Why Chesapeake Energy Is a Bad Bet

In this week's episode of Industry Focus: Energy, Nick Sciple talks with Fool contributor Matt DiLallo about Chesapeake Energy (CHKA.Q). While popular with individual investors, the company's long-term prospects are bleak. Tune in to learn why some of Chesapeake's more bullish indicators are less appealing at second glance, why this company very well could go bankrupt, and what company investors might want to check out instead.

Also, the guys talk about some recent energy news. Has the oil market become immune to geopolitics? And what does the new offshore shale find for Apache (APA -0.03%) and Total (TTE -0.32%) mean for these two companies? Tune in to find out.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 9, 2020.

Nick Sciple: It's Thursday, and I'm joined once again by Motley Fool contributor Matt DiLallo via Skype. Matt, how's it going?

Matt DiLallo: It's going pretty well, how are you doing?

Sciple: I'm doing OK. We were talking before the show. I haven't been in studio with you guys since before Christmas. We pre-recorded our New Year's show. What you been up to?

DiLallo: Just doing all that Christmas stuff. Went to see family. Trying to stay warm. It's very cold up here in Pittsburgh.

Sciple: Yeah, tell me about that. I drove down from up here near Virginia down to Alabama. Got to wear shorts for a couple days. Then you come back up here and it's whipping winds and freezing. But it was nice to get out, living in a city, see the country and see the big, open spaces that I guess you don't see on a day-to-day basis driving around. Anyway, it's great to be back with you. We've got a great show planned today. We're going to be breaking down another huge oil find in South America and why the highest-owned oil and gas stock on Robinhood doesn't belong anywhere near your portfolio.

But first, really the news this week has been the attacks in Iran. Late last week, an airstrike killed Major General Qasem Soleimani, who's the leader of the foreign wing of Iran's Islamic Revolutionary Guard Corps. It's an understatement to say it's an attack that's expected to heighten conflict in the region. World War III was trending on Twitter. Oil prices were up 5% at the end of last week but have since recovered back to below where they were, Matt. Just as an observer of the energy market and a world citizen, what was your reaction to this story?

DiLallo: Initially, I was shocked. I mean, that's a pretty major move that we made. The expectation was that there was going to be some sort of retaliation, which we got on, I don't know, Wednesday night, Tuesday night, something like that. Iran shot some missiles at a U.S. Air Base. So the expectation was that it was going to escalate from there, that the U.S. would respond in kind. However, President Trump, to pretty much everybody's surprise, was like, "This seems like a de-escalation -- we're going to put some economic sanctions on." So oil, which shot up again right after Iran shot those missiles overnight, it collapsed yesterday. Now it's down below the price that it was before the attacks. It's really surprising how this isn't having any impact on the markets.

Sciple: Yeah, we look back to the previous attack, which some have alleged to be from Iran, as well, back in September, attacks on Saudi oil infrastructure. That shot oil up 15%. Less than two weeks later, prices settled back down. Some of the worries after this latest Iran incident was that maybe Iran could attack some energy infrastructure in the Middle East, and that would disrupt supply. Well, we've already seen that happen back in September, and the market absorbed that relatively quickly. Are we seeing just a point where geopolitical events aren't having the same impact on energy markets than maybe they have had in the past?

DiLallo: Yeah, that's definitely the case, just because the market can recover so much more quickly now. A lot of that's due to shale. There's so much extra supply in the market. That's why we're seeing OPEC cut production again. They announced another, like, $500,000 a day cut earlier. That'll start this year. It's just because there's so much extra oil piling up in storage. The U.S. is becoming this superpower of exporting. And then also, shale has changed the way that oil wells are drilled. It used to take a long time -- months to years -- to bring a new oil field online. Shale wells are like a matter of months, and a lot of times, oil companies develop these inventories called duck wells, which are drilled uncompleted wells. And so they just wait for the oil price to rise, and then they send out completion crews that actually do the fracking of these wells. And they can complete them very quickly. Some of them pump a thousand barrels plus a day. So you can really add supply quickly with these. Right now, there's actually a big inventory. I checked: There [were] like 7,500 of these wells. The U.S. is on pace to drill and complete 20,000 wells this year. That's a nice cushion to have. That's why we're just not seeing these big, prolonged spikes in oil.

Sciple: Yeah. Hopefully we don't see global conflict and we don't have to worry about these things, but it really just shows how much shale has just changed the game on a global scale when it comes to energy markets.

Going to the other side of the world, there was a huge story coming out of South America this week, specifically in Suriname. On Tuesday, Apache and Total announced they had found significant deposits of oil off the coast there. That news sent Apache shares up 25%, which was its largest gain since 1973. Matt, what should we know about this news?

DiLallo: Apache, which is pretty much a U.S.-focused driller in the Permian, they've been exploring out in Suriname, which is near Guyana, Venezuela, that part of South America. What they did is, they put out a report probably a month or so ago saying that they completed this well, and they weren't sure how good it was going to be. So the stock fell. However, then they actually put out what they actually found, and they tested three locations, and one of them found a 240-foot column of oil, which is really remarkable. Another found a 164-foot column. To put that in context, Exxon has been drilling in Guyana. Their last two finds were 108 feet and 164 feet. This is much bigger than even those discoveries. Analysts believe it's about 1.5 billion barrels of recoverable oil. So this leads some to say it's transformative, a game changer for Apache. It depends on how much it's going to cost and what else they can find, but it looks like a really big find for Apache. It could really drive them in the future.

Sciple: Yeah, I've seen estimates that it could increase the value of the project up to $1 billion. This is a $12 billion company, so obviously a significant portion. You talked about the costs, and how important that's going to be for this development moving forward, this partnership between Apache and Total. What are the terms of that partnership, and what advantages does it give to both of those operators?

DiLallo: A lot of these drillers will bring on big-time partners that know what they're doing offshore to help offset the cost and bringing their expertise. In this case, French oil giant Total is who had partnered up with Apache. It's a 50/50 partnership, however. Total is going to pay $5 billion of the first $7.5 billion of appraisal and development costs, and then 25% after that first $7.5 billion. So they're going to bear a lot of the upfront costs. That helps reduce the risk or Apache. And then there's some structure in how it pays off. Total gets more of the profits upfront, then it's a 50/50 share. It'll really help Apache through this time period of investment. When we talk about shale, it's very quick. They can bring a well online in a couple of months. These offshore projects, five years minimum is what it'll take. That's what it took Exxon to bring on Guyana. So we're talking about a lot of money being spent over several years before they see a return. That's why they need this partnership.

Sciple: Yeah. Obviously, as we look to this region, we've had two major finds now in Suriname with this Apache find, and then, as you mentioned several times, the Hess and Exxon find out in Guyana. Are there any other companies that have plays out in this region? Could we see some more finds coming down the line here soon?

DiLallo: Yeah, there's several companies. Kosmos Energy is one. They drilled a dry hole in Suriname a couple years ago. They have some more explanation blocks with Chevron, and then another partnership with Chevron. Hess actually has an exploration block out there with ExxonMobil and Equinor. And then, Tullow Oil, they've been in the news a little bit because they're a little bit further along. They're in Guyana. They've got acreage right next to Exxon and Hess. However, they've had mixed results. It's going to be a mixed bag. That's the whole thing with oil offshore exploration. You really don't know what you're going to get. One of these names could turn out to be the next offshore Guyana and just be a major play, or they could drill a bunch of dry holes and write everything off. We just don't know. That's what makes it interesting, but it's something that investors just need to have a high risk tolerance if they're going to chase it.

Sciple: Certainly. It's a textbook case of what you would call speculation. Just a couple months back, there were folks that were down on this Apache development, and then all of a sudden, we see this huge 25% spike. So something to be aware of as you're investing in these E&P [exploration and production] players.

OK, Matt, on the back half of the show, I want to talk about Chesapeake Energy. From time to time, I like to go on robintrack.net and take a look and see what are the highest held stocks on Robinhood, the free online brokerage platform. I recently went online to check to see what the most popular oil and gas stock on that platform was. It actually turned out to be Chesapeake Energy. Matt, does that surprise you, that Chesapeake Energy is the highest owned oil and gas stock on Robinhood?

DiLallo: Unfortunately, it does not. As a writer for fool.com, we get a lot of data on how well articles perform. And I know anytime I write about Chesapeake Energy, people click on it like crazy. So unfortunately, I'm not surprised.

Sciple: Yeah, I'll tell you, this is a stock, just for context, the stock declined greater than 60% in 2019, and ownership was up 55% on Robinhood. The stock really has not performed very well. It's interesting because Chesapeake really was one of the companies that, in the early days of the shale boom, drove this explosion. You had a swashbuckling leader, Aubrey McClendon, really driving a lot of the investment in the industry, getting a lot of people excited about it. Matt, what do you remember about that time for Chesapeake early in the 2010s, when the shale industry was just beginning to explode?

DiLallo: Yeah, actually, from my own personal history, one of the first things I learned about shale was Chesapeake, just locally. I grew up in upstate New York, and before they passed the fracking ban, Chesapeake was one of the companies up there trying to lease land out in the county where I lived. So I was following it there, and then when I moved to Pittsburgh after I got married, there was a lot of shale drilling out here. Chesapeake was a name in the news. That's actually how I got interested in energy and the stock market and became a Fool. So actually, I've written about them for several years now. It's been an interesting story. It's been a terrible investment the whole time. A lot of it has to do with just -- I would call it empire building. McClendon and his team just wanted to build the biggest shale driller in the country, so they leased as much land as they could and piled on as much debt as it took. Capital markets were wide open back then, so they just sold stock and borrowed money to just become -- at one point, they were the second-biggest natural gas driller in the country. Unfortunately, they really didn't pay much attention to profits. They thought that profits would eventually come because gas prices had remained high, and that wasn't the case. So that saddled Chesapeake with all this debt and they've spent the past decade dealing with that.

Sciple: Yeah. It's interesting in that there was this huge explosion in the shale industry, particularly as you've got these old landmen like Aubrey McClendon, the textbook example of these folks. Great dealmakers, great at selling their business. They grew these large empires but never really produced cash flow or profits in a significant way at any point during the cycle, even when energy prices were significantly higher than they are today. If you're an introductory investor, someone who's just reading about Ben Graham, Warren Buffett, you might take a look at Chesapeake's balance sheet, see all the shale assets that it's accumulated and say, "Hey, this company is trading at 0.5X book value... isn't this a great value investment?" Matt, why would that be wrong, if someone analyzed the company in that way?

DiLallo: Valuation is more art than science, anyway. And in the oil sector, it's even more so. You have ever-changing things like commodity price assumptions, and then sentiment, where the values of assets change all the time. Chesapeake has been a perfect example. They'll buy something for several billion dollars or spend several billion dollars building up a position, and then commodity prices fall or companies can't get access to capital, and then that asset is just not worth anything.

In Chesapeake's case, they've been having to sell assets at fire-sale prices. You look at their balance sheet, and in Chesapeake's case, it has $16.5 billion in assets against $11.8 billion of liabilities. So it looks like you've got a company that has some value here. However, trying to actually paint what the value of those assets are is really tough. There's a lot of ways that you can try to do that. You can look at market values. But in Chesapeake's case, they're trying to sell their Haynesville gas asset, for example. [...] 33% of their production, which is amenable. However, it looks like it's only going to sell on the market for about $1 billion. If that's the case, Chesapeake is going to have to write down some of the value that they have on their balance sheet, and that's going to tear that price of book value thing apart.

Sciple: Yeah. You have to remember, when these assets are carried at book value, their book value is usually their cost, unless there has been some impairment down the line. For a lot of energy assets in the U.S., we're starting to see companies take impairments and writedowns. I saw an estimate from Barclays in the Wall Street Journal that said most, at least oil majors, their estimates of their carrying values for their assets are based on an expected oil price of $75 to $90 a barrel. Obviously, we're well below that now in the $60s. We saw this last year, where Chevron took around a $10 billion writedown, Spanish energy company Repsol took around a $5 billion writedown, and Shell took a $2 billion writedown. So we're really starting to see those take place. Chesapeake should be no different.

When you drill down to the other parts of operations, there's something to be lacking there, as well. Man, do you want to talk about that?

DiLallo: Yeah. It's hard to find something to actually like about Chesapeake when you compare it to all the other energy companies out there. Balance sheet is usually where I look at first -- $9.7 billion of debt at the end of the third quarter. This is a company that has a $1.6 billion market cap, so the debt-to-equity [ratio] is way out of proportion. Now, they've done some things to get their debt under control. Recently, they cut it by about a billion dollars through the end of last year through some equity exchanges and things. But one of the metrics that energy investors look at as this debt-to-EBITDA [earnings before interest, taxes, depreciation, and amortization] ratio. Chesapeake's about four times, which is double its target, and most of its peers like to have it less than one time because oil is so all over the place. So their leverage ratio is way out of whack. And then, second, no growth. Chesapeake was once known as one of the biggest growth stocks in the energy sector. Their production is on pace to decline 10% next year. That's a big letdown because they initially thought they were going to grow their oil production 10%. But they just don't have the cash flow to support their debt and grow production. Now, you've got so many of these shale drillers that are producing enough cash at $50 oil to grow 10%, plus pay a dividend, plus buy back stock. So it's just not appealing when you look at it at that aspect.

Then, the third one for me is dilution. Their share count's up 88% the last three years. And the stock's down 87% during that time frame. That's because they used their stock to buy WildHorse, then they've done all these debt and equity exchanges. Chesapeake is more focused on growing and surviving than creating value for their shareholders. That's just not an appealing stock in my opinion.

Sciple: Sure. You look at their capital structure -- I'm seeing $1.7 billion of debt maturing in 2021, another $4 billion maturing in 2023. When you look at a company who's -- from an operational point of view -- not able to produce enough cash to fund continued growth from their assets. You have an environment when it comes to oil and gas where it just doesn't seem that these prices are going to recover during that period of time to be able to support paying down debt and support the company's operations going forward. Do you think this company is potentially a bankruptcy candidate?

DiLallo: It's one of those binary outcomes, where it's either going to double or it's going to go to zero. I think a lot of the people that would buy it on Robinhood will see, "The stock price is less than $1, it can easily double." That's the case if natural gas prices spike, which is really tough. There's just so much gas in the market. I know we've got all these LNG export facilities that are going to help, but I don't see gas prices really rallying. So that really puts the kibosh on Chesapeake, really, actually being able to create value from its assets. So it either goes bankrupt or it spends the next several years in this zombie state where it's selling assets, and it's doing debt exchanges, and it's really not going to be actually doing things that create value for investors. So it's just not a compelling thing for an investor to be looking at.

Sciple: Yeah, I agree, Matt. Hopefully, this company does not remain the highest-owned oil and gas stock on Robinhood much longer. We'll just have to see. If an investor wants to maybe speculate in the E&P markets, they want to speculate on oil prices improving or something like that, are there any E&P players you think might be a more attractive investment for someone to go out and buy?

DiLallo: Yeah, there's a lot of them. For more of a growth one, Diamondback Energy. They're focused on the Permian Basin. Ticker symbol's FANG. At $45 a barrel oil, they can generate enough cash to grow their production 10% to 15% plus pay a dividend, and then anything over that's gravy for them. At $55 oil, they can generate, like, $675 million of free cash flow, which is enough to buy back about 5% of their stock. So you've got a company that can thrive at lower oil prices and really do well if oil prices go higher and generate a ton of cash. That's one of several that have really positioned themselves for this environment.

Sciple: Alright, folks, that's one to add to your watch list. Matt, thanks as always for coming on the show!

DiLallo: Thanks for having me!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Matt DiLallo, I'm Nick Sciple, thanks for listening and Fool on!