Chesapeake Energy Corporation Rig Site

Source: Chesapeake Energy. 

Chesapeake Energy (NYSE:CHK) is America's second-largest natural gas producer, behind ExxonMobil (NYSE:XOM). It's also the fourth-largest North American onshore pure-play oil producer. However, these rankings don't necessarily mean Chesapeake should be considered one of America's blue-chip energy stocks yet. Here's a look at why that is, and what the company can do to move itself into this elite category.

What are blue-chip stocks?

Blue-chip stocks are large, well-established, and financially sound companies that have been around for a long time. A blue-chip stock is typically a market leader and has a reputation for quality, reliability, and profitability in good times and in bad. Blue chips also typically are well known and pay a dividend. The bluest of these stocks make up the 30 members of the Dow Jones Industrial Average.

Why Chesapeake Energy is not a blue-chip stock

That definition of a blue-chip stock only partially describes Chesapeake Energy. Sure, it's large and pretty well established, but the company's financial soundness has always been questionable. Moreover, its reputation has been tarnished by the way in which it deals with leaseholders and other outside stakeholders. On top of that, Chesapeake's profitability has not withstood the test of bad times, as plunging natural gas prices nearly pushed the company to the brink because it used far too much debt to boost production.

That being said, the Chesapeake Energy of yesteryear is not the same Chesapeake Energy of today. The company is under new leadership and is taking a new direction in which it no longer spends wildly to grow at any cost. Instead, the company is investing within its cash flow. Chesapeake also has drastically cut its leverage over the past two years, driving total adjusted net leverage down by $6 billion, or 27%. Add it all up and Chesapeake Energy is on much stronger financial footing and still growing at a nice clip, as the following slide shows.

Chesapeake Energy Corporation Delivering

Source: Chesapeake Energy Investor Presentation.  

Still, while progress is being made, Chesapeake Energy has some work to do before it can be considered a blue chip.

What does Chesapeake Energy need to do to become a blue-chip stock?

Chesapeake Energy's biggest problem is that it is significantly levered to natural gas. Last quarter, 72% of the company's production was natural gas. If natural gas prices plunge again in the future, Chesapeake Energy's profits will take a hit. While the company does hedge some of its production to help mute the impact, currently just 69% of its 2014 natural gas production is hedged. That still leaves almost a third of its natural gas production vulnerable if the price of natural gas were to take a dive this year. Further, Chesapeake Energy has limited protection if natural gas prices were to stay low for an extended period of time.

When we look at other blue-chip energy stocks like ExxonMobil or Chevron (NYSE:CVX) we see a lot more diversification that helps these companies remain strongly profitable even when commodity prices are volatile. For example, both have a much more balanced production profile with a definite lean toward higher-margin liquids -- last year 66.6% of Chevron's production came from liquids, and 52.7% of ExxonMobil's production came from liquids. On top of that, both produce oil and gas from several different sources like oil sands, deepwater, and conventional plays while Chesepeake's production is almost entirely focused on unconventional shale. Finally, both blue chips have oil and gas operations that span the globe and own integrated assets like refiners. So, in order to come close to matching up with blue-chip energy peers, Chesapeake Energy needs to at least diversify its production so that at least half of it comes from liquids. 

On top of that the company would need to plow the additional cash flow generated from higher-margin liquids production into improving its balance sheet. After that the company would then be in a better position to boost its rather anemic 1.4% dividend yield so that the payout is more aligned with higher yielding blue-chip stocks like ExxonMobil or Chevron yield. These moves would put Chesapeake Energy in a better position to match up with other blue-chip energy stocks. 

Investor takeaway

While Chesapeake Energy is heading in the right direction, it's not yet a blue-chip stock.That's not to say the company isn't a compelling investment opportunity, but if Chesapeake wants to achieve that lofty status it must focus on growing higher-margin oil production and then use the additional cash flow to fortify its balance sheet and boost the payout to investors. Until that happens, there are better energy stocks for investors looking for a blue-chip name to anchor their portfolio.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.