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Norbert in Energy,

Let cheap energy juice up your portfolio

Last summer, I wrote that oil prices were going to drop over 30% and that investors should sell oil stocks. I was roundly called out as a Chicken Little and panic monger, as well as, told I was stupid.

Now, I’m telling you to buy energy stocks. I wonder how last summer’s critics will feel this time? If you care more about your feelings than making money, then stop reading now. If you are really looking for “buy low” opportunities, then I believe the two companies I cover here fit the bill.

The oil and gas sectors have been crushed in recent quarters with shares of many companies down 50% or more. In some cases, the beatdowns are warranted, in others, not so much. Sifting through the devastation and finding opportunity relies not only on understanding where value really exists, but controlling our own emotions.

Here is one of the asymmetric upside opportunities that I have invested in recently from higher share-price levels. If in your research you decide that you agree with me that there is a significant value here, then I believe that scaling in over the next month or two could yield you some big gains over the next few years.

Natural gas

Chesapeake Energy CHK, +9.43% is one of the most heavily shorted stocks on the market. It is often said that the “shorts” are the smart money on Wall Street. I think there was some validity to that thinking decades ago, however, I think something different is going on today with many shorts.

At my investment letter I have talked about a phenomenon I call the “networked traders.” This isn’t so much a conspiracy theory, as it is recognition that the Internet, questionable reports by services dressed up as research firms and a market with low demand for stock by fearful retail investors, has made it easier for trend-following traders, hedge funds and high-frequency traders, i.e. “the machines”) to pound down small and midsize company stocks.

Ultimately, an unwinding of short positions in valuable companies will occur when enough people recognize value. I believe one such company likely to see significant upside as soon as 2016 is Chesapeake.

Chesapeake is the second-largest natural-gas driller in America, though very neck and neck with numbers three and four. Its mix of natural gas to oil is roughly 70% to 30%. Criticism of the company centers on debt, transportation and storage costs, and what one “research firm” calls “off balance sheet” obligations. On all three counts, I believe the criticism is overstated.

Currently, Chesapeake projects about $1.5 billion on the balance sheet for year-end and is sitting on a completely undrawn line of credit of $4 billion locked in. With banks reconsidering credit facilities for other companies and capex spending falling across the industry, Chesapeake is sitting in a very advantageous financial position compared to many E&P companies.

The company has also been moving rapidly toward greater efficiency the past few years and this year increased production while reducing costs. They just finished renegotiating a major gas gathering services deal with Williams WMB, +5.23% that will greatly improve their long-term results.

The off-balance-sheet obligations are a reference to royalty lawsuits the company is facing. Chesapeake has been moving forward in those lawsuits, including settling some. These lawsuits are not unusual in the industry during this low-natura-gas-price environment. I have done a calculation as to what the high side of the potential liability is and come up with a number in the middle hundreds of millions. That is nothing to sneeze at, but also nothing that would harm the long-term viability of a company with plenty of assets to monetize. In my opinion, as well as, the opinion of a litigation attorney I have consulted, it is not likely that damages will reach the high-end of the financial risk range.

My sum-of-the-parts analysis of Chesapeake based upon likely economically developable reserves and normalized pricing of oil and gas, with an oil price target of $80/barrel and natural gas target of $3.50/mmbtu in the next few years, values the company at $40 billion to $60 billion net of debt. Surprises from here, in my opinion, are likely to be positive as the industry retrenches and production is placed into the hands of fewer players over the next year. I believe that bad and potentially bad news is more than priced in at this point. Currently, the company’s market cap is about $5 billion. My cost basis is about $11 per share and the current share price under $9.

Kirk and certain clients of Bluemound Asset Management own shares and calls in Chesapeake Energy and shares in SunEdison. Kirk has recommended both Chesapeake and SunEdison to subscribers of his investment letter Fundamental Trends. Neither Kirk nor Bluemound clients plan any transactions in the next three trading days. Opinions subject to change at any time without notice.