Sinopec Is the Latest Beneficiary of Chesapeake Energy Corporation (CHK)’s Deflation

Chesapeake Energy (CHK)The asset bubble that is Chesapeake Energy Corporation (NYSE:CHK) is continuing with its asset sales for the acreage it has amassed using massive leverage. In its most recent quarter, the company increased its output and made significant improvements in crude output, but this was overshadowed by the management tumult and a massive sale of its shale acreage to a Chinese firm at a price three times less than Chesapeake’s own estimates.

The China Petroleum & Chemical Corp (ADR) (NYSE: SNP), more commonly known as Sinopec, is purchasing half of Chesapeake’s 850,000 acres of oil and gas assets at the Mississippi Lime shale field for $1.02 billion. Through this deal, Asia’s biggest refiner will considerably increase its shale footprint in the U.S; and, as I said at the outset, Sinopec won’t be paying any premium for the privilege. While some analysts have identified that the sale is $200 million below estimated value, Chesapeake Energy Corporation (NYSE:CHK) itself had the land valued at an estimated $7,000 to $8,000 per acre for the property in July 2012. Calculating from the mid-point of $7,500, the asset is being sold at less than one-third of what Chesapeake valued it at less than eight month ago.

Nonetheless, Chesapeake Energy Corporation (NYSE:CHK) will welcome the cash injection from the sale as the company, the second biggest gas producer in the U.S., continues to struggle due to an oversupply of natural gas, a mounting pile of debt that nearly crushed it last year and a management crisis that has subsided following the planned departure of its controversial co-founder and CEO Aubrey McClendon.

Chesapeake Energy Corporation (NYSE:CHK) closed a total of ~$12 billion in asset sales in 2012 and is looking at additional $4 to $7 billion this year. The business’s plan is to reduce the net debt to $9.5 billion, and for that CreditSights Inc. has identified that Chesapeake must generate $8 billion to $9 billion from asset sales this year. Selling the Mississippi Shale property at $0.30 on the dollar is not an auspicious beginning to 2012. What is Chesapeake’s loss, however, is Sinopec’s gain.

Just a day before the announcement of its quarterly results and three weeks after McClendon’s announcement of his stepping down on April 1, Chesapeake’s board announced the results of its investigation on its chief, who borrowed more than $800 million from some of Chesapeake’s core financers for personal use in an apparent conflict of interest. The board didn’t find any intentional misconduct by McClendon.

For the fourth quarter, Chesapeake’s profit dropped by 36.4% to $300 million from $472 million in 2011. Excluding one-time items, Chesapeake Energy Corporation (NYSE:CHK) earned profits of $0.26 per share beating estimates. Its average selling natural gas price, its primary product, in the quarter was $2.07 per thousand cubic feet, which is 47% lower from last year. Although natural gas prices were strong in Q4 2012, Chesapeake hedged 75% of its output to contracts that were set below market prices and could not be reflected in Chesapeake’s earnings.

With natural gas prices locked in, it was the company’s crude output, which increased by 69%, that drove Chesapeake’s financial growth. It has been increasing its focus on crude to reduce its exposure to natural gas, which accounted for 77% of the company’s total output, down from 82% in the previous year. However, this was largely ignored by investors, who are more concerned about the company’s management and its inability to extract full value from its overleveraged assets.  Any operational gains are vastly overshadowed by the deterioration of its balance sheet. Following the earnings release — post Feb. 21 — Chesapeake’s stock retreated 5.6% overall, including the 6.8% drop that came after the company announced the Sinopec sale.

Stock 1Y -24.91% -10% 0.41%
P/E N/A 16.6 9.0
EPS -1.46 4.74 9.7
Yield 1.7% 0.4% 2.6%
ROA -2.4% 2.7% 13.3%
ROE -3.3% 12.0% 28.6%

I’m not convinced that the best way to play the shale gas boom in the U.S. and Canada involves producers like Chesapeake or Exxon Mobil Corporation (NYSE:XOM) , though I love Exxon’s portfolio mix and its consistently high return on assets. It is a well-managed and well-connected company and the leader in this space. That said, I believe the real money will be made by those who transport the gas to where it needs to go. An ETN like the Morgan Stanley Cushing MLP High Income Index ETN (NYSEMKT: MLPY) is an interesting play pulling down a 7.55% yield on a portfolio designed to match the underlying index. While the natural gas market in the U.S. is supplied at a price well below the historic average I would be more interested in the transporters than the producers.

The article Sinopec Is the Latest Beneficiary of Chesapeake’s Deflation originally appeared on and is written by Peter Pham.

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