(May 24, 2011)
1) Sale of Fayetteville Shale to BHP for 4.65 billion net proceeds
It's a great move. The debt-reduction part of the 25/25 plan was completed by this single move. The risk of over-leverage hence lowers.
2) 1Q11 result shows the complexity of the company's financial. It said that it had unrealized loss of US725 million in 1Q but will have this amount of gain in the rest of 2011. My guess is that, because it sold the Fayetteville shale, hedge for Fayetteville shale production becomes unnecessary. But those hedge is profitable. So the company took some measures to move those hedge to somewhere else instead of just unwinding the hedge. Net result is insignificant. Wait and see if this is true.
3) New initiation of build up an oilfield service company. Buy Bronco Drilling for 315 million. Recapitalize Frac Tech. Saying that the company's stake at oilfield service already reach 7 billion. I don't know it is good or not. All rely on execution.
4) disclose two huge liquids-rich plays: 1.2 million Utica Shale and 1.1 million Mississippian Carbonate. It is just too early to judge the quality of these two assets.
5) one environmental accident in Marcellus shale.
6) CEO's compensation becomes topic of several blog. It's very high, no doubt. But I think it is acceptable, and not unethical.
7) Natural gas price still remains depressed.
1) the quality of liquids-rich plays still waiting for testing. Asset-wised, downside is limited but upside is huge.
2) financial risks lower.
3) Management continues to deliver.
Chesapeake Energy (CHK) is the second largest natural gas producer in the United States, exceeded only by ExxonMobil (NYSE:XOM). CHK's current valuation is clearly below its asset value. Is CHK an unusually attractive investment opportunity? Or might it rather be a value trap?
My conclusion is that: CHK is a good buy at its current $22 price. But investors should also be mindful the many risks embedded in CHK.
Asset and valuation analysis.
CHK's main assets include:
1)16.7 tcfe of proved natural gas reserves.
2) Unproved reserves. CHK owns number 1 or number 2 leasehold positions in all top US shale gas fields. Shale gas unproven reserves are worth much more than conventional gas unproven reserves. For example, CHK's Eagle Ford leasehold has virtually no proved reserves, yet CNOOC, China's third largest oil company, pays $2.2 billion for a 33.3% interest.
3) Un-booked carry value. CHK has 5 JVs and owns un-booked carry value of $2 billion (un-booked carry is the amount of money those JV parters agreed to pay for CHK's share of operating costs. CHK cannot book those carry into its balance sheet in advance, but can use them to deduct its own costs when it receives those carry)
4) Unrealized hedge value of $2.3 billion.
5) Other assets of about $7 billion, split between midstream assets (gas gathering and transportation, etc), and hard assets, e.g. buildings, rigs, etc.
CHK's most valuable assets are its leaseholds, i.e. the value of its unproved reserves. Generally unproved reserves are difficult to value. Fortunately, we can construct a simple method to assess them:
Of CHK's 13.8 million net acres, about 3 million acres are its shale gas assets. These account for 55% of its proved reserves and 70% of its risked unproved reserves. CHK has done 5 JV deals with all its major shale gas assets, specifically:
1) CHK/PXP: Haynesville and Bossier Shale, CHK sold 20% for $3.16 billion, implied retained value of $12.6 billion.
2) CHK/BP: Fayetteville Shale, CHK sold 25% for $1.9 billion, implied retained value of $5.7 billion.
3) CHK/STO: Marcellus Shale, CHK sold 32.5% for $3.375 billion, implied retained value of $7 billion.
4) CHK/TOT: Barnett Shale, CHK sold 25% for $2.25 billion, implied retained value of $6.75 billion.
5) CHK/CEO: Eagle Ford Shale, CHK sold 33.3% for $2.16 billion, implied retained value of $4.3 billion.
For CHK, total implied retained value of those 5 JVs exceeds $36 billion. Now let's do the math.
Let's assume that all other leaseholds-- over 10 million net acres are worthless, and
1) all un-booked carry, unrealized hedge gains and all other assets become worthless
2) all liabilities remain $19 billion, per Q3'10 balance
Then CHK's equity value should be $17 billion vs. CHK's current market capitalization of just $14.4 billion. Adding back those un-booked carry, unrealized hedge gains and other hard assets, CHK should be worth at least $28 billion, twice its current valuation. And this is before considering the possible value of the additional 10 million net acres.
One might question the valuation given by CHK's JV partners. If, all those JV partners were crazy and bought poor assets for a very high price, then the valuation is meaningless to us. There are three ways to attack the question:
1) are we more knowledgable than PXP, BP, STO, TOT and CEO, especially for the latter four companies, which are all hundred billion dollar companies with long and focus history in the industry?
2) what's the valuation for similar deals with similar assets (XOM-XTO, CVX-ATLS, STO-TLM, etc)?
3) what's the valuation of the companies with similar assets (RRC, HP, etc)
All those approaches suggest positive answers. And my point is that the safety margin is so high here that, even if the implied value in those JVs is cut in half, CHK should still be worth a lot more than its current price suggests.
So why is CHK so cheap?
First is its high debt load. CHK has $11.4 billion of long term debt on its balance sheet. CHK estimates that it can generate about $5 billion dollar in operating cash flow per year in the next three years, but its CAPEX is also projected at $5 billion dollar per year over the same period. CHK does not have the ability to generate operating cash flows to reduce its debt. Balancing this is CHK's plan to be a net seller of its leaseholds in the coming years. It has just closed the deal with CNOOC. Its data room is now open for Niobrara. One or two multi-billion-dollar deals are expected in early 2011. Further, no major principal repayments are due before 2015, which means that CHK has plenty of time to raise cash before it encounters any financial stress. Last, CHK plans to increase its proved reserves to over 20 tcfe before 2012, implying a reduced debt level per mcfe of reserves. In sum, though CHK's leverage level is high, we think the debt level remains manageable.
Second, corporate governance issues concern investors. In 2009, CHK's board re-signed its employment contract with CEO Aubrey McClendon, awarding him $75 million as upfront 5-year bonus. Also, the company bought the CEO's personal art collection of old maps of about $12 million. Related documents can be found in the company's 8-k filings. Follows a link of the transcript from seeking alpha on the issue: seekingalpha.com/article/135500-chesapea.... The 75 million seems large, but it is not unfair. We think the negative media cover on the issue is overdone.
Third, CEO Aubrey McClendon lost virtually all his holdings in the company in 3Q2009 due to the margin call. Follows a link of the transcript from seeking alpha on this issue: seekingalpha.com/article/100644-chesapea.... It is worthwhile to quote the salient points here:
"Certainly the last couple weeks have been challenging for me and all I would say about that is it’s over, it’s behind me. I spent 19 years building a significant stake in the company’s equity. Due to circumstances much larger than me that stake unfortunately was involuntarily lost to some margin culls. A tough deal but life isn’t always fair, and life’s been good to me so I have moved on and started working on rebuilding my position in the company day-to-day and focused of course on providing the leadership along with my colleagues to the company and its employees and our shareholders."
Any successful manager can occasionally overreach. Mr. McClendon's excessive confidence in his own company drove him to the extent that he became a victim of his best idea. This is unfortunate but it should not be a determinant factor in the company's valuation.
Fourth, CHK relies too much on hedging. People even says that CHK is actually a hedge fund in the form of a natural gas company. In its latest presentation, CHK noted that it had earned an accumulated $5.9 billion from hedging activities since 2001. From the company's presentation:
"We don't hedge just to say we're hedged, we hedge to make money, have successfully done so 17 of past 19 quarters. That's not luck, that's skill. "
Realized hedge gains in 3Q10 was $512 million, while income from operation in the quarter was only $817 million. Though the company details its hedge activities in every Q and K, I doubt most investors can completely understand it. Furthermore, I doubt even the CEO himself can fully appreciate the risks and consequences of those numerous derivative contracts. Recent history has proved that even the most respected institutions are vulnerable to derivative meltdowns.
Is it CHK incurring undue risk through its hedging activities? We don't know. But big oil and gas companies also hedge extensively. For example, most of ECA's profit this year is also from hedging. The difference is that, other companies don't think, or don't say that hedge is their expertise. I think the concern over CHK's hedge position is fair and hence, CHK's valuation deserves a discount.
Finally, the greatest concern is CHK's unconventional gas/oil business model. Is this a viable business model?
Shale gas is nothing new to the United States. It has been known for 100 years. But until recently, we lacked the technological means to exploit these resources economically.
Conventional gas and oil are fluid. In the many million years before they are extracted out of the ground, they flowed slowly yet ultimately come together. Conventional gas and oil resources are highly concentrated geographically; we have Saudi Arab, Qatar and a few oil/gas rich countries and one hundred other countries that have no oil/gas. This is not like the 80-20 law, it is a 99-1 law; 1% of the area contains 99% of oil/gas resources. That is why traditional E&P companies are nothing like manufacturing companies. When you explore a wild cat well, you get nothing or you get a lot of things.
Unconventional gas and oil are trapped into rocks. Those very hard rocks keep those oil and gas separated. This is why they are called unconventional. They still can move, but extremely slowly compared to conventional oil and gas. After millions of years, their concentration becomes higher, a bit like the 80-20 law, but somewhere there is 90-10 distribution, somewhere there is 60-40 distribution. Those 90-10 distribution areas are so called sweet-spots.
Once horizontal drilling and fracturing made the development of shale gas commercial viable, the huge potential of shale gas was finally unlocked. But the physically low concentration of gas from shale gas resource makes the business of developing and producing unconventional gas distinctly different from that of conventional gas. Essentially all shale gas drillers can achieve 95%+ success rate on individual wells. We see the E&P model evolving towards a manufacturing reserve model. It is still valuable to locate the sweet-spots and focus on it, but when gas price is high enough, you can just drill any place in those shale gas area and pump out enough gas to earn decent returns.
Thus, when the natural gas price is high enough, operators should accumulate as many leaseholds as possible, because all of them should prove valuable. The higher the gas price, the less important the cost of acquiring the leaseholds.
When Chesapeake's CEO Aubrey McClendon figured it out he must have been extremely exhilarated. In CHK's 2006 annual report, Mr. McClendon boasted his origin as a landman. And he acted as a landman. He spent billions accumulating leaseholds. The bet paid off handsomely before 2008, when CHK's stock price was over 70.
Then came the Lehman crisis and the economic meltdown. Gas prices dropped like a stone. CHK wrote off $3 billion in 2008 and $11 billion in 2009. That is an incredible amount of money, more than all accumulated profits in CHK's entire history.
Clearly, shale gas development is not profitable under low gas prices condition. Especially those non-sweet-spot resources or high leasehold cost resources. Under current depressed gas prices, almost no natural gas companies, conventional or not, can make money, aside from some small, low cost conventional gas producers with limited exploration activity such as Contango (MCF). If we back out the hedge gains and carry, CHK does not make money. Nor does ECA, etc.
The question is not whether a shale gas company be profitable under any gas price condition. Obviously they cannot. The question rather is, can a shale gas company earn an average return (ROE of 10%) throughout the entire gas price cycle. If it cannot, then we can surmise that the manufacturing reserve model does not work.
According to industry data, a $6 gas price per MBTU will give shale gas companies an average 10% return. Can gas prices rise to $6? At $6 per MBTU, the energy content of natural gas is equivalent to about $36 oil per barrel. Now oil prices are over 80 and rising. Can oil prices drop to below $36? It is possible, but very unlikely. Even during the most terrible credit crunch period of 2008, oil prices remained higher than that. So if you are bullish on oil price, or at least not extremely bearish on oil price, you should expect that, one day, gas price will rise to $6 per MBTU or higher. Below that level, people will use more and more gas to substitute for oil, gas production will be reduced, and gas can be exported, etc. All these adjustments take time to develop, but in a market economy, people will figure it out finally. That's why at current gas prices we see CHK shifting its CAPEX towards oil; SD almost disbands gas CAPEX, and almost all natural gas companies plan to cut CAPEX.
In closing, we would have to point out that, CHK has accumulated over 3 million net acres in unconventional oil reserves. The Eagle Ford JV with CNOOC is the first step to unlock its underlying value. Under current oil/gas price ratio, it is likely that those unconventional oil leaseholds could worth more than those shale gas leaseholds. The company has promised to become a top five oil and NGL (natural gas liquid) company by 2015. If it achieves this target, it's value should reach a significant multiple over its current price.
Disclosure: Long CHK