Will CHK Outperform USO?

A question from Fletcher:

“Hey Davy, I enjoy reading your material. I am interested in putting some money into oil, specifically USO. I see you that you really like CHK. Do you see CHK outperforming an oil ETF like USO in the future 1-2 years?”

Thanks for reading, Fletcher. I hesitate to answer questions like these because readers should come to their own conclusions. After all, at the end of the day, each of us is ultimately responsible for individual investment decisions, not this blog or Barron’s or whoever on Bloomberg. So take all my answers and posts with a healthy dose of skepticism.

In my view, the comparison between Chesapeake Energy (CHK) and US Oil Fund ETF (USO) is a flawed one.  Not only is one indexed to a commodity while the other is a going concern but we are talking about two different commodities, oil and natural gas.  While it’s convenient to lump them together, they are distinct energy commodities with different fundamentals driving each market.

Cheasapeake CEO Aubrey McClendon has stated previously that if he had his druthers, CHK would prefer dealing with oil over natural gas — the only problem, he said, is oil is very, very hard to find these days.  Also, I remember an interesting tidbit noting that while the BTU ratio of oil to nat gas is 6:1 (which is the conversion rate translating MCF to BOE), oil has historically been priced closer to 10:1 over nat gas.  Obviously, that’s not the case now but on average, that was the assertion. I can’t source this so take it with a grain of salt or research it yourself.

What does this all mean?  I personally prefer Chesapeake Energy over actual commodities for several reasons:

  • I can estimate an intrinsic value (IV) for CHK but this is murkier for commodities.  Perhaps Warren Buffett provides a possible signpost from a few years ago when he bought physical silver for less than the cost of production. So maybe a good time to buy into a commodity is when it’s selling below the cost of production, though it would be hard to argue that the cost of production is its intrinsic value. In any case, having an IV is important for my discipline as it allows me to set buy/sell strategy.
    • BTW, this is one of the problems I had with the Rogers agricultural index [RJA] and why I haven’t moved into DBA yet.  RJA moved 40% higher and I didn’t know if it was overvalued at that point because I didn’t have an IV. So I weighed taking profits against the short-term tax hit and my greed and held the position. Mistake.
  • If the energy bear market lingers, I’ve positioned myself in Chesapeake preferreds to get paid 8-9% annually to wait.  With USO, it is possible to create synthetic “dividends” by selling covered calls against your position but that requires more decision-making and limits flexibility to some extent as you have to weigh the premium received against duration and risk of getting called away.  Don’t forget about transaction costs as well.
  • A position like USO doesn’t lend itself well to long-term investing (i.e. buy-and-hold). Oil is so volatile that I’d be mightily tempted to trade around it and especially if writing covered-calls, timing becomes more important.
  • Chesapeake offers more potential for investor “bail-out”, especially if prices stay low.  The company is the largest domestic natural gas producer and has valuable assets as evidenced by their various partnerships with major players like BP and Statoil.  During a prolonged slump, they could get taken out or sell themselves. They could sell more assets and reward shareholders. Conversely, they could also go bankrupt which is probably not the case with USO.
  • Keep in mind I am making no predictions as to how long prices will linger at low levels.  It could be 5 years or they could shoot up next summer.  Who knows?  If CHK can maintain is preferred dividend, note that in 5 years, I will have received well over half my investment back in cash with no transaction costs and at a lower tax rate against writing short-term calls against USO.

Theoretically, one invests in a commodity company to gain leverage over the underlying price.  So if natural gas triples from $5 to $15, I would expect CHK to exceed that gain (tripling from its current level would take it to $45).  Note the preferreds behave differently than the common due to the conversion feature.  If oil triples from $35, that would take it over $100.

So after all that, my answer to your question is a big, fat “I don’t know” but I hope my reasoning on it (and correct me if you see any flaws or holes) can help flesh out your own thoughts on the matter.  My guess is you could do well with USO but it would require a more trading mentality to maximize gains.

I will say that if crude drops to $25 and below, I’d seriously consider building a position in my own portfolio and averaging down at that point.  I can almost guarantee that crude will not go to zero (can’t quite say the same for USO so the vehicle itself may need to be researched).

More on this topic (What's this?)
Chesapeake's (NYSE: CHK) Eagle Ford Sale
Is the Shale Revolution Over?
Read more on United States Oil Fund, Chesapeake Energy at Wikinvest

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