3 Reasons to Sell Chesapeake Energy

For Chesapeake Energy (NYSE: CHK  ) investors that had no experience with migraine headaches, the events of recent months have offered an unfortunate introduction to the condition.

Unflattering portrayals by the media aren't always a good reason to hit the "sell" button though. Sometimes overblown concerns make good headlines, but don't mean as much when it comes to an investment thesis.

With that in mind, let's take a look at three legitimate reasons why Chesapeake might be a sell today.

1. Natural gas prices
In times past, Chesapeake liked to refer to itself as "America's Champion of Natural Gas." It was a fitting title -- as of today, the company is the second largest natural gas producer behind ExxonMobil (NYSE: XOM  ) in the United States. But the company doesn't tout that title in quite the same way today.

A glance at the company's most recent quarterly report reveals why. Natural gas prices have been cratering since a peak in 2008. For the first quarter of 2012, Chesapeake notched $478 million in natural gas sales. That was down from $788 million the year prior, and it was thanks to a dive in the average sales price -- from $3.24 per thousand cubic feet to $1.77.

CEO Aubrey McClendon hasn't taken that price drop sitting down -- the company has been spending a considerable amount of money to shift its production to include more oil. For the first quarter, oil sales were up to $743 million from $400 million the year before.

But this is still a very natural-gas-heavy company. At the end of last year, 83% of the company's estimated proved reserves were natural gas. And we don't have to guess at the trouble that sustained low natural gas prices could cause for Chesapeake -- the company spells it out in its quarterly report:

Sustained low natural gas prices, and volatile commodity prices in general, could have a material adverse effect on our financial position, results of operations and cash flows, which could adversely impact our ability to comply with financial covenants under our credit facilities and further limit our ability to fund our planned capital expenditures. In addition, sustained low commodity prices could result in a reduction in the estimated quantity of proved reserves we report and in the estimated future net cash flows expected to be generated from reserves that may require us to write down the carrying value of our natural gas and oil properties, and such amounts could be material.

2. Management
If you've followed Chesapeake at all, you had to know this one was coming. The more that comes to light about McClendon, the harder it is to swallow the fact that he's still the chief executive of this company.

Even after a relentless reputational battering, the market still values Chesapeake at more than $12 billion, and we're talking about a company that boasts total assets of $46 billion. McClendon built Chesapeake from the ground up and I think he definitely deserves credit for that.

That said, McClendon has run Chesapeake like his own personal kingdom. He's taken advantage of sweetheart deals that let him invest directly in Chesapeake wells, gotten the company to sponsor the basketball team that he's a part owner of, and wrangled outsized pay packages that rival those at Chevron (NYSE: CVX  ) and ConocoPhillips (NYSE: COP  ) , two of the world's largest energy companies. In 2010, McClendon had a total pay package of $21 million versus $16 million for John Watson at Chevron and $18 million for J.J. Mulva at ConocoPhillips.

Meanwhile, through a big leveraged gamble on Chesapeake shares, McClendon's ownership has fallen to well below 1%.

Should this matter to investors? It should. A CEO is the steward of the company for the shareholders, who, in the end, are the real owners of the company. In the case of McClendon, it seems like shareholders have a fox guarding the henhouse.

3. The next shoe to drop
The recent revelations about McClendon and Chesapeake have been ugly and, as they continue, they only seem to get worse. The most recent issue to come to light was the alleged collusion between Chesapeake and Encana (NYSE: ECA  ) . That allegation has led to an investigation of both companies by the U.S. Department of Justice.

What's next? It seems like the sky is the limit when it comes to shady dealings at Chesapeake. While the continued drip, drip, drip of new scandals has battered the stock, there hasn't been a report that's really dropped a big bomb on shareholders -- but could that still be waiting in the wings?

The more that Chesapeake has its reputation maligned, the more difficult life may become for it as it tries to sell assets, secure funding, and conduct day-to-day business. If people sitting across the table from Chesapeake start to feel like they can't trust the company, the reputational damage could start to have some very real, tangible costs.

Try another direction
How confident am I that Chesapeake's stock will continue to decline? Not very. If I were, I'd short the stock or at least rate it an underperformer in my Motley Fool CAPS portfolio. While I think there are some very real risks facing investors, I also respect the fact that the stock is very severely beaten up at this point and could have a nice recovery if the disaster train it's on right now starts to turn around.

Instead of going in either direction on Chesapeake, my preference is to simply steer clear and look for other opportunities. Investors that want to stick with energy stocks may want to check out one big idea from The Motley Fool in the free special report, "The Only Energy Stock You'll Every Need." You can get a free copy of the report by clicking here.

 

The Motley Fool owns shares of Chesapeake Energy Corporation and ExxonMobil. Motley Fool newsletter services have recommended buying shares of Chevron and Chesapeake Energy Corporation. 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.

Fool contributor Matt Koppenheffer owns shares of Chevron, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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  • Report this Comment On July 06, 2012, at 2:43 PM, ronbeasley wrote:

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