What Is The Upside In Chesapeake?

Tyler Durden's picture

Three weeks ago, when the hit campaign on Chesapeake was in full swing, we made a simple prediction: hate the company for whatever reasons but not because of the balance sheet. We explained that "under ZIRP, when every basis point of debt return over 0% is praised, and an epic scramble ensues among hedge for any yielding paper no matter how worthless, the balance sheets of companies just do not matter. In other words, for companies that have massive leverage, high interest rates, negative cash flow, which all were corporate death knells as recently as 2008, the capitalization structure is completely irrelevant." Alternatively, some other, far bigger, company with a pristine balance sheet and lower quality assets could swoop in and do a full management purge, removing the Mclendon overhang, firing the disgraced Board and commingling liabilities while boosting the quality of its assets. Think the TBTF putches from September 2008. Because at the end of the day, it is all about the quality of the assets. And the reality is that CHK has some quality assets, which, however, are burdened by many legacy issues. There is of course the issue of near all time record gas prices. But there in lies the rub: the prices are already at near all time lows. They could continue sliding, or in a world in which hard assets (and even gaseous) are becoming more and more precious by the day, they could go up. In which case CHK would be a very interesting bet. Needless to say, two weeks after our preliminary CHK assessment, Carl Icahn put his money, or rather $775 million of it to be precise, to essentially confirm what we had said previously.

Which brings us to the next question: is CHK really worth more? Well, in keeping with the tradition of keeping it simple, we have decided to present one delightfully simple chart from Bloomberg, which shows where the biggest downside in the stock comes from - it's well-known leverage - as well as where the upside is hiding - its asset base - which has the lowest valuation of its peers.

Bloomberg says:

Chesapeake’s equity and net debt are valued at $9.19 for each barrel of oil equivalent, the lowest among U.S. oil and gas explorers with market capitalizations greater than $5 billion, according to data compiled by Bloomberg. While a stock purchase by Carl Icahn helped the $11 billion company’s shares rebound in the past week, Chesapeake is still down 27 percent in 2012 amid investigations into Chief Executive Officer Aubrey McClendon’s personal loans backed by stakes in company wells.

Obviously, a crappy management team and good assets are very easily parted, as Dan Loeb and YHOO demonstrated two short weeks ago. There are of course other concerns:

The second-largest U.S. natural-gas producer said it may face a cash shortfall as early as next year after prices for natural gas,  which accounts for 83 percent of its reserves, reached a 10-year low last month. While a buyer would have to cope with seven joint ventures and $13.1 billion of debt, Exxon Mobil Corp. and Chevron Corp. may see a chance to scoop up the largest holder of  onshore drilling leases before gas prices rebound, said SunTrust Robinson Humphrey Inc. Royal Dutch Shell Plc may also be interested, said Huntington Asset Advisors Inc.

So yes, debt is the biggest concern, which simply means that the proper strategy for a firm like CHK is to have it treated like a sub-TBTF bank: roll it up into another bigger entity, with the capacity to absorb its liabilities, but use its assets to generate growth over the blended cost of capital.

And as it turns out, there are quite a few willing, and capable potential suitors, especially now that an activist is in play, one whose blended entry point in CHK is $15.70 as ZH calculated last week.

A purchase of Chesapeake, which holds reserves vast enough to satisfy more than three years of U.S. household demand, may be a bet on higher gas prices. Gas prices have rallied 28 percent since the low point on April 19. The commodity is still about 85 percent below its 2005 peak.


Natural gas for June delivery closed at $2.429 a million British thermal units yesterday in New York. Commodity traders don’t expect gas to reach $3.50 a million British thermal units until November 2013 and $4 until December 2014, based on New York Mercantile Exchange contracts.


Exxon and Chevron “desperately need” to boost production and may look to acquire Chesapeake, said SunTrust’s Dingmann. Each has about $19 billion in cash and short-term investments. Phil Adams, a debt analyst at Gimme Credit LLC, said Exxon tops his list of likely acquirers because it’s the largest potential suitor and has the highest corporate credit ratings. Chevron is also capable of paying cash without damaging its rating, he said.


Shell may also be interested in buying Chesapeake to reduce its exposure to regions with higher political risks, said Huntington’s Sorrentino.


“We have more than 40 trillion cubic feet of gas in the U.S. and Canada and we bought that quite efficiently, so we have plenty on our plate,” Shell CEO Peter Voser said yesterday when asked if his company is interested in buying all or part of Chesapeake.

In other words, Shell is in the market for nat gas.

As for the price that CHK could go for?

Sorrentino said a buyer could pay about $20 a share, while SunTrust’s Dingmann estimates Chesapeake could fetch a takeover price in the “mid to high $20” range, or as much as a 77 percent premium to the closing price of $16.35 yesterday. The stock reached a record of $69.40 in 2008 and closed as high as $35.61 last year.

Will CHK sell for $20, or more, or less? Who knows - it is very much reliant on the price of nat gas, which is also reliant on market liquidity, on natgas supply and demand patterns, on what the Chinese want to do (in addition to begin importing US gas in a few years tops), what happens with the CEO, and finally what Icahn decides to do.

But one thing is certain: the company has lots of good assets, as well as quite a few legacy liabilities, combined with an industry environment that is as bad as it has ever been. And sure enough, in betting that the environment might actually improve for a change, there are quite a few big firms which may be happy to onboard the assets and the liabilities, knowing they wouldn't impair the right side of their balance sheet, while acquiring some good real estate and substantial reserves on the left, at a valuation that is the cheapest in the industry.

Because in finance, once central planning is (finally) stripped away, valuation is all that matters.

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fightthepower's picture

Fuck you Bernanke!

battle axe's picture

The only upside is if they hang that thief who runs it...

Xkwisetly Paneful's picture

How much is Icahn ahead?

Funny how the one guy concludes, balance sheets mean nothing buy stocks,

while the peanut gallery concludes,  balance sheet means nothing sell stocks.

Sequitur's picture

Love these posts.

George Orwell's picture

I started building a position in CHK about 16.   natty will go up.  The decline rate of fracked wells is very high.   Eventually the supply will come online at a slower rate and prices will rise. 

otto skorzeny's picture

nat gas is the ONLY commodity reflecting the true state of the economy and if we "re-enter" a recession(larf-like we ever got out of one) then nat gas will stay low for awhile. and with the mild winters we have been having...

Buckaroo Banzai's picture

You might want to check your detective work there, Otto. A lot of nat gas demand from the manufacturing secotr got driven offshore in the 2000 decade and I'm not sure how much of it has come back yet. Meanwhile, there are large parts of the country that depend on natty g for their winter heating, and that demand is awfully inelastic. Even if the economy tanks and demand drops further it seems to me that supply will be dropping even faster given that we KNOW that fracked wells only last 18 months or so.

tigersea's picture

barrel of oil equivalent

what gas to oil ratio do they use? 1:6 as the banksters like to use or real world price ratio 1:36?

junkyardjack's picture

The 1:6 is the energy equivalent ratio, not really just a random number that banksters like to use....

Id fight Gandhi's picture

6mm BTUs in barrel oil, 1mm BTU in Mcf of gas

LawsofPhysics's picture

Don't worry I am sure the paper-pushers are working on a way to "print" up another couple million BTUs.  I mean, thermodynamic laws are just "theories" whereas the eCONomic ones are real < sarc off >

ITrustMyGut's picture

more likely to sell to Chinese interests... they need to redeem fiat now! and they know it..

midgetrannyporn's picture

hey, hey, ho, ho, aubrey's got to go...

otto skorzeny's picture

if nat gas continues to drop-which it has after a little jump in the past 1.5 months I may dip my toe in on this play and maybe UNL/UNG-but if nat gas drops down to below $2 again all bets are off as far as nat gas plays are concerned and I'll wait til fall.

slaughterer's picture

NatGas could go to $1.10 before it goes to $4.

RoadKill's picture

Nope. Drilling activity has collapsed, production is flattening, and record surplus situation turned 3 weeks ago. We are now BELOW historic averages on injections & withdraws And this weekend we saw RECORD heat. Its looking like we will have a hot summer off the back of a record warm winter. Then we will probably have a record cold winter to make up for this year, driving gas prices above their equalibrium price around $4. You will probably see $6 before you see $1.

And Im not a perma bull. Ive been doing this for 15 years and Ive thought nat gas was overpriced all but 4-5 times during that period. Right now long nat gas makes up a record 10% of my portfolio. Cash is 10%. Triple levered short ETFs are 60% and the rest is PE/VC.

Casey Stengel's picture

CHK is pumping over 60,000 bbl oil everyday out of the Eagle Ford shale in TX. It goes up 4000 bbl each week. Do the math and its a nice addition to the nat gas income.

otto skorzeny's picture

you've got big brass ones clanging if you're 60% in 3X short ETFs

MrPalladium's picture

Chesapeake is in play and headed higher. Disclosure - I am long the common and the 5% preferred.

Natural gas is headed much higher over the next two years due to increased demand (evidenced by storage adds well below the 5 year average) and decreasing production which is just now beginning as a result of the catastrophic decline in NG rig counts. The best cure for low prices is low prices.

Disclosure - I am not yet long NG but plan to be as soon as this retest of the lows turns upward.

otto skorzeny's picture

get into nat gas now and coal the next year after it's been bitch slapped-esp. if Obummer gets kicked out( he has a real stick up his ass about coal)

jekyll island's picture

I am not so sure.  Natural gas has replaced 15% of coal market in energy production, resulting in mountains of stockpiled coal and mine closures.  NatGas and coal are going to keep eachother low for the forseeable future. If natgas rises, utilities will switch back to coal and then vice versa.  There is going to be a bull market in Natgas in the future, I just don't know when.  Might be a little early right now. 

Acquiring CHK stock only for it's buyout potential is a one trick pony and must be done on the cheap because right now you are buying crappy management in a depressed industry.  Would be better off buying well run companies at firesale prices because you could get price appreciation based on organic growth/management savvy AND buyout potential.  Not in the same field, but I offer Africa Oil Company as an example.  BTW, I think oil explorers in Africa are going to be more valuable sooner than Natgas companies.   

oddjob's picture

And how is Talisman working out for Mr. Icahn?...not so well. If the object is losing half..he nailed it.

LawsofPhysics's picture

I love these posts, something I can trade.  I also like this particular line in this article "but use its assets to generate growth over the blended cost of capital."

Thanks to ZIRP, there is no real cost for capital, right, right?  < crickets >

Fuck you bernanke.

slaughterer's picture

Would rather make a NatGas derivative play on coal than "wait for Godot" for a buyer of CHK.   Could be a while until a buyer materializes, even with Icahn shopping it.   

Marginal Call's picture

They've got leases that expire if they don't drill them.  They lose money if they drill.  So they are forked until a price change.


Their solution is to drill for oil, since they know how to drill holes in the ground.  I'm sure they'll be able to find some undiscovered prime oil plays lying around somewhere.   Maybe they can lead the Kansas oil boom.

mjk0259's picture

Does it make sense to compare the BOE of a mostly natural gas company to that of mostly oil companies given that a natural gas BOE is a lot cheaper than a real barrell of oil?


jekyll island's picture

It does not from a price standpoint.  A BOE of nat gas is about $11. 

RoadKill's picture

That is a horrible analysis.

First looking at bbls of oil equivalent convrts nat gas reserves into oil a 6:1 (btu equivalency). But oil is $88 a bbl and with nat gas at $2.50 the conversion ratio should be 35:1. On a margin basis its probably closer to 50. And then you have to account for reserve life. if CHK has 40 TCF of gas reserves thats a 40 year life. XOM has 10 years. DCF tells you if one asset will take 40 years to monetize and the other takes 10, then Asset B is worth 2x-3x asset A.

Secondly the peer group is BS. Someo.e already mentioned oil vs gas. Also CHK is 100% US vs those other guys with mainly intl operations. Those other companies are much bigger then CHK (except Devon(. And they arent run by incompetant lying meglomaniacs.

Real comps should be UPL, ECA, SWN and PetroHawk.

Here is the math for UPL. Stock is worth 10x normalized nat gas price. If you think nat gas will avg $2 for the next 10 years, UPL is worth $20. If $4 then $40. Back when Nat Gas was $10 UPL was $100.

CHK is worth more like 6x gas price. It was a $65 stock when UPL was $100.

UPL has the industries lowest production costs. A history of the best production growth, great mgmt and a clean BS compared to CHK. $1.9bbn in debt vs mkt cap of $4bbn.

I own 25,000 shares of UPL that I bought below $20. I generally short CHK as my hedge, but right now Im naked cause I think gas has bottomed. Actually bought 19,000 CHK after Aubry blowup and Ichan said he was looking at it. Sold on Friday.

halflink123's picture

Yes CHK is a mess. I'd never heard of UPL till this post. Actually what I dislike about a lot of the US oil and gas co's, like Chesapeake, etc. is they usually have very very high capex, pay no dividends, dilute their stock like there's no tomorrow (UPL doesn't do this), hardly ever repurchase shares, etc.  When looking at their CF statement I just wonder if they're prematurely developing their asset base or something, because they just seem to have such high costs in terms of capex anyway.


Also IMO by far the cheapest nat gas co. is Gazprom.

RoadKill's picture

UPL drills in the Rockies and Wyoming. Not shale gas, more tight gas. They have all in production costs of $1, tied with SWN for lowest in the country. From inception the stock compeated with XTO for best return to shareholders (it went up >20x). Its down from $100 in 2008 to under $20.

Gazprom is always cheap. Its also probably the only energy company more corrupt then CHK. Look at the number of employees vs production volumes. When oil prices go up (Gazprom sells its gas to Europe at oil price linked rate) the pols make them hire thousands of more employees. Also Gazprom has to pay billions a year in bribes.

All resource companies in Russia really belong to the government.

Further Gazprom faces a big risk of shale gas in East Europe. Germany, Hungary, Poland the Ukraine etc... Are sitting on at least as much shale gas as the US. If the enviros let them develop it Russia wont be able to sell its gas to Europe for $10. The local price for gas inside Russia is $1.

To me Gazprom is a short, but if I shorted it Id be afraid thst Putin would have me stabbed with a radioactive needle.

halflink123's picture

Interesting...I am curious about UPL b/c as I said I know literally nothing about it and your post raises interesting points obviously.


As to shorting Gazprom...I don't get it.  There are many ways to value it, but using a rough sum of the parts: they own:

80% of Gazpromneft (predominantly oil, not gas, co)-@market=$16B

10% of Novatek: @ market = $3B

That is 20B right there.

In addition it owns Gazprombank which in turn owns Gazpromedia, the list goes on.

This isn't even counting its core assets, its core business.  I understand the corruption angle but I don't think Russia is alone in this regard (TBTF anyone)?

I can understand not going long but just even the non-core assets alone, I don't understand how this could be a good short (again, even ignoring nat gas prices completely etc the asset base is immense).

RoadKill's picture

I agree with you on share dillution and capex - particullarly CHK. Since mid 90s CHK production has risen 10x but so has Share count. UPL has increased production MORE then CHK over the same time frame but hasnt issued any shares, and in fact bought some back in the past few years.

UPL does have high Capex but thats because is grows production 20%-40% a year. It has a huge asset base and can easily double production in the rockies. And they also bought acres in the Marcellus. In 5 years they will have built everything out and cash flow a butt load of cash.

Stoploss's picture

Don't forget the reserves are overstated by a country mile.

junkyardjack's picture

Unfortunately you have to wait until year end for them to finally be written down

Bob Sacamano's picture

Bot the CHK Conv Pfd D on the sell off -- a more conservative play than common plus some yield while waiting.

halflink123's picture

The prefD IMO has a very high strike price (at which it's convertible to common) so the warrants piece of the preferred is nearly worthless.  The preferred itself is only yielding like 7%-what is the upside?  

I kind of liked the prefA but don't think the price of those has come down all that much.

Bob Sacamano's picture

Purchased just for high sixes current yield.  Am betting they don't go bankrupt.  Theoretically, the $70 pfd D goes back to $90+ if the common makes it back to $24 (where the pfd and common were a few months ago).  But am happy with my yield for now.  Will see...... 

Augustus's picture

As noted, the Bloomberg comparison is incomplete.  It is based upon energy equivalence, not $$$ equivalence  Generally, it takes 7 Mcf to equal 1 Bbl on an energy swap BTU comparison.  So 1 Mcf should sell for 15% of the price of a bbl.  However, NG has traditionally sold for about 10% of the oil price, a discount.  $100 oil should give $10 Mcf NG on a historic pricing basis.

Now, simply using the energy swap values for comparison, 7 Mcf @ $2.50 = $17.50 for the gas that would equal a bbl of oil.  So, if oil is $100, is is worth about SIX Times the ng value.  That is where the Bloomberg piece off base in valuing and comparing the reserves on a BOE chart.  Sure, these are somewhat rough numbers that I hope are useful for illustrating the point. 

The reserves and acreage of the other producers may have a much higher liquids content or some meaningful oil production.  Several of the NG producers are simply too highly valued and the price is distorted because of the use of unadjusted BOE in energy, not $$$$.

I am a Man I am Forty's picture

chk is a shit company with shit management with a shitload of debt, this stock was the same price 7 years ago