Chesapeake Energy Boosts 2008, 2009 Production Forecasts on New Discoveries

Following up my March 12th post on natural gas producer Chesapeake Energy (CHK) (More on Chesapeake Energy), on Monday the company announced major new discoveries and boosted its production growth forecast for the next two years.

Thanks to a huge find in the Haynesville Shale in Louisiana, in addition to seven other new finds, Chesapeake now expects 2008 production to grow by 21% (vs 20% a month ago) and another 16% in 2009 (vs 12% a month ago). An additional $950 million in capital expenditures will be required between now and year-end 2009 to fund these projects, which will result in CHK tapping the financial markets for capital.

While capital raises were not in CHK’s prior plans, the company has already started to increase its hedges (thanks to the recent run-up in natural gas prices), in order ensure that shareholder returns on these new projects are substantial. Chesapeake has now hedged 71% of its 2008 production at $8.77 per mcf, 40% of 2009 production at $9.13 per mcf, and 12% of 2010 production at $9.34 per mcf.

To give you some perspective, CHK averaged $8.14 per mcf of gas in 2007 and $8.76 in 2006. So, CHK’s averaged realized price should be around 2006 levels this year, but production will be about 50% higher than it was two years ago. I bring this up because Chesapeake earned $3.61 per share in 2006 and the current 2008 estimate is only $3.54 per share. It appears CHK will earn more than the current consensus estimate in 2008. Analysts’ 2009 projection of $3.46 also appears too conservative.

Full Disclosure: Long shares of CHK at the time of writing

Should We Buy the PetroChina Stock Warren Buffett Sold?

First of all, let me say that I think Warren Buffett’s investment in PetroChina (PTR) was probably one of the most impressive bets he has ever made. Before China or energy were hot commodities he found a company that was emblematic of both and turned a $488 million investment into $4 billion, an astounding 700%+ return in five years. I’m not sure where that ranks among his all-time best investments (Buffett experts, please let us know), but it is surely his best in recent memory.

Buffett sold his PTR stake in the 150’s, after which the stock soared to above $260 per share. China’s market has since dropped precipitously, and PetroChina shares now sell for around $120 each. Despite Buffett’s decision to exit the stock (20% above current levels), I think PetroChina looks like a good investment today.

Before I get into why I think so, let me share what Buffett had to say about his PTR investment in his recently released annual letter to shareholders:

“We made one large sale last year. In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By 2007, two factors had materially increased its value; the price of oil had climbed significantly, and PetroChina’s management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $4 billion. A footnote: We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government – defense, social security, you name it – for about four hours.”

First of all, the paragraph quoted above tells us that when Buffett says his desired holding period for an investment is “forever,” that is not entirely true. He buys a stock that he feels is undervalued, and when it reaches fair value in his mind, as PTR did, he sells it. I think any investor trying to outperform would be advised to do the same.

Now, there are some interesting things about this story to mention. When Buffett started buying PetroChina the price of crude oil was $25 per barrel. He tells us in his letter that at that time he felt the stock was worth about 1.7 times its actual market price, or $100 billion.

If we use his own valuation and simply adjust it to reflect higher oil prices, we can determine an approximate value for PTR right now. Oil trades at $100 per barrel today, so that implies Buffett’s valuation model gives PTR an intrinsic value of $400 billion, or $223 per share.

Now, you might ask if that math should be trusted why would Buffett choose to sell last year for only $150 per share? Well, it just so happens that crude oil was trading at $70 per barrel when Buffet sold PTR. Since then oil prices have jumped another 50%, which would imply that had he used a $100 oil price assumption, Buffett’s fair value for PTR would be about $225 per share. Pretty darn close if you ask me.

So, did Buffett sell PetroChina too early? Well, that depends on how you view the energy landscape. If you think that energy prices are in “bubble” territory and are overvalued at current prices, then he probably got out at a great time. However, if you are like me and think the bull market in commodities (including energy) has a lot of time left to go which could push crude oil to $150 or more in coming years, then yes, Buffett left a lot of money on the table that investors can now take for themselves. After all, PTR trades at $122 per share right now, about 80% below Buffett’s own fair value calculation if you believe oil prices stay elevated long term.

Full Disclosure: Long shares of PetroChina at the time of writing

More on Chesapeake Energy

“madhatter” writes:

After reading your old post, I’m just curious as to why you personally like CHK out of the bunch? Based on fundamentals alone, it seems like DVN or SJT might be a better play on nat gas (even though I realize the latter is a trust). Does CHK have something that I’m missing? Because their fundies seem to put them in the middle of the pack as just ‘average’ in terms of nat gas players. Thanks for your thoughts.

I neglected to expand very much on Chesapeake Energy (CHK), since I’ve written about it before (to read prior posts simply do a search for “chesapeake” from the left sidebar of this blog), but it has been a while so let me go into more detail. Here are four main reasons for my bullish stance on CHK:

1) Chesapeake is the largest independent domestic natural gas producer

This is beneficial for several reasons. They have a very large, diversified asset base from which to grow production and reserves. When you are such a big player and have extensive experience drilling in different areas of the country, it gives you an advantage that should lead to very high success rates with future drilling programs. Also, it means Chesapeake would be an ideal acquisition target for one of the big oil giants at some point in the future if and when management decides to consider an exit strategy.

2) Industry leading production and reserve growth

Indeed, the numbers back up the points made above. Chesapeake’s organic production and reserve replacement rates are among the highest in the large cap natural gas sector (they might be the highest, but I do not have data in front of me to prove that, so I will include the “among” qualifier). In 2007, CHK increased gas production by 24% over 2006 levels and the company’s reserve replacement rate was a staggering 369%. Company guidance for 2008 is for 21% gas production growth, followed by another 13% in 2009.

I think you will be hard-pressed to find large natural gas producers that are posting organic growth rates much higher than that (clearly small firms can have large growth rates due to a small starting base). As a result of past growth and the expected continuation of it for the foreseeable future, I feel Chesapeake’s fundamental outlook is as strong as, if not stronger than, the competition.

3) Extensive Hedging Program

Chesapeake has the most extensive gas hedging program in the industry. The company has 70% of 2008 gas production hedged, as well as 33% of 2009 production. I like the hedging program because it reduces the commodity price risk the company faces, so its earnings stream is very predictable. The gas market is very volatile, and as a result, Chesapeake doesn’t get hurt too badly when prices fall, but when markets are strong (or weather patterns cause temporarily sharp increases in prices) the company steps in and increases its hedges to lock in high prices that might not be realized otherwise.

4) Superior Management, Insider Buying

CEO Aubrey McClendon has been one of the most aggressive insider buyers of his company’s stock that I know of. Given his superb track record of producing strong financial results, this is not surprising. McClendon has long been singing the praises of his company’s stock, but unlike most executives who do so, he has been putting his money where his mouth is (and he’s been right). He is the largest individual shareholder in the company he co-founded. In 2008 alone he has purchased more than 1.63 million shares of CHK on the open market at prices between 35 and 46 per share. That is ~$70 million of his own money! Investors should feel comfortable that they are investing right alongside him. Plus, with such a large stake in the company, you can bet that when he wants to retire, the company will be up for sale to maximize shareholder value.

The reader mentions Devon Energy (DVN) and San Juan Basin Royalty Trust (SJT) as other, potentially more attractive natural gas plays. I am actually a big fan of Devon. However, it’s not really a pure play on natural gas (they are 50/50 between gas and oil). If you are looking for a well balanced domestic energy exploration and production company, I agree DVN should be near the top of your list.

Royalty trusts are interesting plays, given their high yields, but they tend to be less geographically diversified and have less financial flexibility. SJT, for instance, focuses on New Mexico, so their asset base is not diversified and they are much smaller than Chesapeake.

Also, while the high dividends of trusts are attractive, they really do not allow company management to be flexible in how they grow the business. When you pay out most of your income out as a dividend, you don’t have much capital available to grow faster organically or make acquisitions. Rather, you are forced to sell debt to raise money, which isn’t always an ideal funding mechanism (like now when credit markets are shaky).

So those are my thoughts on Chesapeake. Although I am a big fan of the company, there are definitely plenty of very good energy companies from which to choose from. Do you have other favorites? Let us know which ones and why you prefer them!

Full Disclosure: Long shares of CHK at the time of writing

Natural Gas Update

In July of last year I wrote that the United States Natural Gas Fund ETF (UNG) looked ripe for gains after a 30% drop from $54 to $38 per share. In recent weeks natural gas has become a hot commodity, with prices hitting $10 last week, up from under $6 last year. UNG shares have jumped 25% to $47 each and I think some profit taking is in order. Long term I still like energy in general and gas specifically, but at this point I think owning hedged exploration and production stocks makes more sense than owning the gas ETF after such a large increase in underlying commodity price.

Which gas stock would I point readers toward? Long time readers will be bored with this company, but Chesapeake Energy (CHK) continues to be my favorite domestic natural gas stock (newer readers can refer to my September 2006 piece entitled An Attractive Entry Point For Chesapeake Energy). Like UNG, CHK too has risen sharply (from $29 to $44 since that bullish article), but they have the advantage of being able to hedge prices for their ever-growing production, so they will get hit much less than UNG during the next natural gas sell off, which will surely come despite the recent renewed enthusiasm for the commodity.

Full Disclosure: Long CHK at the time of writing

SandRidge Is An IPO To Watch

In general, IPO investing is not a very rewarding experience. If you can get in on a hot deal at the offering price, then obviously you can make good money, but studies have shown that recent IPOs lag the market in general after they are available to the public. The reason is pretty simple. More often than not, corporations will choose to sell stakes in their companies when they think they can get a very good price. If the firm gets a good price by selling, investors certainly can’t expect to get a good deal when buying simultaneously.

Now, this is all generally speaking. Of course, there are plenty of IPOs that are selling stock because they have reached a certain size and are seeking a way to fund growth. If they succeed in growing as they plan, investors could make very good money investing early on. A recent IPO that I think is worth watching is SandRidge Energy (SD), a natural gas producer run by Chesapeake Energy (CHK) co-founder Tom Ward.

As I have written here before, I am a big fan of Chesapeake as a long term play on the domestic natural gas market. As far as I can tell, they are the best company in the business, and are currently the leading independent natural gas company in the country. CHK was co-founded by Tom Ward and Aubrey McClendon in 1989 and until last year they ran the company together, Ward as COO, McClendon as CEO.

Initially there was worry when Ward left Chesapeake, but as time went on it became clear that he wanted a new challenge. Now he is running SandRidge Energy, a smaller but rapidly growing firm focused on Texas exploration. Is the fact that a very smart and successful guy like Ward is at SandRidge enough of a reason to buy the stock? In my view, it very well could be. When you have someone who has been as successful as anybody at finding natural gas reserves, it bodes very well for a new company he left a great job to focus on.

If you are bullish on the natural gas market long term, as I am, SandRidge is certainly a company to watch. The stock is up nicely from its recent IPO. The stock was initially indicated to price between $22 and $24 per share. Higher than expected demand pushed the offering price to $26 and the stock opened at $32 on the first day of trading. Today it’s trading above $33 per share. I would suggest waiting for a pullback before buying in, but SD is definitely a company to watch as it continues to grow.

Full Disclosure: Long shares of Chesapeake Energy at the time of writing

Thoughts on Crude Oil’s Record High Above $88 Per Barrel

I have recently suggested investors consider taking some profits in the crude oil market, but prices in the low 80’s price range has not stopped the commodity from continuing its ascent. Crude oil is hitting new historic highs today above $88 per barrel. The contrarian in me prefers to buy weakness and sell strength, so even though the current rise could continue, I am not going to jump on the momentum train and suggest people pile into crude in the short term. Longer term, though, I think it is worth taking a look at what will ultimately dictate where oil prices go.

To understand oil market dynamics, one can simply boil it down to supply and demand. There is a debate right now among energy watchers as to whether or not we are actually reaching a peak in world oil production. Obviously, if that is indeed the case, and demand continues to rise on the heels of a global economic expansion, higher oil prices are the likely result. However, official projections from various agencies still project that production will increase to meet higher demand, despite evidence in recent years that production gains are easier said than done.

Consider information from the U.S. Energy Information Administration. The EIA’s own data shows that despite a trend of ever-increasing oil demand around the world, production has actually been leveling off. In 2005 and 2006, world oil production was 84.63 and 84.58 million barrels per day, respectively. Estimates for 2007 stand at 84.72 million barrel per day.

As you can see, world oil supplies have been essentially flat for the last 3 years. Interestingly, energy experts have predicted production increases in the past for this period, but such gains have not been realized. This data gives the “peak oil” theorists some ground to stand on.

Once again, the EIA is projecting 2008 oil production worldwide to increase meaningfully, to 87.06 million barrels per day. If this forecast proves true, those suggesting that international oil production has already peaked will be dismissed. However, if production fails to meaningfully rise during 2008 in the face of higher demand (for the fourth consecutive year), chances are the oil markets will reflect this dim supply/demand outlook in the form of higher prices.

The chart below shows the data I have referenced above in graphical form. In my view, this is the trend we should be watching to see where oil prices are headed in the intermediate to longer term. The short term, however, is anyone’s guess.

Source: U.S. Energy Information Administration web site

Crude Oil Might Be Ripe for Some Profit Taking

Short term movements in energy markets are very much tied to supply and demand. Seasonal variations in the dynamics for crude oil and natural gas can allow for some very successful trading in these areas. With crude oil prices sitting around record highs of $79 per barrel, and the summer driving season winding down, it might be prudent to take some chips off the table if you purchased shares of the United States Oil Fund (USO) as I suggested back in January when the crude oil ETF was down 40% from its high.

Since then shares of USO have risen more than 35% to $59.43. This is not to say that I would get off of the energy train for good. But if you have an elevated exposure to crude oil specifically, maybe take some profits. Oil prices could go up further if we get any strong hurricanes in the next month or two, but the seasonal oil play is nearing an end, so lower prices would not be surprising as we head into the winter.

Rather than move out of energy completely, moving some crude oil funds into natural gas would be a good value alternative given that natural gas prices are depressed right now. Winter heating season is coming soon, so there will be more potential catalysts for that commodity in coming months. Natural gas plays would include the previously recommended United States Natural Gas Fund ETF (UNG), Chesapeake Energy (CHK), as well as Select List pick Gastar Exploration (GST).

You may have noticed that Warren Buffett is trimming his position in PetroChina (PTR), the large Chinese oil producer. I doubt these actions are being made on a short term trading prediction (Buffett is the epitome of a long term investor), but it reinforces the need to buy low and sell high to maximize returns.

Crude oil is on a roll right now, and that fact makes it hard for some people to not want to keep riding the wave, but selling into strength is a crucial strategy for those looking to maximize long term investment returns. Buffett’s purchase of PTR as a play on both China and crude oil, before those two areas were popular investments, should go down as one of his best investments in recent history. And yet, he isn’t being shy about taking some profits.

Full Disclosure: Long shares of CHK, GST, and UNG at the time of writing

Consider Natural Gas ETF for New Energy Investments

Quite predictably, crude oil has been on a roll in recent weeks as the summer driving season has driven seasonally strong performance. With oil trading around $75 per barrel, fresh money investments into the energy sector might not be ideal at these prices. Don’t get me wrong, I am still bullish on oil in general, but investors should not jump on the energy bandwagon with new money when we are in the middle of peak oil season.

For new money right now I would suggest investors take a look at natural gas. In fact, in mid April a new ETF was formed to track natural gas prices. Even while oil has soared from the low 60’s to the mid 70’s, natural gas has collapsed from more than $8 to below $6. Another non-existent hurricane season has contributed to the drop, but natural gas prices will remain volatile in the future, and given the weakness lately, it appears to be an attractive entry point.

The natural gas ETF trades under the symbol UNG and has plummeted from above $54 to $38 in the last couple of months, as you can see from the chart below. After a 30 percent drop, I think it looks attractive for investors looking to add some energy exposure but are wary of buying crude oil stocks at current prices. You can also play this via unhedged natural gas producers, but since this ETF is new, I figured I would point it out as another potential investment vehicle in the space.

Full Disclosure: No position in UNG at the time of writing

Until Consumer Habits Change, Energy Stocks Should Continue to Shine

It’s amazing that gas prices hit $4 per gallon in Chicago and San Francisco even before the summer driving season officially started. There are several reasons why we are paying so much to fill up our gas tanks but the one that I think is most important is not talked about as much as it should be.

As you can see, SUV sales as a percentage of vehicle sales has more than doubled over a ten-year period. Since SUVs are far less fuel efficient than cars, they account for a large portion of the increased oil demand in the United States.

There is no doubt that the Iraq war is contributing to high energy prices (oil production there is below pre-war levels), as is rising demand from emerging economies like China and India. However, the habits of the U.S. consumer is the largest contributor to our country’s sky-high energy use, and as a result, record-high prices. After all, what we do in this country has a profound effect on the energy market. Despite only representing 5% of the world population, we consume 25% of its oil.

The way I see it, the culprit is the rise of the sport utility vehicle in the United States. Many people who drive SUVs are quick to complain about paying $60 to $70 or more to fill up their tanks each week and accuse the oil companies of gauging prices (which is a ridiculous, baseless claim), but they are a large part of the reason gas prices are north of $3 per gallon nationally as I write this.

If you don’t believe that America’s love affair with SUVs is affecting gas prices, one glance at the numbers might change your mind. The statistics below are from the Environmental Protection Agency (EPA), an organization that tracks U.S. energy use very precisely. I don’t think it is just a coincidence that there has been a direct correlation between SUV sales, petroleum use, and gas prices. After all, the oil markets are based on supply and demand. With worldwide supply flattening out, demand is crucial in determining price levels.

I am not a fan of heavy government involvement as far as dictating human behavior is concerned, but I would not be opposed to increasing incentives for people to ditch their SUV, as well as higher CAFE standards for fuel efficiency. If we could reverse the trend of SUV prominence, oil demand is this country would drop, and prices would follow suit.

For those who need to drive SUVs, that’s fine, but they need to understand that higher gas prices might be a cost of driving a larger vehicle, and that blaming the oil companies for high prices is ignoring how the global oil market works. The biggest improvement could come from those who own SUVs without a real need for it.

Until driving habits in the U.S. change, gas prices will remain high and oil companies will continue to reap the benefits on their income statements. As long as the trend shown in the graphic above remains intact, investors should continue to hold a healthy dose of energy stocks in their portfolios.

Response to Iran Rumors Shows that Energy Should Be Owned as a Geopolitical Hedge

In case you haven’t heard yet, oil prices spiked more than $5 per barrel late Tuesday on rumors that Iran had fired shots at U.S. warships. Although the gains were pared once the news went unconfirmed, one only needs to imagine what would happen if heightened geopolitical actions were indeed reality. In such an environment, energy stocks will serve as a hedge for your portfolio and as a result, avoiding them is not advisable given the global political situation we currently find ourselves living in.

The energy sector represents 10% of the market cap of the S&P 500, so it isn’t difficult to determine if you are dramatically underweight these stocks or not. When you couple shrinking global supply with increasing demand worldwide and geopolitical instability, it’s pretty hard to make the case that oil prices are headed back to $30 per barrel. Add in the fact that the summer driving season is right around the corner and it’s not hard to imagine gasoline back over $3 per gallon and oil prices back in the 70’s.

Investors can play the group via the crude oil exchange traded fund (symbol USO) or any number of exploration and production companies. As for individual stocks though, if you want to get exposure to rising oil prices, make sure the company you buy doesn’t have a large amount of their future revenue hedged at lower prices. Such companies will likely see less movement than those who are mostly unhedged.