A Change Of Heart; Chesapeake Energy (CHK)
Seeking Alpha Analyst Since 2013
It has been about 10 months since I turned bullish on Natural Gas. While being mired in a bear market for nearly 4 years, it has started to significantly rebound. My purpose of this writing is not to discuss in great detail the bullish and bearish arguments surrounding natural gas, but it is to give what I believe to be a great investment opportunity for those bullish on natural gas, as I am. This play is Chesapeake Energy (CHK).
A Short Bullish Look
While my reasons for being bullish on natural gas are a composite of many factors, my principle reasons involve an industry rotation into natural gas, the extreme depression of prices relative to oil, and the rising potential for significant export growth. The prolonged bearishness on the commodity, while understandable a few years ago, is now overblown and has started to reverse, and will continue higher.
The U.S. Energy Information Administration has said that natural gas is the world's fastest growing fossil fuel with consumption increasing over the next 3 decades. Coal will take a back seat as more businesses look to natural gas as a primary energy source. Demand is picking up.
The long term expected value of natural gas relative to the price of oil is 10 to one according to economist. Currently the ratio is nearing 30 to one and is dramatically deviated from what is typical for the ratio. Such prolonged disparity is extremely unlikely and I expect to see this normalize. Many economists also agree. Pricing natural gas according to this ratio would put natural gas above $10. While this may be extreme, a move to even a ratio of 20 to one would have major implications for natural gas producers.
Another significant factor for bullish price action in natural gas is the growing government support of expanding natural gas exports. Expanding exports beyond those countries with a free trade agreement would make a dramatic dent in supplies and cause prices to surge. The Obama administration has shown a desire to make this happen.
If you agree with the bullishness entering the natural gas market, consider the following analysis on Chesapeake Energy.
Bearish to Bullish
In spite of my turn to a bullish outlook on natural gas ten months ago, I remained leery of Chesapeake Energy. It had overleveraged itself so much to natural gas and speculative investments that its stock was pounded during the down turn. My bullish plays focused on stocks like Halliburton (HAL) and pipeline stocks; stocks that had leverage to natural gas, but also maintained a strong oil business.
I will not deny the bearish arguments that have existed for quite some time on Chesapeake. I personally have been able to play it short a few times for nice profits. There is a reason it is in the top 15% of heavily shorted stocks on the S&P. That being said, Chesapeake stands to significantly benefit from a bullish natural gas market and a much needed change in leadership that will put the company on a better financial footing.
For years former CEO Aubrey McClendon's aggressive spending policy based on the hope of increased natural gas prices, left Chesapeake Energy with a terrible balance sheet and weak profits. His out spoken support for the use of natural gas in order to spur its demand is well documented. This failed and so did the company. The needed change in leadership cannot be overstated. New CEO and former Anadarko (APC) CEO Robert Lawler has moved away from the irresponsible business strategy of the previous leadership. The company is now improving its balance sheet and moving past the mistakes from the past. While not criticizing McClendon's leadership as openly as I am, note this letter to investors with regards to the overall in business operations and goals. Letter to Investors
The start of these improvements has been the sale of losing assets. The company has sold nearly $4 billion in assets this year combined with $12 billion sold last year. The most recent was its $1 billion sale to Exco Resources (XCO). This has started the process of closing the funding gap. These asset sales are part of non-core assets that drag on the company's financial position. With a stronger financial position the company can meet its funding goals that will lead to investing in higher rate-of-return projects, giving increased value to shareholders. While more is still needed, these moves represent a return to responsibly that I believe Wall Street will reward.
The profit reward will be seen this year. With CAPEX falling by 43% for 2013, the company is still projected to see a net income increase of 282% from 2012 along with a 31% increase in EBITDA. See company projections. With a price-to-book of 1.12 and a forward P/E of 10.65, this stock has become dirt cheap. With the cheap fundamental picture and the increased profit projections, shares of Chesapeake are a bargain.
Along with these changes, the second highest producer of natural gas in the U.S behind Ultra Petroleum (UPL) will benefit from the projected increase in natural gas prices. It remains highly levered to natural gas and the improvements on its balance sheets and investor returns will accelerate tremendously with increased natural gas prices. Ultra Petroleum will also benefit as 97% of its business is natural gas, but I am not ready to be a buyer as the technical action is much weaker.
Bottom-line
With the era of reckless spending on speculative investments in the past, the future for Chesapeake is bright as they return to its strong core business. Its improved financial outlook will allow the company to make sound investments that will lead to significant value to investors. The company will be able to overcome the consequences from its previous mistakes. Combining these improvements with the bull market coming into natural gas, Chesapeake's profits will surge and reward investors who steps in during this turn around process.
Disclosure: I am long CHK.
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