Chesapeake is cheap for a reason, but the shares remain a buy for the brave, says Phil Oakley.
The business
Chesapeake Energy is the second-largest producer of natural gas in America. It also produces oil and natural gas liquids such as propane and butane. It has proven equivalent gas reserves of 18.8 trillion cubic feet (tcfe). The firm also has large amounts of undeveloped land that may help it to grow its reserves in the future.
Chesapeake's strategy is based on discovering and developing unconventional sources of gas and oil in onshore locations. It has a leading position in the US shale gas industry. It also owns oil field services businesses, making it a vertically-integrated' energy company.
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The history
Starting out with $50,000 of capital, Aubrey McClendon and Tom Ward formed the firm in 1989. They wanted to search for gas in unconventional areas and use new horizontal drilling techniques. These techniques promised big improvements in the productivity of gas and oil reservoirs.
The first few years were very successful as Chesapeake built up reserves and production in Oklahoma and Texas. Rapid growth led to a stockmarket flotation in 1993. Further success followed in 1994 with a large gas discovery in Texas.
The company faced tougher times during the late 1990s. High drilling costs and low gas prices put pressure on Chesapeake's profits and finances. So the 2000s saw a change in strategy. Chesapeake aggressively bought land to develop shale gas reserves. This coincided with a rising price of US natural gas and profits soared.
However, the American shale gas boom during the last decade has led to a glut of natural gas supplies and prices have since collapsed. So Chesapeake has looked to develop natural gas liquids (NGLs), for which prices are higher.
But its expansion has come at a cost. High levels of debt and lower profits have placed a great strain on the company's finances. Chesapeake is now having to sell off more assets to fund its investment programme.
The chief executive
Aubrey McClendon has been chief executive since the company was formed in 1989. But he started his first oil and gas company Chesapeake Investments in 1982, aged 23. McClendon is no stranger to controversy. The latest issue, which erupted this week, concerns him borrowing $1.1bn against his stake in thousands of Chesapeake's wells.
Meanwhile, in 2008, he faced a shareholder revolt after receiving a $75m bonus. That same year, after borrowing money to buy Chesapeake shares, he was forced to sell 90% of his holdings after his loan was called in. He is also known for buying art for the company headquarters and amassing a wine portfolio consisting of 100,000 bottles. His basic salary is $975,000, frozen until 2013.
Should you buy the shares?
Putting McClendon aside for the moment, the stockmarket is worried about the combination of low gas prices and Chesapeake's debts. The company's plans to develop more-profitable gas liquids mean it is spending a lot more cash than it takes in. It does not expect to balance its cash flows until at least 2014. Meanwhile, it is selling land and future gas production in advance to balance the books.
But gas prices surely won't stay depressed forever, amid rising demand for use in transport and electricity generation. Some analysts even talk of the US becoming a net gas exporter. If so, then Chesapeake could be a very geared play on this scenario.
The shares look cheap with a 2012 forecast book value of $23.80 per share well below the current price. A return to long-term average gas prices currently around 90% below peak levels could see substantial upside. On the other hand, the CEO's recent actions are concerning, and raise questions over how the company is run. It's a case of buyer beware' with Chesapeake, but given time, it could pay out in style if gas prices rally.
The numbers
Stockmarket code: CHK
Share price: $19.92
Market cap: $13.2bn
Net assets (Dec 2011): $16.6bn
Net debt (Dec 2011): $10.7bn
P/e (current year estimate): 11.6 times
Yield (prospective): 1.2%
What the analysts say
Hold: 14
Sell: 4
Average price target: $28.86
Director shareholdings
A McClendon: 3,272,379
S Dixon: 1,145,643
D Dell'Osso: 355,471
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