Chesapeake Energy CHK
October 12, 2008 - 2:32pm EST by
2008 2009
Price: 16.52 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 9,570 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Chesapeake Energy is the largest producer of natural gas in the United States with very large actual and potential reserves in the most important onshore US basins (no offshore or non US properties). Since the beginning of July the stock has gone from $74 and a market value of $43 billion to a low of $12 on Friday (October 10), closing at $16.52. The entire natural gas sector has been hit with worries about a glut, causing prices to drop about 50% in the last 3 months, concerns about hell bent expansion which has made many of the major independents net borrowers to fund capex, and in Chesapeake’s case, fears about counter party risk for their extensive hedges (eg $50 million exposure to Lehman). Chesapeake’s stock has acted even worse than the industry as a whole despite capex cutbacks designed to slow their growth and stabilize industry prices. After the closing bell on Friday, it was announced that CEO Aubrey McClendon had had a series of margin calls that forced him to sell more than 31 million shares between Wednesday and Friday, including more than 15 million shares on Friday at prices ranging from $12.60 to $16.16. McClendon is left with roughly 1.5 million shares instead of the 6% ownership position he had the week before. The premise of this brief writeup is that 1) arguably the company with the best potential in the business will bounce on news of the wipeout, and 2) more importantly, that McClendon’s irresponsible risk taking makes the company extremely vulnerable to a takeover bid by one of the majors, who are long cash and short growth opportunities. There is no question that rumors will be flying over the next 2 weeks so this idea can be looked at as both a short term trade and a long term investment. And based on today’s (Sunday) NY Times article in which Ken Heebner recommends 1 stock - CHK  - there are a lot of savvy investors who think the stock is oversold.
Chesapeake is a very well known company so I will only cover a few highlights.  In many ways, it’s more important to understand McClendon and his relationship to the company to appreciate CHK’s vulnerability. Chesapeake was created in 1989 by Tom Ward and McClendon (age 30) and has been aggressively managed since going public in 1993.  In 1999 the stock got below $1/share but has appreciated big time since then on a bet-the-farm wager of being able to economically extract natural gas from shale rock. Despite a 25% compound production growth rate since 1999, proved reserves have increased more than 9x.  Along the way, McClendon became a billionaire and a spokesperson for the industry – most recently promoting compressed natural gas (CNG) for vehicles along with his friend, Boone Pickens. Tom Ward left the company in 2006 and took with him somewhat of a moderating influence. A great deal of Ward and McClendon’s wealth was created by the (egregious) “Founder Well Participation Program” which allowed each of them to participate in Chesapeake’s wells up to a 2.5% ownership position as long as they contributed their share of drilling costs. In 2007, McClendon ponied up $177 million for his fraction of such costs but didn’t disclose his income (rumored to be more than $50 million/month).  The income has been reported privately to the SEC at their request but has not been made public, the Company claiming that since the monies are not salary, they do not need to be disclosed.
In 2005 Chesapeake made a $2.3 billion acquisition of Columbia Natural Resources and then proceeded to reinvent the merger metrics of the gas industry by hedging Columbia’s forward output at high prices and paying for the acquisition within 3 years. Management has been a leader in utilizing all sorts of hedging mechanisms to lock in prices. Cash gains of $1.2 billion in each of 2006 and 2007 were realized by taking off many of the hedges and waiting for spot prices to rebound.  Currently, 72% of 2009 production and 46% of 2010 production is hedged at very attractive prices. Unfortunately, the market has recently woken up to Chesapeake’s partial use of (idiotic) “kick out” hedges which lock in an above market prices but which get kicked out (canceled) if the spot price of gas goes below a certain threshold. Additional examples of the aggressive approach to the business are Chesapeake’s hiring of a full time weather forecasting team whose input is integral to their hedging program, the construction of a state of the art technology center to analyze rock samples from all over the country and a liberal amount of debt (Ba3 – senior unsecured). In short, Chesapeake management is regarded as smart and willing to take big time risks if they are convinced of their point of view. McClendon is the both the face of management and the embodiment of its personality.
Chesapeake is having an Analyst Meeting on October 15 and has a presentation on its website that summarizes its key strengths. Page 3 shows an enterprise value of $40 billion (based on a $47 stock price), but using a present enterprise value of roughly $25 billion, divided by 11.8 TCF of reserves, means the market is valuing reserves at a bargain $2.12 per MCF. Through the end of 2009, the company will be cash flow positive and is forecasting reserves of 15 TCF by 12/09 – which would value reserves at a ridiculous $1.67 per MCF. Such numbers give no value to 45 TCF of risked unproved reserve potential, 15 million acres of net leaseholds and a large fleet of their own drilling rigs. Chesapeake has stopped its aggressive leasing program dead in its tracks in the Haynesville, Barnett and Marcellus shale plays in order to reduce cash outlays and convince the market that there won’t be a glut of gas but still has some of the largest holdings in each of those plays which will take years to develop.
Although natural gas prices are down along with oil and most commodities, there is a strong argument for investing in natural gas. Either a Republican or Democratic president is likely to endorse a national energy plan that will encourage domestic production and greater uses of the cleanest fossil fuel (eg subsidies to partially pay for converting trucks to CNG).  Chesapeake has been arguing for a carbon tax on coal that probably won’t fly in the short term but which may become an increasingly compelling argument. At the present relative prices between oil and gas, homeowners have an incentive to switch to gas and apparently have been doing so in a big way in the northeast.
Shell, ExxonMobil, Chevron, ConocoPhillips and BP are all among the dozen largest domestic natural gas producers, but they have been slow to get in on the shale bandwagon as the technology (horizontal drilling, fraccing techniques) has rapidly improved. Arguably, BP is in the best position as an acquiror, having inked a $2 billion joint venture for Fayetteville shale properties with Chesapeake earlier this year and sitting with $20 billion of cash.  Exxon’s $40 billion of cash looms large since the rest of the majors would probably have to borrow to fund the deal – all have depressed share prices. The majors probably don’t want to make a hostile bid but at a high enough price, any merger turns friendly.
Despite my above short shrift of the industry and potential buyers, the key here is that McClendon’s stock was initially sold in the $22 – 23 range last Wednesday and sank as more shares were piled on. I view $22 -24 as the base price for the leading company in the industry, even in this kind of market. Above that base you can argue that the person who knows the most about Chesapeake bought 750,000 shares in July at $57.25 (when there were published reports that the company was worth north of $100/share). It seems to me that an outsider offering to buy the company can either argue that present shareholders are much better served by steady management and/or substantial cash for their shares right now.  In short, McClendon’s behavior has cost him dearly ($billions according to how you calculate) and has left him with no credibility.  With little inside ownership (Fidelity and Southeastern Asset Management together own more than 20%, insiders less than 1%), a $40/share offer from a major would look pretty good to most of the shareholders and would have the added benefit of making sure that McClendon didn’t find some other mechanism to feather his own nest.


McClendon margin call
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