For oil and gas investors, 2019 was an awful year. While a few of the integrated major oil companies managed to scratch out modest gains, nearly all of the smaller companies suffered sickening losses. For Cheasapeake (NSYE:CHK) it was even worse, as CHK stock price tumbled by two-thirds in 2019. The fact that the overall market rose nearly 30% only added insult to injury for the owners of CHK stock.
Reasons to Be Optimism
Energy investors have some reasons for hope in 2020, though. For one, the January effect tends to boost small-cap stocks while punishing last year’s winners. In theory, big tech winners from last year should undergo corrections, while money flows into stocks that did poorly the previous year. In other words, folks should sell Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL) while buying stocks in energy, retail, and other battered sectors.
Secondly, on Jan. 2, the United States killed an Iranian general, Qassim Soleimani, in apparent retaliation for the killing of an American contractor by Iranian-backed forces and in an effort to prevent additional attacks against Americans that Soleimani was planning, according to the U.S. Last night, Iran retaliated with missile attacks against barracks where American soldiers were stationed. However, the U.S. does not appear to have suffered any casualties.
Not surprisingly, the hostilities between the U.S. and Iranian have caused a rally in the prices of oil, gold, bonds, and other such havens. And speculators have moved into energy stocks based on their belief that rising geopolitical tensions will finally lift energy stocks out of their brutal bear market.
Can’t Fool Me Twice?
It’s interesting that the price of oil and related equities haven’t really jumped that much since an 2. The primary oil ETF United States Oil Fund LP (NYSEARCA:USO) has only climbed 2%. The large-cap energy Energy Select Sector SPDR (NYSEARCA:XLE) is actually slightly lower. That’s simply incredible, given the catalyst. Smaller cap energy stocks, which is the category in which CHK stock falls, did advance, but only slightly. What’s going on?
It seems that folks remember the lessons from September 2019. At that time, you may remember, Yemeni forces – perhaps linked to Iran – launched a major strike against Saudi Arabia, taking much of that country’s oil production offline for a few weeks. Unlike this week, however, oil and energy stocks went ballistic. Oil futures surged as much as 18% in one day, and the energy ETFs posted their biggest one-day gains of the year. Smaller-cap energy stocks rocketed higher, with some names surging 50% in a single day.
However, the Saudi incident didn’t amount to anything. The Saudis restored most of the lost production within a few weeks, and global crude supplies were barely affected. Oil prices quickly retreated, and energy equities quickly gave back all their gains. Within a few weeks, the Oil & Gas Production ETF (NYSEARCA:XOP) tanked more than 20%, falling back to its 52-week lows. After suffering that unpleasant outcome, speculators seem shy about trying their luck on another Middle East geopolitical catalyst.
Higher Oil Prices Aren’t a Cure-All for Chesapeake
It’s crucial to remember that higher energy prices do not affect all exploration and production companies equally. pure-play oil producers benefit the most from higher oil prices. But higher oil prices are actually bad for natural gas producers. The outlook of Appalachian producers like Antero Resources (NYSE:AR) and Range Resources (NYSE:RRC) is harmed by higher oil prices.
That’s because, as oil prices go up, companies produce more oil in oil-rich areas to take advantage of higher prices. They also produce more natural gas as a byproduct of that oil production. The Permian producers don’t care what price they get for the gas.
What does this mean for CHK stock? Chesapeake used to be a mostly natural gas play. It’s pivoted more towards oil in recent years. However it still produces a lot of gas, and thus higher oil prices will likely cause its profits from its gas production to decline. So a spike in oil prices won’t necessarily be tremendously positive for Chesapeake Energy stock.
Chesapeak’s Debt Situation Is Perilous
Despite its natural gas exposure, CHK stock had one of the stronger showings among energy stocks on Friday, jumping more than 6%, although CHK stock price is now little changed from its closing price on Jan. 2.
Chesapeake’s stock price probably jumped on Friday because it had already plunged so far. At under a dollar per share, the majority of the remaining value in Chesapeake’s business is now in the company’s debt, rather than its equity. Speaking of the debt, the company recently exchanged a bunch of existing bonds for new issues, only making good on the old paper at 60-65 cents on the dollar. In return, however, the bondholders now get higher interest rates, with Chesapeake paying around 10% per year on the new loans.
The fact that debtholders were willing to eat 30%+ losses on their old bonds is telling. It shows that Chesapeake’s equity has essentially no value, given the current oil and gas prices. In fact, it’s underwater, since its creditors have been forced to accept sizable losses as well. Remember, equity only has value once creditors get paid in full. The market is highly skeptical that this will happen in the case of CHK.
The Verdict on CHK Stock
In general, there’s reason to be optimistic about the oil and gas space. The clash with Iran is arguably a bigger deal than the attack on Saudi Arabia was. If the conflict escalates to a war, several million barrels a day from Iran would be lost for an extended period. That’s a sharp contrast to what happened with Saudi Arabia. Republican leaders such as Senator Lindsey Graham have made it clear that Iran’s refineries will be destroyed during an extended conflict. Oil prices could climb meaningfully over an extended period.
But Chesapeake stock simply isn’t the right way to play this geopolitical event. As its bonds show, Chesapeake may very well not be able to avoid a Chapter 11 filing. A bump in oil prices won’t be enough to turn the tide, particularly if natural gas prices drop at the same time.
Perhaps Chesapeake will rebound in the short-term on improved sentiment towards the industry. But it’s the wrong horse to ride for a turnaround in oil prices over the long haul. CHK simply has too much debt and does not benefit enough from higher oil prices for CHK stock to be a good bet.
At the time of this writing, Ian Bezek held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.