Chesapeake Energy Deserves a Pick

 | Jul 11, 2013 | 12:00 PM EDT
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What if you could buy only one stock today? If I were forced to answer this question, my choice would probably be natural gas producer Chesapeake Energy (CHK).

The past couple of years have been turbulent for CHK, to say the least. If historically-low gas prices weren't enough, the company has had its fair share of unique problems. None has been more publicized than the activities of former CEO Aubrey McClendon, with respect to his personal investments in CHK wells and the fallout that came to him as a result.

Considering that and then some, Chesapeake shares at $21 a share are extremely undervalued, according to many bulls. The principal reason the shares remain depressed, according to these bulls, is that all the attention being spent on Chesapeake focuses on two topics.

The first is the current price of natural gas. Currently at $3.63/British thermal unit, natural gas is far off from the $13/Btu mark of pre-2008. The second issue affecting the stock relates to McClendon's activities: the company's leverage as a result of years of heavy capital expenditures spent on buying up assets. I'll quickly address both and touch on why these conditions have no harmful effect on the long-term intrinsic value of Chesapeake.  

First, even at current natural gas prices, CHK shares are worth somewhere between $40 and $60 a share. Consider the historical price relationship between oil and gas, which has typically been 6 to 1. At $3.63, the current price relationship is 30 to 1. In other words, a barrel of oil would have to drop to $22, or natural gas would need to rise to $16/Btu.

Gas is extremely cheap in the U.S. and very abundant -- some 100 trillion Btu estimated. Natural gas is so cheap compared to oil that it's spurring various end markets to make the switch. Power plants, cars, homes, and trains are all employing more and more natural gas. Terminals are being built to export the stuff overseas. In other parts of the world, natural gas sells for three times the price it does in the U.S., making exporting natural an economic opportunity for the U.S.

No company is better suited to capitalize on this undeniable shift than Chesapeake. With arguably the finest collections of assets and decades of supply, even at current prices CHK will generate tons of cash as it monetizes assets. Higher prices are free options on even further upside.  

Regarding the company's capital structure, Chesapeake's $13 billion worth of debt was a result of borrowing to buy assets. Take a look at what the company has spent on those acquisitions, compared with what some of those assets have been sold for, or could be sold for. When you do that, you start to worry less about the current state of the balance sheet and cash flow statements.

Under McClendon, Chesapeake invested $5 to $6 billion over the past several years in the shale formations. From those investments, CHK has pulled out $20 billion in cash. CHK still retains interests in  the formations, which are probably worth $15 billion or more.  

The reality is that in the short term, the CHK stock price will remain anchored by the current price of natural gas. In the next couple years, however, CHK will begin generating greater levels of cash flow as it continues monetizing the value of its assets.

If the price of the natural gas starts climbing again -- and there compelling reasons to believe that it will -- CHK may well be one of the most attractive investment opportunities today.



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