Chesapeake Energy Offers a Safer Way to Play

Want an energy stock with some downside protection? Chesapeake Energy (CHK - commentary - Cramer's Take) convertibles offer investors a way to participate if the stock goes up or get a nice yield if the market goes back down.

The convertibles are currently paying a 6% yield to investors. Bonds mature at $1,000, and Chesapeake's are trading at $475. Each bond converts into 11.6428 shares when the stock reaches $85.9 a share. If you do the math, it equals $1,000 a bond.

The bonds are rated BB. Technically, they are junk rated. In a bankruptcy, banks and bond holders have first claim on assets. After that, claims go to accounts payable, preferred-stock holders and, at the end of the line, common-stock holders. Should the company go out of business, convertible-bond holders would get a claim on the value of Chesapeake's land, rigs and drilling rights. These assets would be sold, and the cash left over would be given to each class of creditor standing in line.

But Chesapeake isn't going out of business. It's a well-run company in a very volatile industry: natural gas. As of Dec. 31, 2007, it had 10.9 trillion cubic feet of natural gas in proved reserves. It had $4.6 billion in sales in 2005 and $7.8 billion in 2007. That's what you call a growth company!

Natural gas is about $6.50 per million British thermal units. Back in June, it was trading at over $13.

T. Boone Pickens and his buddies are trying to get the government to convert buses, trucks and autos to using natural gas. The U.S. has an abundance of natural gas and a dearth of oil. If this conversion happens, you know that natural gas prices will skyrocket.

Chesapeake's CEO and founder is the famous Aubrey McClendon. He recently bought the Supersonics basketball team and is moving it to Oklahoma. Unfortunately, he had to sell most of his stake in Chesapeake because of margin calls. Lesson to be learned: Don't use margin!

---

At the time of publication, Osborne had no positions in Chesapeake or any of its offerings.

Holmes R. Osborne III is a private money manager, founder of investment newsletter StockRoyalty.com and frequent author of financial columns. He has a degree in finance from the Martin J. Whitman School of Management at Syracuse University and is a CFA charter holder. Osborne is a member of the Pacific Council on International Relations, Malibu Rotary, Business Forum International and was formerly on the board of the L.A. National Association of Business Economists. He spoke this year at the fifth annual Value Investor Conference.