by Aaron Levitt | June 4, 2012 9:42 am
Despite being the poster child for America’s new-found energy independence and the growth in natural gas production, it’s been a rough few years for Chesapeake Energy (NYSE:CHK). Once the darling of analysts and investors alike, the second-largest producer of natural gas and the most active driller of new wells, has fallen hard as a slew of factors have conspired against it.
As revelations about the firm’s finances and inner dealings of CEO Aubrey McClendon have come to light, Chesapeake’s value has plummeted. Adding to these internal woes have been falling natural gas prices. With production surging across the country due to the widespread adoption of hydraulic fracturing, inventories continue to rise. That’s pushed natural gas prices down to historic lows and below the marginal cost of production for many wells.
With so many issues facing the industry stalwart, it’s no wonder why shares have plunged more than 47% during 2012 and recently hit a post-recession low of around $14.
Given that plunge, the question now is whether this represents a buying opportunity. Carl Icahn certainly thinks the natural gas producer has value.
But it’s still clearly caveat emptor here.
Chesapeake’s latest headaches stem from the firm’s controversial Founder Well Participation Program (WPP). Approved by shareholders in 2005, the program granted CEO McClendon a 2.5% stake in each of Chesapeake’s wells until 2015. While the WPP program itself wasn’t necessarily a bad thing — it functioned as a royalty stream for the founder CEO — what McClendon did with it is certainly troubling.
In April, Reuters reported that McClendon had borrowed as much as $1.1 billion in personal loans and mortgages over the last three years against his ownership stakes in wells. The majority of those loans came from an investment firm that’s also a major backer of Chesapeake. And Chesapeake never fully disclosed the total amount McClendon has borrowed, while the board of directors has flip-flopped via various statements on whether or not it was aware of or approved the loans. (And now it appears the board is going to get revamped, with four members to be replaced.)
At the same time, shareholders have been left in the dark about McClendon’s various loans made against the WPP. At the end of 2011, McClendon disclosed that he still owed as much as $846 million on loans taken out against these royalties.
This led to concerns that McClendon’s personal financial deals could compromise his fiduciary duty to Chesapeake, which seems to have happened. Reuters later reported that McClendon partially owned and helped run a $200 million private hedge fund from within Chesapeake’s Oklahoma headquarters between 2004 and 2008. The fund traded McClendon’s own cash in markets, including natural gas and oil, both of which Chesapeake produces.
Analysts have contended that these activities could have been distracted the CEO from his job at Chesapeake, and that he could have also used privileged information to advance his own trading. Both SEC and Justice Department investigations are underway.
As if Chesapeake’s woes couldn’t get any worse, the company’s debt and cash flows are becoming a huge issue as well. As it grew its portfolio of gas and oil fields, the exploration and production firm has outspent cash flows in 19 out the last 21 years, and debt has ballooned to a huge $13.1 billion.
These issues were compounded when Chesapeake reported an unexpected first-quarter loss of $71 million. During that report, it warned that it could run short of cash next year without enough divestitures. Those asset sales have become quite commonplace for Chesapeake over the last few years as it tries to stem the tide of red ink. They’ve included sales to China’s CNOOC (NYSE:CEO), France’s Total (NYSE:TOT) and Norway’s Statoil (NYSE:STO).
So far, the struggling driller has put the “For Sale” sign out on its prized 1.5 million acres in the Permian Basin as well as a half-million acres in Colorado and Wyoming. Chesapeake is also on the hunt for a joint-venture partner in the rich and new Mississippi Lime basin.
While it waits for more buyers of its critical assets, the firm was forced to take a $3 billion “payday” loan from Jefferies (NYSE:JEF) and Goldman Sachs (NYSE:GS) to shore up its balance sheet and to pay down a $4 billion loan commitment from banks. In all, analysts at Moody’s predict that Chesapeake must sell at least $7 billion in assets to avoid breaching a loan covenant. However, it predicts that the firm’s cash shortfall in 2012 will still be at least $10 billion.
From a valuation standpoint, Chesapeake certainly is cheap. Shares currently can be had for a P/E ratio of around 6.26. That’s well below the industry average around 16. However, given all of Chesapeake’s problems, both internal and external, that doesn’t strike me as such a value.
Similar to BP (NYSE:BP) and its legal hangups, Chesapeake’s financial woes are a serious overhang on shares. The fact that it has to turn to costly funding — the Goldman loan comes with a pricey 8.75% interest rate — to fund itself is just one example of its deteriorating finances.
Meanwhile, continued asset sales have put the company in a vulnerable spot. While a variety of other firms have begun to explore more unconventional assets and gain valuable reserves, Chesapeake will lose future production and cash flows associated with the wells. Additionally, analysts predict that potential bidders will take advantage of the company’s weakening liquidity and ultimately offer low-ball bids for its assets. That could cause the firm to sell off more fields than it potentially wanted. Already, it has made moves to rid its self of prized fields, like the Permian Basin fields.
Add this to corporate governance issues with CEO McClendon, and it’s enough for investors to avoid the shares completely. Especially when a whole host of other E&P firms like Range Resources (NYSE:RRC) and EOG Resources (NYSE:EOG) have also fallen hard in the market’s recent mass sell-off.
I think most investors will get a better long-term bang for their buck in those shares, rather than Chesapeake.
As of this writing, Aaron Levitt doesn’t own any securities mentioned here.
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