Trading Chesapeake’s Present & Future

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While it is easy to look at the swirling controversy surrounding Chesapeake Energy (NYSE: CHK) and conclude the company is in trouble, this only considers the near-term view and misses the overall picture. The company continues to struggle to meet its debt obligations, was recently called out for questionable corporate land acquisition practices and is still facing investigation from various entities. Finally, despite recent increases in natural gas prices, many industry insiders are predicting declines based on mounting supplies. Against this mountain of concern is the potential of the U.S. becoming a net exporter of natural gas.

Debt Concerns

Under various debt covenants, Chesapeake had promised to raise cash through divestitures, primarily of land, in order to keep itself from slipping into default. Unfortunately, the company was only able to manage a weak showing in sales of its west Texas properties, while other sales have seen long delays. Facing a near-certain default, the company has managed to convince its lenders to amend the terms of its debt covenants in order to protect the loans from further problems. The original debt ceiling was capped at four times EBITDA, but that level has been temporarily raised to six times. The moves will give Chesapeake additional time to complete asset sales and get the balance sheet in order.

The Land Issue

The difficulty that Chesapeake has faced in selling enough land to meet its debt obligations may seem like poetic justice to anyone who has read a recent report on the “land grab” executed by the company. The report details a series of questionable business practices in which the company used a wide array of tactics to secure drilling rights to over 15 million acres of land in the U.S. While proactively looking for drill sites to meet future demand is not unique to Chesapeake, some of the methods used include relying on antiquated laws that, in some instances, allow the company to secure drilling rights without compensating the landowner at all.

Compounding the “shady” nature of the land grab is the fact that in at least one instance after securing the land, the company defaulted on its lease obligations after a test hole revealed that the site held little promise. The move has led to Chesapeake being named in over 150 breach-of-contract suits in Michigan since 2010. The cases have not been settled thus far.

A Shift to Exporting

While the price for natural gas has been under definite pressure so far this year, largely as a result of excess supply, this is a U.S.-centric problem. Looking at landed prices for natural gas around the globe quickly reveals the argument for exporting. Where prices in the three North American ports range from $2.97 to $2.48 as of October 2012, prices are much higher abroad. The landed price in Rio de Janeiro is $12.10, the price in Spain is $9.82 and the price in China is $13.40. Obviously the disproportionate supply in the U.S. has driven down domestic prices, while global prices have remained strong. This phenomenon is expected to intensify into the fourth quarter, pushing down U.S. prices even further.

While a move to exporting would seem like an obvious choice, there are two primary complications involved with such a move: the lack of modern export terminals and current government regulation. As things currently stand, Cheniere Energy (NYSEMKT: LNG) is the only company with a viable modern export terminal. Unlike oil, natural gas must be transported in a liquefied form after it is cooled to extreme temperatures. Strict U.S. regulations limit the amount of natural gas that can be exported, making the construction of additional terminals meaningless until these regulations are addressed.

Cheniere currently has a “pilot” program in place to study the impact of U.S. exports on global prices, but this seems to be little more than a smokescreen for the political wrangling taking place in Washington. In reality, it will take the political influence of companies like Chesapeake and Exxon-Mobil (NYSE: XOM), the second largest producer of natural gas in the world, to effect real change. Against the backdrop of a U.S. presidential election that regularly highlights U.S. energy independence, it seems absurd that we are unable to export an energy resource we have in abundance.

The Trade

While I have long been a supporter of Chesapeake in spite of the myriad of problems it has faced, the stock has ventured too far afield to not be qualified as a speculative play. Over the long-term, the company is attractive as it will eventually get back on track. Until several of these issues are resolved, however, new positions should only be initiated on significant dips. If you wish to secure natural gas exposure, choices like Exxon-Mobil are much stronger plays at current levels.

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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