Energy: Complacency Breeds Opportunity

Just four short months ago, the rapid rise in oil and natural gas prices was widely considered one of the most acute problems facing the global economy. Energy was a central issue of the 2008 US presidential campaign, the subject of seemingly endless Congressional enquiries and countless news stories.

Sentiment has changed. Just last week I listened to a Congressman from a local district discuss energy and commodity prices. He stated that the commodity cycle had turned and implied that the problem of rapidly rising energy prices had been “solved.”

Sadly, that complacency is widespread. The weak global economy and the resulting slump in global oil demand have certainly granted the world a temporary reprieve from ever-rising energy costs. But the lingering consequences of that price decline are already sowing the seeds for the next rally; the longer prices remain depressed, the larger and more enduring the coming rally.

But there’s a silver lining amid the current market turmoil: The temporary pullback in prices has hit most stocks in the energy space hard, driving down valuations to the lowest levels since 1998, when oil was trading below USD20 a barrel and natural gas sold for less than USD2 per million British thermal units (MMBtu). This marks an outstanding opportunity for investors to buy stocks at depressed prices ahead of the next up-cycle.

And investors aren’t the only group that sees value. With so many energy stocks trading off their highs, we’re likely to see a mini-boom in merger-and-acquisition activity in coming quarters. Larger energy firms with cash and access to debt markets are in an excellent position to acquire oil and natural gas reserves cheaply by buying smaller competitors.

From Demand to Supply

Commodity markets are intently focused right now on only one side of the price equation: global demand. The news on the demand front is clearly negative thanks to a vicious downturn in the US economy. Check out the chart below of the Index of Leading Economic Indicators (LEI) for a closer look.

Source: Bloomberg

This chart shows the LEI going back to the early 1970s. The LEI is nothing more than an index based on 10 key economic indicators; I look at the year-over-year change in LEI as a quick indication of the health of the US economy. When the year-over-year change in LEI turns negative, the US economy is most likely in recession; a quick glance at the chart shows that the LEI has accurately tracked all recessions going back to 1970.

As you can see in the chart, the LEI turned negative late in 2007 and continues to deteriorate. There’s little doubt that the US economy is in recession and has been for close to a year.

The lingering effects of the severe credit crunch experienced in September and October will mean further negative economic news over the next few months. In short: This recession is likely to be similar to the severe contractions of 1973-74 and 1982 rather than the relatively shallow recessions in the early 1990s and in 2001.

This is having a profound effect on global oil demand. The Energy Information Administration (EIA) revised its projections for 2008 and 2009 oil demand sharply lower in its most recent short-term energy outlook, published last week. The EIA is looking for a steep decline in demand from the developed world–offset to a great extent by continued strong growth in oil consumption from developing countries.

The offshoot: For 2008 and 2009 combined, the EIA is looking for total global growth in oil demand of just 100,000 barrels a day (bbl/d). During the past five years, oil demand has risen by an average of 1.48 million bbl/d annually; the current rate of demand growth is the slowest since 1993.

But looking out over the longer term, the big issue facing crude today isn’t demand but supply. On Nov. 12, the International Energy Agency (IEA) released its annual World Energy Outlook, projecting that the world will need to spend more than USD26 trillion dollars between now and 2030 just to meet rapidly growing demand for oil. That amounts to more than USD1 trillion in spending every year.

The IEA also highlighted the increasing costs and complexity of exploring for and producing crude, a point I outlined at some length in a Sept. 18 article for New World, Oil 3.0. This will make it difficult for global oil production to rise, even with massive capital spending on exploration and infrastructure.

Ironically, the current depressed commodity price environment is the most bullish development for crude oil pricing imaginable. The reason is that current prices don’t support the level of capital spending needed to bring new reserves into production; you won’t see the USD1 trillion in investment the IEA says we need with oil prices in the 60s. That means that when demand growth does reaccelerate, there simply won’t be enough productive capacity available to meet those needs.

This point was highlighted in New World 3.0 Portfolio holding Schlumberger’s (NYSE: SLB) quarterly conference call. CEO Andrew Gould stated that if producers decide to cut back on spending due to lower commodity prices or the credit crunch, the result would be accelerating declines in production from existing fields, particularly in non-OPEC countries. The longer prices remain depressed and drilling activity weak, the larger the effect on supply.

Gould predicted that even if there were no growth in global oil demand, the oil market would balance within 18 months. The reason is that global oil supplies would quickly fall and re-tighten the oil market.  

And don’t forget the US has already been in recession for roughly a year. Even the severe recessions of 1973-74 and 1982 lasted for only around 16 months. That means that it’s likely that by the latter half of 2009, the US will already be in recovery mode. A recovery in the US economy coupled with gasoline prices in the USD2.50 per gallon region would quickly result in a jump in demand. A sharp fall in supplies coupled with a stabilization or reacceleration of demand would spell another big rally in crude oil prices.

Demand for natural gas is far less sensitive to economic growth than demand for crude oil. According to the EIA’s short-term energy outlook (STEO), US demand for natural gas is likely to rise by 1.1 percent in 2008 despite the economic slowdown.

The main driver of weakness in gas prices has been fear of a major jump in US gas supply as a result of success in drilling US unconventional gas fields.  I highlighted the tremendous growth in US unconventional gas production in an Oct. 6 New World article, America’s Gas Growth.

But, just as with oil, current depressed gas prices will ultimately mean tighter supply. Producers are already scaling back their drilling activity and idling drilling rigs. Smaller gas producers with higher production costs are making even bigger spending cuts as many just aren’t profitable with gas around USD7 per MMBtu. Fears of a major gas glut are vastly overblown.

Meanwhile, the long-term potential for natural gas demand is impressive.  Gas is the most environmentally friendly fossil fuel; it emits half the carbon dioxide of coal and a tiny fraction of the sulphur dioxide, nitrous oxide and mercury. As more stringent environmental and carbon dioxide regulation is likely in the US over the next few years, natural gas is one of the only ways of meeting demand for electricity and cutting emissions.

Tempting Valuations

Despite this long-term upside potential for both oil and natural gas, energy-related shares have been hit hard since mid-summer due to commodity price weakness.

In addition, many energy-oriented stocks have been slammed by institutional forced share liquidations. Liquidations occur when institutional investors must sell their stocks to raise cash. For example, hedge funds have seen hefty redemption requests from their investors in recent months as the market tumbled; these funds must honor those redemption requests, and that means selling off their portfolio regardless of fundamentals.

As a result of this cash-motivated selling, many stocks are currently trading at distressed valuations. This offers a huge opportunity for investors with a longer time horizon to pick up high-quality stocks at decade-low valuations. Check out the charts below.

Source: Bloomberg
Source: Bloomberg

These charts show the price-to-earnings and price-to-cash flow ratios for the S&P 500 Energy Index going back to late 1997. On both valuation metrics, the index is trading at its lowest valuations since the late ’90s, when oil and gas prices were at a third or less of current levels. A panicky market and cash-motivated sellers have pushed these stocks to valuation levels that don’t reflect market fundamentals.

This is certainly great news for long-term investors, offering an opportunity to pick up the best-placed stocks in the group at an outstanding price. And consider the current market from the perspective of a big integrated oil company. Most of the big integrated names have experienced considerable difficulty replacing their reserves in recent years; in other words, they’re not finding new reserves of oil or gas fast enough to make up for the hydrocarbons they’re producing.

Meanwhile, costs involved with new oil and gas projects are on the rise thanks to rising labor and raw material prices. Also, producers are increasingly turning to complex fields such as deepwater operations; such deals are expensive and prone to delays.

In that light, valuations in the stock market look compelling. Many of the big integrated firms have ample cash and undrawn borrowing capacity to finance multiple multibillion dollar deals without having to negotiate new credit lines or sell stock. These companies now have the opportunity to simply acquire new reserves by picking up smaller producers with promising prospects at distressed prices.

One firm that’s been the subject of periodic takeover speculation is Chesapeake Energy (NYSE: CHK), an exploration and production (E&P) company highlighted in the Oct. 6 America’s Gas Growth piece.

Chesapeake has a leading position in many of the most promising unconventional natural gas reserves in the US, including the Barnett Shale of Texas, the Haynesville Shale in Louisiana, Fayetteville Shale of Arkansas and the Marcellus Shale in Appalachia. In fact, Chesapeake is either the No. 1 or No. 2 player in each of these fields.

Chesapeake continues to announce some impressive results from its drilling operations, particularly in the Haynesville Shale. During its Oct. 31 conference call, Chesapeake announced that its two most recent wells in the Haynesville are producing a combined 25 million to 26 million cubic feet per day. This production rate is consistent with Chesapeake’s prior wells in the area; gas wells with production rates above 10 million cubic feet per day are rare in the US. The Haynesville is shaping up to be the largest and most prolific gas field in the US.

Few would argue with Chesapeake’s impressive asset base and drilling results. Some remain concerned about Chesapeake’s debt levels–the company has traditionally relied heavily on debt to fund acquisitions and drilling activity and carries a higher debt load than most of its competitors. Consider that Chesapeake currently has a debt-to-equity ratio of close to 90 percent compared to 19 percent for Devon Energy (NYSE: DVN) and 22 percent for EOG Resources (NYSE: EOG).

But Chesapeake has no immediate needs to access credit markets. The company’s credit line doesn’t mature until 2012, and it has no senior notes maturing until 2013. Even better, at its analyst day in mid-October and its more recent earnings release, Chesapeake offered more details on its financial position.

Specifically, the company has scaled back its drilling plans in light of weak gas prices. The company hasn’t reduced drilling in promising, low-cost reserves such as the Haynesville; rather, Chesapeake’s activity cuts have mainly centered on higher-cost conventional plays that just aren’t particularly profitable at current prices. The result: Chesapeake reduced its planned expenditures on drilling by around USD3.7 billion over the next two years.

Meanwhile, Chesapeake is well hedged. Roughly 73 percent of remaining 2008 production is hedged at an average price of more than USD9 per MMBtu. A total of 67 percent 2009 and 42 percent of 2010 production is hedged at prices averaging USD8.65 and USD9.81, respectively. Thus, even a further near-term drop in gas prices would have a modest impact on Chesapeake’s revenues and ability to generate free cash flow.

Overall, Chesapeake believes it will be able to generate sufficient cash flow over the next few years to meet its capital spending plans and pay down its debt.

Bottom line: With an unrivalled acreage position in America’s fastest-growing shale plays and a solid financial position, Chesapeake looks like an outstanding play as an independent firm. However, Chesapeake also remains a tempting takeover target for a host of international integrated oil companies.

In fact, several producers have already shown considerable interest in Chesapeake. Consider that back in August, Chesapeake announced a joint venture deal with British energy giant BP (NYSE: BP). Under the terms of that deal, BP purchased a 25 percent interest in Chesapeake’s Fayetteville shale acreage for a total price of USD1.9 billion.

That sale consisted of a USD1.1 billion upfront cash payment plus an agreement by BP to fund USD800 million of drilling expenses for the project. The BP agreement values Chesapeake’s remaining 75 percent stake on the Fayetteville at about USD5.7 billion, more than a fifth of the value of Chesapeake’s outstanding stock and debt. BP also bought up outright Chesapeake’s acreage in the Woodford Shale of Oklahoma for a total cost of USD1.75 billion in cash.

Early in the third quarter, Chesapeake announced a deal to sell a 20 percent interest in its Haynesville Shale play to Plains Exploration and Production (NYSE: PXP) for a total cost of USD3.3 billion. Based on that valuation, Chesapeake’s remaining Haynesville acreage is worth more than USD13.2 billion.

And just last week Chesapeake announced yet another joint venture to sell a 32.5 percent interest in its Marcellus Shale acreage in Appalachia to Norwegian energy giant StatoilHydro (NYSE: STO) for a total price of USD3.375 billion. Based on that price, Chesapeake’s remaining Marcellus acreage is worth more than USD7 billion.

In addition to acreage, Chesapeake has also agreed to a strategic alliance with StatoilHydro to develop unconventional reserves outside the US. Chesapeake’s expertise in developing unconventional reserves in the US could prove useful in finding and putting similar reserves into production overseas.

Finally, Chesapeake has also put together a number of so-called volumetric production payment (VPP) deals. Under such a deal, Chesapeake sells the rights to a certain pre-set volume of natural gas, produced from a certain number of wells over a certain time period. VPPs don’t cover all of the production from a particular area, just production from specific underground formations and wells. VPPs offer Chesapeake a way to sell off some of its production from more mature plays and realize a big, up-front cash payment.

Although Plains is too small to acquire Chesapeake, both BP and StatoilHydro are potential buyers. Both have expressed interest in acquiring a position in America’s fast-growing unconventional gas plays. And both firms have expressed direct interest in Chesapeake by partnering with the firm in joint ventures.

Chesapeake is currently trading at less than six times projected 2009 earnings, the lowest valuation for the stock since its 2002 lows. Meanwhile, concerns over Chesapeake’s debt position are way overblown given its strong hedging position and the cash it’s receiving from joint venture and VPP deals. Chesapeake stock could easily fetch USD40 in an acquisition. Buy Chesapeake Energy under USD26.

Also, consider Chesapeake Energy 4.5 Percent Convertible Preferred of 12/31/49 (NYSE: CHK D, CUSIP: 165167842). This convertible preferred pays a USD4.50 annual dividend in four installments on March 15, June 15, Sept. 15 and Dec. 15. Based on the current price, the preferred offers an annualized yield of roughly 7 percent. Holders of the convertibles can exchange their preferred shares for 2.265 shares of Chesapeake common stock at any time.

Because of the convertible option, the preferred tends to track the basic performance of Chesapeake’s common shares over time. In fact, the preferred topped out over the summer at more than USD170 when Chesapeake was trading north of USD70 per share. The preferred has since declined alongside the common stock.

If I’m correct about gas prices and Chesapeake’s fundamental positioning, the preferred should give you the benefit of that appreciation. In the meantime, you’re collecting a nearly 7 percent yield on your investment.

Chesapeake can force the mandatory conversion of this preferred starting on Sept. 15, 2010, but it can’t do that unless the price of Chesapeake’s common stock exceeds the conversion price of USD44.154 by 130 percent for 30 consecutive trading days. With Chesapeake’s stock currently around USD21, mandatory conversion isn’t an issue at the current time.

Furthermore, if Chesapeake is acquired by another firm, there are provisions designed to benefit preferred holders. Specifically, the conversion price for Chesapeake’s shares is adjusted to equal the market price of the common stock. Put simply, this will allowed preferred holders to benefit from upside in Chesapeake’s common stock if it’s acquired.

Buying preferred stocks can be a bit more complex than buying common stock. If you have trouble finding the preferreds, call your broker and ask how to input the symbol in their system. Most brokers can also easily look up the preferreds using the CUSIP number noted above. Buy Chesapeake Energy 4.5 Percent Convertible Preferred of 12/31/49 under USD68.

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