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Chesapeake Energy

October 13th, 2008 · No Comments

These didn’t have a good time of late, and neither had it’s CEO Aubrey McClendon. What’s going on? Most of it is not hard to guess, but there are a few surprises..

The market is terrible and in the grip of primal fear, the US economy is sinking, and energy prices are down. In short, those are the main explanations for this falling stock. Here is what’s happened the last three months:

One might also want to put things in perspective, it’s two year chart:

You’ll notice this ain’t no garden variety sell-off. Pretty much disaster is priced in, and exactly that seems to be what happened. Apart from plunging markets, fear reigning supreme, and a steep fall in energy prices we also learn that it’s CEO was forced to sell up to 33M shares in the last couple of days to meet a margin call. This is what he had to say for himself:

  • “I am very disappointed to have been required to sell substantially all of my shares of Chesapeake,” McClendon said in a news release. “These involuntary and unexpected sales were precipitated by the extraordinary circumstances of the worldwide financial crisis.”
  • “I have been the company’s largest individual shareholder for the past three years and frequently purchased additional shares of stock on margin as an expression of my complete confidence in the value of the company’s strategy and assets.” [Yahoo]

So even CEO’s who are super-duper confident about their own company can actually be overconfident, and pay the price. Apparently he is a billionaire, so it’s not that he will have to alter his consumption pattern any time soon, and for the rest of us, it provides an opportunity, especially if you also take the following into consideration:

  • McClendon said he looked forward to rebuilding his ownership position in the company. He and Tom Ward co-founded Chesapeake Energy, the county’s largest producer of natural gas, in 1989. [Yahoo]

We think these levels are excellent to add right now. Let’s look a bit more into the fundamentals.

Reserves

  • They have 11.8Tcf of proven (P1) natural gas reserves, and in their estimations, this will rise to 13Tcf at the end of this year, and 15Tcf at the end of the next
  • They have no less than 45Tcf in P3 reserves [CHK investor presentation]

Production

  • Chesapeake overtook BP in the second quarter of 2008 as the biggest natural gas producer in the US, with 3.5% of the market producing over 2.1Bcf of gas per day. [CHK investor presentation]

Revenue

  • Analyst expect on average $7.26B in 2008 and $10.96B in revenue in 2009. [Yahoo]

Profits

  • On average, analyst expect $3.81 per share in 2008 and $3.93 per share in 2009 in profits
  • The company has a history of beating average expectation, although the last quarter they only managed to do that by one cent. [Yahoo]

Debt

  • Their outstanding debt ($13.7B) is now more than it’s market capitalization at these prices ($11B, although this fluctuates quite a bit lately..)
  • Apparently, they are also a bit worried about this, especially in the current credit climate, which is the most difficult on record. They have already taken quite a few measures though:
  • Capex spending will be curtailed by a rather substantial $4.7B through 2010. [The Street]

Cash

  • Chesapeake has $1.5B in cash and cash equivalents, and they are working to increase that by reducing capex spending and sale of some activa. This will result in increasing the cash position to $2.5-$3B at the end of this year
  • Cash-flow from operations will add $1-$1.5B per year through 2010 to that
  • The extra generated cash will be used to reduce the company’s debt position. [Reuters]

Their positions are largely in so called unconventional gas resources, by which is meant that these are gas properties in which normal vertical drilling would not be sufficient to release the gas.

That is because the rock, or in this case, shale, is tight, it doesn’t flow. What is shale gas?

  • Shale gas is natural gas stored in organic rich rocks such as dark-coloured shale, interbedded with layers of shaley siltstone and sandstone. Shale can be the source, reservoir and the seal for the gas. Shale gas plays are classified as a “continuous” type gas accumulations extending throughout large areas, typically with low permeability and perhaps natural fractures. Shale gas plays in Canada are expected to have low production rates over a production life of perhaps 20 to 30 years. Why is shale gas considered unconventional gas?
  • Shale gas is considered an unconventional source as the gas may be attached to or “adsorbed” onto organic matter. The gas is contained in difficult-to-produce reservoirs that require special completion, stimulation and/or production techniques to achieve economic production. Shale gas may also be contained in thin, porous silt, sand and beds interbedded in the shale. In this case, the gas is classified as ‘free gas’ and is produced along with the adsorbed gas. [Alberta government]

So unconventional drilling methods are necessary:

  • The process for retrieving this natural gas from shale is more expensive than the traditional wells and requires breaking up the shale using fracture pumps and horizontal drilling techniques. That said, when natural gas is over $5.50, it works… and there is a lot of natural gas to be extracted.
  • New horizontal drilling technology, including hydrofracturing, has made shale-based natural gas accessible. Natural gas in places like the Haynesville formation in Louisiana is situated in vertical columns. Imagine six milk cartons in a row. If you stick a straw in one carton, you get one carton of milk. If you stick six straws end on end and drill it horizontally through all six cartons, you get all the milk with one really long straw.
  • Profit From the Natural Gas Boom: “But This One Goes Up to 11…” Chesapeake Energy (CHK) has pioneered using six sections and is now using eight sections for its sideways drills.This greatly reduces the cost per unit of gas recovered. In fact, CHK has some rigs down to below $5.50 MMBtu. In hyrdofracture drilling you simply pump pressurized water down into the well. This breaks up shale and releases more gas. You then fill the gaps with permeable sand and pump out the water and gas. The benefit of the Haynesville site is that it is naturally pressurized. This means that instead of pumping out the gas it squirts out by itself, again saving money. Chesapeake believes that it can get its costs down to $5 and change. Today, the futures market values natural gas at $7.50, down from $14. [Seeking Alpha]

Their biggest shale gas properties are in:

  • Haynesville Shale, which is expected to become the largest US gas field (480K acres)
  • Barnett Shale 325-340K acres by 2010
  • Fayetteville Shale (415K net acres), where they have a 25% joint venture with BP
  • Appelachia territories with shale properties like: the Marcellus shale (1.6M net acres) and the Lower Huron (1.2M net acres) [CHK investor presentation]

The fall in natural gas prices in the US lately hasn’t been helpful for their exploration program, obviously. However, heavy use of hedging seems to provide good insulation for profits:

  • 83% of output is hedged at a price of $9.30 per Mcf in 2008
  • 72% of output is hedged at a price of $9.63 per Mcf in 2009
  • 46% of output is hedged at a price of $9.89 per Mcf in 2010 [CHK investor presentation]

Hedging is not always successful though, the occasional loss on futures selling happens.

In their own projections, hedging provides a surreal insulation for profits per share, which stay virtually constant in 2008 at $3.75-$3.76, whether the gas price is $7 per Mcf or $11 per Mcf! [CHK investor presentation]

The biggest risk (apart from a melt down of the financial system) seems to be lower gas prices. Gas is much cheaper in the US compared to the Middle East, or Asia, and has now fallen to levels where shale gas exploration have little margin left. Profits seem to be well insulated through hedging, but future exploitation might come under further pressure.

However, sooner or later, prices will recover with the US economy, and then this company will be up and running again. In the meantime, external circumstances have conspired to make it rather cheap.

Tags: CHK