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Chesapeak Energy - Natty or Nasty?



March 13, 2010 – Comments (6) | RELATED TICKERS: CHK

A couple of days ago, Chesapeake Energy Corporation  (NYSE: CHK)  came up during a discussion with some friends of ours.

Our thoughts were directed around the company as a long-term investment and were based on various articles we had read on the web, while their comments were based on their knowledge of the gas industry.

Since they are gas traders, having spent several years on the floor of the NYMEX, we of course yielded to their expertise.

So overnight last night, we received an e-mail from them that was a follow-up to our prior conversation, and knowing less about gas trading than a hog knows about the hereafter, we simply don't have the faintest idea what most of what was said in the e-mail actually means.

Okay, so we understand the last sentence; but the rest of it? Not a hint.

Here's what we received.

"It almost reads as fiction, but we dug around yesterday, trying to figure out how CHK hedged 60%+ of their 2010 natty at $8+. The results are nothing short of astounding.

It seems Aubrey and company has sold naked crude calls on the curve, converted the BTU’s and labeled them natty hedges, thus gaining roughly $3.50 on the hedge values. CHK, being 93% gas and only 7% oil, is basically speculating crude futures and calling it a gas hedge.

With crude now pushing higher #’s, CHK is clinging to the rim of a toilet that just flushed, one more push up in crude and they are likely toast."

Financial information related to the Chesapeake Energy Corporation, that is contained in this report, is based on the company's most recent Form 10-K filing  for fiscal year ending December 31, 2009 as filed with the Securities and Exchange Commission on March 01, 2010.

What They Do
The company claims to be the second-largest producer of natural gas in the nation and the most active driller of new wells in the United States. According to management, the company's goal from the outset has been to create value for investors by building one of the largest onshore natural gas resource bases in the United States.

Over the past 12 years, the company's strategy to accomplish management's stated goal has been to focus on developing unconventional plays onshore in the United States, where management believes the company can can generate the most attractive risk-adjusted returns.

The company also claims they have an industry-leading natural gas resource base which is integrated with an advanced drilling program coupled to an active property consolidation program, all of which is focused on small to medium-sized corporate and property acquisitions.

During the past three years the company has shifted its strategy from drilling inventory capture to drilling inventory conversion, and in doing so has de-emphasized acquisitions of proved properties while further emphasizing its drilling program and converting its backlog of drilling opportunities into proved developed producing reserves.

Short-Term Investment
The stock price is currently in a downtrend. Normally, since the stock has just started to emerge from an oversold condition, we start to pay close attention to company and industry news, looking for a favorable entry point, especially since the last trading day quote was below the 13 and 50 day moving averages.

But considering the spread  of 3% between a recent close of $25.64 and first resistance of $26.51, and then considering the 4% spread between a recent close and first support of $24.60, we think that the most prudent thing to do is leave a short-term trade to those that have grown a bigger pair than we have.

Long-Term (5 Year Hold) Investment
We looked at the company financials, and realized that while we are certainly not the most dynamic group of folks that ever bathed with Irish Spring,  we we are simply mystified.

What glazed our eyes over was the $11+ billion listed as special income charges, and, which was a new one on us, that selling and general administrative expenses exceeded the direct cost of sales by more than two to one. And while things like this may be quite normal, we have never seen such a phenomena before.

In addition, the company has 39 subsidiaries,  three of which are partnerships. While these sorts of business structures are not uncommon in the oil and gas industry, we simply aren't going to waste our time investigating all of these subsidiaries in order to determine if the company is investment worthy.

Final Thoughts
Our reasonable value estimate for the company is $25-$26, and should the price of the stock fall below $7, we may entertain the idea of risking a very very few dollars, admittedly more as a considered gamble than intelligent investment.

While we still have no idea what a 2010 natty is, it makes us think that perhaps investors should adjust the angle of their Charmin a bit before they attempt to smell their fingers.


To download the Wax Ink Chesapeak Energy Raw Value worksheet, please click here.

6 Comments – Post Your Own

#1) On March 15, 2010 at 10:40 AM, lemoneater (57.41) wrote:

"natty" is a cute nickname for natural gas. Perhaps 2010 natty is refering to natural gas futures?

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#2) On March 15, 2010 at 11:33 AM, portefeuille (98.92) wrote:


Aubrey McClendon.

has sold naked crude calls on the curve

see for example this.

CHK, being 93% gas and only 7% oil

That is what is making part of the short position in "crude calls" naked (at least that is what the author of the email implies).


British thermal unit

converted the BTU’s and labeled them natty hedges


Barrel of oil equivalent


One BOE is roughly equivalent to 5,800 cubic feet of natural gas



basically speculating crude futures and calling it a gas hedge.

So what the author implies is that the CHK used mainly short positions in "crude calls" to hedge the production that is "dominantly" natural gas, converted the amount of hedged oil production (the "underlying" of that short position) to an equivalent natural gas production and declared that equivalent amount hedged.

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#3) On March 15, 2010 at 11:41 AM, portefeuille (98.92) wrote:

It is highly unlikely that someone would simply "convert the BTUs" since natural gas is currently much cheaper than the "energy-equivalent" amount of crude oil. So someone doing that would not simply "hedge the wrong thing" but also hedge too much of the wrong thing. I don't really believe in the message of that email, but I have not tried to verify it and, hey, I have not spent even a second on the floor of the NYMEX, hehe ...

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#4) On March 15, 2010 at 12:43 PM, 10centstop (< 20) wrote:

Push the envelope!!  Traders are paid to trade!!  If you want to control creative trading and suck the life out of original thoughts then move to Tulsa!  In OKC traders trade.

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#5) On March 16, 2010 at 4:54 AM, wax (< 20) wrote:


Thank you for the information, I always appreciate learning new stuff.

The entire thing just seems bizarre to me, that company management would allow all of that hocus pocus to occur. I guess because I wonder about the shareholders. It just seems more like hedge fund behavior than investment behavior.

At any rate, I did go back through their 10-K, and managed to find the following information, which I think was what the original conversation we had with our gas trading friends, was all about.

"Throughout 2008 and 2009, we restructured many of our trades that included knockout features as commodity prices decreased. The knockouts were typically restructured into straight swaps or collars based on strip prices at the time of the restructure. Additionally, in the latter half of 2009 we took advantage of attractive strip prices in 2012 through 2014 and sold natural gas and oil call options to our counterparties in exchange for 2010 and 2011 natural gas swaps with strike prices above the then current market price. This effectively allowed us to sell out-year volatility through call options at terms acceptable to us in exchange for straight natural gas swaps with strike prices well in excess of the then current market price for natural gas."



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#6) On March 16, 2010 at 5:16 AM, wax (< 20) wrote:


You are quite correct about traders being paid to trade. But remember Enron? Towards the end, nobody would trade with them.

What little I know about that world, I learned talking to floor brokers and traders, those folks that actually work the pits of the NYMEX and on the floor of th NYSE.

And what we talked about wasn't futures and all of that, but about mechanics, the mechanics of their world. I was even privileged enough to get to spend some time on the floor of the NYSE.

While CHK may have done all sorts of fancy hedging via swaps and collars, and think they are all the most brilliant people in the world, if the company has indeed put themselves in a posture where they are short oil, and those in the NYMEX pits decide that oil futures need to rise, there is a very strong probability that oil futures will rise.

Which may put the solvency of the company at risk. And that was the point I was trying to make.

Certainly there are many ways to invest, and for those so inclined, an investment in CHK may work for them.

But for the vast majority of investors that will never take the time to read the company's SEC filings, never mind taking the time to understand what they have read if they do read the filings, an investment in CHK is something they might want to pass on.

Just like the traders that get paid to trade, investors get paid to invest. The difference is, a trader's reward happens immediately, while an investor's reward happens over a lifetime.


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