Tuesday, November 4, 2008

Chesapeake - Never Boring

At the beginning of 2008, Chesapeake had a market value of $23 billion. Four months ago this company had a market value of $43 billion. A few weeks ago, that market value had fallen to $7 billion, and today it stands at $12.7 billion. I'm getting a bout of vertigo just typing these numbers.

I know what you're thinking. "What's the big deal? All of the banks are getting killed these days." That's fine, but this isn't a bank. This is the largest independent producer of natural gas in the United States. They have a strong exploration and production track record and hold some large and interesting acreage positions.

$43 billion to $7 billion in a few months. That's a decline of over 80%. That works out to over a 300% annualized loss (it's the new math). Immediately, one's thoughts wander to Enron. These guys must have been cooking the books. They must have overstated the amount of natural gas reserves they own, right? Wrong. So what's going on here?

For starters, we have to put that 80% decline in context. The market overall hasn't been exactly kind to anyone since the end of July. From the time of CHK's peak to its bottom earlier last month, the S&P 500 fell about 30%. It didn't help that natural gas prices fell 53% over this same time period in sympathy with oil prices (down 43%) as the global economy continued to sputter. XOP, the SPDR S&P Oil & Gas Exploration & Production ETF, was down 62% over this period. Still, CHK has outdone itself by falling further than any of these.

There is an added wrinkle to the CHK story. Chesapeake's CEO, Aubrey McClendon, owned about 32 million shares of CHK on October 8th. A couple of days later, most of those shares were gone. Loss of confidence in the company? Not exactly. McClendon was hit with a margin call. Amazingly, this billionaire thought it wise to keep adding to his already sizable CHK stake by buying on margin as the stock started falling this summer. You have to admire his belief in the company while questioning his money management strategy.

It boggles the mind that a billionaire would risk his fortune by buying stock on margin and not diversifying his holdings, but that's what McClendon did. This is a massive failure in Financial Planning 101. Amazingly, he wasn't alone. We've been learning of executives at other firms (see BSX, CPE, DNR, LTM, PROV, PHM, and WSM) also experiencing margin calls, although of a lesser magnitude.

McClendon was forced to unload 31.5 million shares between October 8th and 10th at an average price of just over $18/share. He sold 1.8 million of those shares as low as $12.64 on the 10th. Ouch. With the stock now back at $22, that forced sale has "cost" McClendon another $125 million. Ouch. It doesn't help that this margin call occurred as the market was gapping down to a new low on the 10th.

You can see in the chart below that from the peak on the 9th to the low on the 10th, CHK lost about 50% of its value. With about half of McClendon's shares hitting the market on the 10th, it's pretty safe to assume that the extra 15 million share of selling pressure somewhat exacerbated the stock's decline. Not surprisingly, with that selling pressure now abated and with the market a bit higher, CHK has rebounded a tremendous 83% from its intra-day low on the 10th.

This is all water under the bridge at this point. The more pertinent issue is what to do with the stock now. Is the stock attractive at this level, or is this a value trap? As I've shared in the past, if I can't figure out that a company is inexpensive on the back of an envelope then it isn't worth my time or money. And, as always, I encourage everyone to do their own work.

With that said I'd like to share a couple of comments from last Friday's quarterly earnings conference call (10/31/08) that caught my attention. Chesapeake CEO, Aubrey McClendon, started off the call with an interesting statement:

First, we open the third quarter with a bang, in announcing a very innovative sale of 20% of Chesapeake's Haynesville acreage position in the Plains for $3.3 billion in cash and drilling carry. This was a great transaction for both parties and established a $13 billion value for our remaining 80% in the Haynesville, a value that today ironically exceeds our entire market cap. That does seem very unusual to me.
What makes this even more intriguing is that the Haynesville play accounts for only 20% of the company's total proved and risked unproved reserves. We can argue all day and night about the pros and cons of shale gas production, but this is an actual deal with a knowledgable buyer, so it's hard to dismiss it. To be fair, however, this deal was struck back when natural gas prices were near their peak, so I don't believe for a minute that the company would fetch $13 billion for its remaining 80% today. In defense of management, however, their timing on that sale was impeccable, or impeccably lucky.

McClendon continued,
Second, in early August, we completed another innovative JV transaction, this time in the Fayetteville Shale with British Petroleum to whom we sold 25% of our Fayetteville assets for $1.9 billion, leaving our remaining 75% position in the Fayetteville worth about $6 billion or roughly $10 per share which is about one half of our stock price today. For the record, only about 4% of our proved reserves are booked to the Fayetteville yet this transaction alone established a remaining Fayetteville value equal to 50% of our stock price; again, very unusual.
Again, natural gas prices have fallen since that time. Still, these transactions provide a bit of support and some margin of safety. The company has more of these deals in the works. It will be interesting to see what type of value they receive and its implications for the entire company's valuation.

As I always stress, I don't pretend to know what any stock or market will do in the short-term, but this is the type of situation I like. We have a real company with real assets that is currently out of favor due to a recession of questionable length and severity. If you believe that the recent flood of bad economic and financial news around the world is a sign that the rapture is near, then you'll probably want to pass on this stock (and every stock). Of course, if you believe the rapture is near, why are you wasting your time reading this? If you believe that the economy will eventually recover and you have a long-term horizon, then the following points are worth considering:
  • As with many stocks, this sector is best bought when it's out of favor. Check.
  • Current natural gas prices aren't too far from average industry all-in cost levels. This may provide some price support.
  • Natural gas wells deplete fairly quickly, on average. This helps to balance supply when activity slows due to excess demand.
  • Most everyone is expecting the rig count to continue falling in the coming months, further reducing expected natural gas supply.
  • Natural gas is much cleaner than oil and much closer to home. Demand is likely to resume growing following this recession.
  • CHK's balance sheet looks fine. They have no large near-term debt maturities, they have a nice chunk of cash, and they should generate significant excess cash in coming years.
  • Valuation looks very attractive on a number of metrics.
  • McClendon has to be angry given how much money he recently lost. He probably has a nice-sized chip on his shoulder right now. I wouldn't bet against him.
Importantly, natural gas is a self-correcting market. Lower prices result in less drilling which leads to less supply which leads to higher prices. The only real question relates to the length of time it takes for this to occur, and that depends on how far and fast natural gas prices decline, how quickly firms pull back on their drilling, how quickly wells deplete or are shut-in, and how severe the fall off in demand is. But make no mistake, the stage is again being set for a period of tight supply, higher natural gas prices, and higher equity valuations for this sector.

Disclosure: The Rubbernecker is long CHK and short the rapture.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.