Chesapeake Energy (CHK) is another fallen energy giant that hit my radar as a value investment. Since the collapse of natural gas prices in 2008, Chesapeake has watched its book value and share price fall drastically. The fluctuation in natural gas prices took a very severe toll on CHK shareholders, who thought the company was undervalued in the $30's and $40's based on their reserves and the price of natural gas in the futures market. With 22,900 trillion cubic feet of proven net reserves, things seemed rosy for investors when natural gas traded for $8 per MMBtu. Today the December contract printed $3.70.
While I am watchful of executive compensation and I remember being a bit skeptical of the rosy 2007 annual report, I do not think the company made as major of an error as many analysts think over this time period given the large, abrupt crash in prices for natural gas. After all, if you want to make money selling any commodity, you probably hold a lot of it in inventory and want the price to rise.
While most business owners want the price of their commodity in inventory to rise (for say, a gold mine or oil field owner) there are some instances in which you are ambivalent towards moves in the prices of the commodity you sell. In Chesapeake's case, they have hedged a substantial portion of their assets by selling short natural gas futures contracts. Usually, derivatives make me nervous, but with Chesapeake I think they are being rational and aggressive in protecting their shareholders over the long haul. Say what you will about McClendon, but the man has one of the best long term track records of shareholder value creation.
Could investors be wrongly assuming that the recent fall in natural gas prices is a good reason to sell CHK? This is the topic that concerns me the most. Is CHK undervalued even if natural gas prices fall 50% from here (which I highly doubt and think the opposite is likely)?
From what I can find from my research, CHK shorted some 70,000 or so natural gas futures call option contracts with an $8 stike price with expirations ranging from 2010-2013. While I am no expert in natural gas trading, I have used covered call options for some time and believe in their merit and value. Furthermore, investors should note that CHK claims their "offensive" hedging strategies have earned them over $5 billion over time and that shares of CHK have risen from around $.75 cents in 1999 to $21 today... While the pain from the current drop to $21 and change from the 2008 peak of $65 and change is severe, the value that Chesapeake has created is undeniable.
CHK owns a vast amount of the most valuable shale fields and gas fields in the world. While short term demand or oversupply is hurting the company's profits, an aggressive covered call strategy could make up for a substantial portion of lost profits if properly executed.
The backwardization in natural gas at present makes me sort of nervous for the hedge in a vacuum, but if viewed as a covered call, the option would only start losing money if gas doubles -- in which case CHK will surely grow profits book value and earnings, let alone intrinsic value.
In the end, CHK is tied fairly directly to natural gas prices. I am not worried about their liquidity and I think McClendon is a very capable CEO. I am invested in the January 2011 $15 call options and have sold the November $22 call options against them -- So I guess you could say I have an extra hedge in there myself...
From a valuation perspective, the books show 14.8 billion of net tangible book and the market cap sits at 13.8 billion. While not a big discount, I expect CHK to be very profitable going forward, so the margin of safety should grow from here.
Disclosure: Long CHK call spreads
No comments:
Post a Comment