The Real Reason Chesapeake Energy Is Imploding - Seeking Alpha

If you have not noticed, any stock associated in any way with natural gas production has been crushed in the last three months. This included the long troubled Chesapeake Energy (CHK). We will not rehash the disaster the stock has been up until 2019, but here in 2019 it is a different company. It is producing the highest amount of oil that it ever has, and is shifting more and more toward oil and away from natural gas it seems. This is likely wise considering the pricing of the underlying commodities. We have been following the sector and trading the stocks related to natural gas over at BAD BEAT Investing and today CHK has dominated the discussion. So what is going on here? In this article we discuss the performance of the name (which was strong, all things considered), but hone in on the real reason this stock and its many cousins are imploding. It is not just "pricing." Let's discuss. The stock itself is set to close at the lowest levels it has seen in two decades. Absolute disaster. Take a look at the 5-year chart alone. Not to stir up old memories, but it is painful:
Source: BAD BEAT Investing Chartist Now that is clearly painful. But we started trading this name at our service as well as its cousins recently, so lets look at the perhaps equally painful last few months: Source: BAD BEAT Investing Chartist So we have a stock that fell from $3.44 down to $1.38 in less than 4 months. This is an absolute travesty. While we were swing trading the little $0.10-$0.15 moves over the last few weeks, this hit following earnings was devastating. The stock is now down 60% in the last 3 months-plus. Today's 12% drop and counting has added fuel to the fire. But was it that bad? Performance We will say up front that we felt Q2 performance was mostly better than we expected. We believe that the market initially agreed, but the name began selling off hard after the initial bounce. We will discuss more on that in a moment. The quarter, overall, was solid. The headlines showed a strong revenue beat (and growth) despite the declines in pricing, though a wider than expected EPS loss. Chesapeake reported net income of $98 million and net income available to common stockholders of $75 million, or $0.05 per diluted share. That actually was ahead of our expectations. We were looking for a bullish result of a loss of $0.05 when adjusting (market consensus was -$0.07). Adjusting for items net loss attributable to Chesapeake was $158 million or $0.10 per share. That was wider than expected and perhaps the biggest blemish on the quarter.
Source: Chesapeake Q2 Earnings Slides What we did like was that the company's production shifted more to oil and that margins improved. The above slide summarizes the situation nicely. Average daily production for the 2019 second quarter was approximately 496,000 boe and consisted of approximately 122,000 bbls of oil, 2.034 billion cubic feet (NYSE:BCF) of natural gas and 35,000 bbls of natural gas liquids (NYSE:NCL). We were happy to see production down year-over-year (more on this in a minute). To put this production in perspective, last year in Q2 2018 average daily production was approximately 530,000 boe and consisted of approximately 90,000 bbls of oil, 2.311 bcf of natural gas and 55,000 bbls of NGL. Oil production represented approximately 25% of the company's 2019 second quarter aggregate production compared to 17% in the 2018 second quarter. That is a big positive. But what is more, margins were better. Look energy prices have been in the tank. Despite lower average prices for oil, natural gas and NGL sold, Chesapeake's cash margins increased year-over-year primarily due to a higher oil production mix and a decrease in expenses. This was a very solid result and unappreciated by the market. All told, Chesapeake reduced its cash operating expenses on an absolute basis by $57 million, or approximately $0.40 per boe. We will take it. Why is the market punishing the stock yet again? So why is the stock imploding on an other wise decent quarter. Well, look, debt concerns remain, but that is not the biggest issue. The biggest issue is production. We were thrilled to see a bigger mix toward oil (bullish). We were happy to see production lower overall (bullish). But we are not happy to see the company looking to drive up production in general. What do we mean? The market is fed up with these companies trying to produce their way out of a hole. Make no mistake in many cases there are contractual obligations which require them to produce a certain amount (we are speaking generally about the whole sector). Investors who wish to see the bleeding stop in this sector must watch to see if capex will remain under control and if production hikes will slow. That is the only way supply will slow, unless demand shoots higher, which so far, has not happened. For the longer-term, we continue to watch supply and demand, and expect that natural gas will remain in high supply for the next few years, but oil demand will remain strong. And this is where there is a problem.
While Chesapeake produced 122,000 barrels of oil per day, the highest quarterly oil production in the company's history, and oil production comprised approximately 25% of the mix, they company is guiding for higher production and capex spending to boost production. Chesapeake raised the mid-point of its full-year oil production guidance by approximately 250,000 barrels. However, the market is underappreciating the fact that the company is also cutting expense guidance. So it is a hidden bullish point that there will be higher-margin cash flow from this higher production. Further, Chesapeake will continue to allocate more capital to developing oil and less to gas. This is a good move, but the market is unhappy as overall EBITDAX will remain about the same, despite more oil and less gas being produced. This comes despite less capital going toward gas assets which the company sees volumes of gas showing double-digit percentage growth over 2019. The higher production of oil has the market selling first and asking questions later. Does it make sense? We think not. The debt weighs We wont go into huge detail here but the debt is the concern many have for the long-term especially as commodity prices remain in the toilet. At the end of Q2 Chesapeake's debt outstanding was approximately $10.161 billion, compared to $8.168 billion at the end of Q4 2018. As you probably are a ware this increase in debt outstanding was largely a result of $1.375 billion in debt assumed by Chesapeake and the $353 million of net cash consideration paid as part of the WildHorse acquisition earlier in 2019, which many BAD BEAT trader believe was a costly error. In addition, at the end of Q2 the company had borrowed $1.372 billion under the $3.0 billion its credit facility. That said, getting the leverage down to 2.0X EBITDAX is a primary goal, and we believe that if commodities can get the slightest of boost in pricing, the stock could fly as debt will be repaid:
Source: Chesapeake Energy Q2 Earnings Slides (linked above) As you can see there is going to be a shift in debt maturity, and debt will be pushed out, while being paid down. This buys time. While much of the production remains hedged, the stock needs help from pricing. Will oil and gas rebound? Yes they will, but that does not mean it cannot get uglier before its gets better. That said, oil and gas will rebound. We believe oil will rebound first, before natural gas. We just do not know when. It could turn sharply. It could take months. But we definitely see strong support in the high $40 range for oil, because below this the market forces are simply out of whack and are just not sustainable. So we think that is the time to buy. No one knows where oil is heading but we think risk is to the upside. But this is why we caution you to watch production and supply, and why the market is imploding CHK stock. Natural gas is another story as it is an oversupplied energy source. The fundamentals of natural gas consumption continue to be favorable, but supply keeps up. The demand for cleaner fuels and the commodity's relatively lower price has led to increased electricity generation to 35%, from 25% in 2011. It is also looking like this will expand significantly in the next decade. Exports out of the U.S. are growing and big industrial projects will likely ensure strong natural gas demand. But there is so much supply. The fact that CHK is cutting production of gas is a start to helping pricing, but this is just one company. The problem is that continued record high production in the United States means that supply is keeping pace if not exceeding demand. Therefore, prices are likely to trade mostly sideways, unless we get really bad heatwaves in the U.S., or extreme cold in the winter months. But the production curve MUST shift, or gas prices will be stuck here. That is the problem right now. Take home This selloff and implosion in CHK seems to stem from the decision to shift production mix even more heavily toward oil, but we think that is bullish. Gas prices are stuck. The hedges help, but oil pricing is better. The market wants to see less production overall. Until these companies get serious about oversupply, pain will continue. That said, a boost in energy prices will send CHK roaring higher. While we have been trading these names, from an investment standpoint, we think a buy in CHK sub $1.40 is high return, moderate risk speculation. Rapid-returns can be had. Unless you see bankruptcy in the next few years, this could be a generational opportunity, albeit, speculative.
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Disclosure: I am/we are long CHK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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