One of Chesapeake Energy’s natural-gas drilling operations in Bradford County, Pa.
Daniel Acker/Bloomberg
The early 2000s mantra of “drill, baby, drill” was successful in one regard—it flooded the market with energy supply, pushing prices sharply lower. For investors, though, it was a terrible deal. As U.S. shale oil-and-gas producers binged on debt to increase production, their stocks lagged behind. The energy sector essentially sat out the decadelong bull market following the financial crisis.
Now, U.S. energy executives, investors, and analysts are waxing poetic about “Shale 3.0.” The industry’s new era promises less debt, slower production growth, and more focus on returning cash to shareholders.
Chesapeake Energy
(ticker: CHK), the poster child of the U.S. shale revolution, now has the unlikely opportunity to become the standard-bearer for the Shale 3.0 movement. And its stock looks cheap.
Under the leadership of its swaggering co-founder and CEO Aubrey McClendon, the Oklahoma-based natural-gas producer aggressively pursued growth, loading up on debt to acquire new acreage and pump more and more gas. McClendon was killed in a car accident in 2016, and his corporate creation perished not long after. Chesapeake filed for bankruptcy in June 2020.
Now recapitalized and trading again, Chesapeake has a new lease on life. Net debt is down from some $9 billion to about $600 million, annual interest and preferred dividend payments have been cut to about $700 million, and its management, board, and portfolio have been overhauled.
E=estimate. FCF=free cash flow.
The new Chesapeake is a leaner machine, with the boost of added cash-flow generation from soaring natural-gas prices. The company plans to keep debt to a minimum. More importantly, it has a formulaic approach to shareholder returns, which consists of an annual base dividend of $1.75 per share, paid quarterly, plus 50% of the previous quarter’s free cash flow. That brings the current dividend yield to at least 2.8%, with the promise of much more.
Chesapeake’s approach is well suited to evolving energy investors, who want cash in their pockets sooner rather than later. The devil is in the details, but the 2020s could easily be the last decade of meaningful fossil-fuel use globally. That doesn’t equate to heavy expenditures on the exploration and development of assets that won’t pay off for years.
Chesapeake management knows it still has to win investors back: “Talk is cheap. We get that,” Michael Wichterich, Chesapeake’s board chairman, said on the company’s first postbankruptcy earnings call in May. We have to have great results.”
The stock is cheap relative to other natural-gas producers, which offers a compelling entry point for investors. Chesapeake shares trade for 2.4 times enterprise value to consensus 2022 Ebitda, or earnings before interest, taxes, depreciation, and amortization. That compares with 5.8 times for
Range Resources
(RRC); 4.2 times for
Coterra Energy
(CTRA), the newly merged
Cimarex Energy
and Cabot Oil & Gas; 3.7 times for
Ovintiv
(OVV); and 3.3 times for
Southwestern Energy
(SWN).
Were Chesapeake to hold production constant at current levels, the company expects to generate a cumulative $6 billion in free cash flow by 2025—roughly equal to the company’s market value today. That should be the main point for investors: Natural gas doesn’t have to be a viable business beyond 2025 for them to get paid back at least in full for Chesapeake shares purchased today. Any success beyond 2025 would offer upside to current values.
Meanwhile, investors will start getting paid back directly and immediately. Chesapeake’s new dividend regime kicks in early next year, with the company’s first variable dividend payable in the first quarter of 2022 based on the fourth quarter’s free cash flow. Under that formula and using current natural-gas futures prices, the stock will yield some 12% in dividends next year, according to UBS’ Lloyd Byrne. He initiated coverage of Chesapeake stock earlier this month with a Buy rating and price target of $88, a 45% premium to recent levels around $61.
The rest of Chesapeake’s free cash flow could go toward share buybacks, an increased dividend, or acquisitions. The company is closing a zero-premium deal for
Vine Energy
(VEI) next month, which will give Chesapeake more of a presence in the Haynesville shale straddling the Louisiana-Texas border, adding to its holdings in Appalachia’s Marcellus and Texas’ Eagle Ford formations.
The focus on natural gas also makes Chesapeake a somewhat counterintuitive leader in the industry on sustainability, as far as natural gas can be the bridge between even more carbon-intensive energy sources like coal and oil to renewables like wind and solar.
“From a fundamental perspective, we’re bullish on the commodity cycle and recognize that we don’t have the renewables we need in the short term,” says Vince Lorusso, co-manager of the
Changebridge Capital Sustainable Equity
exchange-traded fund (CBSE).
Chesapeake’s third-quarter results on Nov. 3 could be a catalyst in bringing more investors on board. Cash flow should be more than ample thanks to the high natural-gas prices of late. The company is also likely to offer 2022 guidance and introduce newly promoted CEO, Nick Dell’Osso.
Chesapeake is now a show-me story, having burned investors in the past. An attractive valuation, a deliberate plan, and a changed philosophy make it deserving of a second chance.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com
