Wall Street Likely to Yawn Despite Another Blowout Quarter for Chesapeake Energy

The hardest thing for value investors oftentimes is to stand by one’s convictions, even when Wall Street doesn’t seem to take notice of what you see. Shares of natural gas producer Chesapeake Energy (CHK) have been doing nothing for more than a year. Many investors have likely grown tired from Wall Street’s yawns and have moved on to more hip names. However, CHK’s fourth quarter earnings report issued yesterday afternoon once again shows that the company is clicking on all cylinders.


Chesapeake reported earnings of $0.90, 13 cents above estimates of $0.77 per share. Revenue came in at $1.87 billion, versus the consensus view of $1.52 billion. Spectacular quarters are nothing new for CHK, as they have reported stellar results for many quarters in a row now. However, the stock has merely been tracking the commodity price of natural gas, ignoring the fact that shares trade at 8 times trailing earnings and 5 times trailing EBITDA.

The weakness in Chesapeake shares, relative to its operating results, is likely due to two things. First, CHK has issued a lot of convertible debt to fund increased natural gas production, and continues to do so. In order to hedge their positions, buyers of the convertible debt simultaneously short the common stock in order to lock in the income generated from the convertible securities. The good news is that the land grab that CHK has embarked on is largely over so they are doing fewer acquisitions. In fact, CHK’s long term debt actually fell in Q4 for the first time in a long, long time.

Investors also worry about falling natural gas prices when analyzing Chesapeake shares. This explains why CHK has been following spot gas prices for months now. This logic, though, ignores CHK’s massive hedging activities (they sport the most aggressive hedging program in the industry). The company has hedged 50% of their gas production above the current market price for both 2007 and 2008. As a result, commodity price risk should not be a large concern for CHK investors.

As value investors know, it often takes a long time for Wall Street to realize that they have mispriced equities. Over the long term, CHK stock has reflected the value of its underlying business, even when short term movements do not. This time should be no different. And if the company’s management team grows tired of waiting for their value to be realized, they surely would have numerous options if they were to sell their company outright to get out of the fickle public marketplace.

Full Disclosure: Long CHK common stock, as well as the preferred “D” shares

Is Halliburton’s Discount Warranted?

As energy investors are aware, shares of Halliburton (HAL) have been trading near historically low valuations for much of the recent past. I have largely dismissed the discount as being merely a consequence of having a huge amount of U.S. government business due to the Iraq war. Once that is over, or as soon as the Bush Administration was out of office, my thinking went that huge no-bid contracts allowing the company to charge the government anything they wanted would vanish, and Halliburton’s financial performance would lag. Hence, the stock is discounting this reality in the marketplace.

With the Halliburton spin-off of its KBR (KBR) subsidiary, all of the sudden we have the division with much of the Iraq war criticism tied to it trading on its own. After Halliburton disperses its majority stake to shareholders, Halliburton will look a lot more like a leading oil services company, and much less like a company being propped up by the Bush Administration, and more specifically, former CEO Dick Cheney. Interestingly, in 2006 KBR represented 43% of sales for HAL, but only 7% of operating income.

The KBR-free Halliburton would once again be a good comparable for Schlumberger (SLB), the other large services company that, before the war in Iraq, traded very similarly on Wall Street. With such a scenario unfolding, there might not be a good reason to have a such a wide valuation disparity between the two largest energy services firms.

Both stocks have similar dividend yields of around 1% per year. HAL trades at 12.3 times 2007 profit forecasts, versus 16.8 times for Schlumberger. As much as I wanted to come to another conclusion, based on political views of the Iraq war, I must admit that the stock is cheap. A purely long play on HAL, or a paired trade with a short Schlumberger position to play a possible narrowing of the valuation gap, could be attractive.

Full Disclosure: No positions in the companies mentioned

After a 40% Drop, Crude Oil Might Be Nearing Bottom

With warm weather and worries over a slowing economy globally, crude oil has been under extreme pressure in recent weeks. While such a dramatic turn of events has been great for prices at the pump, energy investors likely aren’t too enthused. As you can see from this chart, the U.S. Oil Fund ETF (USO) has fallen more than 40%, or 30 points, from its summer high.

Is oil making a bottom, or do we have a lot further to fall? I have little doubt that part of the recent selling flurry has been from the hedge fund community, and therefore has exacerbated the move downward. I don’t think we’ll see $35 or $40 per barrel crude oil anytime soon, and as a result, bottom fishing might be in order here.Also consider that energy could hold up relatively well in a market correction, so that portion of one’s portfolio could very well limit losses to some degree, if and when we finally get a meaningful correction in the stock market.

Investors looking to participate in an oil play could go with the USO exchange-traded fund, or turn to individual oil stocks to collect dividend payments in addition to any share price appreciation. Canadian oil trusts tend to offer some of the highest yields in the industry.

Full Disclosure: No positon in USO at time of writing

Chesapeake Energy Delivers Again

The chart above hardly looks like a company that has been clicking on all cylinders for the last 12 months. However, it serves as an example for investors that short-term stock movements oftentimes do not reflect the true fundamentals at publicly traded companies. Shares of Chesapeake Energy (CHK), as you can see, have been moving sideways for a year.

It is interesting to note, however, that CHK management has been doing an exceptional job at creating value for shareholders. During this time, Chesapeake’s book value has risen by more than 140 percent, from $4.2 billion on 9/30/05 to $10.2 billion on 9/30/06. The company’s public enterprise value, though, has only risen by about 10 percent during that time, leaving one to conclude that the stock price has a lot of catching up to do in coming months.

Note: the stock price has dropped slightly over the last year, but the enterprise value of the company has risen due to share count dilution, both from the issuance of convertible preferred stock and additional equity used to fund CHK’s expansion.

Chesapeake reported another excellent quarter last night, as Q3 earnings hit $0.83, 11 cents above consensus estimates and 3 cents higher than the most bullish projection on the Street. Revenue hit $1.93 billion for the period, versus estimates of $1.47 billion. Most impressive of all, CHK raised its production growth targets for 2007 and 2008, from 11% and 6%, to 16% and 12%, respectively.

Wall Street analysts are currently projecting Chesapeake’s earnings in 2007 to be flat, followed by a drop in 2008. However, given the production growth that the company seems comfortable in forecasting, natural gas prices would have to fall meaningfully for such an outlook to prove accurate. I suspect that Wall Street is overly pessimistic about Chesapeake’s earnings power over the next couple of years (and beyond). As a result, I would not expect the stock to continue to trade sideways indefinitely, as it has for the last 12 months.

Full Disclosure: I own shares of Chesapeake Energy (CHK) personally, as do my clients.

Attractive Entry Point for Chesapeake Energy

The recent energy pullback (correctly predicted on this blog a few weeks ago on 8/24) provides some interesting entry points for long-term energy bulls. Crude oil has dropped from the high 70’s to $65 per barrel and natural gas has dropped from $8 to $5 and change.

As I have mentioned previously, for the short to intermediate term, I believe natural gas is a better bet than crude oil. I don’t think we are heading back to $50 crude anytime soon, and most of the correction is likely behind us. However, future catalysts bode well for natural gas prices, as well as leading producers such as Chesapeake (CHK) and Anadarko (APC). After recent corrections, those two names trade at less than 9 and 7 times 2007 estimates, respectively.

Why is natural gas attractive down here at around $5.50 per unit? Two reasons that I can see. One, with no major hurricanes yet this season, investors are beginning to price in the best case scenario for natural gas bears, namely that we will have no damaging storms this year. The investing game is all about comparing current expectations with future probabilities. If we do get a big storm or two, natural gas will zoom right back to $8 or $9. Without a storm, the current expectations prove accurate, and prices likely stay the same. All in all, not a lot of downside from current levels in either scenario.

Let’s look past hurricane season to factor number two; the winter. Last year we had a very warm winter, which served to limit natural gas heating demand, and quickly brought prices down from elevated levels reached after Hurricane Katrina. Now I’m not a weather forecaster, and even if I was the odds I’d be correct wouldn’t be very high, but chances are good that we could have a colder winter this year. Again, it’s all about expectations. Current natural gas prices are pricing in moderation with respect to both the remaining hurricane season and winter temperatures. If we get a surprise on either front, or both, there is nice upside to natural gas prices and the leading domestic producers.

Full disclosure: I own Chesapeake personally and Anadarko would be my second choice if I needed to pick another name in the group.

Hurricane Season Tepid Thus Far

Here we are halfway through hurricane season and we’ve seen very little activity. In fact, peak season is coming up here in September, so if we can get through another month without a major storm, investors need to consider the ramifications of an average season after last year’s devastation.

The prime beneficiaries of a light-to-average hurricane season would be the re-insurers who decided to continue offering coverage, albeit at much higher premiums, in the Gulf Coast and Atlantic regions even in the wake of Katrina. Higher premium income and lower claim payouts make for solid profitability. The catastrophic loss re-insurers are still down considerably from their highs after the Katrina backlash, so upside remains fairly meaningful. It is true, however, that it only takes one storm to ruin everyone’s year.

Without major storms disrupting the nation’s energy supply, we might also have seen the peak in oil for now. Any spikes in natural gas might also be avoided in the short term. The future direction of the energy markets will then likely be determined by how cold of a winter we get. Last year a mild winter brought natural gas prices down considerably, from a Katrina high of $15 down to under $6. Colder weather this year could serve to boost natural gas prices back up as supplies would be diminished greatly. Aside from geopolitical events, it appears that crude oil prices have peaked, at least for now, as summer driving season will be coming to an end.

So, just to recap. Take a look at the catastrophic re-insurers, and if you are interested in energy, there is probably more upside in natural gas than crude oil over the next quarter or two.

So Much for Reducing Foreign Oil Dependence

News that the largest oil field in the United States, BP’s Prudhoe Bay in Alaska, is being shut down is bad news for those who want to reduce our dependence on foreign oil. Prudhoe Bay represents 8% of U.S. oil production and a full 10% of BP’s worldwide daily production.

Crude prices are up nearly $2 per barrel on the news. Hopefully hurricane season will be more modest this year, or else there will be even more pressure on energy prices going forward. Supply constraints might be mitigated slightly given that crude supplies are fairly high and countries like Saudi Arabia have said they can offset some of the lost production in Alaska.

Just what we need… more Mideast oil…

Even at Record Prices, Oil Stocks Barely Budge

If you are in the camp that oil will be heading back to $40 or $50 per barrel anytime soon, I’m afraid you are sorely mistaken. After hitting new record highs earlier in the week, crude prices are still above the previous highs set last hurricane season. Surprisingly though, energy stocks mostly sit decently below their 52-week highs.

I haven’t written about energy lately, but I am still bullish on the sector and recommend investors continue to overweight the group in their portfolios. Single digits P/E multiples coupled with attractive outlooks make the stocks very attractive, especially in a market where very few stocks have worked thus far in 2006.

Energy bears will focus on the lack of supply constraints currently in both the crude oil and natural gas markets. However, merely focusing on what the situation is right now misses the point. Barring a global recession, energy demand will continue to rise and supply will have a hard time expanding at a rate that keeps pace. Surely there will be periods of both low and high supplies, based on weather patterns and other factors, but investors should focus on the big picture. As long as annual oil demand continues to rise, and few new wells are discovered across the globe, the bull market for energy will continue.

As far as where to look for investment opportunities, I continue to focus on the producers and sellers of the actual commodity, as opposed to the equipment and drilling suppliers. Rig owners, for example, will profit based on day-rates, or the price of renting out their rigs. There is nothing stopping more rigs from being built, thereby reducing the prices the equipment companies can charge to lease them. And who knows what would happen to the fortunes of a company like Halliburton (HAL) after the Bush administration has left office.

Conversely, it is much more difficult to find new sources of oil. As a result, those exploration and production companies with the best assets will continue to thrive in a tight energy market. Leading E&P companies can be had for between 6 and 9 times earnings, quite a bargain if you ask me.

 

Anadarko Announces Two Large Buyouts

I can’t recall a time when a company has announced two large acquisitions at the same time. Today we hear that Anadarko Petroleum (APC) will buy both Kerr McGee (KMG) and Western Gas Resources (WGR) for more than $21 billion in cash. With Anadarko’s market cap around $22 billion before the deals were announced, they are essentially doubling the size of the company overnight, creating the country’s largest independent exploration and production company.

Both of these purchases show just how undervalued energy companies are in the public markets these days. Anadarko is paying a 40% premium for Kerr McGee ($16.4B) and a 49% premium for Western Gas ($4.7B). Despite these huge cash premiums, the deals will be accretive to earnings. Few seem to disagree that our natural gas needs will continue to rise, but for some reason the stocks trade at exceptionally low valuations. This has resulted in a lot of M&A activity, and likely will continue to do so.

Different Paths Taken by Enron’s Past Management

Last week Ken Lay and Jeff Skilling were found guilty on numerous charges related to the demise of Enron. Today we hear that Richard Kinder is heading up a bid to take Kinder Morgan (KMI), his energy pipeline company, private in $100 per share deal. It’s very interesting that these two events are coming only days apart.

For those of you who are not familiar with Richard Kinder, he was the President and Chief Operating Officer at Enron ten years ago and was seen as CEO Ken Lay’s successor. However, Kinder left in 1996 after a falling out with Lay, and Jeff Skilling took his job. We all know how that ended up.

Kinder, however, always saw the future of Enron as a dominant pipeline company. Owners of oil and natural gas pipelines act much like toll booths, collecting fees as energy is transported over their infrastructure, regardless of the price of the commodity. Conversely, Lay wanted Enron to focus on energy trading and much more risky ventures.

Kinder, along with partner Bill Morgan, co-founded Kinder Morgan Inc (KMI) and actually bought Enron’s pipelines from Lay. It’s not hard to see which strategy turned out to be right. Kinder is the majority owner of KMI and sees so much value in the company that he wants to take it private for $13.5 billion. Enron is, well, completely worthless.