Why Chesapeake Should Regain Its Energy

26 August 2010 - Barron's  - Johanna Bennett

Down 60% in the past two years, the natural-gas producer's stock is priced to buy. Rig to Rise

CHESAPEAKE ENERGY (ticker: CHK) may finally be rigged for upside.

Weak demand and a supply glut of natural gas have caused prices to fall within the sector. Chesapeake has suffered worse than many natural-gas producers, with shares falling 58% in the past two years, in part because of the hefty $12 billion debt load on its balance sheet.

Yet at about $20 a share – or less than eight times forward earnings – investors appear to have little to lose.

While waiting for natural-gas prices to rebound, the nation's second-largest natural-gas producer is increasing oil production and reducing its debt, moves that could help the stock double within three years.

"Everyone is worried about the balance sheet, and underestimating the value of Chesapeake's oil and gas reserves and its acreage position," says Mike Breard, an analyst with Hodges Capital Management. "The value of this company will be much higher three years from now."

Others seem equally optimistic.

Billionaire investor Carl Icahn revealed in recent SEC filings that his firm dramatically increased its stake in Chesapeake to 12.7 million shares as of June 30 from 2.1 million shares three months earlier.

And last week, BMO Capital Markets analyst Dan McSpirit upgraded the stock to Outperform.

In March, Barron's listed Chesapeake as one of a dozen bargain-bin stocks with upside potential (see Barron's, "High Hopes for Some Low-P/E Stocks," March 29, 2010).

"If investors are patient, they will be amply rewarded," says Harry Rady, founder of Rady Asset Management.

Founded 21 years ago, Chesapeake depends on natural gas for 90% of its production. And under co-founder and Chief Executive Aubrey McClendon, Chesapeake earned fame by helping pioneer the drilling technology used to extract natural gas from deeply buried onshore formations of shale rock.

It gobbled up leases in the nation's most promising onshore natural-gas fields and pursued a breakneck drilling pace to bring those new gas supplies to market.

That growth, however, came at a price.

Chesapeake has one of the highest debt-to-capital ratios among the oil and gas producers listed in the S&P 500, and Moody's and Standard & Poor's have junk ratings on the company's bonds.

The company, however, has made "meaningful progress" fixing its balance sheet, says Kyle Okita, an analyst with Egan-Jones Ratings.

For the last two years, it has aggressively pursued joint ventures with the likes of BP (BP), Total (TOT) and Statoil (STO) to reduce its reliance on debt markets and to fund future drilling.

More deals are coming. And in May, Chesapeake outlined steps to raise as much as $5 billion over the next two years to reduce debt and attain investment-grade ratings.

Like other oil and gas producers, Chesapeake's fortunes are tied to commodity prices.

And while natural-gas prices have climbed a bit off last year's record low of $2.50 per 1,000 cubic feet, they remain weak, squeezing earnings.

The market for oil, however, has been far more resilient, and prices far more attractive to producers.

So in a move described by McClendon as "the single largest strategy shift in Chesapeake's history," the company plans to reduce natural-gas drilling until gas prices rise to $6 per 1,000 cubic feet, and is shifting resources into oil and natural-gas liquids such as propane, butane and ethane.

McClendon remains a vocal advocate for natural gas as a cheaper and cleaner alternative to oil.

But between 2008 and 2011, Chesapeake expects oil and natural-gas liquid production to triple, fueling a 45% gain in total production. And by 2015, it sees oil and natural-gas liquids generating one-quarter of total production and 40% of product revenue.

The Street, meanwhile, expects profits to climb roughly 8% annually over the next three to five years.

"This brighter and more profitable tomorrow can't arrive soon enough for me," McClendon told investors during a conference call earlier this month.

This brighter future can be purchased for 7.5 times forward earnings, or a 42% discount to the S&P 500 index.

And BMO's McSpirit sees the stock climbing 50% over the next 12 months to $30 a share, or 10.5 times the $2.84 a share Wall Street expects Chesapeake to earn next year.

Of course, those gains won't materialize if the joint-venture market dries up, or energy prices fall off a cliff.

And some investors are turned off by McClendon's style.

Chesapeake's CEO was forced to sell almost 95% of his stake in the company in October 2008 to cover margins calls, which added pressure to the company's already falling stock price.

Still, Chris Armbruster, an analyst with Al Frank Asset Management, remains comfortable with McClendon at the helm.

"It won't always be a shareholder-friendly ride," warns Armbruster. "But five years from now, you will be happy that you own Chesapeake."

Full Disclosure

• BMO Capital Markets and/or one of its affiliates had an investment banking relationship with Chesapeake Energy in the last 12 months, according to a research report published on Aug. 16, 2010. BMO has an Outperform rating on Chesapeake.

• Icahn Associates held 12,739,478 shares of Chesapeake Energy as of June 30, 2010, according to StreetSight.net.

• Al Frank Asset Management held 167,696 shares of Chesapeake Energy as of June 30, 2010, according to StreetSight.net.

• Hodges Capital Management held 510,075 shares of Chesapeake Energy as of June 30, 2010, according to StreetSight.net.

• Rady Asset Management held 42,000 shares of Chesapeake Energy as of Aug. 26, 2010, according to Jordan Greenhouse, chief operating officer of Rady Asset Management.

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