Attractive Entry Point for Chesapeake Energy

The recent energy pullback (correctly predicted on this blog a few weeks ago on 8/24) provides some interesting entry points for long-term energy bulls. Crude oil has dropped from the high 70’s to $65 per barrel and natural gas has dropped from $8 to $5 and change.

As I have mentioned previously, for the short to intermediate term, I believe natural gas is a better bet than crude oil. I don’t think we are heading back to $50 crude anytime soon, and most of the correction is likely behind us. However, future catalysts bode well for natural gas prices, as well as leading producers such as Chesapeake (CHK) and Anadarko (APC). After recent corrections, those two names trade at less than 9 and 7 times 2007 estimates, respectively.

Why is natural gas attractive down here at around $5.50 per unit? Two reasons that I can see. One, with no major hurricanes yet this season, investors are beginning to price in the best case scenario for natural gas bears, namely that we will have no damaging storms this year. The investing game is all about comparing current expectations with future probabilities. If we do get a big storm or two, natural gas will zoom right back to $8 or $9. Without a storm, the current expectations prove accurate, and prices likely stay the same. All in all, not a lot of downside from current levels in either scenario.

Let’s look past hurricane season to factor number two; the winter. Last year we had a very warm winter, which served to limit natural gas heating demand, and quickly brought prices down from elevated levels reached after Hurricane Katrina. Now I’m not a weather forecaster, and even if I was the odds I’d be correct wouldn’t be very high, but chances are good that we could have a colder winter this year. Again, it’s all about expectations. Current natural gas prices are pricing in moderation with respect to both the remaining hurricane season and winter temperatures. If we get a surprise on either front, or both, there is nice upside to natural gas prices and the leading domestic producers.

Full disclosure: I own Chesapeake personally and Anadarko would be my second choice if I needed to pick another name in the group.

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2 Thoughts on “Attractive Entry Point for Chesapeake Energy

  1. Chad,
    I couldnt agree with you more. After your reco to me a few weeks back that I look into CHK, I did some homework before I picked up a few shares. Although revenues are down significantly from Q1 of 06, CHK’s new exposure in the Appalachian region (from a recent acquisition), combined with increased efficiency of drilling technologies making it cheaper to seek out smaller sites makes CHK look pretty well positioned. Plus as you mentioned, multiple-wise its a cheap stock & the fundies dont look too shabby. So… when you look at a stock like this, in the NG sector, does the outlook for CHK depend mostly on the price of NG? Is that the definitive factor here? Forgive me if I sound like a simpleton here, not that familiar with energy stocks.

  2. Chad Brand on September 12, 2006 at 3:04 PM said:

    Adam,

    In the short term, CHK shares track NG prices very closely. This is due to the fact that traders use it as a vehicle to speculate on daily movements in the spot price for the commodity.

    However, in the intermediate to longer term, CHK’s value to shareholders isn’t entirely based on NG prices. The company hedges the majority of its future production, so the actual spot price in the market today only impacts a small portion of CHK’s total NG production.

    The key for investors really is the conmpany’s ability to continue to grow production and lock in a certain return on capital. This is what allows CHK to boost shareholder value.

    If you look at the company’s growth in tangible book value over the last couple of years, it is clear the stock price is not reflecting the value they have created, rather the stock just changes based on trends in NG prices. This is a main reason CHK shares look so attractive to me.

    In the long run, share prices will ultimately reflect the value of the company’s assets and the cash flow they will generate in the future. If NG fell to $2 or $3 again, clearly their assets would be worth less, but based on the supply/demand situation domestically, I don’t think prices will go back to those levels.

    CHK is likely worth $45-$50 per share in a buyout. I don’t think they will sell anytime soon, but once they exhaust their growth opportunities, that will be the eventual end game for management and other large investors in the company, in my view.

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