the strength in natural gas demand will continue for the rest of the year due to a variety of factors as discussed below, and this will create more upside opportunities for Chesapeake Energy. Let's take a look.

Why natural gas will continue to improve

As the year progresses, the usage of natural gas in electricity generation will continue to remain strong as the hot summer turns transitions into the winter season. For instance, this month, it is anticipated that cooling demand due to an increase in the usage of air conditioners will lead to an average consumption of 36 Bcf/day of natural gas in the power sector in the current month. This is higher than last month's usage of 27 Bcf/day and last year's usage of 34 Bcf/day.

On the other hand, as 50% of U.S. households use gas to heat their homes, demand for the commodity will remain strong in the latter half of the year as well. In fact, it is estimated that the winter this year will be colder due to the La Nina event that will lead to colder temperatures during the winter season. This, again, is good news for Chesapeake as cold events, such as the Polar Vortex of 2014, tend to lead to an increase in heating demand.

Since natural gas powers half of the U.S.' heating requirements, its demand will increase once the La Nina event comes into place by the fall. Additionally, the consumption of natural gas will also improve going forward on the back of coal plant retirements in the U.S. Over the past couple of years, coal production in the U.S. has dropped by 25%, as a result of which 14,000 MW worth of coal plants were retired last year.

Looking ahead, it is estimated that another 10,000 MW of coal plants will be retired until next year, which will further increase the use of natural gas in electricity generation. At the same time, the oversupply of natural gas in the U.S. will also come down on the back of a surge in exports. In fact, this year, natural gas exports from the U.S. into Mexico have increased 37% year-over-year and are trending 89% above the average seen in the last five years at 3.5 Bcf/day.

On the back of such improvements in demand and exports, the price of natural gas will continue to improve in the U.S. going forward and this will have a positive impact on Chesapeake shares.

Chesapeake will benefit from better gas prices

There is no doubt that an improvement in natural gas prices will have a positive impact on Chesapeake's financials as has been the historical trend. As shown in the chart below, strength in natural gas prices from 2012 onward led to growth in Chesapeake's revenue and operating cash flow and it is likely that the newfound momentum in natural gas will help the company replicate a similar performance:

So, despite the recent weakness in Chesapeake Energy's stock price, investors should remain positive about the company's prospects as the rally in natural gas prices will take the stock higher in the long run. As such, it will make sense to accumulate Chesapeake shares for the long run on dips considering the improving prospects of natural gas and the company's cost reduction moves.

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.