Chesapeake Energy Corporation (NYSE:CHK) stock is now trading at around $5 a share, while in 2014 the stock changed hands for $30 a share. Some might think CHK stock is a bargain.
However, I don’t think buying Chesapeake Energy stock is the way to go. We don’t really know when oil prices will recover; it could be next year, or it could be in four or five years. Chesapeake’s financials aren’t the strongest in the industry. Chesapeake Energy might have trouble riding out a few more years of oil selling at $50 a barrel or lower.
If you’re bullish on energy, you should choose an arrangement with less bankruptcy risk. This might mean oil stock ETFs, oil companies with stronger balance sheets than Chesapeake, or maybe even something like oil royalty trusts.
Today, I want to discuss why CHK stock is problematic, and what makes more sense at the moment.
The Oil Problem
At around $50 a barrel, is the price of oil too low or too high?
Don’t feel bad if you don’t have a clue. Even the major investment banks aren’t able to reach a consensus on this.
Right now, it looks as if the price of oil isn’t particularly low or high relative to historical standards. Oil prices have been cheaper; in January 2016, they plunged to about $25 a barrel. But they’ve also been higher. In 2008, the price of oil hit $145. And in the first half of 2014 it traded at over $100 a barrel.
One can look at oil prices adjusted for inflation at MacroTrends.net. Here oil doesn’t look cheap nor expensive; it’s roughly in line with where it has traded since 1973. And a chart on this article has the price of oil slightly below the average price since 1974, adjusted for inflation.
So there is a case to be made for betting on an oil rebound. Remember how much of a pain gasoline prices were in 2006 or 2011?
That could always happen again; owning oil-related assets could help you hedge against higher energy prices. You want to be buying oil stocks at a time when other people are ignoring them … like now.
Chesapeake Energy’s Downside Risks
Chesapeake Energy is a popular get-rich-quick play because it has been battered and tattered in the wake of low oil prices, and its weak financials make it extremely sensitive to any movement in oil prices. However, CHK stock is not an attractive play on oil; the risks seem to outweigh the rewards.
Consider these fundamentals:
For the quarter ending March 31, Chesapeake held assets of $11.699 billion, but $13.158 billion in total liabilities. This means that CHK has negative book value. Moreover, the company earned $142 million in net income last quarter, but operated in the red throughout 2016. Thus, if oil prices fall, it will return to being unprofitable.
Moreover, Cheseapeake Energy was operating cash flow-negative in 2016. In the first quarter of this year, cash flow from operations was $99 million — not good when you owe $9.52 billion in debt.
CHK stock could go from bad to worse. I would avoid it in favor of something more resilient — something that could weather a couple more years of low oil prices.
What Should You Buy Instead of CHK Stock?
A number of observers, including investment bank Morgan Stanley, have compared today’s bear market in oil to that of the mid-1980s. Too much capacity caused an oil glut, and oil prices needed almost five years to recover. Oil prices experienced a U-shaped recovery, not a quicker V-shaped recovery as in 2009.
It might take even more than five years. Stephen Guillot, a petroleum engineer, found that the price of oil follows a 27-year cycle, and he expects lower oil prices for the next 10 years.
So you should look for oil companies with excellent financials, like Imperial Oil Ltd (USA) (NYSEMKT:IMO). Unlike Chesapeake, Imperial Oil is profitable and has low debt and positive free cash flow. It also has positive book value, and trades at 1.3 times book value and 12.67 times earnings, while sitting just about 2% above its 52-week low.
Or you could just bet on the industry by purchasing an ETF focusing on the oil and gas industry. The Energy Select Sector SPDR (ETF) (NYSEARCA:XLE) invests in a basket of oil and gas companies and yields 2.5%.
What About Oil Royalty Trusts?
Oil royalty trusts could be another option. I like these better than ETFs based on oil futures, which experience something called contango, causing them to underperform.
To develop an oil field, sometimes oil companies will sell shares in royalty trusts, which pay royalties every year to their owners. This arrangement has some tax advantages, and owners can receive dividend yields as high as 10%.
This is one way to hedge against the risk of higher oil prices. Unlike oil companies, oil trusts don’t have to worry about paying employees-generally they have none, since an oil company operates the well.
The oil company also bears the risk of borrowing money to invest in the well. And while stocks can go to zero, commodities have some intrinsic value. Sandridge Energy went bankrupt a few years ago, wiping out shareholder equity, but its royalty trusts haven’t lost all their value (although they are down 82%, 93% and 94%).
But be advised, oil royalty trusts are not stocks. Most stocks generally don’t pay 10% dividends since companies continually reinvest in the business. This isn’t the case for oil royalty trusts-they pay must of the profits out up front. Eventually, an oil well will be depleted, at which point the proceeds from the final sale will be paid out and the contract terminated.
Also, dividend payments fluctuate based on the price of oil. And as I mentioned in my article on AT&T Inc. (NYSE:T), some think years of low interest rates may have pushed some fixed-income investors into dividend-paying assets. A 5% dividend yield beats the 10-year Treasury yield, but if the Fed raises interest rates, new bonds with higher coupon rates may be issued.
Read the fine print before investing in an oil royalty trust, but steer clear of CHK stock.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.
