2017 hasn’t been a particularly good year for Chesapeake Energy Corporation (NYSE:CHK) investors. Year to date, CHK stock has lost about 28% of its value.
In fact, the past decade hasn’t been favorable for CHK stockholders. The shares peaked above $65 in 2008, held $35 in late 2011, and hit $30 as recently as 2015. Only those investors who either bought at late 1990s lows, or when bankruptcy fears swirled in early 2016, have made a return on CHK stock.
But I’d argue that 2017 — and 2016, for that matter — actually have been pretty good for Chesapeake Energy as a company as it has made significant improvements, both in its finances and operations.
Obviously, lower oil and gas prices have hurt. Combined with forward-looking fears of a period of oversupply, those improvements are not being reflected in CHK stock. But those improvements also mean that CHK continues to be one of, if not the, best plays on an oil price rebound in particular. At the same time, however, the performance over the past year and a half shows that CHK stock simply cannot recover without that crude rebound.
Debt is Plentiful, But Now Longer
There’s little doubt that Chesapeake Energy has significantly improved itself over the past few years. Financially, Chesapeake is in much better condition. According to a recent investor presentation, the company’s debt load dropped by over $2 billion in the 18 months between September 2015 and March 2017. What debt is left — and to be fair, it is plentiful — now has longer maturity dates.
To give an idea of just how much the financial condition has changed, one need only look at Chesapeake Energy bonds. The 6.875% issue, maturing in November 2020, traded hands as low as 15 cents on the dollar in early 2016. That price — barely two years’ worth of interest payments — implied that not only would Chesapeake go bankrupt (and soon), but its unsecured debtors would get little or nothing in a restructuring. Less than 18 months later, those bonds are priced above par, or a near-600% return.
Operationally, Chesapeake has improved, as well. Asset sales have focused the company on stronger shale plays, including the Eagle Ford in Texas. Chesapeake is drilling ever-longer laterals, with an Eagle Ford record in the second quarter. Those efforts bring costs down and improve per-well performance.
Add in natural gas exposure and Chesapeake is better positioned to withstand a “lower for longer” oil price scenario.
CHK Stock Needs Higher Energy Prices
So can CHK stock recover if oil prices don’t? The short answer is “no.”
Chesapeake can — probably — get by in a ‘lower for longer’ scenario, particularly with some help from natural gas. But this is not a stock that is as cheap as a sub-$5 price would suggest.
CHK still has a market capitalization more than $4.5 billion; and, it still has some $9 billion in debt. Cash flow has been negative each of the last two years, and the company is targeting break even next year.
Chesapeake needs the leverage provided by higher oil prices in particular, as it emphasizes that product. Simply put, $45 crude and sub-$3 natural gas doesn’t offer enough in the way of margins to turn cash flow sharply positive and start the deleveraging/compounding story that is CHK’s best path to upside. Chesapeake can, and likely will, continue to improve efficiencies, and cut per-barrel costs. But those efforts only can go so far.
CHK Is High-Reward — And High-Risk
The leverage on the balance sheet makes CHK stock one of the best stocks for playing increasing oil prices, as I argued earlier this month. But that leverage also adds risk to CHK stock — most notably if those prices take another leg down.
In the short term, Chesapeake can use hedges to lock in pricing; indeed, as of May, roughly two-thirds of remaining estimated 2017 production was hedged. But as prices fall, so do the value of those hedges. And every dollar lost in pricing comes almost directly off Chesapeake’s cash flow — or adds to its cash burn.
Over the mid- to long-term, Chesapeake simply needs oil prices to rebound. If they do, CHK stock will have tremendous upside. If they don’t, CHK will stay flat — or worse. Chesapeake Energy has done a fine job the past two years controlling what it can control. Now, it needs a little outside help.
As of this writing, Vince Martin has no positions in any of the aforementioned securities.