Quite often in the stock market, the share price of a hot company can suddenly fall out of favor, causing investors to dump the stock. The trick is to find out whether the negative sentiment is in fact warranted. If not, then this oversold stock can represent a compelling buying opportunity.
In the energy industry, sudden price changes in commodities can change the underlying economics of companies that operate in the space. When prices of oil, coal or natural gas are too low, exploration activities can become uneconomical. Alternatively, rapidly-rising prices can cause a frenzy for extracting as much supply out of the ground to quickly bring it to market.
And lately, one commodity in particular perfectly fits this out-of-favor vs. buying opportunity scenario: natural gas, whose prices have plummeted by more than 50% in recent months. To put things into perspective, a little more than a year ago, gas prices hovered closer to $5 per million British thermal units (BTUs) and touched below $2 BTUs just a few weeks ago.
Seeing as how it is one of a small handful of pure plays in the natural gas industry, Chesapeake Energy (NYSE: CHK) is seeing the negative effects of this price drop.
To add insult to injury, news outlets have recently reported that Chesapeake's CEO Aubrey McClendon has personally invested more than $1 billion in wells (up to 2.5% in each well) developed by Chesapeake, a move that market observers see as a serious conflict of interest. Chesapeake's board of directors quickly moved into damage-control mode and worked with McClendon to end the well co-investment program more than a year earlier. McClendon -- who has been hailed as a visionary in the natural gas space -- also agreed to give up his role as company chairman, but will remain CEO.
The strange thing is, this agreement wasn't a secret and had been openly disclosed to shareholders. McClendon has spent most of his time since the 1990s acquiring wells across the United States and employing modern drilling techniques, including horizontal drilling and the increasingly popular hydraulic fracturing, or "fracking" techniques that have revolutionized the industry. In this respect, he has been a pioneer and now leads one of the largest natural gas operators in the world.
Chesapeake's operations are complicated, but worth understanding because of its leading position in the industry. The company now boasts drillable land in nearly every appealing part of the country. Low natural gas prices are obviously a near-term concern, but the company has been shifting to natural gas liquids (as opposed to dry natural gas), which contains more appealing byproducts that chemical companies and other industries can use more efficiently. It will also benefit greatly when dry gas prices inevitably recover.
It is also important to note that some highly-respected investment pros are backing the company. As investors, their primary motivation is to profit. Mason Hawkins, a well-known value investor who runs Southeastern , which runs billions through its Longleaf funds, recently reported a 7.2% stake in Chesapeake, worth nearly $9 billion. This makes Chesapeake its second-largest holding. Hawkins is known for investing in companies that trade for huge discounts from their fair value. More importantly, he looks for honest and able management, which is perhaps the strongest vote of confidence for McClendon.
Billionaire investor Carl Icahn has also reportedly been building a sizeable stake in recent weeks. The Wall Street Journal reported on May 14 that Icahn was buying back a stake of more than 5%, after having cut it in 2011. This suggests he currently sees great value in where the stock trades.
Risks to Consider: The energy industry moves quickly and is susceptible to large and sudden price swings in commodity prices. This can negatively affect companies operating in the space. Chesapeake also has clearly had to deal with a few administration-specific challenges. The key question though is whether these near-term risks are priced into the stock, which they appear to be at current levels.
Action to Take --> Right now, the risk/reward tradeoff for investing in Chesapeake looks very interesting. The stock is trading at about $14 per share, well below its high of nearly $36 last fall. This represents a forward price-to-earnings (P/E) ratio of 7 on 2013 earnings per share estimates of $2. Analysts also expect sales of nearly $13 billion by next year. A decade ago, Chesapeake reported sales under $1 billion and earnings of $0.17 per share.
The stock has been quite volatile over the recent news, but investors have been able to log huge gains in the long run because McClendon has grown the business into one of the largest in the industry. The average industry P/E currently stands at 16.5, and Chesapeake's average in the past five years is closer to 10. Getting to these comparable earnings multiples suggests potential stock gains between 40% and 135%. This is a wide range, but easily suggests to me that there is much more upside potential in the stock than further downside risk.