Can You Rely on This Oil & Gas Stock?

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

Chesapeake (NYSE: CHK) is in the midst of transforming itself from a natural gas producing company to an oil producing company.

Transformation

Chesapeake’s management team did a poor job of adjusting to changes in the natural gas business. The price of gas dropped to near 10 year lows, and they were not prepared. As a result of management’s lack of foresight, the company lost $1.07 billion and increased its debt load by 56% in the first three quarters of 2012. 

Chesapeake is now focusing on drilling for oil rather than natural gas. The transformation has been painful for Chesapeake and its shareholders. Over the last 52 weeks, the stock price has dropped by 25%. When the company announced third quarter earnings in November, the stock fell 8.5% on more than double its normal trading volume. The sell-off was prompted by the $2.1 billion or $3.19 per share quarterly loss, compared to its $922 million or $1.22 per share profit in the third quarter of 2011. Most of the loss was the result of record low gas prices, which forced the company to write down the value of its gas assets by $2 billion. In addition to the terrible earnings report, the company's balance sheet was a mess, with over $16 billion in debt and only $142 million in cash. 

What Happened?

As a result of the new hydraulic fracturing gas retrieval methods, there is a glut of natural gas throughout the United States. The oversupply of natural gas has pushed the price of natural gas to near 10 year lows. Other natural gas producers such as Apache (NYSE: APA), EOG Resources (NYSE: EOG) and Anadarko Petroleum (NYSE: APC) have seen their revenues decline because of low natural gas prices and have made the necessary adjustments

Apache has partnered with Halliburton and Schlumberger to develop ways to use natural gas in hydraulic fracturing. Mike Bahorich, Apache's executive vice president of Technology said, "By using field gas, the United States would import 17 million fewer barrels of oil each year to make the diesel to fuel these fracs." 

EOG has relied on its solid balance sheet, strong growth and solid operational and management teams. EOG's strengths lie in its revenue growth, good cash flow from operations, expanding profit margins, and solid financial position with reasonable debt levels. These strengths outweigh the company's lagging growth in net income.

Anadarko has the advantage of being one of the largest independent oil and natural gas explorers and producers in the world. It reported 2.54 billion barrels of oil equivalent (BBOE) of proved reserves at the end of 2011. In December 2012, the company reported that four of its core U.S. onshore operating areas topped the 100,000 BOE per day milestone.

Chesapeake was slower than its competitors to adjust, but it is finally making decisions based on market realities. During the third quarter earnings call, Aubrey McClendon commented on the company’s change in focus, saying “steady transformation of our asset base from an exclusive focus on natural gas three years ago to a focus that today and in the future, will remain more balanced between natural gas and liquids production.” In the third quarter, Chesapeake had $2.97 billion in revenues, and oil revenues accounted for 61% of production revenues, which was up from 31% from the third quarter of 2011. 

In an effort to finance its new production efforts, and to reduce its enormous debt load, Chesapeake has been selling off assets. During the third quarter earnings call, Mr. McClendon said that the company was “hard at work on sales of non-core portions of our Northern Eagle Ford and Mississippi Lime properties.” The company is also working to sell additional properties and has a goal of selling $17 billion to $19 billion in assets by the end of 2013. The company has already sold $11.6 billion in assets this year. 

The sold assets include $3.3 billion in gas rich assets to Royal Dutch Shell and Chevron in the Permian land basin and a projected $2.7 billion in assets to Global infrastructure Partners. Mr. McClendon said that Chesapeake plans to “reduce the company’s net long-term debt to less than $9.5 billion through value-creating asset sales.” Chesapeake is desperate for cash and is now willing to sell valuable assets at fire sale prices.

Stock Performance

Chesapeake stock has been one of the worst performers in the oil and gas industry. Over the past 52 weeks, the stock has fallen 25%, while the S&P oil and gas index is up by 2.1%. The company's stock performance mirrors its earnings performance. Chesapeake’s earnings per share (EPS) are down 359% on a year-over-year basis, and its cash flow has decreased to $942 million, or 42.24%, when compared to the same quarter of 2011. Chesapeake’s institutional stockholders blame the company’s poor performance on its management team. Chesapeake punished management in early January when it was announced that Aubrey McClendon would not receive a bonus for 2012. The board of directors also reduced total executive bonuses by over 50%. In addition, the board made reforms that will give shareholders a stronger voice in company affairs. 

Final Thoughts

In 2012 Chesapeake’s earnings and stock price suffered because of inept management and depressed gas prices. There is not much that Chesapeake can do about lower gas prices, but a change in management would be a big positive for the company. The good news for Chesapeake is that because of reduced drilling and increased consumption, gas prices have begun to creep higher. Chesapeake has also done a good job of transforming its business as evidenced by the fact that its third quarter oil production increased by 96% on a year-over-year basis. It may take time, but I think that Chesapeake’s earnings will improve.

Right now Chesapeake’s stock is cheap (price to book ratio 0.93), and at a stock price of around $18, some investors may think that it is worth taking a look at. However, I will not recommend Chesapeake as long as Aubrey McClendon is the CEO. Also, I believe that there are other stocks amongst the independent oil and gas producers such as Apache, EOG Resources, and Anadarko Petroleum that are more attractive.


jordobivona has no position in any stocks mentioned. The Motley Fool owns shares of Apache and has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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