Chesapeake Energy: I Increased My Shares By 50% Because Shares Are Undervalued And Oversold

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About: Chesapeake Energy Corporation (CHK), Includes: ET, KMI
by: Steven Fiorillo
Summary

Chesapeake Energy shares are so oversold, they present at least 100% upside potential.

The company is generating a $15.50 / boe EBITDAX margin, which is the highest in four years.

Chesapeake has just over 2.52 million acres across its assets with 1.448bboe proved reserves and a daily production average in Q1 2019 of 484mboe/d.

It’s not easy being a shareholder of Chesapeake Energy (CHK). The energy sector in general hasn’t really recovered since the oil crash a few years back, headlines toward energy are negative and the younger generation seems to hate fossil fuels. Over the past five years, CHK has fallen from a high of $29.61 on June 23rd, 2014, to $1.89 at the close on June 7th, 2019, losing 92.62% of its market value. Over the past year, the company has lost 65% of its market value since July 10th, 2018, when it traded at a 1-year high of $5.40. CHK has been a horrible investment generating negative returns almost at any entry point, as it is trading just off its five-year lows. Chesapeake Energy is not a stock for the faint of heart, and you need to have a strong stomach to follow CHK, let alone invest in the company.

I have been wrong for the past year and a half when looking at CHK’s chart, but I am not throwing in the towel and liquidating what’s left of my investment. I see a true value in CHK, as the company's current market cap is almost $1 billion less than what it paid to acquire Wildhorse in November 2018. The market isn’t factoring in that management has turned the company’s finances around, generated positive earnings over the past two fiscal years, continues to diversify the product mix and has retired a large amount of debt. If you're looking for a value play, CHK could offer huge returns from its current levels. I took this opportunity to dollar cost-average by increasing my shares by 50% at just under $1.86 per share. I believe CHK should be trading over $5 per share right now, and the sell-off is ridiculously overdone. There is a chance CHK is dead money, but I am not buying it and am sticking with the company’s plan no matter how much the Street hates it.

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(Source: Seeking Alpha)

CHK has been making progress, and if it were a technology company, it would be rewarded, not punished

Just over a year ago, on May 23rd, 2018, I wrote my first article on CHK and compared the company's turnaround to Advanced Micro Devices (AMD). It’s just over a year later and AMD has continued to flourish, while CHK has been on the brink of disaster according to the charts. Over the past year, AMD has crushed the market, increasing from $15.25 on June 8th, 2018, to $32.41 at the close on June 8th, 2019, generating a return of 112.52% for shareholders. CHK, on the other hand, has been on a horrible rollercoaster ride from $4.81 on June 8th, 2018, down to $1.89 on June 7th, 2019, losing 60.71% of its market value. CHK and AMD are constantly among the most actively traded stocks, as CHK has an average volume of almost 44 million shares traded daily, while AMD has an average volume of just over 74 million. I truly believe the big difference is the sectors, and if CHK were in a different industry, the company would be rewarded.

AMD was the CHK of the technology industry for years. For the longest time you had high-profile people saying they would rather be in Intel (INTC), yet AMD turned the corner and has been the darling on Wall Street. In 2015, AMD only generated $3.99 billion in revenue, while losing $660 million on its annual earnings. Over the past four fiscal years, the company has increased its earnings and generated $6.48 billion in revenue and $337 million in earnings. AMD certainly has been rewarded for its performance, as it came into 2016 with a share price of $2.87, which has climbed just over 1000% in roughly 3½ years.

CHK went into 2016 with a share price of $4.50, and it basically traded up and down in a lowered trajectory, generating a negative 58% return over the same roughly 3½ year period that AMD generated a 1000% plus return for its shareholders. In my opinion, CHK’s turnaround story is much more admirable, as management patched the entire side of a ship, where AMD basically patched a few leaks. In 2015, AMD generated $3.99 billion in revenue, while losing 660 million in earnings, while CHK generated 12.67 billion in revenue and lost $14.57 billion. In the same year, CHK generated more than three times the revenue of AMD, while losing more than twenty-two times the amount that AMD did. Now fast forward to the close of 2018, AMD increased its revenue by 62% and its earnings by $973 million as it generated $307 million in positive earnings. CHK sold off assets and completely overhauled its business, which resulted in a decrease in revenue by $2.56 billion, but its earnings increased by over $15 billion on an annual basis as the company went from losing a massive $14.57 billion in 2015 to earning $883 million in 2015.

Regardless of how you feel about this management team or the energy sector, the way CHK has transformed its numbers over the past four fiscal years is actually incredible. AMD may be in a more appealing industry, but the numbers speak for themselves. Today is much different than 2-15 for CHK, and it has a lot of breathing room with multiple levers to pull if needed. This management team has made the difficult decisions in the face of adversity and showed everyone what they are made of. The market has crippled the share price of CHK, but this is a battle-tested team of executives who I believe will continue to make progress quarter by quarter, and I am willing to stick with them until they give me a reason not to.

(Source: Steven Fiorillo; Data Source: Yahoo Finance)

CHK is delivering on cost savings, production increases and diversification

We are at the very beginning of a new day for CHK. The Wildhorse acquisition was much needed to reduce CHK’s dependence on natural gas and diversify to become a more rounded company by increasing the production of oil. With the addition of the Wildhorse asset, which is now known as the Brazos Valley, CHK indicated that this strategic move would generate $200-280 million in cost savings annually and a total of between $1.0 and $1.5 billion by 2023. In the very early stages, CHK expected to see the following synergies by 2020:

  • Enhance oil production by 2X
  • Improve oil mix percentage by approximately 60%
  • Increase EBITDA per boe margin by approximately 50%
  • Accelerate deleveraging by 35%

We’re not even halfway through 2019, and at the end of Q1, CHK stated that the synergies from the Wildhorse acquisition are paying off in spades. The company had a $15.50 / boe EBITDAX margin which was the highest in four years, the year-over-year oil production increased by 13%, cash costs were reduced by $81 million, which was 14% lower than in Q1 2018, and the Brazos Valley will be cash flow-positive at the asset level in 2019. Over the first 90 days of Q1 in the Brazos Valley, CHK saw $500K per well savings and decreased the drilling cycle time by 40%, while increasing the max completed stages per day by 55%.

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(Source: Chesapeake Q1 2019 presentation)

The Powder Ridge Basin is truly becoming a huge growth engine for CHK. In Q1 2019, the production was 36 mboe/d with 45% oil, and in April it averaged 39 mboe/d with 46% oil. CHK is expecting 100% YOY oil growth in 2019 in the Powder River Basin. As the oil growth increases, so do the margins through multiple key drivers. At the end of fiscal year 2018, the EBITDAX/boe was $12.89, and CHK is expecting an increase of around 60% by the end of fiscal year 2019, which would be $20.50 EBITDAX/boe. GP&T/boe costs are expected to be reduced by more than 25% in 2019, as gathering agreements will eliminate more than $2/bbl for trucking and the water pipeline system will eliminate more than $1/bbl on trucking costs as well. The Powder River Basin is definitely meeting and exceeding expectations, as it is increasing CHK’s oil production and helping it diversify from being a strictly natural gas company.

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(Source: Chesapeake Q1 2019 presentation)

Chesapeake’s assets are truly world-class and stack up well against larger exploration companies

CHK currently has just over 2.52 million acres across its assets with 1.448bboe proved reserves and a daily production average in Q1 2019 of 484mboe/d. ConocoPhillips (COP), which has a market cap of $66.64 billion, is a multinational exploration company with assets across Asia Pacific and the Middle East, Canada, Europe and North Africa, The Lower 48 of the US and Alaska. The Lower 48 represents the largest business segment for ConocoPhillips today based on production, as it has 397mboe/d, 1.3bboe proved reserves and 10.3 million acres. CHK has just under 25% of the acreage that COP has in The Lower 48, but it is producing substantially more on a daily basis and has larger proved reserves. The large difference is the mix of fuels which each of these businesses generates, as COP generated 58% crude oil, 25% natural gas and 17% NGLs, while CHK’s production mix is 70% gas, 8% NGLs and 22% crude oil. By the end of 2020, CHK is looking to diversify its energy mix where oil is at least 30% of what is produced annually.

(Source: Steven Fiorillo; Data Source: Chesapeake Energy 2019 Q1 Report)

The fears about CHK’s debt are overblown, yet shares are priced as if bankruptcy is around the corner

CHK has $10 billion in debt, which is no small amount, but it is spaced out over the next eight years with $0 in obligations due in 2019. On October 30th, 2018, during the CHK Q3 conference call, CEO Doug Lawler stated the following:

“We have decreased our total debt and leverage by more than $12 billion, eliminated legacy commitments and obligations by more than $10 billion, significantly reduced complexity, delivered industry-leading capital efficiency, and eliminated more than $1 billion in annual cash costs, all while preserving a world-class portfolio of unconventional assets in an extremely challenging commodity price environment.”

This management team has been fully committed to a long-term strategy of retiring debt, returning CHK to profitability, generating value for the shareholders and creating a thriving business for the future. While shareholder value in the form of the share price hasn’t happened, CHK’s management has done an excellent job fixing the balance sheet and reducing costs. Currently, CHK has a breather in 2019, and then it owes just over $3.27 billion by the end of 2023. If the company’s net income doesn’t increase from its current levels and decreases to $800 million, that would amount to $4 billion from fiscal years 2019-2023, which covers the debt for the next 4.5 years.

CHK could also sell an asset, which I wouldn’t agree with unless it absolutely needed to. Hypothetically, if the company were to sell an asset, I believe it would either be the Mid-Continent or Marcellus. The Brazos Valley had a Q1 production of 47mboe/d and has 470,000 acres. The Marcellus asset had a Q1 2019 production of 158mboe/d with 540,000 acres, and the Mid-Continent asset had a Q1 production of 24 mboe/d production with 764,000 acres. I am not sure what CHK would accept on an asset sale, but if the company felt it needed to, I would speculate that it would need to generate at least $3 billion to even entertain it.

CHK and bankruptcy shouldn’t even be discussed. The company is making money, management has a track record of paying down debt and CHK has multiple levers it can pull. At the current rate, it will be able to pay down debt through 2023 without breaking a sweat. Investing is a long-term game, and time is actually on CHK's side, as no debt is due in 2019 and only $302 million is due in 2020. This should give the company a long enough window to execute on management's plan with its transformation.

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(Source: CHK Q1’19 Presentation)

(Source: Steven Fiorillo; Data Source: Chesapeake Energy 2019 Q1 Report)

As the demand for energy increase, so will the need for fossil fuels in addition to renewables

Recently, there have been many articles and news segments discussing a slowdown in economic growth. What is never discussed is negative growth, and that’s what really matters. As long as there is positive economic growth, that should correlate to an increased demand for energy. BP published in its Energy Outlook 2019 Edition that the energy demand will continue to grow substantially through 2040, led by China and India. The EIA Annual Energy Outlook published on 1/24/2019 indicates the United States will become a net energy exporter after 2020 and U.S net exports of natural gas will continue to grow through 2050. The current global population, according to Worldometers, is 7.71 billion. The projected population growth trajectory is set to continuously increase, to 8.5 billion people globally in 2030 and 9.7 billion in 2050. By 2022, India is looking to more than double the natural gas in their energy mix to 15% and will build 11 Liquified Natural Gas terminals over the next seven years. The global trends are showing us that looking five, ten or even twenty years down the road, our global demand for energy and the utilization of energy are going to increase.

When looking at the MLPs, we are seeing many backlogged projects due to the need for increased transportation within the U.S. When looking at Kinder Morgan (KMI), transport volumes via the company’s transmission pipe increased by approximately 4.55 Bcf a day, which is equivalent to 14% in Q1 2019. KMI has $5.7 billion of commercially secured capital projects, with natural gas being the largest focus, as $3.9 billion is allocated to future growth projects from now through 2022. Energy Transfer (ET) is currently working on getting three major export facilities on-line to capitalize on the growing demand for energy. The Lake Charles export facility is a joint venture between ET and Royal Dutch Shell (RDS.A). The facility will sit on a 152-acre site and consist of two existing deep-water docks to accommodate ships up to 215,000 m3 capacity, and will have four LNG storage tanks with a capacity of 425,000 m3. ET is also bringing the Nederland Terminal and Marcus Hook Industrial Complex on-line. The Nederland Terminal is a 1,200-acre site on the U.S Gulf Coast, which has a 1.5 million bbls/d crude export capacity and 200,000 bbls propane/butane export capacity. There are 5 ship docks and 4 barge docks to accommodate Suez Max-sized ships with rail and truck unloading capabilities. The Marcus Hook Industrial Complex is an 800-acre site which will have 280 thousand bbls/d NGL export capacity with room for expansion and 65 thousand bbls/d ethane export capacity. There will be 4 seaborne export docks to accommodate VLGC-sized vessels.

Conclusion

CHK has been a horrible investment for many people, myself included. You need to have a high tolerance for risk and an iron stomach to have CHK within your investment portfolio, even if it is a speculative play. I am looking at the depressed prices as a chance to dollar cost-average, and have increased my share count by 50%. Bankruptcy isn’t even in the discussion, and shares are priced as if chapter 11 is around the corner. I am going to speculate and say that part of the reason shares have sold off so much in the past month is stop losses being hit and computers trading off of algorithms.

The demand for energy is going to increase through 2040, with natural gas and renewables being large winners. MLPs are a great indicator for the future of energy, as they are allocating billions to growth projects. KMI and ET are focused on increasing their transportation capacity and exporting capabilities. Exploration companies such as CHK are going to be needed to feed the demand. I believe shares should be trading over $5 and are worth more, but we will need to wait and see. The company has world-class assets which are favorably positioned in relation to pipeline networks and export facilities. CHK could be a takeover target, as it is a good fit for the majors such as Exxon Mobil (XOM) or Chevron (CVX). I am long CHK as I see major upside potential from the current share price.

Disclosure: I am/we are long CHK, ET, BP. 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.

Additional disclosure: Additional disclosure: Disclaimer: I am not an investment advisor or professional. This article is my own personal opinion and is not meant to be a recommendation of the purchase or sale of stock. Investors should conduct their own research before investing to see if the company fits into their portfolio parameters.