After a great start in 2014 Chesapeake Energy experienced the worst monthly decline in July. (1 - see footnotes below) But what caused this rapid slide in price?
Chesapeake Energy Corporation (CHK) is an US oil and gas company, where it is the second largest producer of natural gas and tenth largest producer of liquids (crude and NGL). The stock pulled back after giving up its 16% gain in H1 2014. A large portion of the decline in July was the result of Chesapeake spinning of its oil field service segment. The value from the business segment was transferred to the new company called Seventy Seven Energy (SSE). (2)
Chesapeake is largely an E&P (Exploration and Production) company. Its core operation involves discovering new resources, extracting hydrocarbons from the ground, and ultimately selling them to refineries. Chesapeake’s production historically consisted of mainly natural gas and the firm benefited from the rise in natural gas prices. Natural gas prices enjoyed a nice run for over a decade before the decline. Prices surged over 500% from 2000 to the most recent peak in 2008. Unfortunately, as fracking became more efficient and prevalent, the supply of natural gas skyrocketed. Fracking allowed companies to gain access to reserves that were out of reach using conventional methods. As natural gas production increased, prices slumped, shedding more than 70% of its 2008 value at its low in 2012. It has since made a modest recovery. Unfortunately, there was no hedge beyond the short-term derivatives, which could not protect Chesapeake from the drastic drop in price. Chesapeake has since shifted focus towards oil production.
Total production increased by 23% from 2011 to 2013 and average sales price increased from $24.12/boe (barrels of oil equivalent) in 2012 to $27.92/boe in 2013. In addition, the management has been keen on divesting non-core and poorly performing assets, including the Permian Basin in 2012 and virtually all midstream assets in 2013. These actions brought the company back into profit zone and decreased production costs by 14% in 2013.
Despite the strong overall production growth, the R/P (reserve/production) ratio was still in line with its comparables in 2013. Reserve replacement ratios (RRR) and Organic RRR were also well above the median of its comparables (see below). This suggests that the company will continue to maintain a strong asset base in the future to sustain production growth without the need for acquisition.
After a strong 2013, Q1 2014 results continued to impress investors. Compared to Q1 2013, liquids production increased drastically, natural gas production decreased, and average prices increased thanks to higher oil prices. All of the above contributed to higher cash flows for the quarter, which is critical for Chesapeake to meet its budgeted capital expenditure.
The management is expected to spend around $5B in capex in 2014. Q1 results showed that Chesapeake was on track to adhere to this guideline with just cash from operations. In addition, the $1B in cash can cushion any moderate shocks as the result of commodity price fluctuations.
The improvements are evident in Chesapeake’s Fundamentals Scores calculated by Market IQ.
Market IQ places Chesapeake in the right quadrant of the Quality/Value chart indicating good Quality and strong Investment Value.
The firm’s qualitative strengths can be seen in the following areas (3):
- ROE increased to 4.53% in FY 2013, up from -4.94% in FY 2012
- Due to increased efficiency and rising oil prices, operating income increased to $733 million in Q1 2014, up from $217 million in Q1 2013
- Debt to Market Cap decreased from 1.21 in 2012 to 0.73 in 2013
- EPS in Q1 2014 grew over 96% from $0.30 in Q1 2013 to $0.59
Based on Market IQ’s valuation metrics, Chesapeake is trading at a discount relative to its peers. Two multiples stand out particularly: EV/Daily Production and EV/Reserve.
Production is directly related to future cash flows, and high reserve numbers represent a strong asset base. Considering these two metrics, Chesapeake exhibits characteristics that are attractive for value-oriented investors. In addition, the fact that Chesapeake has consistently beaten analyst estimates in the past year should provide investors with another layer of assurance. (4)
In order to create a leaner and more efficient company, Chesapeake spun off its oilfield services segment on July 1st,2014; the new company emerged as Seventy Seven Energy on NYSE. The segment’s revenue historically hovered around 1% of Chesapeake’s revenue, thus the spinoff will not have substantial impacts on Chesapeake’s cash flow. This move netted Chesapeake shareholders $400 million in dividends and took away $1.1 B in debt. This also reflects the management’s dedication on divesting non-core assets.
Ever since Mr. McClendo’s (ex-CEO) departed in 2013, Chesapeake has reversed his strategy which involved borrowing heavily. The debt was used to finance speculative resource plays, and ultimately forced the company to divest valuable assets when they failed. Going forward with the current strategy, Chesapeake will continue to reduce debt load while achieving a sustainable growth.
Carl Icahn’s involvement with the company will also ensure stability within the company and make sure that the management will adhere to the current strategy. Carl Icahn has quite a history with Chesapeake, and his most recent investment in the company dates back to 2012. In his letter to shareholders in 2012, Carl Icahn reaffirmed his belief that Chesapeake had top quality resource assets. He believed that the management was taking too much risk and should stick to the basics. Under his pressure, the company continued to divest non-core assets and became a leaner company. The shareholders will not be subjected to too much operational uncertainty in the future given Carl Icahn’s influence.
Thanks to supply concerns, average Q2 WTI spot prices were 4.8% higher than Q1. Combined with increased production, both revenue and earnings may see a significant increase over Wall-Street consensus. Although there were fears of potential disruption of Iraq’s oil production due to ongoing conflicts, they have since dispersed. However, with Libya opening up two of its terminals, additional 600,000 barrels of oil will be added to the global supply per day, thus the downward pressure that surfaced in Q3 may continue. As oil prices are a key driver of Chesapeake’s revenue, expected decline in oil prices may dampen investor enthusiasm.
(1) Stock declined by 10.32%
(2) The shareholders obtained 1 SSE share for every 14 CHK shares.
(3) Quality is comprised of profitability, financial strength, growth, and estimate momentum
(4) CHK has beaten the Wall Street consensus 6 out of the last 7 times.