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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Friday, March 7, 2008

Chesapeake is a Top Energy Play

Chesapeake Energy (nyse:CHK) has risen more than 20% since the end of January and hit an all-time high. CHK shares have been driven mostly by the rally in natural gas prices and strength in the energy sector. Short interest has been increasing, as some investors are betting on a pullback, yet the CEO has been taking the other side of the trade buying more shares. Natural gas is on an upward trend and may find a higher sustained price range. In follow up to my earlier writings on CHK: CHK- Earnings and CHK- Smart Money, here are some other bullish points.

Natural Gas Price Momentum.

Natural Gas prices have been on a tear recently. There has been an increased, longer-term bullishness on the commodity. One reason stems from bloated storage levels that are being worked off. Current levels are about 5% higher than the 5-year average, down from levels that were nearly 35% above 5-year average. Gas has a difficult time moving higher when excess supply exists.

Demand should strengthen as well. Natural Gas is a clean energy, and there has been no shortage of “green” dialog recently. This heightens the pressure for utilizing the clean resource in place of dirty fuels when feasible. Coal energy is a target. Investment bankers are expressing reluctance to engage in bond deals for new coal power plants. Bankers express apprehension about future legislation on carbon emissions that could financially penalize power plants. The fear is that revenues that go towards paying down the bonds would be diverted to paying for carbon credits or some type of pollution permit. (see WSJ article) Five coal powered projects in Florida have already died in the last year, forcing utilities to shift to gas.

Crude oil generates 6 times as much energy than an equal amount of natural gas. This implies that natural gas should trade at 1/6 the price of oil, and historically this has somewhat been the case. Currently, the ratio is almost double. With crude at inflation-adjusted all-time highs, there should be a push towards exploring the use of natural gas since it’s relatively cheap. For applications where natural gas substitution is possible, stronger efforts will be made to use the cheaper alternative. Crude has shown no signs of backing down, and likely will only go higher. Certainly this will be the case in the long-run as accelerating demand continues to outstrip decelerating supply. Natural gas is cheaper, produced domestically and abundant.

Natural gas has been stuck in the $6 to $8 range the past two years, but the CEO believes a multi-year trend is emerging that will result in natural gas prices in the $8 to $10 range. Futures prices support McClendon. Generally, NG prices pull back during the summer months when demand drops, and storage withdrawals switch to injections. However, the future curve depicts higher gas prices all the way out to March 2009. Not only does this suggest higher prices in the future, it also benefits CHK now since it’s an active hedger. CHK applies more coverage than most its peers, reducing sensitivity to the commodity. While this can cap gains to the upside, it limits downside exposure that could destroy a producer. I think it’s a very smart move. Management is placing certainty on an uncertain variable. Natural gas prices are set by the market, and CHK has no control as price-taker. While many companies rely on volatility as a source of profits, CHK focuses on aspects it can control, such as its competitive advantage it drilling.



Increasing Production and Higher Cash Flow

In the last several years, Chesapeake went on an acquisition binge. The company snatched up land at favorable prices during a time when natural gas prices were falling. CHK funded a significant amount of this land expansion with the use of debt and preferred instruments that eventually convert into equity. This has resulted in the share count to almost double over the past five years. Since then, net income has increased five-fold, yet EPS has only doubled. The dilution has caused frustration for some investors. However, share dilution is not always negative, as the term often has a negative connotation. As long as the capital raised from the dilution creates more value than the amount of value diluted, then it’s a positive move. For example, if EPS is $1, but a share issuance doubles share count and reduces EPS to .50, then value will be enhanced when the proceeds generate new $1 EPS, increasing total EPS to $1.50. Dilution caused the outstanding shares to double, yet investors are better off because EPS increased 50%.

Chesapeake has completed its land acquisition phase and is now focusing on development of those reserves. Production will increase, and in a pro-rata basis, capital needs should be reduced. Increased production will generate higher levels of cash flow further reducing needs for external capital. CHK has also announced its intentions of using asset sales as a source of funds, and not access the public capital markets. Not only with this drastically slow the rising pace of the share count, but enhance value though the asset dispositions. Reserves that have little or no future upside for CHK can be sold at almost 2x the level as implied by CHK’s share price. Going forward, CHK will capitalize on the assets that came at the expense of diluting the equity and produce returns justifying those actions. This should quell apprehension among investors and remove any overhang in the stock price that may have arisen from it.

CEO Continues to Buy Stock

Chesapeake’s CEO, Aubrey McClendon, is not stranger when it comes to insider buying. McClendon has been buying aggressively recently, purchasing 600K shares in the last week of February even while CHK shares are hitting all-time highs. Back in January, McClendon picked up more than 500K shares around $36. Barron’s reported earlier in the week that since July 2003, McClendon has bought 254 million in stock at an average price of $28.61. He has been an astute investor as well: data from Thompson Financial indicates that CHK shares have increased 40% in the 6 months following McClendon’s 61 prior buying occasions. He is halfway there on the January buys.

The CEO thinks shares are poised to keep moving up, and he has a track record of being right. It’s often a good idea to follow the smart money. We, as investors, will never have as much information and tools to analyze CHK as McClendon, thus his investment opinion will always be more qualified and informed. Opposed to a gradual rise, CHK’s share price increases in spurts, followed by longer periods of sideways movement. It appears CHK is embarking on its next leg up to a new trading range.

Short Interest Continues to Increase

Chesapeake’s short interest has increased for the past two periods, which has proved to be a poor bet as the share price has risen. I wouldn’t bet against CHK. Certainly not for the long-term, as I am very sure CHK will go much higher. In the short-run, I can’t be so sure. A pull-back is highly possible, and obviously that is what the shorts are betting on. However, the energy sector is exhibiting strength in a very weak market and economy. There are fundamental and technical factors supporting CHK shares. The strong momentum could continue to drive CHK higher. In addition, the increased number of shorts could add pressure if momentum continues, further contributing to higher share prices from a short-squeeze. Hence, in my opinion, the short interest is positive since it represents future share demand, and is not a result of fundamental problem with the company of sector.


Disclosure: long chk

3 comments:

Anonymous said...

dont forget that all the convertible prefs add natural delta neutral sellers of stock as the share price rises. since chk has a large number of convertible's outstanding i would guess that a meaningful amount of the increase in SI is a result of natural delta neutral selling, not bets that the share price is about to decline.

Anonymous said...

oh NOW you come out and write CHK. where were you back in late january? probably recovering from writing about aapl at 200 and goog at 700?

Turley M Muller said...

@ #2 I initially wrote about CHK back in July. I wrote about Apple some ;last fall- it traded pretty rich and wasn't a compelling buy. I think it is now. Same with Goog. Both are extremely wall positioned and have significant potential. The share prices reflected that until recently, making both GOOG & AAPL fairly valued or slightly cheap.

CHK, has been cheap for past couple years, and I think it will move up to high 50's low 60's and form a base, and move sideways for a longtime.

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