I wrote this article for the Motley Fool under the title: “Chesapeake Should Heat Up Over This Cold Winter” I’m expecting demand for natural gas to rise in the short term due to a colder winter than last year for the eastern half of the United States and coal to gas switching among electrical utilities. In the long term I expect a large increase in demand in the US for natural gas from exports and vehicle usage. Chesapeake Energy Corporation is more heavily weighted towards natural gas, than most producers in the sector. A great deal of bad news for natural gas has not been kind to Chesapeake’s share prices but if you read on I think you’ll agree that they are a somewhat risky investment that should produce a large reward in the intermediate to long term.

It’s value hunting season for beaten up natural gas stocks. I’ve got my sites set on Chesapeake Energy (NYSE: CHK) and my eyes glued to weather reports. For the last 12 months, Chesapeake’s share price has risen and mostly fallen in tandem with natural gas spot prices. When the weather turns colder than usual, natural gas prices in the US tend to rise. This year the NOAA is predicting a winter a bit warmer than the 30 year average, but still much colder than last year for the eastern half of the US.

 

 

A colder winter than last year’s isn’t the only reason to expect natural gas spot prices to rise in the near term. The “cash and carry” deals that allowed Chesapeake and other producers to rapidly develop shale plays with the stipulation that they continue drilling regardless of plummeting spot prices have run their course. Other reasons to expect higher prices over winter and into 2013 include:

  • The latest natural gas rig count is at 422, down from over 800 one year ago, according to Baker Hughes.
  • Storage levels are high, but overflow fears are finished.
  • Gross pipeline imports are dropping.

Chesapeake’s balance sheet merits caution.

When something seems too good to be true, it might be insolvent. Taking on heaps of debt to develop assets then producing at below cost have taken their toll on Chesapeake’s balance sheet. As of June 30, 2012 Chesapeake’s current assets aren’t enough to cover its current liabilities and long term debt has piled up to $14.33 billion or 72% of shareholder equity.

Why not choose a producer without liquidity issues?

In a valuation comparison with Apache (NYSE: APA), Devon (NYSE: DVN) and the world’s number one natural gas producer ExxonMobil (NYSE: XOM) it is clear that Chesapeake is clearly the most undervalued. Investigations into CEO, and then Chairman of Chesapeake Energy, Aubrey McClendon’s questionable personal financial deals did his company’s share price no favors. He has been sent to his room without dinner and stripped of his chairman title. He is still CEO and President of Chesapeake, but I doubt his wife will be using the company jet from now on.

 Price/Sales TTMPrice/Earnings TTMPrice/Book ValuePE/Annual Earnings Growth
Chesapeake1.086.470.800.05
Apache2.44NA1.570.64
Devon2.1610.021.080.21
ExxonMobil0.859.482.510.38

One of the reasons I think Chesapeake is still far more undervalued than its peers is poor timing by the SEC. Investigations into McClendon coincided with plummeting natural gas prices. McClendon’s transgressions have been largely forgiven, but investors are waiting for two developments. First, the market is intently watching as the company sells off about $14 billion in assets to shore up liquidity. The second, of course, is a rise in natural gas prices. The company has been moving into more lucrative oil and natural gas liquids recently, but the majority of its assets are ready to produce dry gas.

When sinking money into a company with liquidity issues, especially one that relies so heavily on commodity prices, you cross over from investing to gambling territory. I strongly recommend limiting the size of your position and/or using options to limit potential losses to a number you can live with, at least until the company’s liquidity fears are assuaged. Chesapeake Energy reports Q3 2012 earnings on Monday, October 29th, the call is scheduled for Friday, November 2 at 9AM. It is going to be the most highly anticipated earnings calls in the energy sector this quarter. If Chesapeake’s asset sales prove successful, I suggest increasing your long position and praying for a long cold winter.