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This Shale Pioneer Refocusing on Natural Gas

Forget oil—the real money is in natural gas.

Or at least that’s the message coming from a pioneer of the U.S. shale revolution, Chesapeake Energy (CHK).

From Prince to Pauper to Prince Again?

Once upon a time—when its stock was valued at more than $35 billion and its CEO, Aubrey McClendon, had the biggest pay package of any CEO of a listed firm—Chesapeake Energy was America’s best-known fracker.

But those glory days disappeared quickly, and Chesapeake became the poster child for the shale sector’s excesses.

About a year and a half ago, in the autumn of 2020, Chesapeake was in the midst of bankruptcy proceedings after the coronavirus pandemic-led crash in energy demand proved to be the final straw in the company’s fall from grace.

And for the industry more broadly, the prospects for liquefied natural gas (LNG) exports were looking bleak after a $7 billion contract to supply the French utility Engie went down the tubes on concerns over the emissions profile of U.S. natural gas.

Fast forward to 2022 and the picture has changed dramatically. Natural gas exports are booming!

Thanks to the Russian invasion of Ukraine and subsequent sanctions, Europe is in the middle of an energy crisis. It is buying up as much American LNG as it can. Those concerns about emissions are long forgotten.

In the first four months of the year, the U.S. exported 11.5 billion cubic feet a day of gas in the form of LNG, an 18% increase from 2021. Three-quarters of those exports went to Europe. And European leaders have pledged to ratchet up their imports by the end of the decade. There is also a massive opportunity in Asia, where LNG demand is set to quadruple to 44 billion cubic feet a day by 2050, according to a recent report released by think-tank, the Progressive Policy Institute.

And even here in the U.S., natural gas supplies look set to be tight this winter. Hot summer weather and high demands for power generation are sucking up supplies and leaving storage precariously low.

The investment bank Piper Sandler believes U.S. storage is on pace to fill just 3.4 trillion cubic feet of gas by the time winter arrives. That would be short of the 3.8 trillion cubic feet buffer usually needed to heat the country through a cold winter season. That could send already-elevated natural gas prices even higher in the months ahead.

These factors combined were behind the decision by Chesapeake Energy management to ditch oil in favor of gas.

Chesapeake: All in on Gas

OnAugust 2, Chesapeake announced its plan to exit oil completely and return to its roots as a natural gas producer. The company said it would offload oil producing assets in south Texas’s Eagle Ford basin, allowing it to focus solely on gas production from Louisiana’s Haynesville basin and the Marcellus Shale in Appalachia.

Its CEO Nick Dell’Osso said the company made the decision because of better returns from its gas assets—it has had more success driving down costs and improving efficiency there when compared with oil.

Chesapeake emerged from bankruptcy in February 2021, vowing to shift from its previous model of growth at all costs to one of capital discipline and higher shareholder returns.

The company has expanded its natural gas portfolio of assets since its emergence from bankruptcy. It bought gas producer Vine Energy for $2.2 billion last August to bolster its position in the Haynesville, which sits close to gas-export facilities on the US Gulf Coast. And in January, it bought Chief Oil & Gas, a gas operator in north-eastern Pennsylvania’s section of the prolific Marcellus shale field, for $2.6 billion. Chesapeake also recently offloaded its Wyoming oil business to Continental Resources, the company controlled by shale billionaire Harold Hamm.

In summarizing Chesapeake Energy’s strategy, Dell’Osso said, “What’s different today than the past… is that we are allocating capital in a way that maximizes returns to shareholders, rather than maximizing [production] growth.”

Speaking with the Financial Times, Del’Osso added: “The industry was built on [oil and gas production] growth expectations, and company stocks were valued on growth expectations. That all had to get broken down.” The “reset” had been painful, but management teams would stick with the new model, the CEO said.

The strategy seems to be working. In May, Chesapeake reported record-high adjusted quarterly free cash flow of $532 million from the first three months of 2022.

Also in the second quarter, it announced an agreement to supply gas with the Golden Pass LNG facility. Golden Pass LNG is a joint venture company formed by affiliates of two of the world’s largest and most experienced oil and gas companies: QatarEnergy (70%) and ExxonMobil (30%).

The company now plans to pay $7 billion in dividends over the next five years. That is equivalent to well over half of its current market capitalization!

Chesapeake boasts of its best-in-class shareholder return program. It has completed about a third of its $2 billion share and warrant repurchase program, and it raised the base dividend by 10%, to $2.20 per share annually.

The company has a juicy variable dividend as well. Its next quarterly dividend will consist of the $0.55 per share base dividend and a variable dividend of $1.77. Management projects that, in the third quarter, it will pay out total dividends of $275 million to $285 million. The total dividend payout for 2022 should come in at between $1.3 billion and $1.5 billion.

Chesapeake’s yield is a very impressive 10% and I do not see that changing much as gas prices stay elevated. The stock is a buy anywhere in the $90s.
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Only This Kind of Company Can Save Your Portfolio

I’ve come to think that while some companies strive to make Wall Street analysts and large portfolio managers happy, others put common investors like us first. A company’s dividend policy will be a telling factor about on which side a company’s management team and board of directors fall.

Small investor-friendly companies pay out a significant portion of profits or cash flow as dividends and continuously strive to grow their dividend rates. Investing in stocks like these, with attractive yields and growing dividends, is a proven strategy for building wealth.

Here are some clues that tell you a company is more focused on making the Wall Street analysts happy…

Share Buybacks

Companies refer to share buybacks as “returning capital to shareholders.” I don’t see it working that way. If my shares are repurchased, I am no longer a shareholder. The theory is that buying in shares reduces the share count, which will help increase earnings per share (EPS) for those who remain shareholders after the buyback. But as we all know, growing earnings don’t always boost the share price. Without a corresponding dividend increase, I see share buybacks as throwing money (sometimes a lot of money) down a hole.

Environmental, Social, and Governance (ESG)

Large pension and other fund managers put a lot of weight on ESG scores. These types of investment pools are so large that they have no potential to produce above-average returns, so fund managers can help themselves feel better by investing in companies that are working to save the planet.

Unfortunately, I doubt whether the ESG rules and scores, at least as they currently exist, do much good for the environment or investors. I know they can make a CEO feel better about keeping a corporate jet if they fund the seeding of the rainforest, but I have not noticed how an overly heavy focus on ESG helps my net worth grow.

In contrast to the Wall Street analysts and big money fund managers, we, as individual investors, most want to see our brokerage and retirement accounts grow with above-average total returns. How much you make depends on your risk tolerance and how aggressively you invest, but a significant portion of your returns should be in the form of cash dividends.

The shutdown of the economy due to the pandemic forced many companies to change their dividend policies. Now, two and a half years later, I am watching closely to see what companies continue their pandemic changes versus making a return to taking care of individual investors with great dividend policies.

Here are a couple of examples:

Last week, Main Street Capital (MAIN), a top-tier business development company (BDC), announced an increase in the monthly dividends the company will pay in the fourth quarter. The new dividend rate of $0.22 per share gives the third half-cent increase since the beginning of 2020. Main Street Capital also pays supplemental dividends when its profits allow, and a $0.10 bonus dividend will be paid in September. This is one of those conservative, investor-focused companies from which investors can count on stable, growing monthly dividends.

In early 2021, upstream oil and gas producer Devon Energy (DVN) announced a new dividend policy to pay out 50% of free cash flow as dividends to investors. The dividends are a combination of fixed and variable components. Since the start of 2021, the fixed dividend has grown from $0.11 per share to $0.16. Total (fixed-plus-variable) dividends paid for the last six quarters have been $0.34, $0.49, $0.84, $1.00, $1.27, and $1.55 sequentially. As the price of oil rose and Devon became more efficient, the company rewarded investors with rapidly growing dividends. Based on the $1.55 payout declared last week, DVN yields 10%.

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Oil Service Companies’ Gusher

I continue to love the sector Wall Street seems to hate: energy. Analysts are saying oil has peaked and bad times are directly ahead for the sector. I believe that oil markets are more fragile than the recent price decline might signal.

The same factors that sent energy prices higher over the past year remain in place. Global stockpiles are low and the energy supply system is running near flat. The OPEC+ alliance has very little spare capacity, and what’s left is held almost entirely by Saudi Arabia and the United Arab Emirates. Refiners are producing about as much fuel as they can. And governments (including the U.S.) are drawing down their emergency supplies at a record pace.

All of these factors leave little room for the market to absorb any future supply shocks, which I think are likely.

So the reality, away from Wall Street, is that these are good times for the industry—especially oilfield service providers. These are the companies that carry out the grunt work of drilling and servicing oil and gas wells.

These companies suffered a near-death experience in 2020, when the pandemic shattered demand for oilfield activity and upstream spending by oil companies. The collapse in demand prompted the oil service companies to sack tens of thousands of workers and idle their equipment. But now their fortunes have completely reversed.

The large energy producers, having initially opted to take advantage of the oil price rally to repair their balance sheets and return money to shareholders, are finally expanding again.

This increasing demands from drillers, coupled with widespread shortages in everything from the sand used in fracking shale wells to rig hands and drivers, have greatly improved profit margins for oil services providers.

Of the three major U.S. oil servicers, only Baker Hughes is struggling (its equipment division is still a laggard). The other two companies—Schlumberger (SLB) and Halliburton (HAL)—are doing quite well, thank you.

Schlumberger

In fact, Schlumberger reported a fantastic quarterly profit and sharply raised its outlook for the year.

Schlumberger’s second quarter showed net income of $959 million, more than double the level in the same period last year. Revenues of $6.7 billion were up by a fifth. North American sales rose 42%. The company posted 20% year-over-year revenue growth and an operating margin of 17%—a level not seen since 2015!

CEO Olivier Le Peuch said that the world’s biggest provider of services to the oil and gas industry anticipated its revenue growth rate this year to be in the high-teens, resulting in revenues of “at least” $27 billion, compared with $23 billion in 2021. The company also expects adjusted EBITDA margins to be 200 basis points higher than they were in the fourth quarter of 2021.

Le Peuch added that the industry was in the middle of a “multiyear upcycle [that] continues to gain momentum with upstream activity and service pricing steadily increasing both internationally and in North America.”

In a true sign of management confidence, Schlumberger raised its dividend by 40% in the first quarter of 2022, to $0.70 annually, making the current yield 2%. I expect the dividend raises to continue for the foreseeable future. My eventual target is the company’s pre-pandemic dividend rate of $2.00 per share annually.

Add to that Schlumberger’s exceptional investment history. Over the years, it has rather consistently generated shareholder value through use of its R&D capital investment dollars to develop a wide variety of new products and services. Roughly 25% of revenue comes from new technology each year.

That makes the stock a compelling buy anywhere in the mid-30s per share.

Halliburton

Jeff Miller, CEO of Halliburton, reiterated the concerns about the shortages facing the oil industry.

He said that the North American oil services market remains “all but sold out” this year and that there was no indication of that changing next year. He further pointed out that the shortages of labor and equipment at U.S. oilfields are likely to get worse next year, adding: “What we see in our business is activity [and] demand moving up. We see a tighter [20]23 than we see in 2022,” he said. Keep in mind that Halliburton is the largest domestic frac fleet operator.

His comments came as Halliburton reported revenues of $5.1 billion for the second quarter, up 18% on the previous quarter and 37% on the year-ago period. Net income of $117 million was about half of last year’s income as a result of impairment charges from the company’s exit from Russia. Excluding these costs, it roughly doubled to $442 million.

And Miller dismissed those Wall Street fears of an impending slowdown. He said company discussions with operators were focused on demand for “more equipment or more services” in 2023, “not recession—I can promise you that is not the discussion.”

And like the Schlumberger CEO, Miller reaffirmed his view that the company was entering a “multiyear up cycle” both domestically and internationally. While Halliburton is less exposed to international markets than its peers, it is one of the top players in markets like the Middle East and Asia, where long-term growth is forecast to be the strongest.

The company’s optimism, like Slumberger’s, has spread to its dividend policy. Halliburton tripled its dividend in January, to $0.48 per share annually (the current yield is 1.73%). I expect more shareholder and dividend-friendly announcements over at least the next year or two. My target for now is the company’s prior annual dividend (pre-pandemic) of $0.72 per share.

Halliburton shares are a buy in the $28 to $32 range.
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