2023-09-06 06:35:49 ET
Summary
- Chesapeake Energy would have reported a loss in 2Q if they did not hedge and did not have large gains on asset sales.
- Many investors in the energy sector misunderstand natural gas pricing and rely too much on Henry Hub prices, which can be misleading.
- They have repurchased almost $1.3 billion worth of their stock at an average price of approximately $89.76 per share.
The "new" Chesapeake Energy ( CHK ) stock has increased about 120% since it began trading after exiting Ch.11 bankruptcy in February 2021. Initially I was expecting to continue to rate CHK stock a hold, but after looking into more details regarding their current management, I have downgraded CHK stock to a sell. This article covers a number of issues I wanted to discuss and is not intended to be a complete analysis of the company, nor does it cover my rather bearish natural gas price outlook, which I expect to cover in a future energy article.
The above stock price chart reflects CHK shares issued under their Ch11 reorganization plan when the company exited bankruptcy in February 2021. "Old" CHK shareholders were wiped out under the terms of their reorganization plan.
Confusion About Natural Gas Prices
There are too many investors in the energy sector that appear confused by natural gas prices. These investors often just use Henry Hub natural gas prices to justify purchases/sales of energy companies. I am not sure if they actually understand the complexity of natural gas prices. A natural gas producer may not sell into the Henry Hub and may actually sell into a hub/geographic region that has prices significantly higher/lower than HH. While changes in HH prices often reflect the direction natural gas prices are headed and the current price level, they still can be misleading when placing a valuation on an energy company.
An extreme example is San Juan Basin Royalty Trust ( SJT ) received an average natural gas price in January 2023 of $14.61 compared to an average Henry Hub price of $3.27 for January. (There were "issues" in the Southwest and California, which I covered in a February 13 article .)
The table below gives the latest prices by region.
( 9/1/2023 )
www.eia.gov/todayinenergy/prices.php
The table below is from my February 13 SJT article that shows even greater variance by region.
(2/10/2023)
www.eia.gov/todayinenergy/prices.php
Impact of Hedge on Reported Income Statements
Some investors also seem confused by the impact hedges/derivatives have on income statements. I will keep this very simple. Assume for the sake of discussion that an energy company hedged some of their expected natural gas production at $3 in the year before and that the actual natural gas price eventually received was $5, they would report a loss of $2 on the amount hedged/produced on their income statement. Depending upon how much of their production was hedged at $3, their income statement could be extremely disappointing to investors who do not understand hedging and were expecting "great" results because of high current natural gas prices. This happened to Chesapeake last year, for example.
The reverse is also true. Assume they hedged at $3, and the actual amount received was $1.60, they would report a gain of $1.40 on the amount hedged/produced on their income statement. The reported results could be a pleasant surprise to those who do understand hedging. This is happening to Chesapeake this year because they have extensive hedging positions at prices higher than current natural gas spot prices.
A problem that is too often ignored is the potential for serious cash/capital issues when hedging. For example, if natural gas is hedged at $3.50 and the prices really soar, there could be a margin call that would require a significant amount of cash. As natural gas is eventually produced and delivered, this cash is returned. This risk depends upon the type of derivative and how it is structured.
Share Repurchases and Dividends
I am extremely disappointed by Chesapeake's management, including the board of directors, and how they are managing their balance sheet. Chesapeake Energy still has a black cloud hanging over them because of their Ch.11 bankruptcy that whipped out shareholders. They are in the process of repurchasing/retiring $2.0 billion in CHK stock. Up until June 30 they repurchased a total $1.248 billion (13.904 million shares) at an average price of approximately $89.76 (They repurchased an additional 328,318 shares in July.) I assert that this is completely irrational. That cash should have been used to reduce their $2.036 billion debt, in my opinion. They need to strengthen their balance sheet because the natural gas business is subject to extreme volatility. If a shareholder wants more leverage they should buy the shares using margin accounts, but Chesapeake needs to be very financially conservative.
I am totally against repurchases of stock by any company. Decades ago, some companies repurchased a very modest amount of stock for their various pension/ESOP accounts. Then in the late 1980's Dutch auctions became a popular way to repurchase shares. In 1988 Gillette even had an interesting repurchase rights dividend, which was effectively a European style put option, distributed to their shareholders that allowed them to either sell the rights for cash or sell the shares back to Gillette via the put. Eventually we have gotten to the point where some irrational, in my opinion, shareholders demand stock repurchases. I point to Bed Bath & Beyond ( BBBYQ ) as an example using a large amount of cash to repurchase stock and then within a very short period of time finding themselves being completely liquidated in Ch.11 bankruptcy. Many other companies also have gotten into serious financial difficulties because of prior stock repurchases.
What makes their repurchases even more disturbing is that Chesapeake's bankers have put a "carrot" in front of them under the terms of the credit agreement. (Text of the loan agreement ) If either S&P (BBB-) or Moody's (Baa3) gives them an investment grade rating, many of their restrictive covenants are eliminated/reduced. In addition, if all three rating agencies give them investment grade ratings there are even more restrictive covenants are eliminated/reduced. (I will post the exact potential changes in the comment section below.) One of the easiest ways to get an investment grade rating is to reduce debt/interest expenses. This could have been accomplished already, in my opinion, by using the $1.248 cash used to repurchase stock to pay down their debt. This raises serious questions about management and their current board - again in my opinion.
Their current ratings are BB by S&P, Ba1 by Moody's, which was recently increased, and BB+ by Fitch. Chesapeake seemed to imply in their 2Q presentation that they are rated investment grade. This is extremely misleading - Chesapeake Energy does NOT have an investment grade rating by any of the agencies.
2Q Presentation
investors.chk.com
I hope that management uses the $650 million received, plus another $50 million on the first anniversary of the sale, from selling their remaining Eagle Ford assets that was announced in August to pay down debt and not repurchase additional CHK shares.
While this does not directly relate to stock repurchases, it does relate to prudent financial management. They pay a base $2.30 annual dividend plus a variable dividend of 50% of free cash flow. I give credit to the board for basing part of the dividend on FCF instead of EPS, which are subject to numerous GAAP accounting adjustments. These variable dividends are based on actual cash and not just on some GAAP accounting items. This, however, does not mean that the GAAP income statement should be ignored. The dividend of $0.575 per share payable September 6 was not covered by what I consider operating income for 2Q. They reported 2Q income before taxes of $518 million, but that number includes $472 million of gains on the sale of assets. I like to pull these gains (or losses) out and look at actual operating income, which was only $46 million before taxes. Total dividends being paid on September 6 are approximately $76.1 million, which means they are "short" on dividend coverage by about $30 million.
Second Quarter Results
2Q results were weak because of the return of extremely low natural gas prices. Their Marcellus production had average prices of $1.51 compared to $6.46 the same period last year and Haynesville prices were $1.77 compared to $6.60. Fortunately for Chesapeake they had hedges/derivatives that had a gain of $159 million in 2Q ($1.089 billion for the first six months). So, if they were not hedged and did not have very large gains on asset sales, they would have reported a loss for 2Q.
2Q and Six Months Income Statement 2023 and 2022
sec.gov
Current Hedge Book
Chesapeake uses swaps and collars to hedge their future natural gas production usually on a rolling eight quarter basis. Currently their hedged prices are above spot natural gas prices. For much of last year it was the reverse. Obviously if natural gas prices continue to remain low, the average hedge prices in late 2024 and beyond will decrease. Below are their latest hedging positions. (I am not sure if there were any hedge transfers that were part of the $700 million Eagle Ford asset sale last month.)
Latest Natural Gas Hedges
investors.chk.com/investors
Potential LNG Exports - Not a Sole Reason to Buy CHK
Some investors are bullish on CHK because of LNG export potential from their Haynesville production. The problem with exporting LNG is that it exposes CHK to many additional risk variables. You have geo-political risks of foreign importers, maritime union risks, problems at processing/storage facilities, pipeline risks transporting natural gas from gathering facilities to LNG processing facilities, and this risk list goes on and on. If too many other natural gas producers "over-drill" also expecting to sell into the LNG export market, prices could drop to a level that makes it unprofitable. In addition, based on recent comments made by management they are only looking at a 15-20% production exposure to the LNG Index. LNG looks important but may not have a huge impact on Chesapeake in the future.
It appears that the rapid LNG export growth has already stabilized based on the chart below.
eia.gov
The EIA LNG export forecast has an extremely wide range as seen below by table below. Sorry, but I would not buy CHK based solely on LNG given all the risks and uncertainties.
eia.gov
Conclusion
Some of the issues covered in this article might be too simplistic for regular CHK investors, but I too often read comments by some readers that indicate they do not understand regional natural gas prices and do not understand how hedges/derivatives impact reported income.
I am not bullish on natural gas prices, which I will cover in a future article specifically about natural gas prices. My CHK sell recommendation is based partially on management who I perceive as willing to take a riskier approach managing their balance than what I feel comfortable with given the very volatile natural gas industry. CHK has had a nice price increase recently because of being added to the S&P Midcap 400 and it is a good time to sell into that increase.
For further details see:
Chesapeake Energy Is Downgraded To A Sell From Hold