Ignore Chesapeake Energy at Your Own Peril

The country's second-largest natural-gas producer, Chesapeake Energy (NYSE: CHK  ) , has been going through a rough patch in the past 12 months. Although Chesapeake has boosted production a great deal, cash flows did not witness significant growth, as natural-gas prices have plummeted more than 50% since last year. But I believe things are going to change in the future. Read on, and you will see why.

The problem 
Crude oil currently trades at about $103 per barrel. In contrast, natural gas currently trades for less than $2 per thousand cubic feet, or Mcf -- which means that the current price differential between crude oil and natural gas is around 52-to-1. However, one barrel of crude oil is roughly equal to 5.8 Mcf of natural gas, which gives a ratio of just 6-to-1 on an energy-equivalent basis.

Nothing lasts forever
Even an eighth-grader can spot the enormously skewed nature of energy prices. Either crude-oil prices will have to fall or natural gas is trading well below what it should. Now, falling oil prices seem pretty unlikely, but rising natural-gas prices seem probable in the future. Cheap natural gas will eventually find takers as companies exploit the economies of scale and develop more ways to put this cheap commodity to use. I suspect the trucking and electric-utilities industries are the first in line to do so. Whoever it may be, Chesapeake, as a producer, should stand to gain in the near future.

Things do not look rosy for the company right now. The balance sheet reflects nearly $11 billion in debt and a debt-to-equity of more than 60%. But what looks really worrisome is its tottering capital ratio of 0.4 times. With just $350 million in cash and a burgeoning working capital, liquidity concerns are at an all-time high. This may even affect daily operations, but at present there doesn't seem to be a problem with that.

Wise moves
The company announced three separate cash transactions totaling $2.6 billion to divest oil and gas assets. This also includes a 10-year deal to sell natural gas at $4.68 per Mcf from its Anadarko Basin Granite Wash play, which has proven reserves of 160 billion cubic feet  of natural gas equivalent. Now that's what I'm talking about. Liquidity concerns should be taken care of now. I believe this is the best possible move in current circumstances. SandRidge Energy (NYSE: SD  ) -- another company in debt -- did the same thing by divesting its assets in Wolfberry, N.M., and Texas, only to botch it by making an ill-timed acquisition of Dynamic Offshore. Fortunately, management at Chesapeake hasn't gone for such aggressive and foolish moves.

Quietly moving in for the kill
While Chesapeake has been increasing its liquids production to make the most of current market conditions, there's no doubt about its firm grip on natural-gas assets, because that's where the potential lies. Even private equity firms are planning to cash in on the lucrative natural-gas market. Kohlberg Kravis Roberts (NYSE: KKR  ) is pumping in $225 million, which Chesapeake will be deploying in various projects.

The biggest incentive is from the trucking industry, which sees natural gas as a cheaper alternative to gasoline. Last month, fellow Fool Jeremy Bowman gave us the lowdown on why things are looking ripe for natural-gas demand to pick up. While Jeremy thinks it will take time to see a conversion en masse, it will eventually happen, with trucking companies like Clean Energy Fuels (Nasdaq: CLNE  ) and Westport Innovations already taking bold steps. In fact, Chesapeake has already invested $150 million in Clean Energy, which is building a network of 150 liquefied natural-gas stations along major highway segments.

Foolish bottom line
All in all, Chesapeake looks like a smart investment right now. Foolish investors should dig deeper and move in early, as it is potentially undervalued at this point. All you need to do right now is add the company to your free watchlist.

However, if you're looking for more ideas, our analysts have created a new special oil report titled "3 Stocks for $100 Oil," which you can download today, absolutely free.

Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. The Motley Fool owns shares of Westport Innovations. Motley Fool newsletter services have recommended buying shares of Westport Innovations, Chesapeake Energy, and Clean Energy Fuels. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (7) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 17, 2012, at 3:33 PM, EnergySkeptic101 wrote:

    Peril is the operative word. Nat Gas will continue to plunge as the market becomes oversupplied through the fall of 2012. Chesapeake wisely cut production but the other majors refused to follow suit. Most producers are now operating below the break-even point.

    As this article adeptly reveals Chesapeake's debt position looks scary and they know it. The BlackStone Group and Kohlberg Kravis Roberts releaved some of this debt. But, mark my words, they are not saviours but vultures.

    A quick glance at Blackstone's and KKR's history of collusion (think BioMet here) suggests they might be positioning themselves for an eventual buy-out, afterall this is their speciality. The know the Nat Gas production bust is coming and will be poised to aquire more if not all of Chesapeake at a bargain.

    That won't bode well for Chesapeake's investors in the short run but will ultimately benefit BlackStone and KKR as Nat Gas prices stabilize in 2013 and rebound in 2014 when the economies of scale the article mentions finally come online.

    Bottom line, sell Chesapeake and other Nat Gas producers with high debt and little cash. If you want to invest in Nat Gas for the potential "brave new world" on the horizon, buy Blackstone or KKR, they may own most of Chesapeake soon anyway.

  • Report this Comment On April 17, 2012, at 3:54 PM, EnergySkeptic101 wrote:

    Follow-up:

    Chesapeake Sells $2.6 Billion in Assets to Blackstone, Exxon

    TPG Capital and EIG Global Energy Partners LLC are also in the mix here.

    Is this staging for a buy-out...which could make or break this stock for investors?

    Or is the emerging "investment-energy complex" --coining that phrase here--- looking to shore up Chesapeake so the good times may roll for awhile longer?

    Conpiracy theories aside, this Nat Gas senerio reminds me more of the telecom boom than the 1980s gold fiasco. Well the bottom may fall out soon, the U.S. will be postioned to take advantage of Nat Gas in the future. Yet, the future will arrive too late for a great number of small producers in 2012.

    Sorry for the typos, I'm a commentor not a blogger :)

    Read more: http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2012/04/09/...

    Read more: http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2012/04/09/...

  • Report this Comment On April 17, 2012, at 5:03 PM, ravens9111 wrote:

    Soon they will have to give nat. gas away for free. Nat gas storage companies have been doing well in the past, but if nat gas producers can't turn a profit, why would they continue producing at these levels? It's a no brainer. Stay away from anything nat. gas related. There is no demand for it, no matter the price. The energy policy for the U.S is the culprit. Same can be said for coal stocks. We should all buy solar panels and wind mills for our energy needs. Just look at First Solar. Now that's the company to invest in.

  • Report this Comment On April 17, 2012, at 6:31 PM, TicoHombre wrote:

    When a prolific and highly useable form of energy is as cheap as NG is, the internal economic pressure will eventually acquiesce. I think the author does a decent job of making that point. Yes, I believe an 8th grader can see it, too. Funny how so many smart grown-ups can't.

    Good, balanced article!

    Thanks!

  • Report this Comment On April 18, 2012, at 2:57 AM, isacsimon wrote:

    @ EnergySkeptic101

    Hmm, that's a contrarian view. You could be having a point there. Thanks!

    -Isac

  • Report this Comment On April 18, 2012, at 2:57 AM, isacsimon wrote:

    @ TicoHombre

    Thanks!

    -Isac

  • Report this Comment On April 18, 2012, at 3:12 PM, medgul wrote:

    Ignore CHK at my peril? I am glad I did.

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