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 http://library.corporate-ir.net/library/10/104/104617/items/309286/CHKOctober%20IR%20Pres%20(final).pdf
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
|Subject||Questions for Lil|
|Entry||10/12/2008 07:35 PM|
|This may be a great idea, but you seem to have based your case almost entirely on a takeover that will result from McClendon's loss of credibility. Can you address some of the concerns in the market, such as the company's leverage, its hedge exposures, and whatever else has driven the stock price down so far?
Thanks in advance for your response.|
|Subject||not sure of your reasoning|
|Entry||10/12/2008 08:02 PM|
|While I agree that CHK is tremendously undervalued, virtually all Natural Gas stocks have been hammered. I would have thought you would have found other companies more attractive, considering how little you think of McClendon.|
In particular, with the exception of the three days when McClendon was forced to sell, it is not clear to me why his owning shres of his company on margin was such a terrible thing for shareholders. Isn't is a lot better yo have a CEO with such a stake in the success of his company than all the CEO's with no stake in their company.
Also, it is not clear to me why you think the use of 'kick out" hedges is so "idiotic". CHK did get extra money for having these kinds of hedges. Have you done an analysis to show that is idiotic?
In the worst case, suppose the hedges do "kick out". Isn't CHK still better off than the many companies that hardly hedge anything at all?
In short, I'm not sure if your recommendation is based on real analysis or "schadenfreude" over McClendon's fall.
|Entry||10/13/2008 08:14 AM|
|McClendon has way too much pride to sell "his" company, particularly at these prices. He's been through a previous period of tanking and resurrection, so he'll give it another shot. Besides, he's still got the outrageous well participation program, which was ironically probably the reason he got the margin call. Dont count on a sale.|
The knock-out hedges were silly. One of the things about CHK that screams "stay away" as a shareholder is that they cant do anything in a simple manner. They always try to get too cute about A&D, hedging, JV's, compensation, etc. Big red flag.
|Subject||RE: Questions for Lil|
|Entry||10/13/2008 09:10 AM|
|Chesapeake is known as an aggressive and levered player and in a panicky market, uncertainty fed on itself. The Company has no unsecured debt maturities til 2012 and has more than adequate cash. They have not disclosed the 19 couterparties other than Lehman, but more information may come out on Wednesday at the Analyst Meeting.
There are rumors that the $1.75 billion planned sale or joint venture of their Marcellus properties is in trouble, that other asset sales will be postponed, that volumetric production payments will be cancelled and that scheduled financing of their midstream assets will not be possible. Those cumulatively add up to $billions but the Company has already acted to cancel $1 billion of property acquisitions, walked away from a $350 million acquisition in East Texas and laid off some of their 4500 landman. They can cut drilling capex relatively quickly to get cash inflow and outflow under control. I don’t believe that debt and cash flow are a serious concern given their substantial cash holdings and ability to slow their growth quickly.
The knockout hedges would result in a maximum loss of cash of $300 – 350 million in each of the next 5 quarters. That’s substantial but not disastrous|
|Subject||RE: not sure of your reasoning|
|Entry||10/13/2008 09:17 AM|
|Buffett has said “You need a guy at the top whose DNA is very, very much programmed against risk.” McClendon argued in the WSJ today that his personal affairs are separate from how he runs the Company. I think not.
Knockout hedges are idiotic because they don’t protect you in exactly the horrible downside scenario when you most need to be hedged.|
|Subject||RE: RE: not sure of your reaso|
|Entry||10/13/2008 10:29 AM|
|Regarding "knock out" hedges, are you really saying that having that sort of hedge is worse than having no hedge at all (as is the practice with many E&P companies)? To me, that makes no sense whatsoever. To just say that it is idiotic without considering the extra money that comes in from that provision is just plain emotion, not real analysis|
|Entry||10/15/2008 08:35 AM|
|being held today and tomorrow. Two PDFs are posted on the website as backup for the meeting, totaling over 200 pages. Worth reviewing|
|Subject||RE: Investor/Analyst Meeting|
|Entry||10/15/2008 10:36 AM|
|Here are my comments from scanning the first presentation (the 2nd is about specific fields and areas of development).|
At $5 MCF gas prices, they are valuing each share at $29.54 escalating from there (page 9).
Investors are not anticipating the liberalization of SEC rules re proved reserves. At FYE 2009, CHK could have 20 TCFe of proved reserves (p 16) under the new standard, possibly 25 TCFe (p 58).
Primary counter parties (p 21):
Barclays $ 182 million
Deutsche Bank 104
J Aron (Goldman) 97
Morgan Stanley 80
Calyon (Credit Agricole) 30
All Others (6) 56
$ 701 million
CHK doesn’t use exchange traded contracts (p 34) and thus has no margin requirements (p 35).
The earliest senior note maturity is 11/2012. The biggest chunk of maturities is 2017 & 2018 (p 29).
|Subject||RE: RE: Investor/Analyst Meeti|
|Entry||10/15/2008 12:08 PM|
|I have no position in CHK but they are so promotional it's scary.|
|Entry||10/15/2008 04:39 PM|
|I haven't listened to the presentation today but the CFO apparently stated that they had replaced all of their knockout hedges for the rest of 2008 with costless collars that have a floor of $7.50. That's a smart move and I would assume that when and if winter arrives, natural gas prices will move up enough to rewrite the rest of their knockouts if they want.|