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Energy Winners: Chesapeake Energy

Chesapeake Energy beats the street on just about every count, and investors reward the energy stock with an eye towards a more oil-rich future for the natural gas pioneer.



) -- The energy sector was virtually flat at midday on Thursday, but not

Chesapeake Energy

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, which was up close to 3% and had attained its average daily volume of shares traded -- 13 million -- just after the mid-point of Thursday's trading session.

There were several natural gas earnings released between the close of the markets Wednesday and the open on Tuesday --


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Williams Companies

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released pre-market on Thursday -- but it was Chesapeake's after-market Wednesday earnings that caught the attention of energy investors.

Chesapeake Energy beat the street, upped its guidance for 2010 and 2011, and cut costs to an extent that the street did not expect. What's more, Chesapeake talked about a shift to oil production in its earnings discussion, which, while not entirely new, was the first significant earnings discussion by Chesapeake management of shifting the mix of business away from its primary natural gas strength, according to analysts.

For Chesapeake to move more into oil exploration and production is no surprise to the street or investors, as natural gas is viewed by many as an out-of-favor asset, at least to some extent, due to supply. Analysts noted that Chesapeake management is probably somewhat frustrated with its inability to move its stock price higher, and the focus on oil production should help Chesapeake to pursue higher valuation ambitions.

In fact, RBC Capital Markets analyst Scott Hanold said it was clear on the call that Chesapeake management believes that it is trading at a discount to the true value of its assets, and that Chesapeake used the word "perplexes" to describe its frustration in regards to current share price.

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At least on Thursday morning the Chesapeake earnings story worked -- though maybe being up less than 3% after beating the street on most numbers is a sign of the reluctance among investors to really rally behind Chesapeake shares.

Analysts said that Chesapeake's discussion of the oil strategy was as important a driver as any of the earnings-specific numbers in terms of driving shares of Chesapeake higher.

RBC's Hanold noted that another factor that may have held Chesapeake shares back has been its balance sheet and the fear among investors that the company would have to tap the capital markets again, and there were encouraging -- though by no means explicit -- signs that Chesapeake would not have to tap the capital markets in the immediate future.

"If you look at the guidance, one big overhang on the stock has been its liquidity, and it looks like Chesapeake can be operating on a free cash flow-positive basis in 2010, without additional asset sales or the need to go to the markets," the RBC analyst said.

At the height of the natural gas heyday, Chesapeake shares had been as high as $67 during the summer of 2008, but since the fall of 2008, Chesapeake shares have dipped as low as $13, and only reached as high as $30. On Thursday at midday, after its 65 cent gain, Chesapeake shares were at $27.01.

Marshall Carver, an energy analyst at Capital One Southcoast, said that Chesapeake mentioned six stealth oil plays, and as oil has a premium to gas among investors, oil was "the big mover" on Thursday.

RBC's Hanold would only say that the move to more oil production is going on with all the peer companies in Chesapeake's sector, and there will continue to be a premium for oil. "It's not just more oil, but executing on plans and not having to tap the capital markets again."

Hanold added that he thinks oil may grow to as much as 10% of production by the end of 2010, from a current level near 7%. He noted that for a Chesapeake or an

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it is hard to organically move the needle, to take a huge production base in gas and make it shift to oil to a significant extent all of a sudden.

Another analyst who can't be quoted until publishing research on Chesapeake said that the oil strategy could also be explained as a pre-emptive strike by Chesapeake management before investors start raising questions as to why the company continues to drill so much for natural gas at a time of high gas supply. "It could be to appease investors," the analyst said.

RBC's Hanold did note the more important profile of oil in Chesapeake guidance however. Chesapeake increased its production growth targets for 2010 to 8%-10% from 6%-8%, and for 2011 to 15%-17% from 14%-16%, and all of the uptick was due to higher projected oil volumes.

Chesapeake did not provide details on oil well locations, cost or size, but analysts say the lack of specific info on the oil strategy is typical for energy companies that are still in the phase of leasing acreage -- if they showed any of their cards, that could drive up prices in the lands that Chesapeake has targeted. In fact, another energy analyst noted that this had happened to Chesapeake in the past with Hainesville, La.-based shale gas assets.

Chesapeake's oil strategy will also seek to leverage its expertise in unconventional assets. While Chesapeake has less experience in oil drilling, analysts view the new focus on oil as part of a play exploiting its unconventional drilling expertise.

Chesapeake was tapped for a joint venture by

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at the end of 2009 for its strength with unconventional assets. While Chesapeake doesn't have the same pioneering track record with oil as it has with gas, analysts do expect that even with oil being a more complicated asset to tap, Chesapeake should be able to execute on the oil potential, even though well-specific difficulties can be expected.

The Chesapeake earnings and the positive response from the market as much about the numbers as the oil production increase, and Chesapeake is not turning into an oil company overnight.

Southcoast Capital's Carver said there just was not much negative in the Chesapeake numbers.

Chesapeake reported fourth-quarter earnings of 77 cents a share, versus a street consensus of 68 cents. The better results included higher production and lower per-unit costs. Fourth-quarter production, which had been pre-announced, increased 13% year over year, and 5.4% sequentially.

Stifel Nicolaus noted the cost improvements in a research note it released on Thursday morning about Chesapeake's earnings. "In a quarter in which operating costs came in well below expectations across the board, we view the significant reductions to 2010 and 2011 operating cost guidance as more impressive. Collectively, reductions in the company's operating cost guidance (including interest expense) lowered the midpoint per unit expense to $3.60/Mcfe and $3.65/Mcfe from prior guidance of $3.99/Mcfe $3.99/Mcfe in 2010 and 2011, respectively," Stifel Nicolaus wrote.

Boenning & Scattergood analyst Michael Schmitz has raised his Chesapeake earning per share estimate for 2010 to $2.80, up from $2.30.

RBC's Hanold raised his Chesapeake price target from $34 to $37.

Even amidst the bullish signs for Chesapeake, the stock is subject to the same risks of its peer group, in addition to the hawk-like watch that will continue to be focused on its balance sheet management. Natural gas prices could remain muted over a long period of time, and even with oil production increasing, gas dominates the Chesapeake portfolio. Lower gas prices also raise the issue of Chesapeake's cash flow, and whether or not the company needs to tap the capital markets.

-- Reported by Eric Rosenbaum in New York.


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