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You Make the Call: Is Chesapeake Energy Worth the Risk?

Chesapeake Energy (NYSE: CHK) is one of the most polarizing stocks in the market.

Critics point to instances of corporate malfeasance, while supporters say the stock is undervalued.

Personally, I tend to side with the former. But you may feel differently.

So with Chesapeake reporting earnings on August 6, I thought I’d present you with both sides of the argument and let you draw your own conclusions.

Let’s start with the positives…

The Case for Chesapeake Energy

In a nutshell, the case for Chesapeake can be summed up with these four points:

  • The company has a battery of enticing assets to develop.
  • The stock is oversold.
  • Natural gas prices have bottomed.
  • And the company is a prime takeover target.

This is all true.

Chesapeake has proven reserves equivalent to 3.13 billion barrels of oil.

What’s more, it’s the largest onshore leaseholder of shale oil fields in the United States, with approximately 14 million net acres of land under lease. That includes a top position in some of the country’s largest shale formations, including Barnett, Haynesville, Marcellus, Wolfcamp, Bone Spring, Eagle Ford and Utica.

Yet the stock has plunged some 42% over the past year – and more than 13% year to date.

At a little over $19 a share, its current P/E ratio is a paltry 7.97. The industry average is 16.8.

Furthermore, Chesapeake’s enterprise value – the sum of its stock, net debt, minority interest and preferred equity – is about $29 billion. That’s only 9.2 times the value of its proven reserves – the lowest among U.S. oil explorers, producers and integrated oil companies, according to Bloomberg data.

That not only makes Chesapeake an interesting investment candidate. It’s also what makes the company a huge takeover target. Especially since natural gas prices are on the rise, making now the perfect time to scoop up Chesapeake before the value of its assets charges higher.

Indeed, at $2.78 per million British thermal units (Btu), natural gas prices have surged 46% from the 10-year intraday low of $1.902 reached on April 19.

And if you don’t think that increase is sustainable, consider:

  • Power companies have increased their natural gas consumption by one-third, having shunned coal to take advantage of the cheaper, cleaner fuel.
  • Electricity demand is skyrocketing across the country in response to one of the hottest summers in U.S. history.
  • And the amount of natural gas in storage is growing at a much slower pace than we’ve previously seen, with stockpiles increasing by just 33 billion cubic feet (bcf) for the week ending July 6. That’s far less than last year’s build of 87 bcf and the five-year average of 90 bcf.

Taking all of that in, Chesapeake looks like a heck of a good investment right now.

But you also have to consider the negatives.

The Case Against Chesapeake

Clearly, Chesapeake has many factors working in its favor. But it’s also facing some serious headwinds:

  • Natural gas prices might have bottomed, but the uptick doesn’t justify Chesapeake’s massive expansion.
  • The company has an enormous debt burden.
  • There are other similarly priced energy stocks in the market that are better managed and more profitable.
  • Chesapeake’s controversial CEO was just ousted from his position as chairman.
  • And the company’s currently being investigated by the Justice Department.

Sort of tempers your optimism, doesn’t it?

No doubt about it, Chesapeake’s management is the big question mark here.

CEO, Aubrey McClendon, ran into trouble back in April when it was revealed that he took roughly $1.1 billion in personal loans against his stakes in Chesapeake wells.

Now, that’s perfectly legal. McClendon acquired his stake in the wells through the company’s Founder Well Participation Program, which was approved by shareholders in 1993.

It was previously undisclosed to shareholders, however. And it clearly compromises McClendon’s credibility and fiduciary duty to Chesapeake, especially since he’s lost more than $600 million on the well program in the past three years. ($116.1 million in 2009, $141.9 million in 2010 and $315.3 million in 2011.)

Not to mention, the CEO’s prior missteps certainly didn’t help matters…

In 2008, McClendon was forced to sell more than 90% of his Chesapeake shares over just a few days to meet margin loan calls. This triggered a 60% drop in the company’s stock. After that, the Chesapeake board bailed him out with a generous $110 million compensation package.

So, after this latest indiscretion, McClendon was forced to step down from his role as chairman. But before the dust could settle on that controversy, a new one cropped up.

Earlier this month, the Justice Department began investigating Chesapeake and EnCana Corp. (NYSE: ECA) for collusion. Reuters discovered that the two companies had discussed how to avoid bidding against each other in a public land auction in 2010.

In one email uncovered by Reuters, McClendon himself allegedly told one of his deputies that it was time “to smoke a peace pipe” with EnCana “if we are bidding each other up.”

And these aren’t the only reckless decisions McClendon and the rest of Chesapeake’s management team have made.

The company took on a huge amount of debt to acquire its giant portfolio of leases, outspending its cash flow in 19 of the past 21 years. Chesapeake now carries a $13.3 billion debt burden and just $438 million in cash.

That albatross is the main reason why nobody has come forward with an offer to buy the company out. Potential suitors would rather sit back and wait for Chesapeake to divest its assets to pay off its debt – something the company will have to do if natural gas prices don’t end up bouncing back quickly.

For investors anteing up thousands of dollars, if not tens of thousands, trust in a company’s management should be non-negotiable. And Chesapeake’s management has obviously proven unreliable.

As I said before, I’m not Chesapeake’s biggest fan right now. I’d rather consider other companies with similar businesses that are trading at just as much of a discount. For instance, Apache Corp. (NYSE: APA) has a P/E of 8.1 and Devon Energy’s (NYSE: DVN) is 11.3. Even ExxonMobil (NYSE: XOM) is valued at just 10.3 times earnings.

You know where I stand… what do you think?

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Cheers,

Jason Simpkins

Jason Simpkins

, Energy Editor

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