CHK - Chesapeake Energy

[muscleman]

I will try to find it if I can. It has been over six months so it is not easy.

I think chk seems to own a smart team that can forecast gas prices more effectively than most hedge funds?

Selling calls seems to be a dangerous business to be in. how long are the calls into?

I hope not too long.

I have been thinking about betting on the gas recovery for three years. I think chk is probably a very good bet. If price remains low, it's oil production can still buy us time to wait.

What other companies do you think are good gas bet?

 

I would never invest in CHK for their ability to forecast gas prices, but their track record in doing so is excellent.  Unlike hedge funds, CHK is the most active driller in the country and is involved in the most areas and most wells, so they should have better information on supply than anyone else.  Of course demand (weather) is another story . . .

 

I don't think selling calls on gas is a dangerous business for CHK, because they produce a ton of gas.  They are basically hedging, but instead of entering a forward contract they have simply sold a portion of their upside.  This leaves them exposed to the downside, so it isn't really a hedge, but it gets them money up front.  CHK's logic is basically: "if gas prices rose to $6 per mcf tomorrow, we would be making a bunch of money and shareholders would want us to hedge some of our production, so what's the big deal about selling $6 calls on 20% of what we will produce".  In the meantime, this looks to have been a shrewd bet that more cheap supply would come to market (which CHK would be in a position to know).  Like Buffett's put sale on the market, they have gotten money up front (which can be compounded), and they are winning the bet.

 

CHK discloses what calls they have sold in their financial filings.

 

I don't think anything else is as cheap as CHK, but other good ways to play a gas recovery are:

 

Buy DVN: it's cheap(ish), has good management, a great balance sheet and a lot of production.  I think they get sold in a few years

 

Buy UPL: it has more debt, but I like their assets and management, and its cheap

 

Buy CNX: its cheap(ish), has large cash flow from great coal operations and a lot of decent gas exposure

 

Buy XCO: its cheap and has a touch balance sheet, but Wilbur Ross is involved (see ICO)

 

In short, if you want great assets, you either have to pay up, or accept a weak balance sheet.  I like CHK because the world hasn't realized that their balance sheet isn't weak anymore.

 

Thanks a lot! I have learned a lot from you!  :D

 

When I saw selling call options, my first impression was naked call options. But I forgot that they have productions so it is actually pretty safe then.

[ItsAValueTrap]

I think chk seems to own a smart team that can forecast gas prices more effectively than most hedge funds?

Didn't they do really stupid knock-out hedges in the past?

[muscleman]

I will try to find it if I can. It has been over six months so it is not easy.

I think chk seems to own a smart team that can forecast gas prices more effectively than most hedge funds?

Selling calls seems to be a dangerous business to be in. how long are the calls into?

I hope not too long.

I have been thinking about betting on the gas recovery for three years. I think chk is probably a very good bet. If price remains low, it's oil production can still buy us time to wait.

What other companies do you think are good gas bet?

 

I would never invest in CHK for their ability to forecast gas prices, but their track record in doing so is excellent.  Unlike hedge funds, CHK is the most active driller in the country and is involved in the most areas and most wells, so they should have better information on supply than anyone else.  Of course demand (weather) is another story . . .

 

I don't think selling calls on gas is a dangerous business for CHK, because they produce a ton of gas.  They are basically hedging, but instead of entering a forward contract they have simply sold a portion of their upside.  This leaves them exposed to the downside, so it isn't really a hedge, but it gets them money up front.  CHK's logic is basically: "if gas prices rose to $6 per mcf tomorrow, we would be making a bunch of money and shareholders would want us to hedge some of our production, so what's the big deal about selling $6 calls on 20% of what we will produce".  In the meantime, this looks to have been a shrewd bet that more cheap supply would come to market (which CHK would be in a position to know).  Like Buffett's put sale on the market, they have gotten money up front (which can be compounded), and they are winning the bet.

 

CHK discloses what calls they have sold in their financial filings.

 

I don't think anything else is as cheap as CHK, but other good ways to play a gas recovery are:

 

Buy DVN: it's cheap(ish), has good management, a great balance sheet and a lot of production.  I think they get sold in a few years

 

Buy UPL: it has more debt, but I like their assets and management, and its cheap

 

Buy CNX: its cheap(ish), has large cash flow from great coal operations and a lot of decent gas exposure

 

Buy XCO: its cheap and has a touch balance sheet, but Wilbur Ross is involved (see ICO)

 

In short, if you want great assets, you either have to pay up, or accept a weak balance sheet.  I like CHK because the world hasn't realized that their balance sheet isn't weak anymore.

 

Since CHK is No.1 in cheapness, and its upside is also probably the highest, then there is no need to buy other inferior gas stocks. ;)

I looked through the balance sheets of the past 3 10-Qs, but they look similar. If they have sold a lot of assets, then I would expect the balance sheet to show much less asset and much less liabilities there, right?

 

http://www.energyandcapital.com/articles/chesapeake-nyse-chk-selling-69-billion-to-cover-debt/2566

From this link, it says there is a 6.9 Billion sale. Is that already closed or it is about to close by year end?

I see from the 10-Q for September 2012 that they received debt covenant modification to allow temporary incompliance for the next 4 quarters, because the assets sales will close by the 4th quarter instead of the 3rd, therefore making the debt covenant incompliant.

 

If they do close these transactions at these amounts, and with this news, I believe it has achieved the goal.

 

http://www.bizjournals.com/houston/news/2012/12/12/chesapeake-energy-selling-2b-in.html

 

[T-bone1]

I think chk seems to own a smart team that can forecast gas prices more effectively than most hedge funds?

Didn't they do really stupid knock-out hedges in the past?

 

Yes. 

 

They have used knock out swaps (selling a call and buying a put like a regular collar, but then selling a binary put that calls the whole deal off at a lower price) for a long time.

 

Over CHK's history, they have made more money because they used knock out swaps (including the times they have been "knocked out") than they would have made without using them - because knock out swaps are cheaper.

 

Of course CHK was running a perpetual funding deficit during those years, so it is quite valid to say that they should never use something like that. 

[PlanMaestro]

Man, T-bone1 has surely done his CHK homework. You just sit and listen.

[txlaw]

Man, T-bone1 has surely done his CHK homework. You just sit and listen.

 

Agreed. 

 

T-bone1 clearly is a competent O&G investor.  I'm learning a lot from him.

[ItsAValueTrap]

Over CHK's history, they have made more money because they used knock out swaps (including the times they have been "knocked out") than they would have made without using them - because knock out swaps are cheaper.

Are you sure about that?

 

If you were a really smart investment bank... you would sell these complex derivatives to companies to rip them off.  And then when the spot price of natural gas comes close to the barrier/knock-out price, there would be this "accident" where unusual selling causes the hedge to be knocked out.

[T-bone1]

Thanks guys, unfortunately the homework was the result of underperforming investments rather than in preparation for the current opportunity.

 

With regard to the knock-out swaps, CHK basically said "natural gas goes below $3.00 so rarely that we will take that risk in return for $0.50 extra on our swaps year-in-year-out". 

 

It was a good bet, but one better suited to Berkshire than Chesapeake - a company that needed its hedged cash flow for capex.  With abundant production from shale, it would not longer be a good bet to make, and Chesapeake stopped before this year.

 

I think it was just one more example of Chesapeake doing clever things that were a little dangerous . . . sooner or later these things bite you even if they were a good idea in isolation.  Buffett could lever up and make more money, but he doesn't to avoid tail risk.

 

In either case, I don't think CHK's hedge counterparty could or would manipulate the entire gas market to knock CHK out of its swaps.

[muscleman]

Thanks guys, unfortunately the homework was the result of underperforming investments rather than in preparation for the current opportunity.

 

With regard to the knock-out swaps, CHK basically said "natural gas goes below $3.00 so rarely that we will take that risk in return for $0.50 extra on our swaps year-in-year-out". 

 

It was a good bet, but one better suited to Berkshire than Chesapeake - a company that needed its hedged cash flow for capex.  With abundant production from shale, it would not longer be a good bet to make, and Chesapeake stopped before this year.

 

I think it was just one more example of Chesapeake doing clever things that were a little dangerous . . . sooner or later these things bite you even if they were a good idea in isolation.  Buffett could lever up and make more money, but he doesn't to avoid tail risk.

 

In either case, I don't think CHK's hedge counterparty could or would manipulate the entire gas market to knock CHK out of its swaps.

 

Underperforming? I compared CHK's stock price with gas futures. It looks like CHK is overperforming the gas futures.

[ItsAValueTrap]

Thanks guys, unfortunately the homework was the result of underperforming investments rather than in preparation for the current opportunity.

 

With regard to the knock-out swaps, CHK basically said "natural gas goes below $3.00 so rarely that we will take that risk in return for $0.50 extra on our swaps year-in-year-out". 

 

It was a good bet, but one better suited to Berkshire than Chesapeake - a company that needed its hedged cash flow for capex.  With abundant production from shale, it would not longer be a good bet to make, and Chesapeake stopped before this year.

 

I think it was just one more example of Chesapeake doing clever things that were a little dangerous . . . sooner or later these things bite you even if they were a good idea in isolation.  Buffett could lever up and make more money, but he doesn't to avoid tail risk.

 

I doubt that Berkshire would ever, ever put on the knock-out hedge trade.  To me, it's so obvious that it's dopey and designed to rip off the person buying it.

 

The Berkshire put trade has a few characteristics to it:

A- It games the black-scholes model.  The premise is that stock markets are overly volatile in the short-term / there is excess volatility.  In the long run, they aren't that volatile.

B- No counterparty risk if collateral is posted.

C- Buffett learned about derivatives the hard way when he bought SwissRe and lost a lot of money closing down its derivatives unit.  Some companies will make dumb trades due to perverse incentives (and because they can book accounting profits).  After being the victim, he tried to become the victimizer.

D- It wasn't that great a trade because in 2008/2009 Berkshire lost its triple A rating and couldn't capitalize on market opportunities as much.  But it probably won't be a terrible trade either.

 

In either case, I don't think CHK's hedge counterparty could or would manipulate the entire gas market to knock CHK out of its swaps.

Legally... I'm not sure if it is entirely legal for the counterparty to manipulate the gas market.  If they get caught, I think that the SEC would fine them.  If they don't do the trades themselves but convince their clients that they should sell their long natgas positions... they would probably get away with it.

 

In practice... of course they are going to manipulate the gas market!!!  Investment banks get fined all the time for doing things that they shouldn't.  It happens constantly.  And those are only the cases where they are caught.

 

Taleb's book on derivatives goes into this a little bit.  The subtext in his book is that of course the market will be manipulated.

[muscleman]

Thanks guys, unfortunately the homework was the result of underperforming investments rather than in preparation for the current opportunity.

 

With regard to the knock-out swaps, CHK basically said "natural gas goes below $3.00 so rarely that we will take that risk in return for $0.50 extra on our swaps year-in-year-out". 

 

It was a good bet, but one better suited to Berkshire than Chesapeake - a company that needed its hedged cash flow for capex.  With abundant production from shale, it would not longer be a good bet to make, and Chesapeake stopped before this year.

 

I think it was just one more example of Chesapeake doing clever things that were a little dangerous . . . sooner or later these things bite you even if they were a good idea in isolation.  Buffett could lever up and make more money, but he doesn't to avoid tail risk.

 

I doubt that Berkshire would ever, ever put on the knock-out hedge trade.  To me, it's so obvious that it's dopey and designed to rip off the person buying it.

 

The Berkshire put trade has a few characteristics to it:

A- It games the black-scholes model.  The premise is that stock markets are overly volatile in the short-term / there is excess volatility.  In the long run, they aren't that volatile.

B- No counterparty risk if collateral is posted.

C- Buffett learned about derivatives the hard way when he bought SwissRe and lost a lot of money closing down its derivatives unit.  Some companies will make dumb trades due to perverse incentives (and because they can book accounting profits).  After being the victim, he tried to become the victimizer.

D- It wasn't that great a trade because in 2008/2009 Berkshire lost its triple A rating and couldn't capitalize on market opportunities as much.  But it probably won't be a terrible trade either.

 

In either case, I don't think CHK's hedge counterparty could or would manipulate the entire gas market to knock CHK out of its swaps.

Legally... I'm not sure if it is entirely legal for the counterparty to manipulate the gas market.  If they get caught, I think that the SEC would fine them.  If they don't do the trades themselves but convince their clients that they should sell their long natgas positions... they would probably get away with it.

 

In practice... of course they are going to manipulate the gas market!!!  Investment banks get fined all the time for doing things that they shouldn't.  It happens constantly.  And those are only the cases where they are caught.

 

Taleb's book on derivatives goes into this a little bit.  The subtext in his book is that of course the market will be manipulated.

 

I checked CHK's latest 10-Q but find that the knockout swap section has value of -. I think this means they are no longer doing that, right?

 

Regarding gas prices, I think both parties have the ability to manipulate to some extent.

CHK cut down gas production during Q1 2012 of 60 BCF due to lower gas prices. Given CHK's position in the suppliers, it can affect gas price to some extent, legally.

[argonaut]

Thanks for the LongLeaf update. On a related OID note --- I subscribe and read the extensive Morris Snyder report in OID. Has anyone come across any recent updates from Nick? It seems CHK has been executing well on their plan albeit with prices a little lower than initially forecast. And with an extension of funds now with the recent loan close. I did a Google search but find nothing from him since the original write-up.

[muscleman]

Thanks guys, unfortunately the homework was the result of underperforming investments rather than in preparation for the current opportunity.

 

With regard to the knock-out swaps, CHK basically said "natural gas goes below $3.00 so rarely that we will take that risk in return for $0.50 extra on our swaps year-in-year-out". 

 

It was a good bet, but one better suited to Berkshire than Chesapeake - a company that needed its hedged cash flow for capex.  With abundant production from shale, it would not longer be a good bet to make, and Chesapeake stopped before this year.

 

I think it was just one more example of Chesapeake doing clever things that were a little dangerous . . . sooner or later these things bite you even if they were a good idea in isolation.  Buffett could lever up and make more money, but he doesn't to avoid tail risk.

 

In either case, I don't think CHK's hedge counterparty could or would manipulate the entire gas market to knock CHK out of its swaps.

 

T-bone1, have you done any research on the natural gas prices?

I see that supply is likely going to go down next year, and General Motors is going to sell natural gas trucks in late 2013.

I am concerned if the current fiscal cliff things will hurt the demand for gas.

[T-bone1]

Hi Muscleman,

 

I've done a lot of research on gas supply and demand . . . But I can't say it has led to any definitive conclusions.  I am bullish on the gas strip, which is to say that I believe future prices will be higher than is currently predicted by the futures contracts. 

 

With regard to the spot price, I really have nothing of value to add.

 

Despite a lot of talk about unlimited gas supply at ever lower prices (people said $6 two years ago, now they say $4), I don't think low prices are here to stay.  The only observations I can offer that may have some value are:

 

1) the all in cost of bringing on new supply is $1-2/mcf in some places, but to maintain production I believe that wells with a $5-6 all-in cost will need to be drilled in the next three years

 

2) it takes about a year to really ramp up production in an area.  A large inventory of existing drilling pads and midstream pipelines might lower this to six months, but prices will have to rise before the redeployment starts in places like the Barnett

 

3) low ethane prices will hurt the profitability of a lot of wet gas plays, slowing their growth

 

4) weather will continue to be unpredictable, but this will help the gas price at some point (hot summer, cold winter)

 

This probably isn't very helpful, but it's all I've got unfortunately

 

Cheers

[muscleman]

Hi Muscleman,

 

I've done a lot of research on gas supply and demand . . . But I can't say it has led to any definitive conclusions.  I am bullish on the gas strip, which is to say that I believe future prices will be higher than is currently predicted by the futures contracts. 

 

With regard to the spot price, I really have nothing of value to add.

 

Despite a lot of talk about unlimited gas supply at ever lower prices (people said $6 two years ago, now they say $4), I don't think low prices are here to stay.  The only observations I can offer that may have some value are:

 

1) the all in cost of bringing on new supply is $1-2/mcf in some places, but to maintain production I believe that wells with a $5-6 all-in cost will need to be drilled in the next three years

 

2) it takes about a year to really ramp up production in an area.  A large inventory of existing drilling pads and midstream pipelines might lower this to six months, but prices will have to rise before the redeployment starts in places like the Barnett

 

3) low ethane prices will hurt the profitability of a lot of wet gas plays, slowing their growth

 

4) weather will continue to be unpredictable, but this will help the gas price at some point (hot summer, cold winter)

 

This probably isn't very helpful, but it's all I've got unfortunately

 

Cheers

 

Thanks a lot T-bone1.

GM is going to launch a natural gas---gasoline bi-fuel truck in 2013. That is bullish for the gas prices.

I heard that utilities are switching to gas too, but if prices go up, they will switch back to coal. Is there any environmental regulations that favor gas over coal?

This winter is really warm, and do you think the gas price will usually drop in spring?

[enoch01]

What good reasons would someone have to short Chesapeake here?

[plato1976]

Can it survive in a prolonged low NG price environment ?

Let's say $3 - $2 NG price for 5 years +

Anyone calculated (let's suppose they cannot sell their assets)?

 

In many places in the U.S. , if you don't drill  you lose the lease (and if you drill you lose your cash )

 

 

What good reasons would someone have to short Chesapeake here?

[muscleman]

Can it survive in a prolonged low NG price environment ?

Let's say $3 - $2 NG price for 5 years +

Anyone calculated (let's suppose they cannot sell their assets)?

 

In many places in the U.S. , if you don't drill  you lose the lease (and if you drill you lose your cash )

 

 

What good reasons would someone have to short Chesapeake here?

 

The current environment is sufficient to bring in $4.5 to $5 bn cash from operations, which is sufficient to fund their capex in oil.

After 4 years, they will have sufficient oil wells to support the company, and the gas operations will become a big call option for free.

That was my thesis when I bought.

I am bullish on the natural gas price, with so many gas producers dropping rig counts, and General motors going to release a natural gas truck this year.

For other gas producers, they are dry gas, so I am worried if they can survive prolonged low gas prices. But CHK has liquids to support it during the tough periods.

They will put in 15% of the capex into drilling gas wells, which I  think is for maintaining the minimum lease requirements.

[Evolveus]

Just as an interesting aside (re:capex) I just got a solicitation letter from CHK to buy my mineral rights that I have in gas fields in Tarrant County (near Fort Worth). It says:

 

"Chesapeake is actively pursuing the acquisition of additional interested in Chesapeake's wells. Additionally, Chesapeake would also have an interest in acquiring your non- Chesapeake interests in the Mid-Continent, Fort Worth Barnett Shale, Delaware Basin, south Texas, Texas Guld Coast, Ark-La-Tex and Appalachian Basisns."

 

The size of my interests are insignificant to chk, but I was a little surprised to see "active pursuit" of additional interests across several different plays.  I would also note that I got a letter from another O&G company to buy the rights about two weeks before this. That offering price was very low.

[compoundinglife]

Haven't seen this posted yet:

 

http://www.forbes.com/sites/abrambrown/2013/01/02/two-celebrated-investors-want-to-fix-their-funds-and-chesapeake-energy/

 

Article about Mason Hawkins and Staley Cates, talks about CHK. This made me happy WRT Lou's presence on the board:

 

“Lou has actually been a real hard-ass. He’s not the friendly old uncle that Buffett is seen as,” says Cates.

[luck]

yeah, nice article.  glad lou is on top of it.  he also bought 2.6 million dollars worth at $26.69 in november 2011 i believe.

[compoundinglife]

yeah, nice article.  glad lou is on top of it.  he also bought 2.6 million dollars worth at $26.69 in november 2011 i believe.

 

I thought it was 200,000 shares total at a cost around 5.3M, I will look it up tomorrow.

[compoundinglife]

yeah, nice article.  glad lou is on top of it.  he also bought 2.6 million dollars worth at $26.69 in november 2011 i believe.

 

I thought it was 200,000 shares total at a cost around 5.3M, I will look it up tomorrow.

 

Ok, couldn't resist looking up before bed. You are right 100k purchase in Nov, 2011 but he also bought 100k shares in August of 2011:

 

http://www.marketwatch.com/investing/stock/chk/insiders?pid=41724793

 

 

[nkp007]

This thread has been enormously helpful. I decided to make a concentrated investment today. This isn't a clean investment and there are many reasons why traditional Buffett type-investors will shy away from Chesapeake, but I like the new levels of oversight as well as (most importantly) the long-term characteristics of natural gas on the supply and demand side.

 

I look for asymmetric opportunities. I believe this is one.

 

Positives:

-Natural gas at trough margins, below cost of production, potential supply reductions in 2013 - 2015

-New group of activist investors who have taken control of the board

-Transition to some oil production

-Asset coverage limits downside and debt maturities really start big in 2017

 

Negatives:

-Aubrey is a wildcatter with capital allocation (main risk, though more oversight now)

-Cash flow covenant breach possibility

-Share offering risk if asset sales don't happen

-They were wrong about the total value of their Permian assets upon a stressed sale (even if I discount their other assets by the same discount, I still find downside limited)

-Commodity

 

It's not pretty and tied up in a bow, but great investments rarely are. The main thing here is that the downside is very limited, even after I take very liberal discounts to asset value.

 

 

 

 

[muscleman]

This thread has been enormously helpful. I decided to make a concentrated investment today. This isn't a clean investment and there are many reasons why traditional Buffett type-investors will shy away from Chesapeake, but I like the new levels of oversight as well as (most importantly) the long-term characteristics of natural gas on the supply and demand side.

 

I look for asymmetric opportunities. I believe this is one.

 

Positives:

-Natural gas at trough margins, below cost of production, supply reductions in 2013 - 2015

-New group of activist investors who have taken control of the board

-Transition to some oil production

-Asset coverage limits downside and debt maturities really start big in 2017

 

Negatives:

-Aubrey is a wildcatter with capital allocation (main risk, though more oversight now)

-Cash flow covenant breach possibility

-Share offering risk if asset sales don't happen

-They were wrong about the total value of their Permian assets upon a stressed sale (even if I discount their other assets by the same discount, I still find downside limited)

-Commodity

 

It's not pretty and tied up in a bow, but great investments rarely are. The main thing here is that the downside is very limited, even after I take very liberal discounts to asset value.

 

How much discount did you take for the assets?

I think this year will be bullish for nat gas, with Dodge Ram releasing a nat gas-gasoline bi-fuel truck, and also I heard Dodge cart is on the way too. It is worth to check the pre-orders for these trucks. I heard it is very popular, but I haven't found the exact number yet.

BTW: I long both Fiat and CHK to play the nat gas theme. :)