Chesapeake Comes Back From The Dead

To say that it has been a rough third quarter for Chesapeake Energy Corp. (CHK) would be the understatement of the year.  Shares of the largest natural gas company in the United States have fallen from a intra-day peak of $74.00 all the way down to a measly $9.84.  Rumors, all of which ended up being false, had speculators predicting that the natural gas giant would default.  Credit default swap spreads on Chesapeake that default in a one year period have risen to a high of 1200 basis points in September (essentially giving a 12% chance to Chesapeake’s ultimate defaulting).  Fear caused the stock price to plummet, but that is exactly what CEO Aubrey McClendon has erased with his most recent press conference that was held on Monday, December 8th.

Last Monday, Aubrey McClendon and the rest of Chesapeake’s board held a press conference to calm investors and the markets alike and to give full transparency.  You would think that the finances of an energy company would be relatively simple, compared to many of the new complex financial instruments that we have seen used in the financial world. However, Chesapeake managed to get wrapped up in disaster that is currently unfolding. Their fall from the top was fueled by liquidity problems, the same problems that plagued many of the financial firms that no longer exist.  Luckily for shareholders, Aubrey and the rest of the world took drastic and fast action to make sure that long-term shareholder value would be preserved.

The root of the problem was in Chesapeake’s capital expenditure program.  Aubrey McClendon saw the massive upside in his leases as natural gas rose from $7 per Mcfe (1000 cubic feet equivalent) all the way to $13.60 per Mcfe and decided to leverage the company in order to begin productions from as many wells as possible as soon as possible.  This strategy would have worked to perfection if we were not headed into one of the two worst financial crises in the history of the United States, but unfortunately that is the case.  Natural gas prices falling to around $5.5 per Mcfe destroyed the short-term high hopes of Aubrey and almost caused irrecoverable damage to the company.  Chesapeake was planning on financing capital expenditures at levels that would be beyond their free cash flow.  This type of financing employs a degree of leverage that can only be sustainable for short periods of time, and under particularly favorable circumstances.  Before this financial crisis started, Chesapeake would have had the ability to do this… but when lending came to a halt Chesapeake was forced to scale back their drilling expansion.  This, in turn, lead to much lower near term earnings as their production growth is now going to be much less than previously estimated.  Now, instead of growing earnings at rates of 10-20% in 2009 and 15-25% in 2010, Chesapeake’s earnings will be growing at rates closer to 5-10% in 2009 and 10-15% in 2010.

The good news is that now Chesapeake has become financial stable through a number of transactions as well as cuts in their capital expenditure program.  Highlighting some of the key points from the conference call, you can see how much more stable the company is than it was even a few short months ago.

• Chesapeake currently has $1.5B in cash, and they will have between $2B and $2.5B in cash by year end
• Cash balance will be built to ~$4B by the end of 2010 through monetizing assets
• Chesapeake’s new capital expenditures program is free cash flow neutral to positive, in other words they will not be employing heavy amounts of leverage to grow organically
• Over the last 5 months Chesapeake was able to sell $12B in assets for a $9B gain
• In order to stabilize future cash flows, Chesapeake was able to hedge 76% of production at $8.20 in 2009 and 50% of production at $9.50 in 2010.  These prices are substantially above the current NYMEX natural gas price of $5.83
• Chesapeake will be adding 2.5 Mcfe of reserves to their balance sheet in 2009, more than any other publicly traded company in the world, at a cost of only $1.20 per Mcfe
• Aubrey McClendon has estimated assets valued at $25B-$30B in proved reserves, at least $25B-$30B in undeveloped leaseholds, and another $5B in non-core assets
• Chesapeake was trading at a ridiculous 1.4x cash flow (not free cash flow, just cash flow) at the time of the call

As you can see, these points above act as evidence of a company that seems to no longer have a liquidity issue.  The other great news is that Chesapeake is heavily hedged through the next two years and low short-term commodity prices will not be a problem.  As long as commodity prices make a rebound before 2011, Chesapeake should have no long term problem.  Aubrey McClendon also mentioned that Chesapeake is going to operate under the assumption of $50.00 average crude oil and $5.00 average natural gas spot prices for 2009.  He also mentioned that the company could even operate at natural gas prices as low as $4.00 per Mcfe.  While this is extremely unlikely, it goes to show how far management has gone to make sure that the company stays very liquid even during the worst of times.  Chesapeake has estimated at the breakeven price for North American natural gas production is somewhere right below the $6.00 level, so any sustained move by natural gas below these levels will eventually cause some firms to begin operate at a loss and will over time shut in production.  This, over the long run, would be extremely bullish for natural gas spot prices.

Obviously the ride down has not been to enjoyable, but if you are in for the long haul this could be a great entry point for Chesapeake.  The risks to the company are now much more transparent and priced into the common stock, so the only large variable that remains is the extent of the upside. This type of optimism could surround the company in the future, but in the current global economic crisis this seems unlikely for at minimum the next 12 months.  That being said, a complete financial disaster would be horrible for the company, but it would be horrible for more than just Chesapeake.

Disclosure: The mutual fund the author manages, the author’s family, and the author are all long CHK.

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