Chesapeake Delivers Again

If you are going to invest in a natural gas company, I doubt you can do any better than shares of Chesapeake Energy (CHK). CHK has everything investors should want; a great management team, a low valuation, and strong business fundamentals.

The company did little to sway my opinion after reporting first quarter earnings last week. Net income excluding one-time items came in at $1.07 per share, well ahead of expectations. The conference call was equally impressive, but you wouldn’t really know it from the share price. After jumping about 4% after the numbers came out, the stock has barely budged.

I want to point out a few things that I think investors are missing when it comes to analyzing Chesapeake. As is the case with many commodity-related companies, the day-to-day movements of the stock tends to track commodity prices (in this case, natural gas) and not company-specific fundamentals. Of course, the prices energy companies get for their production is a key component of how their financial results will turn out, but focusing simply on daily fluctuations in natural gas prices, and trading CHK shares based on that, is very misguided for long term investors (yes, it does make sense for day traders since we know that is how the stock has been trading lately).

What is interesting about Chesapeake is that they are actively engaged in a natural gas production hedging program that seeks to lock in prices for their gas well into the future, in order to ensure that they can earn returns on capital that are acceptable for shareholders. Amazingly, CHK has hedged 80% of their 2006 natural gas production at $9.45 per mmbtu. Why is this amazing? The current natural gas price is about $6.65, so CHK is getting 40% more for their gas than their competitors who have not hedged. As a result, it doesn’t take a rocket scientist to figure out that not ALL natural gas stocks should track natural gas prices.

Let’s take this silliness one step further. For some reason (which I cannot explain in a way that makes logical sense) Wall Street analysts exclude any gains from CHK’s hedging program in their quarterly earnings estimates. The company’s first quarter numbers were reported as $1.07 versus estimates of $0.98 per share. Estimates for 2006 are around $3.40 per share, putting Chesapeake’s P/E under 10. But the hedges aren’t even factored into these numbers!

Chesapeake made $122 million in Q1 from their hedges, which comes out to $0.29 per share. In reality, the company reported $1.36 in earnings, not the $1.07 that was reported by the press and analysts. Since this is real money that the company is generating, I can’t ignore it when valuing the company. After all, investors haven’t ignored the hedging program at Southwest Airlines (LUV), which is a big reason they have performed so well even with $70 oil.

Including adjustments for hedging gains, CHK could earn north of $4.50 this year (annualized Q1 hedging), which puts its adjusted P/E at around 7 rather than 10. Yup, that’s right, the stock appears cheap and is actually even cheaper!

 

It’s Tough Not To Like These Guys

For those of you who follow energy companies, and Chesapeake Energy (CHK) more specifically, I highly recommend you listen to the company’s fourth quarter earnings conference call that was hosted this morning.

The company’s shares have been weak lately as natural gas prices have been cut in half and the company’s co-founder and chief operating officer, Tom Ward, suddenly announced his retirement from the company at the fairly young age of 46 years old.

I can’t recall a more impressive conference call this quarter. They even had Ward on the phone to address any concerns over his unexpected departure. You don’t see that type of focus on shareholders’ interest every day from management teams of publicly traded companies.

The Energy Debacle

The following numbers were pulled from the October 2005 report from the Energy Information Administration:

Total worldwide oil demand:
2004 – 82.5 million barrels per day
2005 – 83.7 million barrels per day
2006 – 85.6 million barrels per day

Total worldwide oil supply:
2004 – 83.0 million barrels per day
2005 – 84.3 million barrels per day
2006 – 85.5 million barrels per day

As readers of this blog are aware, I think buyers of energy stocks are current prices will be handsomely rewarded. Most are down 20% or more this month alone. ConocoPhilips (COP) has forward P/E of 6.4x. Occidental (OXY) is 7x. Plains (PXP) is 8x.

It is true that dramatic commodity price erosion from here would put these estimates in jeopardy, and therefore make these P/E’s irrelevent. However, when I see numbers like the ones from the EIA, along with $60 oil and $13 natural gas today, I tend to think the reaction right now on Wall Street is out of line. We’ll just have to wait and see.

OXY Purchase of VPI Implies Energy Undervaluation

Late yesterday we learned that Occidental Petroleum (OXY) is buying Vintage Petroleum (VPI) for $20 cash plus 0.42 OXY shares. This represents a huge premium (33%) over yesterday’s closing price and 12.5 times VPI’s 2006 estimate of $4.13 per share. This deal very much backs up my contention yesterday that energy multiples are too low.

Take Plains Exploration (PXP) for example, and their 2006 consensus expectation of $4.44 in EPS. If investors put the same 12.5 multiple on PXP that OXY was willing to pay for Vintage, you get an implied buyout value of $55 per share for Plains, about 50% higher than its current share price.

Energy Selling Overdone

With the XLU down 15% from its high, you’d think energy prices were tanking. Instead we have $63 crude oil and $13 natural gas. While a warm winter would bring natural gas prices down considerably from here, earnings estimates for energy companies right now are probably based on no more than $50 oil and $7 natural gas, nowhere near where we are now.

Stocks like Chesapeake (CHK), Suncor (SU), and Plains (PXP) are trading at 8-10 times 2006 earnings. Plains is getting crushed today, in fact, on news of charges it will be taking from its hedging positions. However, that will be money well spent since it assured they could get high prices for their product in 2006.

Unless energy prices plummet from here, current earnings numbers will prove conservative. The volatility is hard to stomach, but these stocks are too cheap to ignore if you don’t have your 10% position in energy yet.

The Epitomy of a Contrarian Stock Market Bet

1) I am the most heavily shorted stock on the New York Stock Exchange with over 240 million shares sold short as of May 2005, equal to 45% of my float.

2) I am the cheapest stock in terms of price-to-book ratio in the S&P 500 index, trading at less than 50% of my tangible asset value.

3) My share price was once as high as $58 in 2001, but since then my stock has dropped by 95 percent.

4) Wall Street analysts dislike my stock immensely and many have a “sell” rating on it.

5) I am in the midst of a restructuring focused on selling assets and paying down and/or refinancing debt.

6) I am Peridot Capital’s most recent purchase.

WHO AM I?

Market Holds Up Despite Oil Spike

All year we’ve heard numerous pundits citing high oil prices as a main reason for the market’s year-to-date losses. However, after seeing oil spike from the mid $40’s per barrel up to nearly $57, along with a stock market that is holding up very well, we can see that oil has not been the primary driver of stock prices, up or down.

Instead, it’s all about interest rates. Speculation of the Fed stopping at 3.5% Fed Funds, coupled with tame inflation data recently, has more than made up for higher energy prices in the minds of investors. This is not to say oil prices are completely irrelevent, but rather to imply that if the market gets everything else it is looking for, $60 oil most likely will not hold back equity prices in a meaningful way.

So, where are interest rates headed? You may have noticed that in a relatively short period of time the consensus view has shifted from “Greenspan always overdoes it and will take rates too high which will slow the economy” to the current view that “Inflation is low and Greenspan doesn’t want to overdo it again so he’ll stop after 1 or 2 more hikes, taking Fed Funds to 3.25% or 3.5%.”

The consensus on the 10-year bond has also shifted from “It’s just a matter of time before we see 5%” to “We could stay under 4% for a very long time.” Bill Gross of PIMCO has even said publicly that he sees the 10-year going to 3% in the next couple of years.

While I certainly think we could see the rate hikes come to a halt at 3.25% or 3.5%, and would welcome such a development from an investor standpoint, I’m not as convinced as most are that this will occur. I still think there is a good chance we’ll get to 4% Fed Funds, with the 10-year bond around 4.5%.

If this happens, the market will have to once again adjust expectations and we could give back some of the recent gains. I have been playing this thesis by trimming some equities during this run-up, along with shorting the 10-year bond under 4%.

Plains Exploration Update

Here’s a quick update to the piece I wrote on April 1st regarding one of my favorite energy stocks, Plains Exploration (PXP). If you missed it a few weeks back, you should take a look, but the jist of it was that Plains sold some oil wells to XTO Energy (XTO) and used the proceeds to get rid of some old oil price hedges it had in place (that were preventing it from reaping the full benefits of $50+ oil).

As I pointed out, the stock was up 3% that day, to $36 a share. Since then, oil has fallen from a high of $57 to the current $50, and Plains stock has dropped from 36 to 31. It was obvious that earnings estimates were going to rise with the new strategy, but how much exactly was unclear on the day of the announcement.

Well, a quick look at Wall Street’s updated profit numbers for PXP shows even more of a positive impact than I had anticipated. EPS estimates for 2006 have gone from $3 to $4 per share. The stock, meanwhile, has dropped 15 percent. The current P/E on ’06 is less than 8 times.

On days when oil prices are weak and the stocks are suffering, Plains is one stock that should be accumulated, in my opinion.

Why Do Analysts Hate NOVA Chemicals?

Investors can look to three places for thoughts on a particular stock; Wall Street analysts, the company itself, and one’s own personal opinion. Shares of NOVA Chemicals (NCX) have dropped 12 straight points. The analysts hate it (Prudential just slapped a “sell” on the stock yesterday). The company is very upbeat and current earnings estimates look impressive. So why is the stock getting crushed?

I think the main reason is that chemical companies are very cyclical and are extremely reliant on commodity prices cooperating in order to make a nice profit. With input prices rising and uncertainty as to if that trend will continue or come back down to earth, investors are afraid of these stocks.

That said, at what point do we say that all of that has been more than priced into the shares? NCX stock trades at 9.3x 2005 estimates and 5.7x 2006 profit expectations. Yes, that’s less than six times earnings! Even if you use the lowest estimate for 2006 on the Street, you get a P/E of 7.4x.

Investment theory says that low P/E’s on cyclical companies are a signal of a peak in their profit cycle. However, the company is fairly early in their recovery and company executives don’t see 2006 as the peak. Instead, they figure 2008 is a better guess. NOVA is a controversial name in a controversial industry, but I think the stock is worth much more than $40 per share.

Unlike Airlines, Plains Exploration Updates Hedging Strategy

A press release issued today by Plains Exploration and Production (PXP) shows what smart management teams can do for investors. In prior pieces I have highlighted that mismanagement of oil price hedges has caused the major domestic airlines to lose billions of dollars. A deal announced today by Plains worried me a bit after reading the headline. It said “Plains Exploration to Sell 275 Oil Wells in $350 Million Deal With XTO Energy.”

I wondered why Plains, a stock I own personally and for clients, would be selling oil wells at this point in time. After all, those very wells are the reason I own and like the stock. However, after reading the release I realized how great of a move this was.

Plains Exploration will use the deal’s proceeds of $350 million to eliminate all existing 2006 oil price swaps and collars. You see, all oil companies have some type of hedging program in place, for the sake of some predictability of cash flow. So even if crude oil was $55 per barrel, energy companies rarely get market prices for all of the oil they produce. Plains has 2006 oil price swaps in place involving 15,000 barrels of oil per day at an average price of $25.28 and an average ceiling price of $34.76. With oil in the mid $50 range, you can see that they would have to leave some profit on the table with these hedges in place.

However, eliminating these swaps and collars will cost about $295 million. The proceeds from the XTO deal will more than cover that expense, and the move will tremendously increase future cash flow. “These transactions remove the significant headwind that the company has experienced in 2004 and 2005 from our previous hedge positions, which negatively impacted cash flow,” said Chairman, President and CEO James Flores. In addition, the company has acquired $45 put options on about 40,000 barrels of oil per day in 2006. These options ensure $45 per barrel, whereas the ceiling from their prior swaps was less than $35 per barrel.

Not surprisingly Plains shares are rallying 3% today. Still, shares only trade at 12x 2006 earnings estimates, and those estimates will surely prove too low given the company’s new hedging strategy.