Chesapeake Energy (CHK)

The CEO, Aubrey McClendon has been on a buying spree; he bought 20 million worth of CHK in January. Ostensibly, A CEO wouldn’t snap up shares on margin if he/she didn’t think the stock was going higher. Nobody can predict future stock prices, but CEOs are in the best position.

Management said it best: “It’s also been a, it’s been a kind of corporate finance challenge to be able to pay for all this stuff [drilling].” In a recurring theme with these Chesapeake updates, the current ratio slid to 0.46 from 0.51 at YE 2007 and debt increased 12% to $12.3B (107% of equity). During the quarter, it sold off non-core assets in the Rockies & Woodford Shale for $243M. Shortly after the quarter, it raised $1B in an equity offering, completed a $623M VPP transaction and issued $2B in senior notes and convertibles. Obviously, the never-ending finance hamster wheel still dominates the balance sheet at Chesapeake.

If management lives up to its prior track record, the answer is an unqualified yes and then some. McClendon, one of the most respected CEOs in the industry, has gone on record stating that this (Haynesville) could be the biggest thing to ever happen to the company and eventually expects returns from Haynesville to exceed those of its Barnett Shale position.

He also presents an interesting case that Chesapeake is being grossly undervalued by the market, basing it on the SEC’s PV-10 valuation and then adding in midstream assets, 37 tcfe unproved reserves and ignoring millions more less-glamorous acreage that the company feels is valuable nonetheless. According to this math, the company is worth at least $61B ($99 per share net of debt) compared to an enterprise value of $39.5B around the time of the conference call.

Chesapeake Energy Corp., Oklahoma City, (NYSE: CHK) has acquired or has commitments to acquire its stated goal of 500,000 net acres in the Haynesville shale discovery in northwestern Louisiana and East Texas, according to the company, and continues leasing. Chesapeake is currently using five operated rigs in the play and anticipates 12 or more by year-end 2008 and at least 30 rigs by year-end 2009.

During May, the company successfully completed two additional horizontal wells in the play at flow rates comparable to its first four horizontal wells. It anticipates completing two more horizontal wells by the end of June.

McClendon, one of the most respected CEOs in the industry, has gone on record stating that this (Haynesville) could be the biggest thing to ever happen to the company and eventually expects returns from Haynesville to exceed those of its Barnett Shale position.

He also presents an interesting case that Chesapeake is being grossly undervalued by the market, basing it on the SEC’s PV-10 valuation and then adding in midstream assets, 37 tcfe unproved reserves and ignoring millions more less-glamorous acreage that the company feels is valuable nonetheless. According to this math, the company is worth at least $61B ($99 per share net of debt) compared to an enterprise value of $39.5B around the time of the conference call.

The CEO, Aubrey McClendon has been on a buying spree; he bought 20 million worth of CHK in January. Ostensibly, A CEO wouldn’t snap up shares on margin if he/she didn’t think the stock was going higher. Nobody can predict future stock prices, but CEOs are in the best position.

After reviewing Chesapeake’s recent Haynesville play announcement along with the 2007 results, I am inclined to raise the intrinsic value due to several factors:

• Raising the base range of natural gas prices from $5 - $7 to $6 - $10.
• the new prospects recently announced which the company has fingered at 10 tcfe and 1B BOE in additional reserves

That last point is NOT A TYPO! An addtional 10 tcfe in nat gas reserves combined with an extra billion barrels of oil reserves (with oil priced at ~11:1 price-to-btu ratio, nearly double the traditional 6:1 ratio) would more than double the company’s current reserves and obviously, do nice things to NAV.

With their track record, I would expect them to exceed their announced totals in the Haynesville as well as the other announced plays. In my original report, I mentioned their drilling and seismic data as a boon to operations and that combined with their new Reservoir Technology Center should continue to provide impressive results going forward.

The impetus behind raising new capital is to drill these new plays as well as ramp up production in the Barnett and other areas. Management complained of other E&P companies bidding up leaseholds in some areas like the Barnett and Marcellus — their solution is to drill as fast as possible so as to avoid renewing leaseholds at mark-up prices. The financing portion of all this drilling appears to be getting a little trickier as the company’s previously planned capital raising efforts — selling off mature production [VPP] or assets, monetizing their midstream assets, sales-leaseback transactions — are already accounted for in the previous budget. Luckily, costs are projected to flatten this year.

Currently, the company is projecting up to $6.8B in capex. Last year, they generated $4.9B OCF. They’ve hedged 70% of 2008 production at an avg $8.69 mcf vs. last year’s nat gas equiv. realized price of $8.47 and are projecting a 20% increase in production this year. So assuming prices realized roughly equal last year’s, we get a rough $5.9B OCF based on production increase. The share offering will gross them around ~$1B, the 2nd VPP offering is projected @ ~$600M and the midstream partnership should see ~$700M to Chesapeake with $300M staying in the new entity. Combined with the increased OCF (~$8B total), that should provide the funding necessary to power CHK’s aggressive drilling program. ^[1]

1. ↑ Enlightened American

CHK has massive amounts of acreage that it acquired at attractive prices. It has been ramping up drilling, and production will continue to increase drastically. Rising gas prices coupled with increasing production will provide a significant boost to revenues.

Furthermore, Natural Gas prices have been on a tear recently. There has been an increased, longer-term bullishness on the commodity. One reason stems from bloated storage levels that are being worked off. Current levels are about 5% higher than the 5-year average, down from levels that were nearly 35% above 5-year average. Gas has a difficult time moving higher when excess supply exists.

Natural gas has been stuck in the $6 to $8 range the past two years, but the CEO believes a multi-year trend is emerging that will result in natural gas prices in the $8 to $10 range. Futures prices support McClendon. Generally, NG prices pull back during the summer months when demand drops, and storage withdrawals switch to injections. However, the future curve depicts higher gas prices all the way out to March 2009. Not only does this suggest higher prices in the future, it also benefits CHK now since it’s an active hedger.

CHK applies more coverage than most its peers, reducing sensitivity to the commodity. While this can cap gains to the upside, it limits downside exposure that could destroy a producer. I think it’s a very smart move. Management is placing certainty on an uncertain variable. Natural gas prices are set by the market, and CHK has no control as price-taker. While many companies rely on volatility as a source of profits, CHK focuses on aspects it can control, such as its competitive advantage it drilling. Natural Gas is a clean energy, and there has been no shortage of “green” dialog recently. This heightens the pressure for utilizing the clean resource in place of dirty fuels when feasible. Coal energy is a target. Investment bankers are expressing reluctance to engage in bond deals for new coal power plants. Bankers express apprehension about future legislation on carbon emissions that could financially penalize power plants. The fear is that revenues that go towards paying down the bonds would be diverted to paying for carbon credits or some type of pollution permit. Five coal powered projects in Florida have already died in the last year, forcing utilities to shift to gas.^[1]

1. ↑ Chesapeake- A top energy play

Natural gas has been stuck in the $6 to $8 range the past two years, but the CEO believes a multi-year trend is emerging that will result in natural gas prices in the $8 to $10 range. Futures prices support McClendon. Generally, NG prices pull back during the summer months when demand drops, and storage withdrawals switch to injections. However, the future curve depicts higher gas prices all the way out to March 2009. Not only does this suggest higher prices in the future, it also benefits CHK now since it’s an active hedger.

CHK applies more coverage than most its peers, reducing sensitivity to the commodity. While this can cap gains to the upside, it limits downside exposure that could destroy a producer. I think it’s a very smart move. Management is placing certainty on an uncertain variable. Natural gas prices are set by the market, and CHK has no control as price-taker. While many companies rely on volatility as a source of profits, CHK focuses on aspects it can control, such as its competitive advantage it drilling.

CHK has massive amounts of acreage that it acquired at attractive prices. It has been ramping up drilling, and production will continue to increase drastically. Rising gas prices coupled with increasing production will provide a significant boost to revenues.

Furthermore, Natural Gas prices have been on a tear recently. There has been an increased, longer-term bullishness on the commodity. One reason stems from bloated storage levels that are being worked off. Current levels are about 5% higher than the 5-year average, down from levels that were nearly 35% above 5-year average. Gas has a difficult time moving higher when excess supply exists.

Natural Gas is a clean energy, and there has been no shortage of “green” dialog recently. This heightens the pressure for utilizing the clean resource in place of dirty fuels when feasible. Coal energy is a target. Investment bankers are expressing reluctance to engage in bond deals for new coal power plants. Bankers express apprehension about future legislation on carbon emissions that could financially penalize power plants. The fear is that revenues that go towards paying down the bonds would be diverted to paying for carbon credits or some type of pollution permit. Five coal powered projects in Florida have already died in the last year, forcing utilities to shift to gas.^[1]