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IVS: Chesapeake Energy (CHK)
Chesapeake Gets Religion

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By TMFAdmiral
December 11, 2008

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Hi Insiders,

I'm writing an article on Chesapeake Energy but I thought that I'd post the main contents here first

Two week's ago I and many others castigated Chesapeake management's filing to issue shares to fund capital expenditures (CapEx) and future acquisitions - particularly at current share prices. After the announcement the shares dropped by 50% in a week. This week the company reversed its decision canceling the CapEx filing and cutting the acquisition filing in half to 25 million shares. These shares are earmarked to resolve some Haynesville lease disputes and to acquire other leaseholds. CEO McLendon clearly stated on the conference call (cc) that in no way would these shares be issued at current prices.

Asset Monetization
The other really great news is that McLendon has finally got the message that investors want Chesapeake to grow from its own cash resources and stop issuing a combination of shares and debt to finance excess CapEx. In other words they'll balance expenditures to income (better stick with it this time!!) In addition the company has announced a new VPP (Volumetric Production Payment - essentially selling future production) and is likely to announce another shortly. This year the company has sold one play, entered into joint ventures (JV's) and VPP's that will realize $11.7 billion. Chesapeake estimates the cost of these assets at $3 billion making a net gain to shareholders of some $8.7 billion. In addition one of these JV's will result in the partner paying $2.3 billion in future CapEx to shareholder benefit. Although asset monetization reduces reserves it is the most efficient source of cash today - much better than issuing shares or debt.

Capex and Growth
On the other side of the ledger Chesapeake will reduce drilling CapEx by $2.9 billion for 2009/2010. The drill rig count will drop to 110/115 by early 2009 - down from the present 130 and the summer peak of 158. In addition acquisition CapEx will drop by $2.2 billion for 2009/2010. Combined with the asset sales this will drop production growth to between 5% and 10% in 2009 and 10% to 15% for 2010. For per share valuation purposes the reduced growth is pretty much balanced by the reduction in share dilution so I'm staying with $56 valuation.

Debt and Liquidity
Chesapeake carries a significant debt load and in these credit conditions liquidity has been a concern. On the cc McLendon stated that current cash was $1.5 billion and that he expected that to rise to between $2b and $2.5b by the year end. CHK intends to have $4b of cash by 2009 year end. Year end debt is expected to be $12 billion (down from $14.5b) and shareholder's equity $18 billion - up from $16.5b (D/E ratio 0.67 - down from 0.87 - still somewhat on the high side although lower than XTO Energy it's a lot higher than Cimarex (XEC) conservative 14%). Additionally none of the long term debt is due in the next five years. The revolving credit line is good for another 3 years and the company has no concerns that it is anywhere close to its covenants.

Natural Gas Prices & Hedging
Many are concerned about NG prices (CHK is 92% NG and 8% oil) at below $6 per mcfe. But as McLendon pointed out in the cc CHK has 76% (only 12% knockout swaps) of 2009 NG hedged at an average $8.20 per mcfe. What this means is that if NYMEX NG prices average $7 in 2009, CHK will still realize about $8 - even at $4 average NG, CHK would realize around $6.50. I think that the $7 average to be likely and normally winter will see prices top out around $8. Going forward into 2010 50% of NG is hedged at an average $9.50 per mcfe. For my base valuation I have the long term average at $7.90 (that is $7.50 at the CHK wellhead. McLendon has forecasted $7 to $9 over the next two years (due to lower demand) but expects the long term between $8 to $10.

Reserves
One way of valuing an O&G company is to put a price on its reserves as this is the likely acquisition cost for the company. One recent deal valued the sold assets at $4.50/mcfe and one prospective deal is expected to realize $5.60/mcfe, earlier sales were at lower prices. The company had 12.1 tcfe of reserves at the end of September and expects between 13.5 to 14 tcfe by 2009 year end. Using $12 tcfe & $4/mcfe as a base this puts the proved reserves alone at $48 billion. With net debt at $10 billion this values the company on proved reserves alone at $36 billion - allowing for the 25 million share dilution this puts the per share value at $57 with no allowance for probable reserves. New proposals to allow companies to allow a percentage of probable reserves in the reserve calculation would put Chesapeake's 2009 year end reserves close to 20 tcfe - at the same valuation basis this puts shares in McLendon's $100+ range. A bit optimistic I think but at least the potential is there.

Final Thoughts
McLendon and Chesapeake's management have presented themselves to the investment community as a team that switches its capital allocation and CapEx policies at the drop of a hat. Combined with McLendon's jaw dropping margin call in which he lost 95% of his share holdings this has given the impression of a wild "full speed ahead and damn the torpedoes" approach to risk. Some of this is undoubtedly warranted but not all of it. To fuel growth the company had clearly stated that it was funding by a mix of debt and share issues. Once the "land grab" was over the company set its course for balanced growth based on its own cash flows. Then Haynesville happened and the company went back out on its land grab and secured 700,000 acres in Haynesville (remember NG prices were at a staggering $12+ per mcfe). Then came the credit crunch, recession and a monster fall in NG and share price. In face of this the company announces that they will issue more shares - a huge mistake for which they have apologized. Now we are back on the balanced growth train. My feeling is that the market does not trust McLendon to stay on the train and at the first sniff of the "next Haynesville" he'll switch the train for his rocket ship again. We may all gain hugely from Haynesville but we do not want to see the company put at risk. For that reason I want Chesapeake to maintain the course announced this week and to develop the reserves from the acreage that it already possesses. Of course there will always be some acreage acquisition but with a reserve life of 16 years (reserves/annual production) and enormous probable reserves the company needs to convert its resources to cash as there has to be a payoff for shareholders.

I'm still staying at $56 per share although I think there is a large upside if management can stay its new course and prepare in advance for those torpedoes

Best Regards
Philip