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Chesapeake Energy (NYSE: CHK): What Justifies Value?

|Includes: APA, APC, BP, Chesapeake Energy Corporation (CHK), CVX, EOG, KMI, MRO, RRC, WMB, XOM
February 1, 2011| Filed Under: CHK

Author:  Karl Miller

We like natural gas and we like CHK. However, we see no justification for the substantial run up in CHK stock price to excessively speculative level of $29-30/share.

We get the strategy that the Company has built itself upon, but that model was based upon a land value/reserve value analysis, or old school reserve valuation analysis for natural gas. Additionally, CHK was the king of buy and flip, perhaps they even inspired the financial institutions to do the same thing on the mortgage backed securities (MBS) market.

Problem is, that model is no longer in effect, no longer profitable, and irrelevant in a "just in time" domestic natural gas market, which is the U.S.

We like natural gas but will not overpay for producer equity in over-supply market at $4-5/mmbtu w/ no pricing power and the fundamentals are looking worse each month.

When natural gas was in excess of $10/mmbtu, debt was plentiful, and the U.S. Economy was seemingly growing at a very high rate, CHK's lease, flip, sell forward Volumetric Production Payment (essentially a mortgage on its natural gas production) allowed the Company to amass tremendous amounts of debt to do the next deal. Problem is, the natural gas market collapsed as did the U.S. Economy, massive amounts of new natural gas production came on line and continues today, and the debt markets evaporated.

Now today, natural gas
storage facilities are full across the U.S., Natural gas is close to $4/mmbtu, production continues to increase, and natural gas has become a "just in time" commodity.

There is no pricing power, there is no premium in storage, and there is no growing industrial demand, at least not in the next 3-5 years of any meaningful nature.

So where does that leave domestic, on-shore natural gas producers like CHK?

From our analysis, with $4/mmbtu prices, mortgages on production in form of VPP's, and other debt, CHK is in a circular death spiral which requires management to sell assets to raise cash, then continue to execute more mortgages/VPP's to meet existing drilling/leasehold and interest payments, and round and round they go.

The only way for CHK to break out of this circular death spiral is for natural gas prices to increase dramatically, which as we know will not happen due to massive market oversupply, or for management to take on substantially higher financial (debt/trading/hedging) risk and higher operational risk.

So essentially what we are left with is to justify the current price range of $29-30/share for CHK, it is based upon management going way out on the risk curve, betting what is left of the Company's value (which has not been mortgaged through VPP's and other asset sales/JV's).

We are professional commodity and asset risk managers. We know the commodity business and the energy sector, and on our best day, we do not believe we could execute the "Hail Mary" pass that CHK management must execute to survive without one mistake, which could prove fatal.

CHK must unwind itself form the complex web of debt, VPP's, hedges, and other complex contractual agreements, but this will only be done in time. Nothing can be done overnight to fix the problem.

Thus, we conclude that CHK shares are worth $22/share "as is" and $25/share with "extrinsic speculation" premium.

When you dig a big hole, it takes time to fill it in!