Fallout From Chesapeake’s Land Grab is Over

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According to a Reuters report, the second largest natural gas producer in the U.S., Chesapeake Energy Corp (NYSE: CHK), has collected drilling licenses now covering 15 million acres roughly the size of West Virginia. Its strategy has been to amass as many licenses as possible to outmaneuver its competitors piling on debts and either begin drilling or sell the rights at a premium. The company’s total debt now stands at $30 billion and it has a debt-to-asset ratio (debt ratio) of 63.3%. On the other hand, BP and ConocoPhillips both have much lower debt ratios at 16.3% and 20.2% respectively.   

Rounding out the top three natural gas producers ExxonMobil (NYSE: XOM) and Anadarko Petroleum Corp (NYSE: APC) also have a high debt ratio of 50% and 62% respectively.  Chesapeake’s mark-to-market asset levels are most likely a lot lower, as seen by recent sales, so its true D/A ratio is likely a lot higher than this. 

It is the risk-heavy tactics that Chesapeake employed to increase its acreage that has brought all the criticism and the big question mark over its ability to repay its debts when natural gas prices are expected to remain below $4 per MM BTU. Chesapeake has spent $31.2 billion in the last 15 years to acquire drilling rights, as opposed to ExxonMobil, whose revenues are 33 times larger than Chesapeake, which spent $27 billion in the same period.

Reuters has examined dozens of other cases that push the boundaries of law and has left its investors questioning the wisdom of their executives. Chesapeake’s board has authorized several acquisitions that played very fast and loose with the law while acting unethically. This eventually resulted in the board being overhauled.

Moreover, earlier this year, Chesapeake co-founder and CEO Aubrey McClendon arranged a $1.5 billion loan, primarily from EIG Global Energy Partners, that is also an investor in Chesapeake. The obvious conflict of interest resulted in a strong reaction from the shareholders who replaced almost half of the company’s directors while the embarrassed board of directors removed McClendon from the company’s chairmanship and got Archie Dunham, the former ConocoPhillips CEO in his place. In the meanwhile, US Justice Department is investigating whether Canada based Encana Corp. colluded with Chesapeake that gave the latter an unfair advantage on land deals, which is in violation of antitrust laws.

To avoid the wrath of shareholders, Chesapeake needed to reduce its debt levels through selling some of its acreage in West Texas and it was hoping to net premium prices. However, this did not happen because the natural gas industry is already suffering from excess supply while gas hit rock bottom to less than $2 per mm btu as Chesapeake nearly went bankrupt earlier this year when it hastily sold some of its assets and acreage with a target to raise up to $12 billion.

Chesapeake has now gone to the lenders with a request to temporarily increase the debt ceiling from 4 times of EBITDA to 6 times, which will be reduced to 4.25 times within a year. The lenders, showing confidence in the new chairman and directors, have agreed. Investors are now hoping that this is a sign of a drastic change in company strategy: to live within its means.

Since the beginning of 2012, Chesapeake’s shares have dropped by 13.7%, while its rivals APC and Exxon’s shares are down 9.5% and up 9.2% respectively.

<table> <tbody> <tr> <td> </td> <td> <p><strong>XOM</strong></p> </td> <td> <p><strong>CHK</strong></p> </td> <td> <p><strong>APC</strong></p> </td> </tr> <tr> <td> <p><strong>ROA (2011)</strong></p> </td> <td> <p>13.3%</p> </td> <td> <p>4.5%</p> </td> <td> <p>-5.0%</p> </td> </tr> <tr> <td> <p><strong>ROE (2011)</strong></p> </td> <td> <p>27.3%</p> </td> <td> <p>12.2%</p> </td> <td> <p>-13.7%</p> </td> </tr> <tr> <td> <p><strong>ROA (5 yr avg.)</strong></p> </td> <td> <p>13.2%</p> </td> <td> <p>-0.1%</p> </td> <td> <p>5.4%</p> </td> </tr> <tr> <td> <p><strong>ROIC (5 yr avg.)</strong></p> </td> <td> <p>24.8%</p> </td> <td> <p>-0.1%</p> </td> <td> <p>3.3%</p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>9.7</p> </td> <td> <p>6.3</p> </td> <td> <p>xx</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>9.5</p> </td> <td> <p>3.0</p> </td> <td> <p>(2.7)</p> </td> </tr> <tr> <td> <p><strong>Div</strong></p> </td> <td> <p>2.3</p> </td> <td> <p>0.4</p> </td> <td> <p>0.4</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>2.5</p> </td> <td> <p>1.8</p> </td> <td> <p>0.5</p> </td> </tr> </tbody> </table>

Neither APC nor Chesapeake can compete with ExxonMobil overall.  One is a diversified producer from exploration to refining that is the industry standard, while Chesapeake is more of a derivative play attempting to upscale themselves through aggressive land-grabbing.  The vast portfolio of Exxon has made it immune to the current drop in gas prices as it continues to deliver higher ROA, ROE and ROIC than its competitors.  Exxon used the drop in natural gas prices to its advantage buying up distressed assets, including some from Chesapeake.

The gas prices in US are not likely to pick up in the near future as the problems associated with over capacity still persist. The current rebound has brought the prices to $3.50 from $1.91 per million BTU’s in April but they remain a far cry from their peak of $13 just a few years ago. Corporations such as Exxon and ConocoPhillips are planning to export U.S. natural gas production, by constructing an 800 mile pipeline that extends from Alaska’s northern slope and reaches a port in the southern coast of Alaska from where it will be shipped to Asian and European buyers who are willing to pay higher prices.

Similarly, Cheniere Energy (NYSEMKT: LNG) is also developing two liquefaction trains at Sabine Pass that will convert shale gas into liquid which will then be exported overseas. Other companies, including Chesapeake, might be able to improve their performance by investing in China’s shale gas sector, whose recent auction is open to foreign bidders.

In the meantime, Chesapeake’s stock was trading at $19.23 when markets closed on Friday October 5.  Now that they have squared away most of their near-term funding issues and cleaned up the front office, Chesapeake looks attractive at a P/E of 6.4 with a 1.8% yield and rock-bottom prices.  Stories like this one will bottom out well before the good news begins to flow.  Natural Gas at sub $4-5 per MM BTU is unsustainable given the foreign demand is steady between $15-18.  That arbitrage will be filled as the North American infrastructure catches up with production. 

PeterPham8 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, short JAN 2014 $17.00 puts 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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