"Exxon-Mobil and XTO Energy. Exxon is buying XTO for $41 billion. A natural gas play and all stock deal, Exxon-Mobil the biggest percentage loser in the Dow, down 4%." — Fox Business Network 12/14/2009

On Monday morning, Exxon Mobil (XOM) announced their largest acquisition since Mobil in 1999.  Exxon will pay around $51.69 (.71 shares of XOM) per share of XTO Energy (XTO) as well as assume about $10 billion in debt, in sum the deal will cost about $41 billion.  Although the offered price represents a 25% premium over XTO’s Friday closing price, Exxon is acquiring America’s largest unconventional natural gas producer. (following ratings chart of XTO)

This increased emphasis on natural gas will put further distance between Exxon and other major oil firms in terms of natural gas reserves.  Exxon hopes that natural gas will find favor in Washington and gain wider use as a domestic energy source over coal.  Proven reserves of natural gas in the United States have ballooned in recent years thanks to "shale gas" which is attainable through modern drilling techniques and makes natural gas an extremely abundant domestic resource.  Clearly, Exxon, already a heavy hitter on K-Street, will commit substantial resources towards these goals.

Exxon has a reputation for being one of the most conservative of the oil giants.  Led by CEO Rex Tillerson, Exxon has made a statement with today’s deal that they believe there is a long term trend that will benefit natural gas producers.  They obviously see a shift in the way natural gas is utilized, as prices have been suppressed for more than a year and a record 3.7 trillion cubic feet in storage proves supply is swamping demand.  However, Tillerson has said that he believes demand for natural gas will outpace both oil and coal in the coming years, based on his belief that natural gas will find more frequent use as a source of electricity generation in the future.  Gas burns cleaner than coal, and if cap and trade legislation passes through Washington a shift may be inevitable. (following ratings chart of XOM)

Exxon is looking towards natural gas for growth, and with the natural gas prices still low they hope to have bought valuable resources for a good price.  According to Bloomberg, this deal will cost Exxon $13.42 per barrel of oil equivalent reserves, which is expensive when compared to recent deals priced at around $10 per barrel of oil equivalent reserves.  But XTO’s assets in the Barnett Shale and other prodigious fields may justify the premium.  As for our methodology, we had an Undervalued stance on XTO as of Friday’s closing price $41.52, and given the current fundamentals the offered price does not seem unreasonable.  Given current revenue and earnings strength, we think any price south of $60 would have been in line with fundamentals.

This is no doubt a bold strategic move for Exxon and it will be very interesting to see if other domestic natural gas producers like Devon (DVN) or Chesapeake (CHK) are next to be targeted in a wave of consolidation.  If Exxon is right and natural gas sees wider adoption for electricity production, this will undoubtedly be a boon to shareholders.  From our view, the price paid is well worth the potential that this deal holds for the long term energy market.

Chesapeake Energy (CHK) reported a fiscal first quarter that was a major disappointment.  The company ended up taking a massive $5.75 billion loss on the quarter or $9.63 per share, because of a massive $6 billion impairment charge from the declining value of its oil and gas properties, which represents 16% of its asset value as of 4Q08.  Excluding the one-time charge the company made 46 cents per share in the quarter which was below analysts expectations even though revenue was ahead of projections.  Chesapeake is America’s largest producer of natural gas, and as such it has been particularly hamstrung by the decline in energy prices.  The company’s stock was trading in the $70’s when gas was selling around $13/mmbtu, but the price of gas cratered to around $3 and so did Chesapeake’s stock.

Clearly, the massive one-time charge is making investors nervous as the stock dropped more than 10% today.  Coming into the day, the stock was up 41% year to date and had greatly outperformed many of its peers including XTO and EOG.  The $6 billion one time charge sent a jolt into Chesapeake stock that it was probably coming at one point or another anyway. 

Interestingly, the company made a bullish call on some of its gas price hedges by monetizing 20% of its options for 2010.  The company is still expecting production to be up slightly (1%-2%) in 2009 but that production in 98% hedged.  As of the 1Q report, the company has pulled back on its hedges for 2010 to just 55% of production which is projected to grow more than 10% in 2010.  This could entail more risk for the company, but they are taking action to get more bullish on the price of natural gas in 2010.  Obviously, if the “green shoots” in the economy begin to take hold and we start to see growth there is a great chance that gas prices will go higher.

Ockham currently has a Fairly Valued stance on Chesapeake shares, but the decline in price today is starting to make the stock look more appealing.  Earnings have not been overly impressive, but CHK is selling well below its historically normal price-to-sales range.  It was disappointing to see that CHK was not cutting costs as successfully as some of their competitors, and that is something we will be watching out for as the low price of gas necessitates some cuts.  We are not yet ready to upgrade the stock, especially as the market still needs to digest the massive write-down on the first quarter, but if shares continue to decline down to about $17 per share then it is will most likely warrant an upgrade.

On a day where markets were down from the start and showed nary a glimmer of hope even with the signing of the economic stimulus package, the hits continued with Chesapeake Energy (CHK) swinging to a loss as they reported after the close.  The company reported net loss of $886 million, mostly because of $1.8 billion in one time charges related to writing down assets that are less valuable now that the price of natural gas has fallen so much recently.  In terms of real operations (excluding one-time charges) the results fell just short of consensus estimates as the company generated net income of 73 cents per share versus estimates of 74 cents.  Furthermore, the company increased revenue in the quarter by an impressive 43% on a year over year basis.

Chesapeake was off nearly 8% on the day, and has fallen further since the earnings were released at the close.  However, when you compare the $1.8 billion write down to the $7.1 billion write down reported recently by Chesapeake’s competitor Devon Energy (DVN), Chesapeake’s assets look comparably far more attractive.  Chesapeake is considering selling stakes in some of its highest producing fields including the Barnett Shale, currently the largest and most prolific unconventional natural gas resource field in the U.S., according to the release.  This property’s available average daily production increased 55% from a year ago and is home to 25 rigs at present.  Over the past several months, Chesapeake has sold stakes in all three other major shale operations, with Barnett being the only remaining holdout.  CEO Aubrey McClendon commented,

“Looking ahead, we believe that investors will increasingly recognize Chesapeake’s competitive advantages, including our industry-leading asset position in the Big 4 shale plays, our strong hedge position and our $4 billion in drilling carries, which will enable Chesapeake to deliver operational and financial results that we believe will be among the best in the industry for years to come.”

The fact that Chesapeake is willing to part with a portion of its leases in the valuable Barnett Shale speaks to just how tough things have gotten for natural gas producers as the price per unit has dropped from about $14 to just over $4.  One of Chesapeake’s biggest problems right now is debt, as the company has a not insignificant amount of long term debt of more than $11 billion.  We have little doubt Chesapeake will generate enough cash over the long term that the long term debt is not so much of a problem.  However, more pressing are the company’s current liabilities of $2.7 billion which will come due in less than a year.  With so much of Chesapeake’s assets tied up in leased property, as much as they may not like it, selling some of these assets may be the best way to cover the $1.3 billion gap between current assets and current liabilities.

So, although the price of CHK does look appealing compared to historical norms as sales growth has been quite strong and earnings are decent (excluding write downs), we are maintaining our Fairly Valued rating.  At this point, the company has too much debt to ignore even if its shale leases are increasing production at an attractive rate.  Of course, were the price of natural gas to recover in short order than Chesapeake would likely  be able to keep its interests in all of its leased properties.  All in all the company is managing fairly well to stay profitable considering the drop in gas prices, but at this time there is still a lot of risk until the company can get its debt liabilities under control.

As a result of development for Ockham’s new product RazorWire, I have been watching some of the late night replays of popular business television shows.  The always entertaining Jim Cramer has a term that he uses for stocks that pay a decent dividend but because of significant price erosion now have an impressively high dividend yield.  He says that these stocks have an “accidentally high yield,” assuming the dividend is safe this is certainly a positive factor.  One stock that fits this description very well is BP (BP), formerly British Petroleum.  BP has aggressively boosted its dividends consistently for more than 10 years and has always paid a fairly generous dividend.  However, now that the stock has lost about a third of its value in the last half year, the stock is currently yielding more than 8%.

The 8% yield surely is an enticing portion of our analysis, but this high yield is only attractive if it is relatively safe.  Obviously, we will know more about this after the company reports earnings tomorrow (Tuesday) mornings, but based on the information we have as of right now we think the dividend is safe.  For starters, the dividend payout ratio (using consensus earnings estimates) will be about .37 for the year, which is not a huge concern.  The company appears to be in good shape to meet all immediate debt requirements as the quick ratio (current assets over current liabilities) is greater than 1.  Longer term debt does not seem to be of huge concern either as the company only has about $28.3 billion, which for a company with as substantial cash flow as BP is generating is understandable.  Of course, circumstances are always evolving and were the prices of oil and natural gas to fall another 30%, maybe then BP management would have to revisit the dividend issue.

BP is diversified with operations in exploration and production as well as refining and marketing.  The company has significant exposure to both crude and natural gas, with its recent acquisition of 25% of Chesapeake Energy (CHK).  No one knows for sure where the prices of these commodities is headed, but at current prices many projects have been shelved and BP has also slowed its refining capacity.  With supply contracting throughout the industry, there will be less barrels of oil and natural gas available when demand begins to accelerate once again.  These projects are far from a tap that can be turned off and on at producers will, once demand begins to take off energy prices will increase steeply as production will not be fit to meet global demand.  However, BP is increasing production and will benefit when oil prices do rebound. 

Like him or not, at least as far as BP goes Ockham agrees with Cramer on this one.  To paraphrase Cramer on this topic, from last Thursday, he believes that for natural gas BP is the preferable play to Chesapeake, as BP management has focused on improving profitability through reducing costs.  He expects to see production growth of about 6% when they report.  Furthermore, he thinks that BP will deliver higher margins and keep the “juicy” dividend.

The Ockham valuation is positive on BP as well; we currently have BP as Undervalued.  Of the major integrated oil and gas producers we have BP behind only COP in valuation, and as you can see it has performed worst in the last 13 weeks.  The stock has taken a beating along with the price of crude and gas, and now is near its lowest point in almost 6 years.  The company has historically traded for 3.7x to 5.15x cash flow over the last ten years, but the stock is currently at just 3.4x.  Furthermore, as long as you don’t think that the price of oil and gas have another 30% downside risk than the 8% yield should be enticing enough to make investors want to park some money in BP.  The upside potential of BP is great when oil and gas prices begin to ascend again.

Energy stocks have retreated quite a bit since the commodity bubble popped in mid-summer. The energy sector as a whole is down about 40% during this time frame while the S&P 500 is down a relatively moderate—in comparison—23%. Chesapeake Energy (CHK) has been particularly hammered in recent months, down a whopping 62% from its peak. Chesapeake is the nation’s largest natural gas producer and its stock has suffered from plunging gas prices as well as a debt load that is worrisome in this credit environment. There was also the embarrassing news story of the company’s CEO receiving a margin call as a result of the stock’s decline. Well, Chesapeake reported earnings yesterday and while the earnings were nothing spectacular they do give additional insights into the health of the company.

Chesapeake reported earnings of $.85 per share, excluding one-time events, which missed consensus estimates by 3.4%. Chesapeake had beaten estimates for the previous 3 quarters. However, the company had hedged pretty effectively against the falling price of natural gas and oil during the quarter which amounted to a gain of $2.8 billion and when you incorporate those profits into the results the company earned $5.61 per share. Clearly, there is a reason that analysts do not account for “one-time” events but it is certainly worth noting when there is such a huge difference. CHK hedged by securing higher prices in the past for delivery in the future, which could have come back to bite them had prices risen. Also in response to the lower price of natural gas Chesapeake has chosen to slow its production. During the past quarter, production fell .3% from the prior quarter and 15% from one year ago. This is a logical response to low prices and with demand for gas likely on the rise with high profile energy independence plans such as the “Pickens Plan” getting a lot of attention, odds are the price of natural gas will rebound.

Chesapeake stock has had an especially painful run of late because the company does have a substantial debt burden. The total liabilities have declined in the most recent quarter and total assets have increased. The ratio of total debt over total assets has fallen from 73% in the previous quarter to 59% in the quarter just ended. While 59% is still a large debt burden in such environment, the company is clearing enough cash right now to easily service this debt. Furthermore, the company has no senior notes maturing before 2013. In Chesapeake’s business, debt is inescapable as drilling requires substantial initial costs, and interestingly, the company’s asset-to-equity ratio of 2.44 is actually below its historical average of 3.1. It seems to me that CHK is generating enough cash to continue to reduce its debt exposure and, were the credit situation in the macro-economy to improve, CHK’s debt burden would seem pretty benign.

The assets Chesapeake owns undoubtedly have substantial value, and some particularly important assets are portions of the Marcellus Shale a huge natural gas field in the Appalachian Basin. Preliminary estimates are that this field holds up to 1.9 trillion cubic feet of gas (according to a 2002 U.S. Geological Survey), although these reserves are spread out over a massive area. Chesapeake, in its Oct. 19^th conference call, estimated that its interests in the Marcellus Shale to be worth about $13.5 billion. That’s not too bad for a company with a market capitalization of about $12.5 billion. No wonder Chesapeake has considered selling some of these assets to the likes of BP (BP).

The fact of the matter is that Chesapeake calmed investors in with its recent quarter’s results. Yes the company has debt, but it is shrinking and not due for some time. Management effectively handled the eroding price of gas by hedging a significant portion of its production at higher prices. CHK has assets that, according to their own estimates, are worth more than the entire companies stock, so book value per share in theory exceeds the share price. Both price-to-cash flow and price-to-sales are significantly below their 10 year historical averages. So, although there are a lot of value plays in this market for patient investors, Chesapeake could be one of the best.