Chesa-peake Too Far

The controversial shale gas extraction

The major energy development of the past five years has been the development of unconventional oil and gas in the USA – known as shale gas and tight oil. One company that was at the forefront of the exploration and development of these unconventional energy assets was Chesapeake Energy. Yet in its rapid expansion to become the USA’s second largest natural gas producer, Chesapeake may have tried to climb one too many mountains too quickly. This looks like a company ripe for shortselling activity.    

Chesapeake reported an 87% drop in its earnings in 2012 from US$1.94 billion to US$285 million, due to rising oil production failing to compensate fully for the rapid fall in the price of natural gas as a result of the huge supplies of shale gas uncovered by firms such as Chesapeake in the USA. In fact, the large decrease in the price of natural gas forced Chesapeake to writedown US$2 billion of the value of their oil and gas reserves last year. In addition, the company has net debts of US$12.3 billion. They also entered into structured finance transactions called “volumetric production payments” which committed them to pay future flows of oil and gas in return for upfront cash payments, which has been a bust on the company’s balance sheet. To further exacerbate their financial woes (if possible), Chesapeake made the decision not to hedge against the large decrease in the price of natural gas, which dented natural gas sales revenues in 2012.  

The terrible financial state of the company is prompting Chesapeake to sell its one great competitive advantage – its oil and gas fields. The company made US$12 billion in disposals last year and plan US$7 billion in disposals in 2013. Chesapeake are attempting to find buyers for oil and gas fields in the Mississippi Lime region of Oklahoma and Kansas as well as the attractive Marcellus play in Pennsylvania. Chesapeake also plans to reduce its spending on drilling and completing wells from US$8.8 billion in 2012 to US$6 billion this year.

Chesapeake won't climb this mountain

In order to combat Chesapeake’s problems, they have pushed to increase production of more lucrative tight oil rather than gas. Yet oil production still accounted for only 15% of total production with 85% coming from dry gas and natural gas liquids. Whatever is left of Chesapeake in the future isn’t worth investing. The founder, Aubrey McClendon, was forced out as CEO by activist shareholder Carl Icahn. The extreme reduction in capital expenditure over the past few years ensures that Chesapeake have less production and cash flow to build a profitable future. Furthermore, the new natural gas market brought about by the advent of shale gas provides the challenge of low prices that require deep pockets to circumvent – only international oil companies such as Exxon Mobil, Chevron, BP, Shell, and independent companies without a build-up of debt can afford this new environment. Chesapeake is not of them. I would therefore recommend shortselling Chesapeake’s share price, currently at US$18.47 per share to reach a target of US$14 by the end of June.

Simultaneously buying Range Resources Corporation stock, another company with large holdings in the attractive Marcellus play (1.1 million acres), would be a fortuitous investment. Range Resources has developed a low cost structure and strong balance sheet over the past five years, which has coincided with a 41.3% increase in share price. Range Resources’ share price currently sits at US$71.78, which should be bought with a target of US$83 in mind to sell at by the end of June. Moreover, for a company with market capitalization of US$11.45 billion, it has ensured a low amount of debt of US$1.79 billion. Their financial results in the past two years have been record-breaking, with proven reserves and production both growing by 13%. If natural gas prices increase from the current nadir of around US$3-4, watch this stock price soar.