Has Icahn Outsmarted Short Sellers With This Oil Bet?
Fabled activist investor Carl Icahn doesn’t seem to care much about what short sellers think.
On March 11, he bought nearly seven million shares, then worth about $93 million, of one of the most heavily shorted stocks in the S&P 500: exploration and production firm Chesapeake Energy Corp. (NYSE: CHK). The move boosted Icahn’s stake in Chesapeake by a percentage point (to 11% or roughly 73 million shares).
Buying more of the stock may seem reckless considering its 55% price decline since June and exceptionally high short interest, which currently stands at almost 111 million shares. That equates to about 19% of the float.
However, time should prove Icahn right about Chesapeake, even if the near-term looks ugly.
As the second largest natural gas producer in the United States, next to Exxon Mobil Corp. (NYSE: XOM), Chesapeake is highly vulnerable to the natural gas supply glut resulting from North American overproduction. The glut pushed the price of natural gas down by more than 40% since last June, to around $2.65 per million British Thermal Units (BTU).
Despite that drop, natural gas prices remained high enough in 2014 for Chesapeake to finish out the year strong, with revenue growing to $21 billion, a 20% increase, and a nearly 160% spike in per-share profits to $1.87.
Thanks to asset sales and falling oil prices, sales are expected to drop more than 25% this year, to around $15 billion. And the company will likely only generate break-even results.
However, Chesapeake is strengthening the hatches to weather the current industry storm. The firm recently announced that exploration & production (E&P) spending will fall by $2.4 billion, to around $4 billion this year.
Rig counts are set to fall, too, as wells are idled to cut operating costs. In its latest guidance, Chesapeake estimated it would run an average of 25-to-35 rigs this year, compared with 64 in 2014. Still, total production will be nearly flat as the company is idling less productive rigs.
Moreover, new drilling projects will be focused in areas where Chesapeake already has plenty of expertise and an established cost advantage. In the Utica shale of Ohio, for example, the firm can build new wells for $6.6 million apiece, compared with about $9 million each for competitors.
#-ad_banner-#Across its asset base of nearly 10 million acres, which includes stakes in many of the nation’s best shale plays, Chesapeake has also been shifting its product mix toward oil and natural gas liquids (NGLs) to improve diversification. Oil and NGLs now account for 29% of total output.
Chesapeake isn’t completely out of the woods. The company faces a $1.9 billion free cash flow shortfall in 2015, according to UBS. That could lead Chesapeake to sell more non-core assets this year to raise cash, just as it did in 2014. In the fourth quarter, for example, the firm gleaned $5.4 billion from divestitures, mainly through the sale of more than 400,000 acres of its Utica and Marcellus shale holdings in Pennsylvania and West Virginia.
Thanks to asset sales and cash conservation measures, Chesapeake began 2015 with ample liquidity, according to CEO Doug Lawler, an industry veteran with a reputation for fiscal discipline. Lawler took over from the company’s founder, Aubrey McClendon, who had been criticized for, among other things, overuse of debt.
Under Lawler, Chesapeake has reduced long-term debt by more than 13% last year to just over $11 billion. That’s the lowest level of debt since 2007.
Lawler projects Chesapeake will finish 2015 with roughly $6 billion in combined cash and borrowing power under its credit facility. He also anticipates the firm being cash flow neutral by the end of the year, an impressive feat considering it posted negative free cash flow in each of the past three years.
Risks To Consider: Management foresees a substantial write-down in the value of its oil and gas properties this quarter, and further write-downs are possible in subsequent quarters if energy prices fall substantially further. The result could be a progressively weaker balance sheet that scares off more shareholders and impairs Chesapeake’s access to capital markets.
Action To Take –> Low energy prices are making 2015 an extreme challenge for energy producers and could trigger more bankruptcies, in addition to the dozen or so already announced. Most bankruptcy declarations have been limited thus far to smaller, highly-leveraged Texas firms. While there’s no way for Chesapeake to avoid the downturn, the firm should not only survive, but emerge in better financial shape with Lawler at the helm.
That’ll set the stage for a profitable 2016 if energy prices rebound, as is widely expected. The latest Energy Information Administration natural gas forecast, for example, is for an average price of $3.48 per million BTU next year — a roughly 30% spike from current spot prices.
The key takeaway: Carl Icahn has identified a top energy play that every investor should consider, regardless of what short sellers are doing.
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