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