Chesapeake Investment Report

 

CHK:  05/10/2007

 

Current Price: @ US $33.91

 

Chesapeake Energy is a leading independent natural gas producer in the US.  The company focuses on the Mid-Continent region, east of the Rockies, with an emphasis on unconventional plays.  Currently, the company ranks 6th in U.S. natural gas production among all companies, including the big oil companies (recently passed Exxon-Mobil) and currently has a booked reserve life of 14.5 years.

 

Risks

  • Standard risks regarding oil and gas companies:
    • Exploration risk – looking for new assets requires heavy capital investment and carries the risk of hitting a dry hole
    • Production may not match booked reserves
    • Costs to produce oil/gas may rise more than expected
    • Oil and gas prices are volatile (though Chesapeake is an aggressive hedger and less vulnerable than most peers).
    • Government and environmental risks, etc. etc.
  • Highly leveraged by industry standards.  The company is extremely active with acquisitions and drilling, both of which are expensive.  CapEx has exceeded operating cash flow for the last 5 years.  As a result, the company’s current ratio is 0.56 as of 03/31/2007 (current assets to current liabilities)
    • Chesapeake has current liabilities of US $2.2 billion but only US $1.2 bil to pay these obligations.
    • Company did not break out the hedge portions of the current assets/liabilities for Q1 2007 but as of year-end 2006, excluding hedges, current ratio was 0.51 as opposed to 0.62 with hedges.
    • Chesapeake also carries around US $1 billion in liabilities off the balance sheet covering transportation, drilling, new rig and compressor costs.
      • About US $400 - $500 of this is “current” (due 2007).
      • So current liabilities is closer to $2.6 billion.
  • Company has a history of diluting shareholder equity, most recently announcing a US$ 1 billion convertible notes offering on 05/08/2007 which would be 3.2% dilutive if fully converted at a price of $51.50.  
    • From FY 2005 to FY 2006, basic shares increased ~24%.  Fully diluted, shares outstanding increased over 25%
    • This year-over-year (YOY) increase does not include the 4.125% preferred stock outstanding prior to conversion (equal to another roughly 2.5% dilution)
  • Chesapeake is arguably the most active hedger in the industry with natural gas swaps and collars in place for over half of anticipated production in 2007 & 2008. We agree with Chesapeake that natural gas is in an era of structurally higher valuation but that doesn’t mean we can predict pricing in the near future.  If natural gas prices were to rise or if a major hurricane was to hit the U.S., Chesapeake would largely miss out on these possible profits.
    • While the company realized an additional US $1.2 billion last year in hedging gains, it realized losses of US $402 and $155 million in 2005 and 2004.        
  • Management risk – Chesapeake’s CEO and co-founder, Aubrey McClendon, is widely recognized as one of the best in the business.  The company may be adversely affected if he was to leave.                  

 

 

Upside:

  • Chesapeake has massive asset growth potential.  They currently have 9.4 tcfe of proved reserves and a reserve life of 14.5 years.
    • Risked unproved reserves added an additional 18.5 tcfe
    • Unrisked unproved totals 73 tcfe
    • 26,000 drill-sites inventory (10 year backlog)
    • Company traditionally conservative in reserves & production estimates.
    • SEC definition of reserves is limiting as it pertains to unconventional plays, which Chesapeake specializes in.
  • Company is the most active driller in the U.S., responsible for 13% of all land drilling activity.
    • In-house drilling and trucking segment lowers costs by 25% according to mgmt estimates for company-operated wells.
    • Able to negotiate better rates as evidenced by the letter sent to drilling contractors in early 2007.
    • They receive drilling data for 15% of all activity east of the Rockies, which is the only area they are interested in.
    • Developed expertise in shale drilling from Barnett experience which may be applied to other areas such as Fayetteville play.
    • As a result of all this, the company has a success drill rate of 99% for owner-operated rigs, 98% otherwise.
      • Reserve replacement rate of 348% of production in 2006.
      • Projected production growth of 14-18% in 2007 when other companies are having trouble maintaining production
  • Future growth will come mostly from drilling which is cheaper than acquisitions.
  • Hedging program allows company to predict and ensure future cash flows and ensure capital investment. 
  • Assets are geographically concentrated in a stable political state and all of them onshore, reducing political and weather risk.
  • Focus on unconventional plays reduces exploration risks (even if engineering risks remain).
  • In-house drilling segment with a fleet of 81 rigs by mid-2007 would rank it as the 6th largest U.S. drilling contractor if it were a separate company.
    • Management estimates that income from the drilling segment would be around US $200 million annualized if recognized on income sheet
  • Operational cash flow of over US $4 billion in 2006 as well as ample assets suggests that any short-term funding issues can be managed effectively.
  • Management insight on the industry and ability to foresee trends is proven and second-to-none.
  • Aggressive acquisition, drilling and 3-D seismic data programs have led to robust asset growth and extensive exploration backlog.
  • Acquisition and production costs are in-line with industry norms despite their aggressiveness.

 

 

 

Competitors

I reviewed the following industry competitors (as compared to Chesapeake):

 

1.      Devon Energy – attractively valued but paying more for revenues; more balanced gas/oil portfolio

a.      Pros

                                                                           i.      Barnett Shale holdings rivals or surpasses Chesapeake’s and should provide stable reserves replacement for years

                                                                         ii.      Slightly higher net margins

                                                                        iii.      More exposure to oil

b.      Cons

                                                                           i.      Growth primarily through acquisitions ($5.5 billion in goodwill)

                                                                         ii.      Riskier exploration plays (10,000 feet deepwater Jack project, Brazilian offshore, etc).

                                                                        iii.      Jackfish oil sands project in Alberta subject to oil sands difficulties (higher costs, nat. gas and water shortages, etc)

                                                                       iv.      Lower ROIC than peers

                                                                         v.      Production was down 4.3% in 2006

2.      EOG Resources – low cost producer in the industry; trades at a premium as measured by P/E ratio

a.      Pros

                                                                           i.      Shuns acquisitions, focusing entirely on drilling for growth

                                                                         ii.      Has some Barnett exposure

                                                                        iii.      Extremely cost-conscious and fiscally conservative

b.      Cons

                                                                           i.      Not attractively priced

                                                                         ii.      Position in the Rockies may not be as economical due to infrastructure and government challenges

3.      Anadarko Petroleum – most aggressively leveraged as well as risky plays

a.      Pros

                                                                           i.      Have grown reserves faster than production for each of the last 25 years

                                                                         ii.      Considering spinning off some assets as a Master Limited Partnership (MLP)

                                                                        iii.      Highest net margins of the companies I looked at

b.      Cons

                                                                           i.      Debt-to-capital: 67% high for the industry

                                                                         ii.      Has leveraged future growth to deepwater Gulf of Mexico and Rockies

                                                                        iii.      Risky in both operational sense and capital structure sense.

4.      EnCana – refocused on Canadian oil sands projects and North American natural gas

a.      Pros

                                                                           i.      Huge gas wells drilled in the Deep Bossier region of TX

                                                                         ii.      Partnering with ConocoPhillips in the oil sands play

b.      Cons

                                                                           i.      Oil sands subject to significant cost overruns

                                                                         ii.      Rockies exposure not ideal

 

 

           

 

Management:

  • Integrity: B+. Aubrey McClendon, CEO: Chesapeake management is very straightforward about their strategy, operations and assumptions as it pertains to running their business.  They release extensive material to help investors understand the company.  McClendon’s experience in the business runs over 2 decades and they obviously have the pulse of the industry.  My only disappointment with them is on the day of the Q1 conference call, McClendon went out of his way to dispel any rumors of equity dilution and then a few days later, the company announces a $1 billion convertible notes offering.  While he might have been true to the letter of the word, so to speak, as these notes will not affect financial results until they are converted, the essence is that possible diluted shares outstanding is now increased and it seems, at the very least, a Clintonian truth and somewhat dishonest in spirit.
  • Past Performance: A-. Chesapeake was founded in 1989 and has been through the peaks and troughs that are a key mark of the energy industry.  The company was pushed to brink in the late 1990’s due to risky exploration plays as well as disastrous price collapses in oil and gas.  The fact that the company was able to recognize a structural change in the industry (peak production in natural gas), define a strategy to bring the company back and then execute for the last 7 years is proof that McClendon and his team can deliver through good times and bad.  

 

The Reasoning:

Chesapeake Energy has positioned itself at the forefront of the natural gas industry in the U.S. at a critical juncture in history.  U.S. oil production peaked over 30 years ago and domestic natural gas production is probably peaking sometime this decade. Additionally, the world grapples with the question of global warming and carbon emissions and natural gas is the cleanest burning fossil fuel available.  So how lucky is it that within a few years, Chesapeake might possibly become the largest producer of natural gas in the country?

 

Well, maybe luck is where preparation and insight meets opportunity.  If so, it is quite lucky that the best management in the business had the insight to acquire the land, the people, its own drilling rigs and the geological data necessary to build such a promising position.

 

Ultimately, an investment in Chesapeake represents a belief that the energy markets will stay strong for some time.  The days of cheap oil are probably over and while natural gas may be more volatile, eventually the market will realize that natural gas is more valuable than currently priced now.

 

Obviously, Chesapeake feels this is the case and they’ve begged, borrowed and stolen every penny they can get their hands on to make this play.  As a result, the biggest risks in this investment are the tendency to dilute shareholders’ holdings and the possibility that adverse business conditions may affect short-term operations as their current ratio is not ideal.  However, these risks can be managed: management has large shareholdings (McClendon regularly buys hundreds of thousands of shares with his own money on the open market) so shareholder dilution is not care-free for them.  Hedging future production, debt facilities, possible sales of assets and yes, equity or notes offerings can mitigate any short-term funding issues.  Management has stated that the resource acquisition phase is now over and they are shifting into resource conversion (monetization).   As such, we expect that capital investment will ease, cash flows will increase and the balance sheet should strengthen.  We’ll keep a close watch on how this next phase plays out.

 

In the meantime, what did they get for all this money they’ve spent? 

·         A large portfolio of natural gas assets that are inherently less risky than other plays such as off-shore plays or land located in political shaky countries. 

·         A huge catalog of 3-D seismic and drilling data to help target future exploration targets. 

·         Synergized operations with their own rigs and trucking operation working within a concentrated region. 

·         A large talent pool in an industry strapped for people (Chesapeake nearly doubled their workforce last year, going from 3,000 to 4,900 employees).

 

The upside is huge.  Natural gas is inherently a local market as it’s not easily transported.  Liquefied natural gas (LNG) imports may supplement domestic production but will not smother it.  The supply-demand dynamic is favorable as more activity is needed to maintain supply while demand is steadily increasing.  In a recent conference call, McClendon stated that he no longer feels that natural gas supply will decline precipitously as he misunderstood the nature of reserves.  However, the majority of future production will come from unconventional plays such as shale, which will keep prices up as these are more expensive to produce. 

 

Chesapeake also feels that natural gas will be a vital component of the global warming solution.  To this end, the company has changed its logo to express this “green” belief.    They’ve also helped sponsor a new organization, the American Clean Skies Foundation, to advocate for natural gas as a solution to climate change.  McClendon very publicly opposed the TXU (Texas Utilities) plan to build new coal-fired plants in Texas on environmental (wink-wink) grounds. 

 

Finally, the company is available for investment at attractive prices.  One day, the world will revalue its energy resources but that day is not here yet, which gives us time to take our places.  I do feel that natural gas will be priced higher in the future but to be conservative, I used a range of $7.00 - $8.00 /mcfe for pricing (current price: $7.63).  This gives us a net asset value (NAV) range of $43.92 - $56.10 according to company figures.  A margin of safety of 30% puts us at $31 - $39.  I can sleep better if we mark that down to $28 - $32.  We don’t get underwater until the nat gas price hits $6 / mcfe.   Obviously, if prices rise, our margin of safety (or our gains) rises though somewhat muted by hedges in place.

 

Return on Invest Capital (ROIC) by my calculations is around 23% for 2006.  The earnings yield is 18% or inversely, 5.5 (comparable to the P/E ratio).   Both are good.

 

Certainty Rating: B+.  I’m making an allowance for possible corporate mishaps in terms of (mis-)managing their fiscal situation or for unexpected price downturns but these are pretty unlikely as a) their cash flow more than covers their current ratio gap and b) drilling and production fundamentals just don’t support a price collapse.

 

Accumulation Range: $28 - $32

Intrinsic Value Range: $44 - $56