The Future of Chesapeake Energy: Four Scenarios
Soroush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With a market capitalization of $9.5 billion, Chesapeake Energy (NYSE: CHK) is not the largest natural gas producer in the United States, though it might be the most aggressive. Long-term investors are excited about CHK’s unconventional exploration methods, whether it's the company’s shale deposits, geopressurized gas, or coalbed methane operations.
Over the past few months, however, Chesapeake Energy has distinguished itself as a consistent bearer of bad news. The company’s share price has fallen more than 30 percent YTD and almost 40 percent in the last three months. In comparison, competitors like ConocoPhillips (NYSE: COP), Apache Corp (NYSE: APA), Devon Energy (NYSE: DVN), and EOG Resources (NYSE: EOG) have all been in the red, though each has fared better than CHK. For a look at one of the best buys in the oil and gas E&P industry, see this article.
Here’s the bad news surrounding CHK:
- Management – Former CEO Aubrey McClendon’s misconduct is a major black eye and the incident has attracted an informal inquiry by the SEC.
- Financial Health – CHK carries large amounts of debt on and off its balance sheet and is wracked by liquidity problems. The company faces a $6 billion funding shortfall in 2013 that must be plugged through the monetization – aka sale – of valuable assets. At the end of this year’s first quarter, CHK had a working capital deficit of $2.7 billion and a current ratio under 0.6. A measure of a company’s ability to pay short-term obligations, a current ratio under 1 typically spells trouble.
- Asset Monetization – In an attempt to raise more cash, CHK has sold off a number of its assets. Unfortunately, several sales and liquidations have been delayed. The company’s beleaguered position combined with weak demand may force it to accept low prices for valuable assets in its Mississippi Lime, Permian Basin, and Texas Panhandle Granite Wash regions. The company may also be forced to sell its liquid plays – the very assets it is attempting to develop as the primary component of its shift in strategy that will be described below.
- Profitability – CHK lost $71 million (0.11 per diluted share) in the first quarter of 2012. Both net income and gross profit fell dramatically from previous periods.
- Gas Prices – Prices have recovered from lows of under $2/MMBtu but are still depressed. (Just to note, MMBtu stands for million metric British thermal units, which is a commonly used measure in the oil and gas industry.) Additionally, the number of active rigs in the U.S is down 31% from May 2011 and more than 60% from 2008, to fewer than 600. Working inventories are 38% greater than both a year ago and 5-year average inventory levels. Higher inventory levels typically mean that companies are unable to meet their sales expectations. Moreover, the price gains that may have resulted from falling rig production should be tempered by supply increases in other areas of the world.
On the other side of the coin, bullish investors are focusing on these points:
- Shift to Liquids – CHK’s attempt to shift emphasis to natural gas liquid (NGL) production could substantially reduce the company’s vulnerability to fluctuations in the price of natural gas. In layman’s terms, NGLs are by-products of natural gas exploration and production, and consist of: ethane, propane, normal butane, isobutane and pentane. Like all gases, NGLs must be processed and purified in order to be used as sources of energy.
- Valuation Metrics – Price/Earnings (6.27), Price/Book (.81), and Price/Sales (.87) ratios that are each more than 50 percent below industry averages.
- Solid Dividends – CHK’s shares offer a healthy 2.1% yield. Payouts have been regular and consistent since 2002.
- Assets – Chesapeake owns a number of valuable, undeveloped liquids and natural gas plays across North America.
- Carl Icahn – Icahn’s purchase of a 7.65% stake in the company is a significant vote of confidence in Chesapeake’s potential for turnaround. He is infamous for improving the financial position of any company he touches.
- Corporate Reforms – McClendon’s removal and a shake-up in the Board of Directors may have a positive effect on CHK, if the new blood can work well with Icahn.
- Long-Term Developments: The U.S. is increasing its utilization of natural gas as a source of power and heat generation. Additionally, high natural gas prices abroad may stimulate exports of excess supplies. Both of these developments would bolster demand and drive revenue growth for energy producers.
In the short to medium term, CHK’s fortunes depend on its ability to monetize assets to cover existing obligations and implement its shift in strategy toward greater liquids production. In the longer term, CHK’s fate rests on natural gas prices and the rapidity of the success of Icahn’s strategic shift. It's interesting to note that monetization is a sufficient condition for strategic shift in the short run because the shift is to be funded by asset sales, so the two go hand in hand to some degree. Also, CHK projects that liquids will only comprise 30% of overall production by the end of 2013, thus natural gas prices will still have a significant effect on the company’s fortunes. From this perspective, CHK’s future is a function of 1) asset monetization and strategic shift in the short run and 2) natural gas prices in the long run.
CHK’s future can then be broken down into four broad scenarios depending on these variables.
1) Successful monetization and shift to liquids; Natural gas prices rise.
This optimistic scenario assumes that the company can implement its stated goals of shifting production emphasis to liquids, successfully monetizing assets to meet its obligations and capital expenditure requirements, and containing collateral damage from the SEC inquiry. This scenario further assumes that some combination of various forces (perhaps including natural gas exports, rising U.S. dependence on gas for electricity generation, and increased demand from chemical companies attempting to take advantage of low input prices) bolster prices and drive demand growth in coming years. CHK would rapidly regain financial health through strategic shift to capitalize on liquids sales while also benefiting from higher natural gas margins. Result: CHK diversifies; rapidly regains financial health.
2) Successful monetization and shift to liquids; Natural gas prices stagnate.
In this scenario, management’s successful implementation of a shift to liquid production would reduce the company’s dependence on natural gas for revenue. Furthermore, successful asset monetization would afford the company sufficient resources to undergo a successful strategic transition. Sustained low prices will drag on revenues and income, but the company would be able endure current economic weakness and begin to regain its financial health as a more diversified energy producer. Result: CHK diversifies; slowly regains financial health.
3) Unsuccessful monetization and shift to liquids; Natural gas prices rise.
Rising gas prices would undoubtedly give CHK some financial breathing room, but if management fails to transition to greater liquids production, everything will depend on how fast prices improve. Unsuccessful asset monetization implies that CHK would need to finance its obligations either through more borrowing, which would adversely impact the company’s credit rating and increase its already large amount of debt, or cash from operations, which could only support Chesapeake’s vast obligations if natural gas prices increased quickly and dramatically. Result: CHK remains focused on natural gas; financial health determined by natural gas prices.
4) Unsuccessful monetization and shift to liquids; Natural gas prices stagnate.
This scenario implies a stillborn shift in strategy and sustained low natural gas prices over the next few years. CHK would either: 1) become a much weaker and smaller competitor in the sector it had once championed; 2) be acquired by another company with the resources to simply wait out periods of low natural gas and/or liquids prices; or 3) collapse. Result: No diversification; no return to independent financial health.
The bottom line is that CHK’s short-term fortunes are entirely dependent on successful implementation of a new corporate strategy funded by asset monetization. Absolute failure and the company fails. Mediocre success and the company will be financially and competitively weak for years. If there is success, investors can look to see the company end 2013 in a fairly solid financial position.
Over the next decade, profitability and cash flows at CHK are dependent on natural gas prices but the rapidity of the implementation of the new strategy will determine the degree of this dependence. CHK is in an awful financial position and investors should be wary of overly optimistic projections of company growth. Shares in Chesapeake may experience a small bounce as the spigot of bad news runs dry, but poor fundamentals could persist for years. Buy at your own risk.
This article is written by Denis Hurley and edited by Jake Mann. They don't own shares in any of the companies mentioned. The Motley Fool owns shares of Devon Energy 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.