CHESAPEAKE ENERGY CORP CHK
October 07, 2011 - 12:34pm EST by
ncs590
2011 2012
Price: 25.91 EPS $2.80 $2.86
Shares Out. (in M): 660 P/E 9.2x 9.0x
Market Cap (in $M): 17,122 P/FCF 0.0x 0.0x
Net Debt (in $M): 11,700 EBIT 0 0
TEV ($): 31,887 TEV/EBIT 0.0x 0.0x

Sign up for free guest access to view investment idea with a 45 days delay.

Description

I am recommending a long position in Chesapeake Energy. Chesapeake is the second largest producer of natural gas with one of the lowest cost structures in North America and is rapidly becoming a major producer of oil and natural gas liquids. I think the stock is currently undervalued in the short term due to uncertainty regarding their Utica shale joint venture, and due to underfunded future capex plans (which the aforementioned joint venture would solve).

In the longer term, there are other reasons that this company is undervalued. The market takes a dim view of the company's management and corporate governance, and many investors think the company is too complex to value due to the amount of non-producing assets, financial engineering, and corporate complexity. I will discuss these issues and take a stab at coming up with a firm conservative valuation below. Questions are more than welcome, thanks.


Chesapeake Management:

BEARISH VIEW:

• Aubrey McClendon and Tom Ward nearly bankrupted CHK in the late 90s by levering up the company to build a huge position in what turned out to be "non-core" Austin Chalk before prices collapsed for a number of years.
• McClendon lost about $2 Billion personally in 2008, after margining his 30MM share CHK equity position to buy millions more in CHK stock at prices as high as $57.25.
• The highly compensated ($400k + per annum) and management friendly board of directors paid McClendon $100 million dollars in what amounted to a personal bailout of their Chairman in 2008. The company also elected to buy $12 million dollars of antique maps from McClendon, which decorate company headquarters.
• Management has declared on numerous occasions that they were done raising capital and buying assets, only to raise billions in capital and expand first into the Haynesville shale and then recently into numerous oil/liquids shale plays.
• Chesapeake may have expanded beyond their core competency (of producing low cost natural gas) into "lease brokering", an aggressive hedge program that can only be called energy trading, and most recently into oil/liquids production.

MY TAKE:

His supporters will say - and we think history will show - that Aubrey McClendon is a visionary. He seems to have learned his lesson with regard to "non-core" acreage in the Austin Chalk, and has created the #1 or #2 "core" leasehold positions in the five largest gas shales and four of the five largest oil shales in the US - all at very attractive prices. This was accomplished by running the most "information only" rigs, building the largest geophysical reservoir evaluation lab, having the most landmen, and having a willingness to move quickly.

Aubrey McClendon is regarded by many in the investor community as reckless, willing to expand at any cost, and unwilling to be left behind. Analysts I've spoken to don't doubt the value of the assets McClendon has put together, but there is a widespread fear that he will keep "creating value" until it bankrupts the company. Chesapeake expanded aggressively into the Barnett, Marcellus (partially through a fortuitous acquisition of CNR), Fayetteville, Haynesville, Eagle Ford and Niobrara shales. Each time this happened, there were concerns that the company had spent too much money on land and would have a liquidity problem.

In each play, CHK was able to sell a fractional JV interest for a multiple of what they paid - essentially recouping their entire investment for both the portion they sold and the majority they kept. Each time this has happened, detractors have chalked it up to luck and suggested that the acquirer foolishly overpaid. Considering that the acquirers were BP, Total, Statoil, CNOOC, and PXP, this is very unlikely (except perhaps in the Haynesville, which PXP bought into at the top of the market). Despite this 6/6 record of wildly accretive billion dollar JV deals; the market currently doubts whether CHK can do it again with their recently acquired Utica acreage.

To understand whether CHK has just been lucky or actually has some advantage in acquiring land, one can look at their recent Eagle Ford JV. In late 2009 and early 2010, they drilled and cored ten vertical wells and acquired 830 square miles of 3D seismic. At Chesapeake's reservoir technology center - which analyses more shale core than the rest of the industry combined - they delineated the area of the "oil window" up-dip as well as the area where the formation was thickest within this window. They identified and avoided the Western section, where despite some of the thickest shale the oil was too immature and viscous to be productive. After fracture simulations at the technology center and actual test wells confirmed the economics of the play, CHK was able to rapidly lease 600,000 acres in the thickest part of the mature oil window for a total cost of $1.4 billion. Within twelve months, CHK was able to sell a 33% stake to CNOOC for $2.16 billion, with half up front and the rest payable over two years as a drilling carry.

If one uses a present value for the 33% stake purchased by CNOOC of $2 Billion (using a 10% discount rate), that means CHK spent $1.4 billion and turned it into $6 billion of value in just one year - a third of which in cash to immediately recoup their investment. This was not reckless and it was not lucky - Chesapeake was able to turn their temporary informational advantage into a permanent structural advantage; 400,000 net acres in the best part of the play at a negative net cost to the company (after the CNOOC deal). A number of large recent transactions in the Eagle Ford have been completed at prices of more than $20,000 per acre, which would value CHK's 400,000 net acres at $8 Billion dollars (the company actually has 450,000 net acres now due to additional leases signed after the JV deal so this number is higher). To put this in perspective, this is more than $10 per fully diluted share for this one asset, and the net cost to Chesapeake was negative.

Chesapeake runs 15 "information only" drilling rigs - more than most public E&Ps have for production. This company has consistently been able to gain an informational advantage, not only in finding plays, but in delineating the extent and "core" or sweat-spot of plays others have discovered. By leasing the best acreage, they have consistently turned a 6-month information advantage into a permanent cost-advantage. The company has signaled that this land rush is now essentially over and they have already seen core samples of every depositional basin in the country.

Chesapeake's management has been creative in raising capital; pioneering the large scale use of VPPs for financing, courting Asian SWFs for capital, and doing the first US oil and gas deal with a Chinese company. Chesapeake is completely vertically integrated, the most active driller, the largest owner of onshore US seismic data, and the largest customer to the service industry. These are major advantages in both producing and discovering gas, and probably also gives them an advantage in their hedging program (which has generated $7.7 billion in realized gains from 2001-2011).

McClendon may change the direction of the ship more often than investors would like, but his moves have been correct and created value. His bold expansions have been a capitalization on CHK's informational and technological advantages, not the shoot-from-the-hip moves of a manic empire builder. He was right on the gas shales, and is being proven right on the oil shales. Every major expansion McClendon has undertaken has generated a multiple of the expenditure in value to the company. This value is not reflected in the stock, but it is easily verifiable (and will be delineated in the valuation section). The investment community apparently believes McClendon and his team were wrong to create this value because the share price hasn't gone up yet.

I disagree with those who want Chesapeake to stop doing large and highly accretive land deals, but it looks like that crowd will get their wish in 2012. There are only so many depositional basins in the United States, and at this point, E&P companies have gotten a look at all of them. There is no chance of finding another shale play in Nevada, for instance - shale is the source rock for conventional oil and gas pools, and it only exists where there has been conventional production for years. There could be another large discovery in an existing basin, but it is increasingly unlikely.

Both McClendon and his (essentially captive) board are very well compensated, but it is not as egregious as the headlines suggest. His "$100 million payday" was really $75 million payable over five years (with no other bonus during this time). He is still very highly compensated and gets a lot of perks, but so do a lot of people at Goldman Sachs - and none of them made a $4 billion gain on one deal for the company in 2010 like McClendon did. While the $12 million purchase of the maps was egregious, it focused shareholders and the media on the poor corporate governance at Chesapeake, which has improved now that the board is under a spotlight. This company is promotional and controversial, and investors need to make a judgment as to whether Aubrey is smart and aggressive or just crazy - the track record of consistently successful value creation suggests the former.

In January of this year, Lou Simpson, of Berkshire Hathaway and Geico fame joined the board of directors. I view this as a very positive move from a corporate governance standpoint and a vote of confidence in the integrity of management. In August, Mr. Simpson purchased 100,000 shares in the open market at an average price of $27.46.

I think that the majority of corporate governance issues have been addressed. As to whether management's bold and unapologetic style is something to be concerned about, I think an investor has to look at the track record of what they have accomplished rather than a collection of minor public relations gaffes. If the skill of an investor is ultimately judged by his long term track record, then Aubrey McClendon is one of the greats. The last ten years of hedging, acquisitions, and divestitures has been nearly flawless. Despite a crash in natural gas prices and some minor forays into shale plays that didn't work out (the company wasted about $350 million leasing in Michigan), this company is batting around .800, and has been doing so for years.

By the end of this year Chesapeake will JV a portion of their newly acquired Utica shale asset in Eastern Ohio. The market did not react well when the company announced a year ago that they planned to spend $1 billion on this - then unnamed - "liquids" shale play. Since then they have spent a total of $1.5 billion, and have announced that they will sell an interest in it by the end of this year. The company says their acreage is worth $15-20 billion. This is a very large number, but the company has a perfect track record at selling joint venture deals within both the timeframe and valuation range they have announced beforehand. If they sell just 25% of the play at a valuation of $15 billion, they will have taken care of any future capex shortfalls and retained an asset worth more than $11 billion dollars at a negative net cost to the company. It is worth noting that Exxon recently bought into this play (buying private Phillips exploration) at a reported $10,000 per acre, which suggests CHK's acreage is worth $12.5 billion - and this was without seeing the results of Chesapeake's wells.


Financing

BEARISH VIEW:

• Chesapeake is one of the most highly levered players in the space, and consistently outspends cash flow.
• While the company has been successful is selling assets in order to make up the shortfall over the last few years, it is unclear if they will be able to do so going forward, potentially causing a liquidity problem which could lead to dilution.
• Chesapeake has sold volumetric production payments (VPP) to financial players, getting cash up front for gas to be delivered in the future. This is considered by some to be a form of off-balance sheet debt.


MY TAKE:

Chesapeake has been extremely creative in financing their growth. While they have $9.7 billion in debt, they pay a blended rate of only 5.8% and have an average maturity of seven years. They termed out their revolver to 2015 and expanded the capacity from $3.5 billion to $4 billion (with the option to expand to $5 billion).

The VPP deals are definitely not debt, off balance sheet or not. In these deals, Chesapeake has sold an overriding royalty on certain mature producing wells in a given area for a certain amount of time. The volume they sell is about 80% of what the wells are expected to produce during that timeframe, and while ownership of the wells reverts to Chesapeake after the VPP term, due to decline rates and the time value of money, there is little value left. If these wells blow-up, sand-up, or otherwise disappear, Chesapeake has no further liability. The only liability the company retains is their 20% interest; in the unlikely event that the wells do not produce as much gas as expected, the difference comes out of Chesapeake's remaining 20% interest in the production from that well group - but this is specific to a group of wells, not an area, subsidiary, or any other entity. There is no liability to CHK, other than the potential to give a little more gas out of a given underperforming group of wells, up to but not beyond the ownership interest CHK retains in that group.

As with the recent Eagle Ford and Niobrara joint ventures, the investment community seems to think that Chesapeake will not be able to get a joint venture done in the Utica and thus will be unable to fund its (discretionary) capex next year, and thus will dilute shareholders. Every piece of evidence, not to mention their track record, suggests otherwise. The company is also planning to sell a royalty trust in their granite wash play for $500 million, will sell more midstream assets into their publicly traded midstream subsidiary, will divest some portion of their 1.1 million acre Mississipian lime play in 2012 and plans to IPO their service business sometime next year (which will likely net them $1.5 billion).

The bottom line is that investors have been concerned about CHK's ability to fund its expansion for years, and they have always found an intelligent way to do it. There is no chance that CHK won't be able to fund their discretionary spending plans, just a small danger that they will have to go to the capital markets if they somehow can't raise money elsewhere (JV's, VPPs, and midstream MLPs being preferable and much more likely). In addition to the planned monetizations above, they could sell a further interest in the Marcellus shale to Statoil or sell a portion of their huge Permian basin position. Judging from the unbelievable returns on the Eagle Ford investment, it is unlikely that the net result of any major expenditure currently occurring will be dilutive, regardless of the funding source.

 

Valuation:

BEARISH VIEW:

• At current rates of drilling, Chesapeake has 40-60 years worth of inventory in their major shale plays, suggesting that the PV10 value of most of this acreage is negligible.
• Natural gas prices have fallen since CHK signed major JV deals in the Haynesville and Fayetteville shale plays, suggesting that their partners overpaid and that this acreage is not worth the price implied by these deals.
• Chesapeake assumes well lives of up to 65 years in calculating estimated ultimate recoveries (EUR) for its wells, potentially understating their finding and developing cost of these wells (for which there is less than a decade of historical data) decline at a greater than expected rate.
• Some of Chesapeake's acreage may not be "core" or even have any value, particularly their Marcellus acreage in New York (where there is currently a drilling moratorium) and in Central West Virginia.


MY TAKE:

In the last two years, numerous comparable transactions by Chesapeake and others have put firm values on the majority of their assets. Chesapeake puts out a monthly presentation which shows all of their plays which may be helpful to look at in conjunction with the below.

http://www.chk.com/Investors/Documents/Latest_IR_Presentation.pdf

Like everyone else, I ignore what Chesapeake says their assets are worth, but I have found good public comps for most and have discounted the values of other assets in a conservative manner:

Chesapeake sold 25% of their Barnett shale operation to Total two years ago (after gas prices had already crashed) for $2.25 billion. After discounting the cash flows received from Total (not all up front) and subtracting the $1.15 billion price of a VPP they subsequently sold in the play, CHK's interest is valued at $5.2 billion. While this play is not their most economic, the large amount of current production there drives the value.

In the Eagle Ford Shale, Marathon paid $3.5 billion or nearly $25,000 per acre to buy out Hilcorp in June. BHP is purchasing Petrohawk for $15 billion, which yields similar metrics but not an exact figure because Petrohawk had other assets. At $20,000 an acre Chesapeake's 450,000 acres is worth $9 billion.

Chesapeake has drilling carries (future payments as part of past joint ventures) due to it from Total, Statoil and CNOOC with a present value of $2.6 billion. The company also owns 34.6% of its publicly traded midstream company (CHKM) worth $1.3 billion.

In the "Niobrara" (now called Powder River and DJ Basin), Chesapeake sold 1/3 of their position to CNOOC this year for a discounted value of $4,200 per acre. There is less information available on this play or good comps from shrewd acquirers (CNOOC doesn't get a lot of respect on the street), so I value the remaining interest in this play at half of that price, or $1.25 billion.

In the Mississippian lime Chesapeake has 1.1 million acres. Sandridge Energy sold a royalty trust (essentially a publicly traded JV interest because the royalties will come on wells that have yet to be drilled) which valued this play at $15,000 per acre. I think the value is currently closer to $5,000 per acre, but without public comps to look at I will use half of this value and say it is worth $2,500 an acre. I also assume not all of CHK's land is "core", so I will assume they only have 800,000 rather than 1.1 million acres. This yields a value for the Mississippian of $2 billion.

Looking at their property plant and equipment, Chesapeake owns one of the largest drilling contractors, service companies, compression companies, oilfield trucking companies etc. Both Frac Tech (their 30% owned completion company) and the newly defined Chesapeake Oilfield Services are likely to be IPO'd next year at a total value of $7 - 10 billion according to the company. This segment will do $1 billion in EBITDA next year, and comps currently trade at the low end of the range given by Chesapeake (HP trades at 6 times EBITDA, HAL at 7.5 times, EXH at 6.5 times). I value this entire segment at only $1.5 billion because that is what I estimate Chesapeake will actually raise in cash from IPO'ing these companies.

Chesapeake has a huge amount of legacy production in the Permian, Appalachian, and Anadarko Basins. I value this at proved-only PV10 value (the discounted value of future cash flows from the proved reserves on these properties) of $13 billion from the last time Chesapeake broke out this value in 2010. I think this is pretty conservative because it ascribes no value to the huge undrilled inventory in the Permian, Granite Wash, and Cleveland plays - all of which are oily. Chesapeake has 835,000 acres in the Permian alone, which is probably worth $15,000 per acre based on comparable transaction (which would value this one portion at $12.5 billion).

This leaves the Marcellus and Haynesville shale plays, which are tougher to value. I previously modeled wells in the Marcellus, Haynesville and Fayetteville shale plays using ten year gas strip prices, known well "type curves", and the next ten years of drilling based on planned rig counts in each play. I assumed wells dried up completely after ten years (there is some controversy over projected 45-65 year well lives), and that drilling ceased after ten years. I assumed 40% of the acreage in each play was worthless and that the undrilled portion of the remaining play was worth only the lowest comparable transaction price. I also discounted the value of current production in each play and got a total value for the Marcellus of $11.7 billion, for the Haynesville of $4 billion (nearly $1.5 of this from current production) and for the Fayetteville of $1.5 billion ($1 billion from production).

After I modeled this about a year ago, BHP bought the Fayetteville asset for $4.75 billion (I assume $500 million of this was for midstream assets - but still more than double my value), so I feel pretty confident that my approach is conservative. Results in the Marcellus have improved since then and Exxon is actively leasing in the Haynesville.

Range Resources is basically a pure play on the Marcellus, so there is a good comp here. If one (generously) values RRC's Permian acreage at $15,000 per acre, and their Anadarko acreage at $5,000 per acre, the market is valuing their 800k acres in the Marcellus at over $10 billion today, or $12,500 per acre. I think this is reasonable, and if I apply this metric to just 60% of CHK's 1.75 million acres in the Marcellus I get a value of $13.1 billion.

BHP's $15 billion purchase of Petrohawk this year almost certainly valued the Haynesville shale at more than double my valuation (or the Eagle Ford much higher), so I feel very comfortable valuation CHK's Marcellus at $12 billion and the Haynesville shale at $4 billion.

The last major asset is the Utica Shale. I believe all of the circumstantial and geophysical evidence suggest that this will be worth the $15-20 billion the company says it will. This joint venture will likely occur in the next month or two and place a firm value on the remaining acreage. For now I will value their 1.25 million acres at the $10,000 figure XOM reportedly paid for Phillips, or $12.5 billion.

There are other assets that could be added, but I think this is a very conservative and firm valuation of the company's assets. Essentially I think they could sell any of these assets tomorrow for the price I give without any problem or disruption to their business (which is why I value the service company etc. only at the cash they will extract from it).

The total (in $ billions):

Barnett shale: $5.2
Eagle Ford shale: $9
Drilling carries: $2.6
CHKM ownership: $1.3
"Niobrara": $1.25
Mississipian: $2
Service companies: $1.5
Permian and Anadarko PV10: $13
Marcellus shale: $12
Haynesville shale: $4
Utica shale: $12.5

Debt and negative working capital: -$12

Equity Value: $52.35 billion

At this valuation, the convertible preferreds would convert to equity so I use a fully diluted share count of 765 million shares, for a value per share of $68.43.

I think the breakup value of the company is probably significantly higher than this, and that the ultimate value (when natural gas recovers in 2012/2013 - which is much longer topic than this write-up) is certainly in triple digits.

Conclusion:

Six times Chesapeake has been criticized for spending too much on land, and six times they have avoided any funding crisis and successfully recouped their investment with a JV, within the timeframe and valuation McClendon claimed. This record will be tested in the next month or two with the Utica joint venture, but history would suggest that the most active driller, with the best information, and a track record of doing identical deals on a similar scale with 100% success knows what they were buying this time around too. Even without these deals, the company is not currently facing a funding crisis, so there is little justification for their huge undervaluation compared to peers, and large market transactions by the oil majors.

The Author, his family, and clients are long CHK equity, preferred stock, and call options

 I am recommending a long position in Chesapeake Energy. Chesapeake is the second largest producer of natural gas with one of the lowest cost structures in North America and is rapidly becoming a major producer of oil and natural gas liquids. I think the stock is currently undervalued in the short term due to uncertainty regarding their Utica shale joint venture, and due to underfunded future capex plans (which the aforementioned joint venture would solve).

In the longer term, there are other reasons that this company is undervalued. The market takes a dim view of the company's management and corporate governance, and many investors think the company is too complex to value due to the amount of non-producing assets, financial engineering, and corporate complexity. I will discuss these issues and take a stab at coming up with a firm conservative valuation below. Questions are more than welcome, thanks.


Chesapeake Management:

BEARISH VIEW:

• Aubrey McClendon and Tom Ward nearly bankrupted CHK in the late 90s by levering up the company to build a huge position in what turned out to be "non-core" Austin Chalk before prices collapsed for a number of years.
• McClendon lost about $2 Billion personally in 2008, after margining his 30MM share CHK equity position to buy millions more in CHK stock at prices as high as $57.25.
• The highly compensated ($400k + per annum) and management friendly board of directors paid McClendon $100 million dollars in what amounted to a personal bailout of their Chairman in 2008. The company also elected to buy $12 million dollars of antique maps from McClendon, which decorate company headquarters.
• Management has declared on numerous occasions that they were done raising capital and buying assets, only to raise billions in capital and expand first into the Haynesville shale and then recently into numerous oil/liquids shale plays.
• Chesapeake may have expanded beyond their core competency (of producing low cost natural gas) into "lease brokering", an aggressive hedge program that can only be called energy trading, and most recently into oil/liquids production.

MY TAKE:

His supporters will say - and we think history will show - that Aubrey McClendon is a visionary. He seems to have learned his lesson with regard to "non-core" acreage in the Austin Chalk, and has created the #1 or #2 "core" leasehold positions in the five largest gas shales and four of the five largest oil shales in the US - all at very attractive prices. This was accomplished by running the most "information only" rigs, building the largest geophysical reservoir evaluation lab, having the most landmen, and having a willingness to move quickly.

Aubrey McClendon is regarded by many in the investor community as reckless, willing to expand at any cost, and unwilling to be left behind. Analysts I've spoken to don't doubt the value of the assets McClendon has put together, but there is a widespread fear that he will keep "creating value" until it bankrupts the company. Chesapeake expanded aggressively into the Barnett, Marcellus (partially through a fortuitous acquisition of CNR), Fayetteville, Haynesville, Eagle Ford and Niobrara shales. Each time this happened, there were concerns that the company had spent too much money on land and would have a liquidity problem.

In each play, CHK was able to sell a fractional JV interest for a multiple of what they paid - essentially recouping their entire investment for both the portion they sold and the majority they kept. Each time this has happened, detractors have chalked it up to luck and suggested that the acquirer foolishly overpaid. Considering that the acquirers were BP, Total, Statoil, CNOOC, and PXP, this is very unlikely (except perhaps in the Haynesville, which PXP bought into at the top of the market). Despite this 6/6 record of wildly accretive billion dollar JV deals; the market currently doubts whether CHK can do it again with their recently acquired Utica acreage.

To understand whether CHK has just been lucky or actually has some advantage in acquiring land, one can look at their recent Eagle Ford JV. In late 2009 and early 2010, they drilled and cored ten vertical wells and acquired 830 square miles of 3D seismic. At Chesapeake's reservoir technology center - which analyses more shale core than the rest of the industry combined - they delineated the area of the "oil window" up-dip as well as the area where the formation was thickest within this window. They identified and avoided the Western section, where despite some of the thickest shale the oil was too immature and viscous to be productive. After fracture simulations at the technology center and actual test wells confirmed the economics of the play, CHK was able to rapidly lease 600,000 acres in the thickest part of the mature oil window for a total cost of $1.4 billion. Within twelve months, CHK was able to sell a 33% stake to CNOOC for $2.16 billion, with half up front and the rest payable over two years as a drilling carry.

If one uses a present value for the 33% stake purchased by CNOOC of $2 Billion (using a 10% discount rate), that means CHK spent $1.4 billion and turned it into $6 billion of value in just one year - a third of which in cash to immediately recoup their investment. This was not reckless and it was not lucky - Chesapeake was able to turn their temporary informational advantage into a permanent structural advantage; 400,000 net acres in the best part of the play at a negative net cost to the company (after the CNOOC deal). A number of large recent transactions in the Eagle Ford have been completed at prices of more than $20,000 per acre, which would value CHK's 400,000 net acres at $8 Billion dollars (the company actually has 450,000 net acres now due to additional leases signed after the JV deal so this number is higher). To put this in perspective, this is more than $10 per fully diluted share for this one asset, and the net cost to Chesapeake was negative.

Chesapeake runs 15 "information only" drilling rigs - more than most public E&Ps have for production. This company has consistently been able to gain an informational advantage, not only in finding plays, but in delineating the extent and "core" or sweat-spot of plays others have discovered. By leasing the best acreage, they have consistently turned a 6-month information advantage into a permanent cost-advantage. The company has signaled that this land rush is now essentially over and they have already seen core samples of every depositional basin in the country.

Chesapeake's management has been creative in raising capital; pioneering the large scale use of VPPs for financing, courting Asian SWFs for capital, and doing the first US oil and gas deal with a Chinese company. Chesapeake is completely vertically integrated, the most active driller, the largest owner of onshore US seismic data, and the largest customer to the service industry. These are major advantages in both producing and discovering gas, and probably also gives them an advantage in their hedging program (which has generated $7.7 billion in realized gains from 2001-2011).

McClendon may change the direction of the ship more often than investors would like, but his moves have been correct and created value. His bold expansions have been a capitalization on CHK's informational and technological advantages, not the shoot-from-the-hip moves of a manic empire builder. He was right on the gas shales, and is being proven right on the oil shales. Every major expansion McClendon has undertaken has generated a multiple of the expenditure in value to the company. This value is not reflected in the stock, but it is easily verifiable (and will be delineated in the valuation section). The investment community apparently believes McClendon and his team were wrong to create this value because the share price hasn't gone up yet.

I disagree with those who want Chesapeake to stop doing large and highly accretive land deals, but it looks like that crowd will get their wish in 2012. There are only so many depositional basins in the United States, and at this point, E&P companies have gotten a look at all of them. There is no chance of finding another shale play in Nevada, for instance - shale is the source rock for conventional oil and gas pools, and it only exists where there has been conventional production for years. There could be another large discovery in an existing basin, but it is increasingly unlikely.

Both McClendon and his (essentially captive) board are very well compensated, but it is not as egregious as the headlines suggest. His "$100 million payday" was really $75 million payable over five years (with no other bonus during this time). He is still very highly compensated and gets a lot of perks, but so do a lot of people at Goldman Sachs - and none of them made a $4 billion gain on one deal for the company in 2010 like McClendon did. While the $12 million purchase of the maps was egregious, it focused shareholders and the media on the poor corporate governance at Chesapeake, which has improved now that the board is under a spotlight. This company is promotional and controversial, and investors need to make a judgment as to whether Aubrey is smart and aggressive or just crazy - the track record of consistently successful value creation suggests the former.

In January of this year, Lou Simpson, of Berkshire Hathaway and Geico fame joined the board of directors. I view this as a very positive move from a corporate governance standpoint and a vote of confidence in the integrity of management. In August, Mr. Simpson purchased 100,000 shares in the open market at an average price of $27.46.

I think that the majority of corporate governance issues have been addressed. As to whether management's bold and unapologetic style is something to be concerned about, I think an investor has to look at the track record of what they have accomplished rather than a collection of minor public relations gaffes. If the skill of an investor is ultimately judged by his long term track record, then Aubrey McClendon is one of the greats. The last ten years of hedging, acquisitions, and divestitures has been nearly flawless. Despite a crash in natural gas prices and some minor forays into shale plays that didn't work out (the company wasted about $350 million leasing in Michigan), this company is batting around .800, and has been doing so for years.

By the end of this year Chesapeake will JV a portion of their newly acquired Utica shale asset in Eastern Ohio. The market did not react well when the company announced a year ago that they planned to spend $1 billion on this - then unnamed - "liquids" shale play. Since then they have spent a total of $1.5 billion, and have announced that they will sell an interest in it by the end of this year. The company says their acreage is worth $15-20 billion. This is a very large number, but the company has a perfect track record at selling joint venture deals within both the timeframe and valuation range they have announced beforehand. If they sell just 25% of the play at a valuation of $15 billion, they will have taken care of any future capex shortfalls and retained an asset worth more than $11 billion dollars at a negative net cost to the company. It is worth noting that Exxon recently bought into this play (buying private Phillips exploration) at a reported $10,000 per acre, which suggests CHK's acreage is worth $12.5 billion - and this was without seeing the results of Chesapeake's wells.


Financing

BEARISH VIEW:

• Chesapeake is one of the most highly levered players in the space, and consistently outspends cash flow.
• While the company has been successful is selling assets in order to make up the shortfall over the last few years, it is unclear if they will be able to do so going forward, potentially causing a liquidity problem which could lead to dilution.
• Chesapeake has sold volumetric production payments (VPP) to financial players, getting cash up front for gas to be delivered in the future. This is considered by some to be a form of off-balance sheet debt.


MY TAKE:

Chesapeake has been extremely creative in financing their growth. While they have $9.7 billion in debt, they pay a blended rate of only 5.8% and have an average maturity of seven years. They termed out their revolver to 2015 and expanded the capacity from $3.5 billion to $4 billion (with the option to expand to $5 billion).

The VPP deals are definitely not debt, off balance sheet or not. In these deals, Chesapeake has sold an overriding royalty on certain mature producing wells in a given area for a certain amount of time. The volume they sell is about 80% of what the wells are expected to produce during that timeframe, and while ownership of the wells reverts to Chesapeake after the VPP term, due to decline rates and the time value of money, there is little value left. If these wells blow-up, sand-up, or otherwise disappear, Chesapeake has no further liability. The only liability the company retains is their 20% interest; in the unlikely event that the wells do not produce as much gas as expected, the difference comes out of Chesapeake's remaining 20% interest in the production from that well group - but this is specific to a group of wells, not an area, subsidiary, or any other entity. There is no liability to CHK, other than the potential to give a little more gas out of a given underperforming group of wells, up to but not beyond the ownership interest CHK retains in that group.

As with the recent Eagle Ford and Niobrara joint ventures, the investment community seems to think that Chesapeake will not be able to get a joint venture done in the Utica and thus will be unable to fund its (discretionary) capex next year, and thus will dilute shareholders. Every piece of evidence, not to mention their track record, suggests otherwise. The company is also planning to sell a royalty trust in their granite wash play for $500 million, will sell more midstream assets into their publicly traded midstream subsidiary, will divest some portion of their 1.1 million acre Mississipian lime play in 2012 and plans to IPO their service business sometime next year (which will likely net them $1.5 billion).

The bottom line is that investors have been concerned about CHK's ability to fund its expansion for years, and they have always found an intelligent way to do it. There is no chance that CHK won't be able to fund their discretionary spending plans, just a small danger that they will have to go to the capital markets if they somehow can't raise money elsewhere (JV's, VPPs, and midstream MLPs being preferable and much more likely). In addition to the planned monetizations above, they could sell a further interest in the Marcellus shale to Statoil or sell a portion of their huge Permian basin position. Judging from the unbelievable returns on the Eagle Ford investment, it is unlikely that the net result of any major expenditure currently occurring will be dilutive, regardless of the funding source.

 

Valuation:

BEARISH VIEW:

• At current rates of drilling, Chesapeake has 40-60 years worth of inventory in their major shale plays, suggesting that the PV10 value of most of this acreage is negligible.
• Natural gas prices have fallen since CHK signed major JV deals in the Haynesville and Fayetteville shale plays, suggesting that their partners overpaid and that this acreage is not worth the price implied by these deals.
• Chesapeake assumes well lives of up to 65 years in calculating estimated ultimate recoveries (EUR) for its wells, potentially understating their finding and developing cost of these wells (for which there is less than a decade of historical data) decline at a greater than expected rate.
• Some of Chesapeake's acreage may not be "core" or even have any value, particularly their Marcellus acreage in New York (where there is currently a drilling moratorium) and in Central West Virginia.


MY TAKE:

In the last two years, numerous comparable transactions by Chesapeake and others have put firm values on the majority of their assets. Chesapeake puts out a monthly presentation which shows all of their plays which may be helpful to look at in conjunction with the below.

http://www.chk.com/Investors/Documents/Latest_IR_Presentation.pdf

Like everyone else, I ignore what Chesapeake says their assets are worth, but I have found good public comps for most and have discounted the values of other assets in a conservative manner:

Chesapeake sold 25% of their Barnett shale operation to Total two years ago (after gas prices had already crashed) for $2.25 billion. After discounting the cash flows received from Total (not all up front) and subtracting the $1.15 billion price of a VPP they subsequently sold in the play, CHK's interest is valued at $5.2 billion. While this play is not their most economic, the large amount of current production there drives the value.

In the Eagle Ford Shale, Marathon paid $3.5 billion or nearly $25,000 per acre to buy out Hilcorp in June. BHP is purchasing Petrohawk for $15 billion, which yields similar metrics but not an exact figure because Petrohawk had other assets. At $20,000 an acre Chesapeake's 450,000 acres is worth $9 billion.

Chesapeake has drilling carries (future payments as part of past joint ventures) due to it from Total, Statoil and CNOOC with a present value of $2.6 billion. The company also owns 34.6% of its publicly traded midstream company (CHKM) worth $1.3 billion.

In the "Niobrara" (now called Powder River and DJ Basin), Chesapeake sold 1/3 of their position to CNOOC this year for a discounted value of $4,200 per acre. There is less information available on this play or good comps from shrewd acquirers (CNOOC doesn't get a lot of respect on the street), so I value the remaining interest in this play at half of that price, or $1.25 billion.

In the Mississippian lime Chesapeake has 1.1 million acres. Sandridge Energy sold a royalty trust (essentially a publicly traded JV interest because the royalties will come on wells that have yet to be drilled) which valued this play at $15,000 per acre. I think the value is currently closer to $5,000 per acre, but without public comps to look at I will use half of this value and say it is worth $2,500 an acre. I also assume not all of CHK's land is "core", so I will assume they only have 800,000 rather than 1.1 million acres. This yields a value for the Mississippian of $2 billion.

Looking at their property plant and equipment, Chesapeake owns one of the largest drilling contractors, service companies, compression companies, oilfield trucking companies etc. Both Frac Tech (their 30% owned completion company) and the newly defined Chesapeake Oilfield Services are likely to be IPO'd next year at a total value of $7 - 10 billion according to the company. This segment will do $1 billion in EBITDA next year, and comps currently trade at the low end of the range given by Chesapeake (HP trades at 6 times EBITDA, HAL at 7.5 times, EXH at 6.5 times). I value this entire segment at only $1.5 billion because that is what I estimate Chesapeake will actually raise in cash from IPO'ing these companies.

Chesapeake has a huge amount of legacy production in the Permian, Appalachian, and Anadarko Basins. I value this at proved-only PV10 value (the discounted value of future cash flows from the proved reserves on these properties) of $13 billion from the last time Chesapeake broke out this value in 2010. I think this is pretty conservative because it ascribes no value to the huge undrilled inventory in the Permian, Granite Wash, and Cleveland plays - all of which are oily. Chesapeake has 835,000 acres in the Permian alone, which is probably worth $15,000 per acre based on comparable transaction (which would value this one portion at $12.5 billion).

This leaves the Marcellus and Haynesville shale plays, which are tougher to value. I previously modeled wells in the Marcellus, Haynesville and Fayetteville shale plays using ten year gas strip prices, known well "type curves", and the next ten years of drilling based on planned rig counts in each play. I assumed wells dried up completely after ten years (there is some controversy over projected 45-65 year well lives), and that drilling ceased after ten years. I assumed 40% of the acreage in each play was worthless and that the undrilled portion of the remaining play was worth only the lowest comparable transaction price. I also discounted the value of current production in each play and got a total value for the Marcellus of $11.7 billion, for the Haynesville of $4 billion (nearly $1.5 of this from current production) and for the Fayetteville of $1.5 billion ($1 billion from production).

After I modeled this about a year ago, BHP bought the Fayetteville asset for $4.75 billion (I assume $500 million of this was for midstream assets - but still more than double my value), so I feel pretty confident that my approach is conservative. Results in the Marcellus have improved since then and Exxon is actively leasing in the Haynesville.

Range Resources is basically a pure play on the Marcellus, so there is a good comp here. If one (generously) values RRC's Permian acreage at $15,000 per acre, and their Anadarko acreage at $5,000 per acre, the market is valuing their 800k acres in the Marcellus at over $10 billion today, or $12,500 per acre. I think this is reasonable, and if I apply this metric to just 60% of CHK's 1.75 million acres in the Marcellus I get a value of $13.1 billion.

BHP's $15 billion purchase of Petrohawk this year almost certainly valued the Haynesville shale at more than double my valuation (or the Eagle Ford much higher), so I feel very comfortable valuation CHK's Marcellus at $12 billion and the Haynesville shale at $4 billion.

The last major asset is the Utica Shale. I believe all of the circumstantial and geophysical evidence suggest that this will be worth the $15-20 billion the company says it will. This joint venture will likely occur in the next month or two and place a firm value on the remaining acreage. For now I will value their 1.25 million acres at the $10,000 figure XOM reportedly paid for Phillips, or $12.5 billion.

There are other assets that could be added, but I think this is a very conservative and firm valuation of the company's assets. Essentially I think they could sell any of these assets tomorrow for the price I give without any problem or disruption to their business (which is why I value the service company etc. only at the cash they will extract from it).

The total (in $ billions):

Barnett shale: $5.2
Eagle Ford shale: $9
Drilling carries: $2.6
CHKM ownership: $1.3
"Niobrara": $1.25
Mississipian: $2
Service companies: $1.5
Permian and Anadarko PV10: $13
Marcellus shale: $12
Haynesville shale: $4
Utica shale: $12.5

Debt and negative working capital: -$12

Equity Value: $52.35 billion

At this valuation, the convertible preferreds would convert to equity so I use a fully diluted share count of 765 million shares, for a value per share of $68.43.

I think the breakup value of the company is probably significantly higher than this, and that the ultimate value (when natural gas recovers in 2012/2013 - which is much longer topic than this write-up) is certainly in triple digits.

Conclusion:

Six times Chesapeake has been criticized for spending too much on land, and six times they have avoided any funding crisis and successfully recouped their investment with a JV, within the timeframe and valuation McClendon claimed. This record will be tested in the next month or two with the Utica joint venture, but history would suggest that the most active driller, with the best information, and a track record of doing identical deals on a similar scale with 100% success knows what they were buying this time around too. Even without these deals, the company is not currently facing a funding crisis, so there is little justification for their huge undervaluation compared to peers, and large market transactions by the oil majors.

The Author, his family, and clients are long CHK equity, preferred stock, and call options

 

Catalyst

Utica Shale JV in Q4 2011
Rising oil/liquids production and associated cash flows in 2012 and beyond
    show   sort by    
      Back to top