Thursday, February 10, 2011

Natural Gas Bull Turns Bear: Oil Fracking Not Holy Grail Either

We have backed Chesapeake Energy and other U.S. Natural Gas producers for years. We will continue to lobby Washington for longer term usage of Natural Gas in the U.S. Economy.

However, as pragmatic investors, even we have concluded that the U.S. Natural Gas producers have absolutely no pricing power at the current time.

We have advised investors not to get excited about Chinese making select investments in U.S. and Canadian Energy assets; The Chinese State owned/controlled energy companies are buying technology education to utilize outside of the U.S.

We have also advised investors not to assume that U.S. Shale Gas Producers can make meaningful and profitable shift to "turn the ship around on a dime" and become major oil producers for convenience purposes. That is more public relations than reality at the current time.

Accordingly, we have placed Sell Opinions on U.S. Shale Gas Producers, as they are over-valued, over-levered and have fairly dismal earnings prospects over the next 3-5 years.

Chesapeake Energy (NYSE: CHK) has purposely placed itself in the spotlight as the most aggressive domestic producer and benefits the most in rising price and high volatility market.

CHK got caught in the crossfire of massive debt, massive oversupply of natural gas with no pricing power, and years of proliferation of extremely risky off balance sheet debt/forward sales to mortgage their production assets.

While we have valued CHK common equity at $22/share, as we conduct further analysis into the Company debt structure and complex web of off balance sheet financing, we are finding it extremely difficult to stand behind our current equity valuation, which is well below the current market price range of $30/share.

CHK is looking more like a pure debt play and we may revise our Net Asset Value downwards upon further review.

However, as with any investment similar to a futures contract, the sword cuts both ways. Chesapeake Energy also suffers the most in a severely depressed market due to their massive debt load, opaque off balance sheet debt/production payments, and heavy capital expenditure requirements.

Natural Gas will have its time in the sun, but not for several years into the future and we must therefore conclude that any capital tied up in U.S. Natural Gas Producers in the interim will under-perform the broader market.

Even if Washington were to mandate the greater usage of Natural Gas today the fact is the transportation industry would not be geared to capitalize on such mandates for many years into the future, nor would demand be substantial enough to put a dent in the substantial supply surplus.

Natural Gas is plentiful and we are back to the valuation methodology of the 1990's. The longer term you discount the potential production reserves, the closer to $0 value you get.

In a oversupply condition, with no premium in the forward curves, no premium in storage, the fundamental value of natural gas reserves in the ground, wet or dry is substantially reduced.

Bottom Line: There is no urgency or premium required in the U.S. Natural Gas market and re-confirm our Sell Opinion on natural gas producers. We see premium in energy service companies and longer term build out of pipeline and distribution companies.

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