Chesapeake Energy and the Nature of Risk

Perhaps at some level, you can say that investing is almost solely about risk management -- comparing the risk of a given investment against its reward, and only diving into those opportunities with the best trade-off. Risk management is certainly a big part of running an energy company as well, so it might be that Chesapeake Energy (NYSE: CHK  ) is both riskier and less risky than the sector to which it belongs.

First things first. Chesapeake reported another quarter of strong growth in revenue, earnings, and production. Revenue jumped 51%, operating income 58%, and EBITDA 77%. Production was up 26%, with nearly half of that coming from the company's own "organic" efforts. Chesapeake is rather unusual in the extent of information it offers to shareholders, including up-to-date reserve information that continues to show strong reserve replacement, but at fast-rising costs.

Chesapeake Energy is all about natural gas and U.S. production. In fact, while others like EOG, XTO Energy (NYSE: XTO  ) , EnCana, and Devon (NYSE: DVN  ) all feature high proportions of gas to oil and U.S. to international production, Chesapeake is tops in both among its peer group.

But here's the thing about that. First, it is risky to be essentially a one-product company (natural gas in this case), but Chesapeake has hedged a substantial part of that risk away -- more than 90% of the next quarter's production is hedged, as well as about two-thirds of '07 and half of '08. Moreover, since Chesapeake owns and operates its own drilling rigs, it's effectively hedged against rising rates from Nabors (NYSE: NBR  ) and Patterson-UTI (Nasdaq: PTEN  ) as well.

Moreover, the company is pretty much solely interested in U.S. onshore opportunities. That means no risks of nationalization or expropriation like we've seen at Occidental (NYSE: OXY  ) , no threat of the hurricane damage sustained at Apache's (NYSE: APA  ) Gulf of Mexico operations, and little need to worry about expensive gas-to-liquid conversion to bring product to market.

Of course, we're still talking about a company that has made aggressive bets on a future with sustained higher gas prices. Production and finding costs are trending well above recent averages, and it's true that those hedges only go so far (in terms of timing and production coverage). And while I definitely believe that Chesapeake merits real consideration at today's prices, I also believe that near-term worries about natural gas prices (whether exaggerated with respect to Chesapeake's particular degree of exposure or not) could make for a rockier go of it at times.

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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).


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