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CHK - Chesapeake Energy


bmichaud
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After reading the "Unconventional Oil Plays Not Appreciated by Investing Public" thread on the general discussion board, I did some reading on CHK and wanted this board's opinion regarding CHK's valuation. (information taken from the Company's November 2010 Investor Presentation - please find attached)

 

In a November 2010 Investor Presentation, management values the Company on a sum-of-the-parts basis using recent third-party transactions, arriving at an estimated NAV per fully diluted share of $71. In the same presentation, management estimates that 2011 net income per fully diluted share will be $2.45 (assuming $5.00 nat gas and $85 oil). For the sake of argument, let's assume the company-estimated NAV is accurate, and that the 2011 EPS is representative of sustainable free cash flow to equity.

 

Based on recent transactions for acreage similar to CHK's, it is apparent the oil/gas industry values CHK's assets much higher than the equity market does. IMO, this is due to the equity market's focus on earnings versus the true value of CHK's assets. This is where my question for the board comes into play...

 

Although CHK's NAV, based on recent transactions for comparable properties as seen in the investor presentation, is well above the Company's current equity market capitalization, shareholders will not realize that value in the form of cash flow unless those assets are sold. While these assets have "hidden value" if you will, the only cash flow currently available to equity holders is via FCF to equity. With nat gas prices so low, I do not believe shareholders will realize the same value from ongoing operations as they would if CHK focused solely on selling its leasehold interests. Yes NAV is estimated to be well above the current market price of equity, but unless the return generated on those assets via operating activities is above the cost of those assets, the market may never value the assets equivalent to the recent transactions in the marketplace.

 

This is where I am struggling - the value of CHK's acreage is highly valuable in a strategic sale scenario, but based on the FCF to equity generated by the assets, the estimated intrinsic value is much lower than the estimated NAV (20X 2011 EPS of 2.45 is $49). By the way, using EPS as an estimate for sustainable FCF to equity is presumptuous IMO b/c I believe the Company underestimates depreciation expense in its EPS calculations - in depth analysis is still needed, I am just trying to get a feel for how this board approaches a situation like this.

 

So my question is simply, how does this board approach a situation such as this, where NAV is very high relative to a FCFE-based intrinsic value estimation? Will the market ultimately realize the value of these assets or will depressed cash flow continue to devalue the assets?

 

Thanks in advance for any responses!

 

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My issue is I dont know much, but I am guessing that not all acreage is created equally. Who knows whether they are selling the best acreage for high prices and then extrapolating that to the rest of the position. Also the majors can afford to wait out higher gas prices. This could be a 10 year transaction for them. Buy, hold, and wait till prices hit $8. Buy, work to increase demand and exports via lobbying, hedge, then drill. They also need to keep reserves flat and gas works for that. If not they will be seen as companies in liquidation.

 

You may not have a 5 year to 10 year time horizon. I know I dont. Still on the sidelines but will buy one day probably.

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Ya it's tough - it's such an asset-rich company but I could see it wallowing for awhile at today's prices. Who knows.

 

Perhaps a Berkshire "elephant" candidate? Buffett has a 100y investment horizon as evidenced by the Burlington deal, so he would be more than fine letting Sokol run CHK while waiting for higher nat gas prices. Just a thought

 

 

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Hi,

 

I wrote the article you referred to you in your post.  I've been wrestling with what to do (if anything) about CHK for months.  You can follow my thinking as I regularly contradict myself here:

 

http://valueinvestorcanada.blogspot.com/search/label/CHK

 

Where I currently am in my thinking is this.  I agree that the share prices the NAV calculations today arrive at (verified by numerous asset sales) are not likely ever to be reached if we are stuck at $4 going forward.  However, I don't think there is much chance buying today results in much of a loss of your investment over time even if $4 gas persists.  There are a couple of very real chances for a homerun here.  One is obviously that natural gas prices improve which is possible (given CHK and others are going to decrease drilling).  The second is that they claim to be amassing a huge portfolio of unconventional oil and liquids assets.  If you look at just the Eagle Ford acreage they recently did a JV on you can see they created about $7 of shareholder value in about 6 months.

 

I still only hold a token amount of shares, but I'm sure I'll see something again this week that either tempts me or convinces me not to buy.

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I am long Chesapeake and here is my analysis. I believe in inverting any analysis so I welcome counter thoughts.

 

The dollar is no longer a store of value so what can you buy for that purpose? Bonds are dangerous because the low interest rates will invevitably rise back to normal returns. Most quality stocks such as J&J have a high price which may reverse if the economic environment worsens. What will the price of these stocks be when interest rates double? Bad economic policy usually ends with a weak currency and inflation. Ask any Mexican. So cash seems good now but it is risky.

 

Energy is a good store of value. Natural gas is a bargain relative to oil. You don't buy CHK for the near term cash flow. You buy it for insurance. Buffett described how time is the friend of stock in a good company. Time is a friend to Chesapeake because it is a store of value for times of trouble. When investors become frustrated and desperate to preserve their wealth the cost of that insurance will rise sharply. One day investors will realize it is safer to hold a store of value like Chesapeake rather than cash or bonds and its price will rise accordingly. In the meantime the CEO seems to repeatedly create value by buying the next big thing before his competitors.

 

 

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So my question is simply, how does this board approach a situation such as this, where NAV is very high relative to a FCFE-based intrinsic value estimation? Will the market ultimately realize the value of these assets or will depressed cash flow continue to devalue the assets?

 

Isn't that the classic assertion, or question, for a value investor?

 

The balance sheet gives you one value and the (adjusted) income statement another.

 

Reading Graham, or Walter Schloss for that matter ("good things will happen" if you buy cheap enough), there are many statements to the effect that price will rise to value in due course. It's a statement based on their experience -- and supported by their respective records as investors over many years (and compare Buffett's discussion in The Superinvestors of GrahamAndDoddsville article).

 

But to any of us, there is something of an article of faith about it. From our own experience, we know that price doesn't necessarily rise to value -- there's even an expression for that circumstance: we've bought a "value trap".

 

It's why Buffett (following from Graham's teachings) makes the point again and again that "you're not right because others agree with you; you're right because your facts and reasoning are right".

 

Possible answers to your question can be summed up in two positions, namely that someone, somewhere is right, or someone, somewhere is wrong. Teasing the threads apart, here are some possibilities:

 

  • CHK management, perhaps together with the industry itself, is simply fooling itself and paying way more for these properties than can be justified from fundamentals. In other words, they are speculating (in Graham's use of that term). The properties are currently priced as if they were Rembrandts -- and as long as healthy market for Rembrandts exists CHK may be able to unload them (or JV them) at a profit. Long term, of course, this strategy will mean a loss of capital -- Just as happened when Time Warner merged with AOL Online at the peak of the internet craze.
  • The corollary of the above item is that this is where circle of competence comes into play in a massive way. Those who actually know the industry and understand how values are calculated will be able to make a proper judgement about these buys. The bet in CHK may still not work out -- things happen, after all -- but if your process is correct, that's as well as any of us can do.
  • It may be that your FCFE analysis is wrong. The CHK analysts who set the purchase price for these properties must fundamentally be using some method that uses discounted cash flows. I read Lowenstein's book on the mortgage crisis. He follows some small-ish investors who took the other side of the subprime bet. They were constantly asking where their analysis (that subprimes would fail spectacularly) was wrong. "Who's on the other side of the bet, and what is their motive?"
  • On a slightly different point, perhaps the choice of FCFE as the valuation model for CHK isn't the best. Perhaps there's some sort of option value going on here.
  • We don't have this ability (being, in Whitman's phrase, POMI - passive outside minority investors), but in the situations you mention, guys like Graham took an active part in the company management, and forced the sale of assets that weren't earning their keep, or caused a change in management who did a better job in putting the assets to use.
  • Being a little more modern, guys like Gabelli look for trigger events (they use a different term for it, which I don't remember at the moment), events that will force a sale. Five years is a long time in a company's life; a lot can change. If there's no trigger in sight for CHK, it may simply be that an investor in CHK (like me) is early.

 

No doubt there are other possibilities.

 

Cheers,

 

jacko2

http://priceisnotvalue.com

 

 

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for what its worth, the new acreage is in McMullen County in the Eagle Ford Shale . . . I would assume in the northern part of the county where the oil window is - and where CHK already owns acreage. This looks like one of the best parts of the play, with 100'-200' foot thick Eagle Ford, and 40MM barrels of oil in place per section (CHK anticipates a 6-10% for oil).

 

at 640 acres per section, that works out to 3,750 - 6,250 barrels of oil recoverable per acre.

 

That is a cost of $2.30 per bll at a 6% recovery and only $1.38 per bll at a 10% recovery . . .

 

obviously wells need to be drilled and the oil produced over a number of years (also, there is twice as much wet gas in each well as there is oil, which is not included in the above numbers). A well will produce about 200k bbls of oil and 2.4Bcfe of wet gas, about half of which is produced in the first ten years (25% of the total in the first two years! which really helps the economics). Wells cost $5.5 million, so the payback period is probably about one year.

 

These wells won't be drilled for a while (although 30% of CHK's rigs are currently in this county last time I looked).

 

Breakeven for these wells is under $50 per barrel, so paying about $2 per barrel (what CHK is paying for the land), sounds like a good idea if they can drill it with a one-year payback and likely a 100%+ IRR by the time they get to it.

 

I believe CNOOC has the option to "participate" in 1/3 of any further acquisitions, which I assume they will do here.

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  • 3 weeks later...

Any thoughts on natural gas pricing? It still seems several years away at best....

 

cheers

Zorro

 

 

for what its worth, the new acreage is in McMullen County in the Eagle Ford Shale . . . I would assume in the northern part of the county where the oil window is - and where CHK already owns acreage. This looks like one of the best parts of the play, with 100'-200' foot thick Eagle Ford, and 40MM barrels of oil in place per section (CHK anticipates a 6-10% for oil).

 

at 640 acres per section, that works out to 3,750 - 6,250 barrels of oil recoverable per acre.

 

That is a cost of $2.30 per bll at a 6% recovery and only $1.38 per bll at a 10% recovery . . .

 

obviously wells need to be drilled and the oil produced over a number of years (also, there is twice as much wet gas in each well as there is oil, which is not included in the above numbers). A well will produce about 200k bbls of oil and 2.4Bcfe of wet gas, about half of which is produced in the first ten years (25% of the total in the first two years! which really helps the economics). Wells cost $5.5 million, so the payback period is probably about one year.

 

These wells won't be drilled for a while (although 30% of CHK's rigs are currently in this county last time I looked).

 

Breakeven for these wells is under $50 per barrel, so paying about $2 per barrel (what CHK is paying for the land), sounds like a good idea if they can drill it with a one-year payback and likely a 100%+ IRR by the time they get to it.

 

I believe CNOOC has the option to "participate" in 1/3 of any further acquisitions, which I assume they will do here.

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  • 3 weeks later...

There may be a discount, too, because McClendon has somewhat of a mixed reputation for corporate governance after his forced sale of stock from a margin call in '08:  [ftp=ftp://http://www.chk.com/news/articles/Pages/1208445.aspx]http://www.chk.com/news/articles/Pages/1208445.aspx[/ftp].

 

He was then reloaded with stock by the BOD, which raised further concerns about corporate governance.

 

 

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  • 1 month later...

 

I think this one is a bigger deal than the others.  This is a transaction specifically for debt reductions.  The others just kept help funding more acreage buys (which was well worth it). 

 

The market wanted debt reduction, now they have confirmation that it is actually coming. 

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  • 2 weeks later...

OMG.. I think there is some big disconnect between the market and these transaction prices.

 

I think the Majors are overpaying (reserves dont create themselves), but they have the muscle to really push nat gas as a transportation fuel so perhaps not.

 

Its nice to see CHK get cold hard cash, and nice to see the assets in deep firm hands. Perhaps more rationality will return to the gas markets.

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