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ABOUT THE COMPANY

Chesapeake Energy (CHK) is one of the largest American independent producers of natural gas and oil. The Oklahoma City-based company was founded by Aubrey McClendon and Tom Ward in 1989 with only $50,000 in capital. Four years later, Chesapeake completed its initial public offering to help fund large scale growth, which was cut short thanks to disappointing geological discoveries and the collapse of commodity prices in the late 1990s. Financial challenges were met by a new business plan aimed at diversifying operations through land acquisitions and investments in exploration. The company vigorously expanded its acreage position in unconventional plays during the following years. Now, in addition to being the second-largest natural gas producer (behind Exxon Mobil (XOM Free Exxon Stock Report) and a top fifteen oil producer in the United States, Chesapeake offers marketing, midstream, drilling, and other oilfield services.

PERFORMANCE & RECENT CHANGES

Aubrey McClendon announced that his retirement from the company’s lead post is set for April 1, 2013, though we have already begun to see changes reflecting new management. The departure marks the end of an era, but controversy surrounding his tenure will certainly not die down. The longtime boss has been at the center of an informal SEC investigation for nearly twelve months following reports that he used his position in Chesapeake’s wells to secure over $1 billion in loans. His compensation package attempts to align the company’s interests with McClendon’s personal wealth by allowing him to purchase a 2.5% stake in every one of the company’s oil and gas wells, which number in the tens of thousands. He was then using these loans, and a group of other funds, to further invest in wells. Essentially, critics argue that McClendon ran a hedge fund that traded in the very commodities he produced, sparking a conflict-of-interest and price manipulation debate. An internal investigation found no evidence of intentional wrongdoings within the outgoing CEO’s personal finances, though news that the SEC might beef up its inspection forced down Chesapeake’s share price in early May of 2012.

Notwithstanding the investigation, McClendon’s more-speculative style does not fit what the market currently requires from Chesapeake. New management seems to be building momentum through a more conservative approach, though an aggressive mentality during the “gas shale land grab” has left Chesapeake ahead of some of the competition, including Devon Energy (DVN), Encana (ECA), and Chevron (CVX Free Chevron Stock Report), on the natural gas scene. Core operations currently span the Haynesville, Bossier, Barnett, and Marcellus Shale, and smaller businesses in a few other locations. In fact, the company’s 2008 discovery of the Haynesville Shale could become the largest natural gas play in the country. However, deflated commodity prices have since changed the face of our energy markets. Over 80% of rigs were drilling for natural gas while it traded near $13 ptcf (percentage to cash flow) in 2008 as opposed to the same percentage of rigs currently focused on oil reserves and gas prices hovering around $3.50 ptcf. That said, Chesapeake currently has cut its rig count to about 80, from 160 in 2011. This has lessened expenses without decreasing revenues thanks to wells that have been producing at better-than-expected levels. 

Drillers generally suffer from poor sales and noncash write-offs if prices are below $4 ptcf. This has slowed the company’s recovery after overextending itself financially in the mid-2000s to acquire what was once prime real estate. Additionally, many lease agreements stipulate that new landlords must develop relatively quickly, which has left management looking for partners and potential buyers for some of its contracts. Asset sales will likely play a large role as new leadership looks to clean up the balance sheet. Recently, it was announced that the company will receive just over $1 billion from Sinopec, the state-backed Chinese oil giant, to execute a joint venture in the Mississippi Lime. Also, this year’s natural gas hedge ratio has been raised to 50% of production from 11% last year and 85% for oil production, which is up by 16% from 2012 hedges. Extra protection creates a more stable cash flow, which should support a higher stock valuation.

CONCLUSION

Lately, low natural gas prices have provided headwinds for the entire industry. We expect negative reserve growth to complicate Chesapeake’s goal of solving the funding gap. Therefore, it is likely that recovery will take some time. However, since the perception of ill-equipped management has been addressed and last quarter’s report showed promise, we are left viewing shares of Chesapeake with a bit more optimism.

For those interested in learning more about Chesapeake’s prospects, along with the particular investment merits of the stock, subscribers are encouraged to review our full report in The Value Line Investment Survey.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.