Chesapeake Energy (CHK) is the second-largest producer of natural gas in the United States and has interests in around 45,000 natural gas and oil wells. According to its website, the company is focused on "exploring for and producing unconventional natural gas and oil onshore in the U.S." Chesapeake has "natural gas assets in the Barnett Shale...the Haynesville Shale...[and] the Marcellus Shale, [and recently] built a substantial resource base of onshore U.S. liquids rich assets" as part of the company's strategy to "transition [to a] more balanced and likely more profitable portfolio between natural gas and liquids."
This is critical for the company as conventional natural gas prices recently hit a two-year low amid record production and unseasonably mild weather. The rock-bottom prices have hurt Chesapeake--the company "said recently that to meet its 2012 operating expenses and debt-reduction targets it would [have to] pair $7 billion in planned asset sales and other financial deals with $6 billion operating cash flow." This could be problematic given that the "$6 billion [operating cash] forecast...assumes an average natural gas price that [is]...50% higher than current levels" according to the Wall Street Journal.
In 2012 Chesapeake will reportedly "divest its stake in oil producer Chaparrel Energy and oilfield service company FTS International Inc." These deals come on the heals of a string of asset sales in 2011 intended to "fund drilling, close [the above mentioned] funding gap," and reduce debt.
For example, last week, the company sold its Appalachia Midstream Services LLC division, which owns 200 miles of pipeline in the Marcellus Shale to MLP Chesapeake Midstream Partners (a subsidary formed with Global Infrastructure Partners) for $865 million. Chesapeake Midstream's interest in the pipelines will be 47%. This is the second such deal completed by Chesapeake with its MLP subsidary. In 2010, the company "sold its network of Louisiana pipelines [to Chesapeake Midstream] for $500 million."
Earlier in the year the company sold its Fayetteville Shale assets to mining giant BHP Billiton (BHP) for $4.75 billion in cash. The company also sold 142,500 acres in the Utica shale for $2.1 billion, a good deal considering it only paid "$2 billion for its entire 1.3 million-acre position in the region" according to MSN Money.
Some would argue that owning shares of the second largest producer of natural gas in the United States at a time when natural gas prices are near two-year lows seems problematic on its face. This is indeed true, but it is important to remember two things. First, the best time to buy is often when others are selling and this seems to be that point for natural gas.
Second, Chesapeake is "undergoing a strategic shift toward oil and liquids." In fact "oil and NGL could represent 40% of Chesapeake's revenue by the end of [2012]," and already represent 40% of unhedged revenue based on last quarter's report. Additionally, liquids production during the third quarter rose "91% year over year and 21% sequentially." NGL is much more profitable than conventional natural gas, and oil prices should remain elevated in 2012 thanks to geopolitical turmoil in Iran and Iraq and the reversal of the Seaway Pipeline.
That doesn't mean that persistently low natural gas prices aren't a concern, but investors should know that the company is partially hedged against falling natural gas prices. Chesapeake uses derivative instruments such as swaps, call options, put options, knockout swaps, and basis protection swaps to hedge its exposure to price swings.
As a side note, Chesapeake also has around EUR344 million in euro denominated bonds on which it must pay a set interest rate of 7.49%. Chesapeake however, is not affected by the recent weakness of the euro as the company "eliminated any potential variability in its expected cash flows related to changes in foreign exchange rates" by way of cross currency swaps.
While many anticipate a widespread movement toward natural gas to the detriment of coal and oil in the future, investors need not depend on a natural gas energy revolution to justify their purchase of Chesapeake's shares. While the company has had difficulty living up to its potential for the past few years, its plan to pay down debt and shift production toward NGLs and oil should bode well for the shares going forward.
Additionally, as natural gas prices have fallen, "rigs in the U.S. targeting gas reservoirs have fallen to 809, down 110 from a year ago," according to the Wall Street Journal. Although this has yet to affect prices as terms of leases and joint ventures force natural gas companies to drill regardless of demand, perhaps it will lead to a decrease in supply later on down the road. Any rise in natural gas prices will be icing on the cake for Chesapeake.
The consensus opinion on Chesapeake Energy is generally bullish. Fifty seven percent of analysts who cover the company rate it a buy/hold or better. S&P has a 'buy' rating on the shares with a 12-month price target of $38, a 70% increase from the most recent price of $22.29. I'd buy the shares here but purchase some put protection at the same time just in case a deeper-than-expected recession in Europe pressures commodity prices in 2012.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours.
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