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No. of Recommendations: 10
I had the chance to interview (former TMF'er) Tom Jacobs and Jeff Annello of Complete Value Investor for Here is the column. I am long all three companies they cite. As noted below, Tom endorsed my book.- Hewitt

Three Plays on Nat Gas
By Hewitt Heiserman Contributor
12/10/2008 2:00 PM EST

Tom Jacobs and Jeff Annello are analysts and portfolio managers at Complete Value Investor, a value-oriented investment service that buys "50-cent dollars." They just issued buy recommendations on <bATP Oil & Gas (ATPG), Contango Oil & Gas (MCF) and Chesapeake Energy (CHK) , all of which they own. Here is an edited transcript of why these E&P companies are compelling values for patient investors.

Oil and natural gas prices are down. Why buy these companies now?

Jacobs: We like "down." We're not interested in companies everyone wants at high prices. There's no margin of safety, which Ben Graham advised. Instead, we want to buy good businesses cheap.

In 2006 and 2007, energy investors believed trees would grow to the sky. Today, they believe they will grow upside down. Well, they were wrong before and they are wrong now. Anyone who thinks natural gas will never be $7 per thousand cubic feet (mcf) again or that these companies don't have the balance sheets to survive until then are wrong. Good for us -- we get valuations unseen in decades, and most likely for the last time.

Annello: The market often discounts far worse events then are likely to occur. We're seeing that now more than any time since 1973-1974. Once a stock falls off a cliff, we look to see if the market has overreacted. In recent weeks, the answer is often "yes." Few sectors have dropped like energy stocks. For example, ATP just sold less than 10% of their proved reserves for $430 million cash, which is more than two times their entire current market capitalization. Unless you think their executives are bandits, the valuation is crazy.

Let's go through your reward-risk analysis for each company. Start with ATP.

Annello: Net asset value approaches $50 a share, or about 7 times the current quote of $7, after taking out debt. And this isn't a "believe us" number, but what you get extrapolating ATP's recent asset sales to its remaining reserves. Even when we made extremely conservative assumptions we couldn't get anywhere close to the price ATP trades at today, between $5 and $7 a share. ATP's discount to net asset value is so big that oil and gas could be $40 a barrel and $4 per million BTU (mmbtu) (vs. $5.60), respectively, and the reserves are still worth more than today's market price. The company has sold some interests in the North Sea for cash and has more up for sale both there and the Gulf of Mexico. Add in some infrastructure assets it owns and might place into an MLP, and we believe ATP's upside dwarfs any potential losses.

ATP has $1.6 billion of debt. Any risk of bankruptcy?

Annello: About $600 million matures in 2011, the rest in 2014. So refinancing risk is off in the distance. There is a small risk that the fall in prices could lead to a breach of a covenant relating the reserves' value to net debt. However, the risk seems small because the net debt side of that equation -- $1.6 billion -- is already reduced and getting smaller. ATP just sold $430 million of reserves to take debt down by at least $322 million to about $1.2 billion. It also has some cash that nets against the debt, about $175 million worth. Thus, the debt looks manageable considering the asset sales and the likely increase in reserves at year-end, when the covenant is tested.

Next, Contango.

Annello: The market cap is $750 million, but we think fair value is $1.4 billion to $1.7 billion, so you get roughly a double with little risk. It has the least potential upside of our three but offers the strongest margin of safety.

Contango is a unique E&P company because it uses little if any debt, doesn't do its own drilling or seismic work, and doesn't own any infrastructure. In fact, the company has just six employees, one of which is founder Ken Peak. Hedge fund manager Mark Sellers calls Peak the "Warren Buffett of natural gas."

Contango owns 369 billion cubic feet equivalent of natural gas in the Gulf of Mexico, dozens of undrilled lease interests, more than $100 million in cash, and no debt. Contango is completely unhedged, so you have to believe that natural gas will stay above a certain price -- we put it at about $6/mcf (vs. today's $5.60 mcf) -- for the long term to buy the investment story. Terrific company, fortress balance sheet, massive reserves, and it's cheap.

Last, Chesapeake Energy.

Jacobs: Chesapeake Energy, the No. 1 U.S. gas producer and largest landholder in the unconventional "shale" plays, is worth about $75 a share at $7/mcf natural gas. Even at today's depressed $5.60/mcf, it's worth about double using recent asset sales as a guide -- you get half the company for free right now using the most conservative model. So the potential return is 2 to 5 times today's quote of $14 and change. It's cheap because investors misunderstand its asset values, cash and debt, expenses and cost structure -- all delightfully to our benefit.

In today's environment of low natural gas prices, BP (BP) and StatoilHydro (STO) have bought part ownership of some Chesapeake assets and partnered for future exploration and production; what they paid for 25% to 33% of some of Chesapeake's assets implies the rest of Chesapeake is free.

Chesapeake will have $2 billion to $2.5 billion in cash by the end of 2008 and no senior debt due before 2013. So Chesapeake is liquid.

As for expenses, the asset sales provide that the buyers share capex going forward; all the while, Chesapeake has hedged 76% of 2009 production at $8.20/mcf (vs. $5.60 today) and 50% at $9.50/mcf in 2010. Investors misunderstand the hedges and fear that low prices bring "knockouts" -- release of the counterparty to pay -- but the company's downside here is not significant. Oh, and Chesapeake will add 2.5 tcf -- that's "t" for trillion -- of reserves in 2009 at a cost of $1.20/mcf. Yowza.

Finally, investors misunderstood the company's Thanksgiving filings allowing it to issue $1 billion in stock for some purposes and/or 50 million shares for others. These were contingencies only, but everything is suspect in this market, and the shares plummeted. So on Dec. 8, the company rescinded the $1 billion stock offering filing and reduced the 50 million share authority to 25 million. The stock responded appropriately well.

Chesapeake is reducing rig count. This is good for business?

Jacobs: Very good. As the No. 1 U.S. producer, Chesapeake's production influences natural gas prices strongly. Reduce the production, reduce the supply, increase the price. Moreover, Chesapeake has reduced future capital expenditures to bring its cash balance to about $4 billion in the next year or two. And of course the company is idling third-party leased rigs first, not those it owns outright. The company is all but certain to remain operating cash flow positive.

So much of your thesis depends upon the value of hidden, in-ground assets -- what gives you confidence these reserves exist?

Annello: Remember, they get independent audits each year. If they were lying, not only would the companies issuing the reports be in trouble, but the wonders of Sarbanes-Oxley are that the executives would probably go to jail, the company would be hit with massive fines, and they finally would be forced to restate. Given that all three companies have heavy insider ownership, this is unlikely. Insiders own 24% of Contango; Paul Buhlman, the chairman of ATP, owns 18% of his company; and until his margin call, Aubrey McClendon owned the largest stake of Chesapeake. Each company has its interests aligned with that of minority shareholders, and that helps us sleep well.

Do we know if the Obama administration is friendly to the oil and natural gas industry?

Annello: We haven't heard Obama's take on natural gas yet. But there's little chance it would be hurtful. Natural gas burns cleanly and is abundant in the U.S., reducing our dependence on foreign oil, a huge priority, especially for the Democrats. In addition, given his environmental stance, Obama isn't likely to be keen on offshore drilling, which would add supply to the market and reduce prices. The critical breakthroughs in alternative energy have yet to be made, and luckily for us, one of the best alternatives right now is natural gas.

Jacobs: And natural gas also has the advantage as a gasoline replacement in retrofitted cars at certain price levels.

Thanks, Tom and Jeff.


A note: Tom Jacobs provided an endorsement for my book It's Earnings That Count.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider ATP Oil & Gas to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.


Know what you own: Heiserman mentions Chesapeake. Other companies in the natural gas space include Devon (DVN) and EnCana (ECA) .

At the time of publication, Heiserman was long Chesapeake, ATP Oil & Gas and Contango Oil & Gas, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit Earnings Power.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email. has a revenue-sharing relationship with under which it receives a portion of the revenue from Amazon purchases by customers directed there from
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