Carl Icahn’s Big Energy Bet

He recently increased his stake in this beaten down gas company suggesting he expects to shake out big profits.

The collapse in oil prices has claimed many victims, ranging from whole countries whose economies are energy dependent such as Russia, right down to the little boom towns of the Dakotas.

Even savvy investors have suffered severe losses as shares of energy stocks dropped 50% or more from their summer peaks.   Among the worst hit were those tied to natural gas as the surge in production from the shale and fracking boom, and the restrictions on U.S. companies exporting, sent gas prices into a spiraling down some 40% to below $2.60 a BTU.   At that price assets such as land with known reserves and active wells went from gushing profits to leaking losses.

But as history has shown havoc leads to some of the best opportunities as smaller players with little money and less conviction are forced off the field.   So when Carl Icahn, one of the most opportunistic and deep pocketed investor, recently increased his investment in this energy company one would do well to pay attention.

Icahn ramped up his stake in Chesapeake Energy (CHK) through two successive purchases of 8 million shares on March 11th and then an additional 4 million shares on March 23rd at an average price $13.70 a share. This bring his holdings to nearly 73 million shares or 11% of the outstanding shares.

Aside from the size of the investment, which now stands as Icahn’s 5th largest holding, the interesting items here include the timing and execution. Icahn already had a substantial and active stake in Chesapeake since 2012; he was instrumental in ousting founder and CEO Aubrey McClendon in 2013 which provided a momentary lift to the stock. But that might have had more to do with macro energy picture than any of his activist actions.

Despite stock recently climbing some 9% to $15 Icahn is facing a large losses The recent successive purchases of suggests he is not only betting on a recovery of gas prices but plans on shaking things up to accelerate the company’s return to profitability and boost its share price.

Restructuring Underway

Chesapeake, based in Oklahoma City, is the nation’s second largest producer of natural gas behind ExxonMobile (XOM). In 2014 it saw revenues decline some 25% and now faces $1.9 billion free cash flow shortfall in 2015.

It has already taken steps to stop the bleeding including; shutting down less productive wells, rig count is expected to drop to around 35 in 2015 from 65 in 2014.   It is also slashing CapEx spending, a new reduction brings exploration and production spending down to $3.5 billion from $5 billion in 2014. Most importantly it is shedding assets and is expected to raise some $5.billion to both shore up its balance sheet and help it focus on the more profitable core businesses.

For example, new drilling projects will be focused in areas where Chesapeake already has plenty of expertise and an established cost advantage. In the Utica shale of Ohio, the firm can build new wells for $6.6 million apiece, compared with about $9 million each for competitors.

The company has now reduced its long term debt by 13% to $11 billion, its lowest level since 2007.   It also expects to become cash flow neutral and turn a $0.05 per share profit. Modest in absolute terms but great strides from three prior years of negative cash flow and last year’s loss. This steps should help protect the current 35c dividend which represents a 2.5% yield at the stock’s current $15 share price.  The chart shows a bottoming process seems to be occurring of late.

CHK 040615

But even with the business stabilized and gas prices showing signs of bottoming skeptics abound. In fact over the past two months short interest leapt by 30 million shares and a total of 70 million or 23% of the float.

Of course, these short sellers represent embedded buyers and with the proper nudging from Icahn could be the catalyst for a huge short squeeze could occur.

The Trade:

Icahn obviously sees value at current levels and plans to be in this position for the long haul.   I want to use LEAP options to gain some leverage and time for the investment thesis to play out.

I’m targeting the January $15 calls for $2.00 a contract.

These at-the-money calls expire in January 2016 giving it plenty of time to hit my $20 price target. But the low $2 cost will keep risk limited if the company, or gas prices, fail to recover.

— Steve Smith

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About the Author: Steve Smith