Description

Chesapeake is a company that's easy to hate.  A messy balance sheet, an awful management team, and the street loves it.  This recommendation has two components.  First is a macro call and my opinion that we will see a stunning crash in gas prices in the next two years.  Second is that CHK is not only a company completely void of any serious long-term investment merits, but will also be adversely affected worse than most E&P's if gas goes lower.

Nat Gas: A History

I realize the inherent risk in recommending a crash in gas prices have already gone from $13 to $5, but that's what I think is going to happen.  Here's a very brief history lesson on gas.  For a long time gas production in the US was flat despite more drilling and more spending - we were running to stand still.  In the early 2000's the industry finally figured out how to produce gas from shale through new technologies, primarily horizontal drilling and fracture stimulation.  As more companies got into the shale game, which is unimaginably large, and the techniques were refined, gas production in the US began to increase by 5-10% annually, at an accelerating rate.  People were so euphoric about all the new reserves they forgot that overall, this much gas is bad for business.  So in 2008, prices crashed with the rest of commodities as demand vanished, while investors started to wonder whether the long-term fundamentals, driven by tons of new shale reserves and a weak economy, would keep gas prices low for a long time. 

Now we're at a place where prices are low and people are expecting the Econ 101 reaction from the industry, which is to produce less and watch prices rise.  Many forecasts have been made about this rational expectation, with 2010 estimates ranging from down 3% to down 12%.  Regardless, if there's one thing that almost everyone can agree on is that production needs to decline, otherwise we're in a lot of trouble.  There is almost no debate on this, we are simply producing too much gas right now...heck, we were producing too much gas before the recession when demand was strong.  And almost universally, people are expecting huge production declines in 2010.

Nat Gas: Why 2010 Is Going To Be Ugly

In 2009 people started building models to forecast the supply/demand picture for gas.  Analysts started looking at well decline curves (very steep for shale), rigs employed, initial production (IP) rates, capital spending, etc in order to gauge where there thought supply would bottom.  There are 3 macro models that are notable.  Two are from energy boutique investment banks - Tudor Pickering Holt, and Simmons & Co.  The third model is from none other than Chesapeake, as they are one of the few companies to publicly talk about their own model, and many people seem to look at them for macro insight.  

The TPH model was unveiled to much hullabaloo a few weeks ago, complete with a fancy slide deck and conference call.  They have modeled out about 25 basins from the ground up, forecasting production by using an average well curve and ratcheting the rig count up or down.  Simmons has done something similar, as has Chesapeake I believe.  These models are unstable and reminiscent of CDO models.  I know this because it's easy to build a model for say, the Fayetteville Shale, I've done it myself.  The problem you find is that very small changes in your inputs - days to drill, first year decline, increasing efficiencies - can have game changing effects on the results.  

These models are proving to be incorrect for one basic reason: newer shale wells have very high initial production.  For example, a Haynesville Shale well might produce 5-7x the amount of a Barnett Shale well, therefore cutting the rig count wont matter because most of the incremental production easily offsets the 50% decline in rigs.  Production is declining in certain areas like the Barnett Shale, but new, larger plays like the Haynesville Shale and Marcellus Shale are offsetting the losses.  I say forget the production models, if it's future production data you want, ask and ye shall receive.  Just poll the companies who actually produce gas, and see what they say they're going to do.  I looked at 40 of the largest US gas producers, and what they are telling you is the exact opposite of what analysts and companies are predicting. 

Despite what everyone is forecasting about production being down in 2010, I could only find 7 companies who have either guided lower US gas production or the street expectation is for a production decline.  These 7 companies only represent about 15% of total US production.  Meanwhile, when you look at the 40 largest companies and do a weighted average based on current production, as a whole these firms plan to increase production by 5% next year.  Combined, they make up about 60% of total US production.  This would mean that in order for 2010 production to stay flat, private companies would have to cut production by 5%.  In order to hit TPH's target of down 7%, private companies would have to cut by 22%.  And to hit Chesapeake's target of down 11%, private companies would have to cut by 33%.  Those production declines will never happen, and I expect 2010 will be an historically bad year for nat gas.

 Other than company guidance, why am I so sure that production will remain too high in 2010?  First, capex budgets were already down substantially in 2009, and companies appear very reluctant to cut them further.  They see 2009 as the adjustment year, they're not ready for another year of pain.  Second, the industry has raised billions in fresh capital and has delevered quite a bit, so they've still got money to spend.  Third, it's what managements are paid to do.  These guys' bonuses are mostly based on production growth either directly or through other measures that derive from production such as EBITDA and reserve replacement.  If you're not growing, you're not getting paid...shrinking companies isn't in their DNA (at least not intentionally).  Finally, most companies have hedged 2010 production at decent prices, so they wont necessarily be forced to slash their budgets. 

The fact of the matter is that today's prices are the worst possible place for the industry.  Nat gas is high enough that there's no immediate need to hit the panic button and firms can increase production in the aggregate (for now).  Unfortunately, prices are also low enough that very few firms are creating any value, and living within cash flow is leading to weak growth.  I was reassured by my take on all this when Ken Peak, the CEO of value junkie favorite Contango Oil & Gas, and probably the smartest CEO in the energy business, had this to say:

"Industry supply trends together with my gleanings from a number of recent industry conference calls lead me to believe the industry may be on its way to drilling gas prices back to the $2.00 to $4.00/Mcf price level. Even though demand for natural gas is likely increasing, supply from the onshore lower 48 since November 2008 has been basically flat despite an approximate 50% drop in rigs drilling for natural gas. In essence the increase in production from shale wells has overcome ongoing industry-wide geologic decline while drilling significantly fewer wells. Thus, a second round of gas price declines may be in front of us." - Ken Peak, 11/9/09, first quarter press release

At some point all this has got to stop.  The only way to get aggregate production to a stable level that allows prices to rise is to physically cut these companies off from their sources of capital.  And the banks/shareholders are complicit until they're forced to stop.  The only way I see this happening is if there are some blowups (or near-deaths) in the industry and people become much more suspicious about giving these companies money.  There is going to be an ugly transition in this industry, and as the growth rates and profitability come down they'll bring stock prices with them.  I find it amazing that many E&P's were hitting 52 week highs just 2-3 weeks ago.

Chesapeake: At Best A Stock You Never Want To Own 

1) The historical performance of this company is terrible, but you'd never know it from listening to management.  Aubrey cant open his mouth without talking about "shareholder value creation", although he uses it as nothing more than a hollow catchphrase.  

"This singular focus gives us a chance to be the very best in the industry at one thing, and when you can be the best at one thing you have a chance to create increases in shareholder value year after year." - Aubrey McClendon, 2/25/03, Q4 Conference Call 

"We are now distinctively positioned to continue reaping the rewards from those timely investments, and to continue delivering top-tier shareholder value for years to come." Aubrey McClendon, 2/23/05, Q4 Conference Call 

"I believe you will be very impressed with what we will deliver to you in shareholder value creation in the years to come." - Aubrey McClendon, 10/27/06, Q3 Conference Call 

"We don't believe you can find a better combination of great growth and value in the industry and are excited about the shareholder value creation that has occurred to date." - Aubrey McClendon, 5/2/08, Q1 Conference Call 

 "I believe in what I do for a living; I create value...While this company has had its ups and downs along the way, we have consistently delivered shareholder value over long periods of time and we will continue that in the years ahead...it's there today; you can't see it, but it is there, and it will be recognized over time." - Aubrey McClendon, 6/19/09, Annual Meeting [this one's my favorite] 

If Chesapeake has created so much shareholder value, why do they have negative retained earnings?  Why is the entire book value of this company paid-in-capital?  All of those impairment charges add up...they weren't non-cash when you spent the money.  Why has Chesapeake's stock underperformed other large-cap E&P's by 40%, and larger shale-focused companies by 55% in the last 10 years?  It's actually the worst performing stock over the last 2, 6 and 12 years among its comp group.  Chesapeake trades at the same price today as it did when "Macarena" when the #1 Billboard song (Summer 1996).  Why has the debt-adjusted production and reserves per share declined over time?  This company has done nothing but destroy value, and I believe they will continue on this path indefinitely.

2) Chesapeake is a chronic issuer of new capital, with little to show for it.  In this decade, Chesapeake has sold $10.4 billion in common and preferred stock and raised $12.3 billion in net debt.  The shares outstanding have increased over fourfold, from 150 million to 625 million.  Against this, Chesapeake has returned $600 million to shareholders via dividends and buybacks.  Net capital invested is $23.2 billion.  What has all that money bought?  How about a PV10 of $7.6 billion, $5-12 billion in unproved acreage, and $4 billion in other stuff.  Meanwhile, the company sports an enterprise value of $28.9 billion.

Chesapeake had gone on a company/acreage acquisition binge throughout the early/mid 2000's, constantly outspending cash flow.  Shareholders were getting fed up with the capital raises even then, so around 2006-2007, after the $2.3 billion acquisition of Columbia Natural Resources, the story about the company changed.  Management repeatedly stated that the asset accumulation phase was over, and now was the time to harvest those best-in-class assets and finally watch the per share production/reserve/cash flow metrics take off.

"Nothing else has to work for us. No acquisitions, no stealth plays. We just keep our heads down and keep drilling ahead on the acreage that we own...please recall that now we can deliver all of this value creation without adding debt or increasing our share count." - Aubrey McClendon, 2/15/08, Q4 2007 Conference Call

Net increase in debt since that quote: $2 billion.  Net share count increase: 150 million, or 31.5%.  This management simply does not know how to run a business without continually diluting shareholders. 

3) Aubrey McClendon is a terrible CEO and is single-handedly responsible for Chesapeake's poor performance.  He took Chesapeake to the brink of ruin in the late 1990's by levering up the company to go after the Austin Chalk, then getting killed when the Chalk wasn't that good and gas prices plummeted.  Last year he almost blew it up again by levering up to buy billions of new leases right before gas prices crashed.  And in an event that redefined schadenfreude, Aubrey almost became a household name in 2008 from getting the mother of all margin calls, losing $2 billion and single handedly tanking the stock of his company.  He has proven time and time again that he does not understand the concepts of value creation or risk management.  The third quarter conference call was particularly enlightening, it gives you a good flavor for what he's like.  Among the things he discussed: 

• 2010/2011 reserve guidance assumes that current reserves are merely "temporarily" depressed
• 2010/2011 reserve guidance was based on what they thought prices will be
  • Btw, nobody else in the industry gives reserve guidance, let alone on forecasted prices
• They consider not paying down debt deleveraging as long as reserves are growing
  • Note that they ignore the value of those reserves
• Aubrey tried his hardest to publicly humiliate every E&P company for not having the same technical capabilities and skill at identifying and acquiring land
• Management believes that they themselves are a competitive advantage
• Aubrey stated that his hedging "creates" shareholder value whereas competitors' hedging "limits" shareholder value
• Despite having only 20% of 2010 gas hedged, Aubrey stated that it "was not possible" that 2010 FCF could be negative

He's notorious for being one of the most promotional CEO's in the industry.  I would encourage people to read his opening remarks from the last couple years' conference calls, it's nothing but pure bewilderment over the "value creation" that goes on at the company.

4) Chesapeake is one of the least hedged companies in the industry at 22% in 2010...heck, management seems downright proud of this.  And with the knockouts and 3-ways they're at risk of losing 50% of that small amount of hedges.  The knockouts and 3-ways aren't going to make-or-break the company in 2010, but they certainly wont help.  More important is simply that Chesapeake is the most exposed E&P to gas prices next year.  This is really the crux of my short argument, because if gas declines, Chesapeake will be the first company to feel it.  There's not really much else I can say about this point, it speaks for itself.

5) Chesapeake uses needlessly risky hedging strategies.  Last year, management came under quite a bit of fire for their reliance on knockout swaps.  Knockout swaps are fake hedges.  Chesapeake will enter into a swap and receive a slightly better price than they would with a plain vanilla swap.  So if the strip is at $6.00, they'd actually be able to hedge at $6.50.  The flipside is that if the underlying falls below a certain price, say $4.00, the whole deal gets called off and the counterparty walks away.  This is like getting health insurance that only covers a common cold and ear infection...the whole point is to be covered in case the crap hits the fan.  If you're an e&p company, there is no worse product than this, it defeats the entire purpose of hedging.  Still, Chesapeake continues to use knockouts for a good portion of their "hedges."  188 bcf (22%) is hedged in 2010 at about $8.50.  But 70 bcf of that is with knockouts that vaporize at prices between $5.45-6.75. 

Management also uses 3-way collars in addition to the knockouts.  A normal collar  involves selling a high priced call and buying a lower priced put, typically in a costless transaction.  It guarantees the producer will receive a price no lower than the put price, yet no higher than the call price.  But Aubrey implements 3-ways which include the extra transaction of selling a put at an even lower price, stretching for a little extra premium.  Again, if gas falls below your written put price, you'll find that you're no longer hedged as your written put is now costing you money.  26 bcf of 2010 production is hedged this way, with the puts ranging from $4.25-5.50.

6) Chesapeake uses the most aggressive assumptions when reporting well sizes (EUR's).  For example, management uses a 65 year reserve life to model Haynesville EUR's.  This is inappropriate, as the oldest Haynesville wells have only been on production for less than two years, and the oldest shale wells have only been around for 6-8 years.  Besides being inappropriate it's also irrelevant because it completely ignoring present value.  Management's take on this topic provides an example of both their character and judgment of returns.

"I have seen a number of other EURs from companies that are at 40 or 45 or 50 years and that actually means that our curves are more conservative, that it takes us 65 to get to say, 6.5 bcfe. So if somebody else is at 6.5 bcfe at 50 years, then it means that we probably have some upside in our EUR over time, if they are getting there in 50 years and our curves take 65 to get there..." - Aubrey McClendon, 8/4/09, Q2 Conference Call

You got that?  Aubrey is saying that he's the one being conservative by using the longest well life in the industry.  Good grief.  But does it even matter?  Anyone who knows freshman finance can tell you that whether you want to use 40 years, 50 years or 65 years, the present value difference is negligible in every case and worthless to me today.  Using an appropriate discount rate (the industry, for better or worse, clings to 10%...meanwhile, Chesapeake is issuing 10 year debt at 9.5%) anything beyond 30 years has no value at all. 

This also highlights one of the big problems in the industry, which is that F&D cost (capex divided by EUR) doesn't tell you much about profitability.  F&D doesn't change with the movement of gas prices in the short-term (it will in the long-run as service costs adjust), so it's generally the same whether gas is $10 and the well is insanely profitable or gas is $3 and the well is a money loser.  But if you actually model out these wells, including all the extra charges that the companies don't like to report, $6.00 gas is too low for most of these companies to make money.

7) Chesapeake is reshaping the company into what I suppose you could call a lease broker.  They had some extraordinary success doing JV's recently, so now they want to make it an official component of the company.  Actually, they appear to now be relying on these types of transactions in order to fund their capex program. 

"We are also in the often much more profitable business of identifying and developing big unconventional plays and selling leases in those plays to other companies who perhaps have not yet developed all of our capabilities in developing these big unconventional plays on their own. We believe this is perhaps the simplest part of our business model, but somewhat mysteriously to us, many observers of our company apparently find this aspect of our business model difficult to understand or appreciate." - Aubrey McClendon, 11/3/09, Q3 Conference Call

Actually, it's not difficult to understand, but it is difficult to value. 

8) In present value terms, Chesapeake's leases are worth a lot less than people think.  The idea is simple.  Let's say you're an E&P company and you've got 500,000 quality acres in a good shale play.  Wells have an average EUR of 5 Bcfe, with an optimal spacing of 80 acres, leaving you with 6,250 potential locations and 31.3 Tcfe of unbooked reserves.  Many management teams and analysts will look at this, assign a value of $.50 per unbooked reserve and call it a day thus creating $15.5 billion in value ($31,000/acre) just like that.  Sometimes they'll "risk" it by haircutting the figure by 50% or so, but they're really only doing that so that their valuation doesn't look ridiculous.  Let's also assume that it takes 30 days to drill a well, so one rig can drill 12 wells per year, while a well costs $5 million.  Now we're looking at a schedule like this.

Here's the problem with having such a large acreage position - if you don't put a ton of rigs to work in it, it will take you a generation or two to drill all of your wells.  Having a 20, 30 or 40 year backlog of inventory is a terrible thing once you account for the cost of the lease, the capitalized interest, the landmen and corporate and legal expense, etc...these leases now have a negligible or negative PV.  As an investor today, why should I care about a well we're going to drill in 2039???  What kind of discount rate do you even use on that???  And how do you account for the fact that this particular company cant grow without diluting shareholders?  Because of this, there are diminishing marginal returns to having a large acreage positions like Chesapeake's.  When Chesapeake signs new Haynesville leases, that new acreage either goes to the back of the line in which case it's got a negative PV, or it goes to the front of the line which means some other lease essentially got condemned.  Companies talk all the time about "high grading" their acreage, but all this really is is an admission that they lost millions of dollars in leases signed a few years ago.  This is one of the problems with gigantic companies like Chesapeake - they'll never be able to drill up all of the acreage, yet many people still assign it equity value anyway.  And those analyses are essentially assuming that those future wells are profitable at all...remember, at today's prices many companies are losing money. 

So what are the Chesapeake's of the world forced to do to counteract this PV problem?  Drill the crap out of their acreage.  Gas prices too low?  Screw it, gotta keep drilling. Service costs too high?  Can't afford to stop drilling.  They've got to pull as much of that production forward as possible...and I'm not even accounting for lease expirations.  This helps explain why Chesapeake is planning to spend 45% more on drilling in 2010 even though gas prices remain exceptionally weak.  Below lists Chesapeake's main stats on their featured shale plays.  I believe that if you use an appropriate discount rate for a company like Chesapeake, anything beyond 10 years out has zero value.

Now you might argue that this acreage still commands a high value because it's worth that price to someone who isn't in the play.  I would say normally, this would be correct, but these are some odd times.  First of all, the nat gas market is broken right now and I believe headed even lower.  The appetite for non-cash flowing leases is soft and will probably get worse.  Second, almost every E&P now has a sizable acreage position in one shale or another.  No one is desperate to get into a play anymore, virtually every E&P has some kind of meaningful shale position to exploit. 

9) Chesapeake began using off balance sheet financing in recent quarters.  In January 2008, Chesapeake announced their first volumetric production payment (VPP) in the sale of 210 Bcfe for $1.1 billion to Deutsche Bank and UBS.  Four more VPP's have since followed, all told Chesapeake has raised $3.1 billion by selling 570 Bcfe of reserves through VPP's.  Investors love these deals, and while I agree that they've been good transactions for Chesapeake, I don't think the market really understands what VPP's truly are.

VPP's are transactions whereby a company agrees to deliver a certain amount of gas from a field(s) over a specified time frame via an overriding royalty interest.  The seller is required to maintain production, pay all expenses and taxes, retain all environmental liabilities, and will take back the sellers interest after the maturity.  The buyer receives the production free and clear of all expenses - they're only purchasing the revenue stream.  They then hedge out the price risk to lock in a yield that meets their particular rate-of-return hurdle.  Basically, the seller is selling a temporary revenue interest in a group of wells where the production has a small risk of underperforming.  The whole deal is usually off balance sheet for the seller.  The reserves in the deal are considered divestitures and the company books the cash received without accounting for the obligation to deliver the gas to the buyer or any gain-on-sale.  The seller must still spend capital to maintain production as if they still owned the field outright.

What's interesting about VPP's is that they allow the seller to report some impressive sale prices to the public.  For example, in Chesapeake's last VPP in July they sold 68 Bcfe for $5.55/reserve.  Considering gas was trading for $4.00 and the market tends to value PDP's around $1.50-1.75, this was one hell of a deal for Chesapeake.  This is typical of VPP's, since the price/reserve metrics are usually done at small discounts to the strip pricing.  Management touts their enviable sale metrics to the public and gets to report a deleveraging of the balance sheet, meanwhile everyone is awestruck that this company is smarter than everyone else and a lot more sophisticated at executing asset sales.

But there's a lot more going on here. How can a company sell PDP's at prices above the spot price of gas, while the market typically values them at a fraction of gas?  In reality, VPP's are not asset sales at all, they are secured loans that remain off balance sheet in SPE's (as long as the company uses Full Cost accounting, which Chesapeake does)...they're the CDO's of the E&P world, it's nothing more than a securitization that arbitrages the cost of capital vs the contango in the strip.  VPP's are rated by S&P/Moody's.  It's usually banks who provide the capital.  The deals require reserve overcollateralization.  They're non-recourse to the buyer and bankruptcy remote.   The asset is transferred back to the buyer after maturity.  Sure sounds like debt to me, yet Chesapeake is allowed to report them as asset sales.  What is it that makes  VPP's look so attractive when a company like Chesapeake reports them?  Unlike a normal loan which is made against cash flow, a VPP is a loan made against revenue.  VPP's are like getting a commercial mortgage based on rents instead of FFO.  Of course you can borrow more when you're guaranteeing the lender your revenues while you remain on the hook for all of the expenses and production risk.

I'll admit that VPP's are lower risk debt because of the production profile of the wells, but it's debt nonetheless.  There's exposure to the seller in that they have to pay for all of the production expense (typically high for VPP wells), transportation, G&A, workovers, but they can't ever shut-in or suspend operations.  Do I think the use of VPP's is necessarily inappropriate, or puts the company's future in peril?  Not really.  But they are still $3.1 billion in debt instruments that management is able to hide, and the expenses associated with these deals are ongoing fixed costs (maybe $130-150 million annually) that management wont talk much about. 

10) Management compensation is as ridiculous as any company you'll find.  The issues with Aubrey's pay are well known even outside of the energy world.  I encourage people to read the 2008 proxy cover to cover, it's filled with all sorts of goodies including Aubrey selling his $12 million map collection to Chesapeake (your capex dollars at work!), Aubrey steering events to a restaurant he owns, $1.4 million billed to Chesapeake in the last four years for Aubrey's accounting support (two words, dude: Turbo Tax), and plenty of other interesting stuff.  Did I mention he got paid over $100 million in 2008?

What Chesapeake Has Going For Them

My hat goes off to Aubrey in one regard - he managed to pull off one of the most one-sided JV agreements in history by selling a 110,000 Haynesville acres to Plains Exploration for $28,000/acre.  Plains should've filed a police report for getting ripped off that badly, but I guess the Kool-Aid was flowing like water at the time.  Plains needs $8.00 gas just to be breakeven on the deal.  Aubrey also executed two other JV's (Statoil in the Marcellus, BP in Fayetteville) while selling the Woodford Shale properties at high prices.  These deals were admittedly great for Chesapeake and provided desperately needed cash infusions which probably saved the company.  They also have drilling carry clauses in their JV's which mean that up until $X are spent, the partner has to put up say, 50% of the capital in order to receive a 20% interest, after which point the working interests revert back to the normal ratios.  Normally, the carries are a great deal for Chesapeake  because they earn a much better return on their investment.  Unfortunately, at current prices those reserves just aren't worth that much.  This is an extremely important point, and it's why Aubrey loves to talk about F&D while brushing aside PV10.  The sad reality is that much like selling telecom equipment in the early 2000's or selling newspapers today, producing nat gas isn't a very profitable business right now, and it might take a few years to get back to normal.  While they do  have the drilling carries, Chesapeake would be 1,000 times better off if they just received all of the money up-front in cash and paid down debt.  Through these JV's Chesapeake amazingly did show that they might sorta understand the concept of PV, although they were also under serious liquidity constraints which helped guide their behavior.

Cash Flow Valuation

This analysis is predicated on two macro assumptions.  First, that in 2010 gas prices hit very low levels.  Second, gas prices will probably remain low throughout the next few years as the industry goes through a painful shakeout process.

Let's take management at their word about 2010 production growth of 8-10%.  Next year, Chesapeake will produce 900 bcf of gas (2.48 bcf/d) and 12.5 million barrels of oil (34 mbbl/d).  I am using wellhead prices of $3.00 gas and $65 oil.  They'll make $3.5 billion from production, after half of their hedges get blown up they'll make $680 million from hedging, and they'll make another $120 million from service and midstream businesses.  Assume $1.04/mcf in production expense, 3.7% of oil/gas revenues in severance tax expense, and $.41/mcf in G&A and they'll generate about $2.8 billion in EBITDA and $1.9 billion in cash flow ($2.90/share).  Every $.10 change in gas prices affects EBITDA by about $78 million.  No EBITDA multiple will save them in this case, so just valuing it at 4x cash flow, which is the historical average and very reasonable, the stock is only worth $12/share.

On the spending side, they'll incur about $900 million in cash interest charges, they'll spend about $4.6 billion drilling wells, $260 million in seismic, $190 million in common dividends, back out $120 million in option expense, which all totals negative $2.5 billion.  So now they've got, as usual, a funding problem.  Management has already guided for $1.0-1.4 billion in asset sales, but these are highly uncertain and still wont be enough to plug the hole.  Chesapeake will be forced to tap the markets for more capital, which will crush the stock, or they'll slash their capex which means another year of no/negative growth. 

There is another problem here which is that Chesapeake will easily trip their debt/EBITDA covenant of 3.75:1 on their revolver next year.  They are actually very close to tripping it today, as of 9/30/09 the ratio stood at 3.48:1 and that's with the benefit of some higher prices from 9-12 months ago.  Although the banks would likely modify the covenant, it's still possible the maturity of the loan could be accelerated to be due immediately.  The banks might feel different if gas averages $3.00 throughout 2010, and Chesapeake's debt/EBITDA spikes to 5.0x. 

Some notes about their financial reporting.  Chesapeake capitalizes about 75% of their interest so it wont screen well as being dangerously levered.  I add all capitalized interest to the income statement.  Also, debt is $1 billion higher than what is stated, as they back out the negative equity value from their converts ($2.7 billion total outstanding, the conversion prices are all much higher than the current stock price).  I calculate that as of 9/30/09, Chesapeake has $13.5 billion in debt ($460 million is preferred stock) and $520 million in cash.  The weighted average interest rate on the debt is 6.5%.

NAV Valuation

This analysis certainly has its merits, but it's important to understand that Chesapeake has levered up to buy non-cash flowing assets, and the value of their assets can change dramatically with changes in gas prices and investors can stop caring about the value of the non-cash flowing assets in a hurry.  When things go south, people start valuing these companies on how much they actually make rather than what their NAV is.

Their PV10 is only 68% producing reserves, so I haircut it to avoid double counting the PUD's and the leases.  A PUD is nothing more than a low risk lease, but because of the economics and success rate of shale it really doesn't matter much what a company tells you their PUD's are, any dummy can figure it out (btw, accounting rule changes will soon allow companies to book whatever the feel like as PUD's, so people are going to start getting used to separating the PUD's from the PDP's in the NAV's).  My sensitivity is based on management's guidance that every $.10 change in NYMEX affects PV10 by $400 million (at 68% it's $272 million).  I'm using the 9/30/09 as the reference point, which reported $7.6 billion in PV10 ($5.2 billion for the PDP) at $3.30 NYMEX.  My sensitivity comes out pretty close to prior quarters of what the company has reported.  The midpoint is current NYMEX. 

On the acreage I do my best to account for a couple things.  First, they report their total net leasehold position, so I try to back out the developed acreage based on various data points.  Second, areas like the Marcellus are highly variable and while they report having 1.5 million acres a much smaller percent of that is worth anything.  For example, they have a ton of acreage in New York and West Virginia which is hardly worth anything at all.  Finally, I'll admit that they've got hundreds of thousands of other leases, but I just don't know how to value them, the company doesn't provide enough information.  I'm trying to only focus on the high impact plays. 

Here is what remains beyond reserve related assets.  It's mostly the midstream business and various equipment.

Tie it all together and here's what we've got.  Obviously, this is a strikingly wide range of values, but even in an optimistic scenario the company is fairly valued today.  I feel pretty confident about the midpoint being the appropriate mid/long-term valuation to use because of the broken fundamentals in the nat gas market.  So either way I value this company, I think fair price is about $10/share. 

Conclusion

Here's how I think this plays out.  Next year gas sinks to $3.00 or less and all of the stocks get [ahem] drilled.  Shorts start circling Chesapeake for having the worst management, the highest debt, and the fewest hedges.  Analysts start to press management on why they're spending $4.6 billion on drilling (a 45% increase yoy) when gas is so low and they're losing money.  The company has a difficult time finding buyers for assets at reasonable prices, and as Aubrey's history with hedging shows he's willing to risk the entire company to get a better price on a deal.  Liquidity problems emerge as debt covenants gets tripped and we replay the events of 2008.

So management either (a) significantly reduces the capex budget, which kills growth while still doing little to delever the balance sheet, (b) sells more assets than anticipated, and at lousy prices, or (c) issues a lot more equity to plug the gap and show some kind of deleveraging (my guess is over $1 billion, so maybe another 12-20% dilution, but who knows).   I bet you'll see a combination of all three, but in any case the stock will get killed and I think it will trade down to about $10/share, perhaps lower if there's real panic, which is entirely possible with this company...nothing would surprise me at this point. 

The sell-side gets this stock all wrong because (a) they take management at their word about future multi-billion dollar asset sales, (b) they remain anchored to their NAV's, (c) their nat gas estimates are still too high, often well above current strip, (d) they don't properly account for capitalized interest in their CFPS estimates, and (d) Chesapeake generates millions in fees for these firms...they're a banker's dream.

I realize a lot of this is predicated on sharply lower gas prices, so what if I'm wrong about my gas call?  Using the current strip ($5.25 average for 2010; knockouts and 3-ways stay intact), Chesapeake is still FCF negative by $1.0 billion in 2010 assuming no asset sales.  They'll generate $4.7 billion in EBITDA, which at 5.0x (this might be generous) is a fair value of $17/share.  Alternatively, cash flow per share will be about $6.00, which at 4x is $24/share.  Using 2011 strip price average of $6.15 gets you to $5.4 billion in EBITDA and $7.00/share in cash flow, for a mid-high $20's price target.  What is the upside to this stock???  Even if gas prices rally Chesapeake will always garner a valuation discount because of management and the high debt load.  The bottom line is that this company only works if gas is much, much higher, which is why in their own guidance they're forced to use $7.00 and $7.50 gas prices for 2010 and 2011, respectively.

Catalyst

Nat gas moves lower

Equity raise

Capex cuts

Analyst downgrades