I added a roughly 5% position in Chesapeake Energy (CHK) to the All-Cap Value portfolio in January. The position was funded with proceeds from reducing the portfolio’s position in the Vanguard Total Stock Market Index ETF (VTI).
For those who are not familiar with the company, Chesapeake’s recent history revolves around two main story lines. The first is the company’s audacious, debt-fueled land grab orchestrated by founder and CEO Aubrey McClendon that has resulted in the company holding drilling rights on approximately 15 million acres in most of the top unconventional onshore oil and gas drilling plays in the U.S.
McClendon’s skill as a wildcatter was demonstrated by his repeated ability to sell fractional interests in recent acquisitions to reputable industry players at prices that more than covered what Chesapeake paid for the entire tract.
The second story line, which came to a head in the spring of last year when the stock lost almost half of its value in two months, involves corporate governance issues, also centering primarily around McClendon. Fortunately, this story seems to have a happy ending, at least from a shareholder point of view.
Last May, McClendon was replaced as Chairman of the Board by former ConocoPhillips CEO Archie Dunham, and four former directors have been replaced by independent directors selected by activist investors and large shareholders Carl Icahn and Southeastern Asset Management.
Needed reforms have been made or proposed in compensation policy and policies that influence corporate control. Last week, McClendon announced that he will also be stepping down as CEO on April 1st.
Chesapeake has unveiled a coherent plan that I believe maximizes the expected outcome for equity holders. Recognizing that the firm is stretched financially and that great deals on new properties are increasingly hard to come by, the company has committed to reverse course and sell non-core assets to reduce debt and achieve investment grade status.
Chesapeake will focus on drilling the very best of their core assets and shifting their mix of output away from gas and toward oil and natural gas liquids. More than 75% of the company’s reserves are in natural gas.
While there is some bankruptcy risk here if enough things go wrong, I believe that Chesapeake’s plan will stabilize the company in the short-run. In the long run, in my opinion the price of natural gas will determine whether Chesapeake stock has the potential to revisit its pre-crisis highs and yield triple digit returns.
Since bottoming out at under $1.90 per million Btu in the spring of 2012, Henry Hub spot gas has crept up to about $3.40 per Btu in recent weeks. The price reached highs above $12.60 per Btu in 2008. In the long-run, we think prices are unlikely to spend significant time below the average cost of an efficient producer like Chesapeake.
In my opinion, the upside to prices will ultimately depend on demand, which in turn will depend on the extent to which gas gains share in electricity generation and establishes momentum as a motor fuel.
The investments discussed are held in client accounts as of February 27, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
