Chesapeake valuation seen luring major oil merger deal

Chesapeake Energy Corp. (CHK)’s depressed valuation is making the company a potential target for acquirers willing to bet that natural-gas prices will rebound from a decade low.

Chesapeake’s equity and net debt are valued at $9.19 for each barrel of oil equivalent, the lowest among U.S. oil and gas explorers with market capitalizations greater than $5 billion, according to data compiled by Bloomberg. While a stock purchase by Carl Icahn helped the $11 billion company’s shares rebound in the past week, Chesapeake is still down 27 percent in 2012 amid investigations into Chief Executive Officer Aubrey McClendon’s personal loans backed by stakes in company-operated wells.

The second-largest U.S. natural-gas producer said it may face a cash shortfall as early as next year after prices for natural gas, which accounts for 83 percent of its reserves, reached a 10-year low last month. While a buyer would have to cope with seven joint ventures and $13.1 billion of debt, Exxon (XOM) Mobil Corp. and Chevron Corp. (CVX) may see a chance to scoop up the largest holder of onshore drilling leases before gas prices rebound, said SunTrust Robinson Humphrey Inc. Royal Dutch Shell Plc (RDSA) may also be interested, said Huntington Asset Advisors Inc.

“For any of the major integrated oil companies that want to pick up reserves on the cheap, this would be a good one,” said Peter Sorrentino, who helps oversee $14.7 billion at Huntington in Cincinnati. Chesapeake and other gas producers will be “worth a whole lot more than they are today. We’ll look back on this and say, ‘Wow, this was really an opportunity.’ There may be some people that end up kicking themselves.”

Chesapeake “had a bit of a drama around it,” he said. “But that doesn’t change the fact that these are very desirable assets.”

Exxon, Shell

Michael Kehs, a spokesman for Oklahoma City-based Chesapeake, declined to comment on whether the company is for sale, may be for sale or has been in talks with potential buyers of the whole company.

Kimberly Brasington, a spokeswoman for Irving, Texas-based Exxon, and Russell Johnson, a spokesman for San Ramon, California-based Chevron, declined to comment on potential acquisitions. Jonathan French, a spokesman for Shell in London, declined to comment on whether The Hague-based company has considered an acquisition of Chesapeake.

“We are happy with the portfolio we have acquired and built organically in North America over the past years, but we are always looking at opportunities worldwide,” French said, when asked if Shell is looking to add resources on the continent.

Personal Loans

McClendon, 52, co-founded Chesapeake in 1989 and built it into the second-largest U.S. natural-gas producer behind Exxon by embracing techniques such as horizontal drilling and hydraulic fracturing that revived U.S. oil and natural-gas production. The company has outspent cash flow in 19 of the past 21 years as it amassed a portfolio of gas and oil fields.

McClendon, who was allowed to take a 2.5 percent stake in almost every well the company drilled and was required to pay development costs proportionate to his stake, had amassed $846 million in loans as of Dec. 31 to cover his share of the costs.

The board announced May 1 that it will strip McClendon of his chairmanship as it reviews his personal loans. The Internal Revenue Service and Securities and Exchange Commission are also investigating.

The decline in gas prices, coupled with McClendon’s personal-loan entanglements, led to a 47 percent drop in Chesapeake’s shares in the last 12 months. Natural gas, the fuel for heating and power plants, fell to a 10-year low of $1.902 per million British thermal units on April 19 because of a glut of production from new wells in shale formations from Texas to Pennsylvania.

Cash Shortfall

On May 1, the company posted an unexpected $71 million first-quarter loss and warned it may run short of cash next year without enough divestitures. Chesapeake increased planned asset sales through the end of 2013 by 17 percent to $20.5 billion.

“The knee jerk reaction is the stock is down so much, it’s a real opportunity, but unless they’re able to sell these assets and get good prices for these assets, the debt burden is choking them,” Tim Ghriskey, who oversees about $2 billion as chief investment officer of Solaris Group in Bedford Hills, New York, said in a phone interview. “This has always been a bit of a higher risk name.”

Chesapeake’s depressed valuation may still be enough to entice a buyer, said Neal Dingmann, a Houston-based analyst at SunTrust.

‘Cheap Enough’

Chesapeake’s enterprise value, which is the sum of its equity, net debt, minority interest and preferred equity, is almost $29 billion, 9.2 times the value of its proved reserves. That’s the cheapest among U.S. oil explorers and producers and integrated oil companies with market values higher than $5 billion, data compiled by Bloomberg show. The industry is valued at a median of about 15.5 times. Chesapeake held proved reserves equivalent to 3.13 billion barrels of oil at the end of 2011.

“There are a lot of people that talk about Chesapeake and say it’s too convoluted and too complicated to have somebody buy it out,” Dingmann said in a phone interview. “But if assets are cheap enough, buyers are going to find a way to get through all these issues.”

Chesapeake’s largest investor, Southeastern Asset Management Inc., said in a May 7 letter to the board that the company should be open to takeover offers that aren’t “lowball” bids relative to its net asset value.

Icahn’s Investment

“We also don’t want to use this large price-to-value gap as an excuse to refuse discussions with any potential acquirers who would be willing to pay a price today that recognizes the longer term value of the company,” Southeastern Chairman and CEO Mason Hawkins said in the letter.

Hawkins, who is based in Memphis, Tennessee, didn’t return a phone call seeking comment.

Icahn, who is known for pushing for change at the companies in which he invests, last week disclosed that he purchased a 7.56 percent stake in Chesapeake. Icahn, 76, called for at least four of the nine directors to be replaced.

Susan Gordon, a spokeswoman for Icahn, didn’t respond to an e-mail asking if he will push for Chesapeake to consider a sale.

“The company is definitely vulnerable to a takeover given where it is now,” Andre Cillie, managing partner at Fountainhead Partners Fund, said in a phone interview from Cape Town. Chesapeake is Fountainhead’s second-largest investment. “The possibility must be there, especially given the fact that Carl Icahn has gone activist against the company and has a large shareholding.”

Gas Prices

A purchase of Chesapeake, which holds reserves vast enough to satisfy more than three years of U.S. household demand, may be a bet on higher gas prices. Gas prices have rallied 28 percent since the low point on April 19, still leaving the commodity about 85 percent below its 2005 peak.

“Natural gas has shown signs of bottoming,” Huntington’s Sorrentino said in a phone interview.

Natural gas for June delivery closed at $2.429 a million British thermal units yesterday in New York. Commodity traders don’t expect gas to reach $3.50 a million British thermal units until November 2013 and $4 until December 2014, based on New York Mercantile Exchange futures contracts.

Exxon, the world’s biggest energy company with a market value of $383 billion, and Chevron, the second-largest U.S. oil company, “desperately need” to boost production and may look to acquire Chesapeake, said SunTrust’s Dingmann. Chevron’s year- over-year oil and gas production has declined for five straight quarters, while Exxon’s was down in the last three quarters, data compiled by Bloomberg show. Each has about $19 billion in cash and short-term investments.

Exxon, Chevron

“For somebody like an Exxon or Chevron, where they just don’t have much in the way of production growth right now, the easiest way to get that is to go out and acquire it,” Dingmann said. “Both are sitting on billions of dollars of cash right now that’s really not doing anything.”

Exxon surpassed Chesapeake as the largest U.S. natural-gas producer with its 2010 acquisition of XTO Energy Inc.

Phil Adams, a Chicago-based debt analyst at Gimme Credit LLC, said Exxon tops his list of likely acquirers because it’s the largest potential suitor and has the highest corporate credit ratings. Chevron, rated the second rung of investment grade by Moody’s Investors Service, is also among companies capable of paying cash for Chesapeake without damaging its debt rating, he said.

Takeover Price

Shell, Europe’s biggest oil company, may also be interested in buying Chesapeake to reduce its exposure to regions with higher political risks, said Huntington’s Sorrentino. All of Chesapeake’s sales are generated in the U.S., while about 32 percent of Shell’s $470 billion in revenue last year came from areas including Africa and Asia, according to its annual report.

“If you want to try to clean up and eliminate some of your political and geographic risk, these would be nice assets,” Sorrentino said. “There’s nothing here that’s terribly risky.”

“We have more than 40 trillion cubic feet of gas in the U.S. and Canada and we bought that quite efficiently, so we have plenty on our plate,” Shell CEO Peter Voser said in an interview in Calgary yesterday when asked if his company is interested in buying all or part of Chesapeake.

Sorrentino said a buyer could pay about $20 a share, while SunTrust’s Dingmann estimates Chesapeake could fetch a takeover price in the “mid to high $20” range, or as much as a 77 percent premium to Chesapeake’s closing price of $16.35 yesterday. The stock reached a record of $69.40 in 2008 and closed as high as $35.61 last year.

Joint Ventures

An acquirer would have to take on Chesapeake’s seven joint ventures and $13.1 billion in debt, surmount the board’s takeover defenses and convince McClendon to sell. Chesapeake is protected by an Oklahoma law that prevents a shareholder from engaging in a “business combination” without approval by the board of directors or two-thirds of the other shareholders, according to company filings. The law makes an exception if the investor owns 85 percent of the company’s stock.

“I don’t believe they’re an attractive target,” Tim Rezvan, a New York-based analyst at Sterne Agee & Leach Inc., said in a phone interview. “There are too many joint ventures and too much uncertainty about all those moving parts. Anyone looking to make an acquisition can find a lot cleaner assets out there.”

A takeover may still be a bargain for any buyer that agrees with McClendon’s valuation estimates. In a March interview, McClendon said the Permian Basin accounts for 5 percent of the company’s value and divesting holdings there will generate at least $5 billion, implying that Chesapeake as a whole could be valued at $100 billion. That’s more than nine times its current market value.

“If one is willing to look past the near-term volatility, given the plunge in natural-gas prices and the management turmoil, I do think Chesapeake will rebound and is certainly a valuable company,” Todd Smurl, president and chief investment officer of Houston-based Ascendant Advisors LLC, where he manages the Ascendant Natural Resources Fund (NRGCX), said in a phone interview. “Definitely the attraction to an acquirer would be the assets that they own.”