Chesapeake Energy: Hedge Outperforms The Stock

| About: Chesapeake Energy (CHK)
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Oil is falling, but our hedge is holding on.

Last time we checked, the hedged position has lost 20%. Right now, it is outperforming by more than 10%.

A hedged position should be less volatile and should reduce returns; our hedge does the opposite.

In an upward convergence scenario, Chesapeake's stock should significantly appreciate, reflecting higher cash flow and less worry about debt troubles.

In a downward convergence scenario, the hedge will most certainly work out, as it will directly benefit from the decline in futures.

Oil (NYSEARCA:USO) plunged to a 3-month low yesterday. For a producer like Chesapeake Energy (NYSE:CHK), this was obviously not good news. Around a month ago, I proposed a fundamental-based hedge for Chesapeake, which consisted of pairing short positions on oil and gas futures with a long position on the stock itself. Last time we checked, the hedge wasn't doing so well.

At the time, the spot prices of both oil and natural gas (NYSEARCA:UNG) fell, but our futures contracts (June 2017) increased in value. You can read more about the details in the article linked above, but the end result was that the overall position suffered around a 20% loss. However, our hedge has bounced back since then.

Source: Data from Interactive Brokers, author's calculation

The graph seems to be very strange. Not only has the hedged position outperformed thus far, it is more volatile than the unhedged position. The volatility of the unhedged position is 5.1% while the volatility for the hedged position is 8.1%. Typically, a hedge reduces one's potential gain and reduces the volatility, but our hedge does neither.

It's important that we recognize that the hedge is based on fundamentals, not historical correlation with Chesapeake's stock; hence, there are no guarantees. But unless the market has gone completely haywire, we can safely assume that Chesapeake will track commodity prices. However, investors tend to only pay attention to what's happening right now, meaning that spot prices are weighed more heavily than future prices. This is what our hedge is taking advantage of.

Even though there is no guaranteed correlation between long-term futures and Chesapeake, we have to recognize that long-term futures eventually become short-term futures, and eventually, they become spot contracts. This convergence is what is driving our hedge's performance as we inch towards the expiration date in 2017.

Upward Convergence

Since the inception of the hedge on June 24th, the spot rate of natural gas has climbed from $2.641/mmbtu to $2.717/mmbtu. While this $0.076 change may seem inconsequential, these pennies could bring over $84 million of incremental cash flow per year to Chesapeake based on the annual natural gas production of over 1000 Bcf. Of course, this is already public information. The market has already reacted, as evident by the 18% rise in the stock price. But investors can't seem to look just a bit further.

For the hedge, natural gas prices are locked in at $2.991/mmbtu, or $0.274 higher than the current spot. This could add another $302 million of cash flow. A big concern with Chesapeake right now is its ability to manage debt due to low natural gas prices. If natural gas prices rebound and the company rakes in hundreds of millions of dollars in incremental cash flow, not only will the company gain more value from a fundamental perspective (i.e. more cash flow), the market sentiment will likely become more positive as well (i.e. no more debt worries), which could boost the stock even higher.

Downward Convergence

Of course, spot prices don't have to converge upward, longer dated futures could fall. This is in fact the primary goal of this hedge (read Prepare for $40/bbl Oil and $2 Gas). If prices do fall, then the hedge will almost always work out, as it will no longer have to rely on its correlation with Chesapeake, but will profit directly from the futures instead. But what about the long Chesapeake leg?

Well, the only way the hedge would underperform is if the stock increases while commodity prices decrease. While I've seen a lot of crazy things in the market, I do not think that this will happen, especially since the market has already removed the bankruptcy discount in my opinion (read Chesapeake Has Been Repriced).

Certainly, the hedged position may still incur a loss, but under conceivable scenarios, the gains in the short positions should partially offset losses from the long position in Chesapeake, making the hedge a success.

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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.