$23.03
-0.37 (-1.58%)
Chesapeake Energy Corp (CHK)
CAPS Rating:
An oil and natural gas exploration and production company engaged in the acquisition, exploration and development of properties for the production of crude oil and natural gas from underground reservoirs and the marketing of natural gas and oil.
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Why I like Chesapeake Energy:
1) Price increases. For natural gas prices to remain as low as they have been, producers would have to continue to pump out gas at costs that exceed the price it can be sold at, not counting hedges already in place.
2) Write ups. Last quarter's write downs on the value of reserves turned an operating profit into an operating loss of $9 billion. For scale, the company's largest ever annual operating income was $3.4 billion in 2006. Yesterday's write down sets the stage for tomorrow's write up as natural gas prices move up.
4) Joint Ventures. The company has joint ventures where the partners are on the hook to pay $4 billion of drilling costs. The company gives up some gas for that, but gets that much more drilling done without having to worry about cash flow.
3) Hedges. The vast majority of 2009 production and about half of 2010 production is hedged to sell at more than double today's market rate.
Concerns:
1) Cash is near zero. Liquidity is provided almost exclusively by short-term derivative instruments, which were purchased for hedging. Volumetric production payment deals are likely to provide a quick boost for cash, but if they fail to come through, a dilutive offering may be in the wings. And, this is a company that has demonstrated a willingness to raise cash even right after saying they wouldn't.
2) Is the CEO thinking of shareholders? CEO McClendon gets paid a lot, but doesn't own a lot of shares. He used to, but he lost most of them to an October margin call, and his selling badly acerbated the stocks fall. The board has recently paid McClendon an obscenely large bonus and required him to invest it in the company's wells. The board claims that's aligning interests. Investments in the company's wells are not the same as investments in the company's equity. McClendon has used company money for personal interests, such as his NBA team and art collection.
3) Bought Board. The median annual compensation package for non-employee directors is $680 thousand. No wonder McClendon's eccentric expenditures are rubber stamped.
Valuation:
In the ground are 11.8 trillion cfe of proved reserves and 236 trillion cfe of unproved reserves of various quality. Giving the company credit for 30% of its unproved reserves yields a total of about 80 trillion cfe. Say the company can sell the gas for $1 more per thousand cfe than it costs to get the gas (including paying McClendon and everybody else). That would value the company at about $80 billion. Subtract $14 billion for debt, for a value of $66 billion. With 626 million shares outstanding, that's $105 per share. If I were more comfortable with management, I'd tack on a premium for their management of this resource and another boost for my rosy expectations for gas prices in the long run. But, Management is a concern, and my 30% credit for unproven reserves may be to high, so I'll just stick with $105 for now.
I made a mistake and added the company’s risk adjusted estimate of gas in unproven reserves to their total estimate of unproven reserves. Unproven reserves are only 166 trillion cfe. Looking closer at the company’s assessment of risk, I think the company is giving themselves credit for roughly 35% of these unproven reserves. I’ll stick with 30% for now.
Adjusting my per share valuation to $76.
Adding another concern:
4) Regulation. Hydraulic fracturing is likely to lose its exemption from federal regulation. A probable outcome is a change in the chemical mix used in the process with a resulting decrease in well efficiency.
Careful with this one and go to the link at the end of this reply before speculating on Natural Gas providers.
Exxon Mobile has just brought their Liquefied Natural gas business on line which will be dumping huge amounts of Natural gas into the US markets at about $2 per million British thermal units. This Natural gas is coming from the Middle east, and is produced as a buy product, at a cost of almost nothing. The average cost to produce Natural gas in the US is $7.79 per million British thermal units. With this in mind, US Natural Gas Companies are in big trouble!
http://online.wsj.com/article/SB124595565700755357.html
Valuing CHk on its 'unproved reserves' is more than a little risky. Even valuations on proved reserves is difficult given the current level of Natural Gas pricing. It looks to me that futures prices in the next 3 years won't average more than $6/mcf and maybe that gets you the one dollar more than costs. It is not for sure.
Valuing 236 Tcf of 'unproven' reserves is crazy. Could the adjective have been 'probable' or 'possible' rather than unproven? Both of the terms above describe natural gas that might be found depending on price conditions and costs and do not belong in the same financial catagories with proved reserves.
I would suggest another look at your method of evaluation.
Another reason to like CHK: They are sitting on the monster Haynesville Shale in and around Louisiana, and they almost never drill a dry hole.
CREWatcher:
Is Hydraulic fracturing the method NG drillers use to extract NG from Shale? Thanks for a link or any explanation on that method as well as any other source that I could look to for more coverage of that drilling technique.
Regarding hydraulic fracturing, yes, it is an important part of the process of extracting NG from shale. A reasonable explanation to start with is at Wikipedia: http://en.wikipedia.org/wiki/Hydraulic_fracturing
As for including unproved reserves in the valuation, I have only given the company credit for 30% of their unproved reserves. That leaves room for a 70% margin of error. I think any larger discount would error too much on the conservative side, but I did close my pitch mentioning that my 30% credit may be too high. If you want a larger discount, use one. For instance, using an 80% margin of error reduces the estimate of gas in the ground to 60 trillion cfe, and give a company value of $44 billion, or $70 a share, with the simple model I'm using.
I'm not sure either whether the company will get $1 more than costs for selling the gas, but it is, I think, a reasonable estimate to work with. Henry Hub Natural Gas futures, as of the moment, are priced at $7 for Jan 2011 and aren't lower than $6 after that. This, though, seems to me the wildest part of the valuation. If the economy craters from here, the company could have to settle for small numbers of pennies for years. If all of this stimulus fuels higher than normal inflation, say possibly 3 or 4 years from now, the company could pocket $4 for its gas.
Regarding imports, I expect their price to rise with demand recovery in Europe.
Sorry, in my example for the 80% margin of error I copied my work from my first post, and included the same mistake that I had corrected in my first reply. Incorporating the correction, the example should run: Using an 80% margin of error reduces the estimate of gas in the ground to 45 trillion cfe, and gives a company value of $31 billion, or $50 a share.