But looking a bit further in the future, the oil markets are already sowing the seeds of another big rally. Weak oil prices spell a moderation in new exploration investment and shrinking supplies of crude. I suspect we’ll see the global economy begin to recover in the latter half of 2009. When that happens, oil demand will stabilize, and the supplies needed to meet that consumption simply won’t be there.

As we wait for this story to play out, I recommend adding a bit of income to your portfolio. Dividend and interest income offers investors a steady source of returns in a tumultuous market environment. In the November 5 issue, I profiled the Master Limited Partnerships (MLP), a high-income group that’s currently trading at the most depressed valuations in years.

In This Issue

The bonds and preferreds I outline below offer yields of 7 to 13 percent–with an upside kicker as credit and equity markets return to health.

A little more time, a little more effort: That’s what it takes to make wise investment choices in the current market. For a look at the advantages to be gained by exploring beyond equities, see Bonds and Preferreds.

The mechanics of buying bonds and preferreds are a little different than those for stock purchase, but the processes are becoming more and more similar–and easy. For a primer on getting your bond and preferred trades executed, see Buying the Story.

As you make your way through the recommendations, you’ll find many different “yield” numbers. For the meat of the matter, see Yields and Returns.

Buying bonds and preferreds isn’t nearly as difficult as it once was—because more and more investors are learning about the subject matter. To dig deeper into your education, see Other Considerations.

Already up to speed in the intricacies? Ready to step and put money to work? See Bond and Preferred Buys.

Most individual investors primarily own common stocks, securities that represent equity ownership in a particular company. There’s nothing inherently wrong with that bias; common stocks often offer the most potential upside.

Investing in stocks is simple because most brokers are set up to facilitate the purchase of common shares. In most cases you simply enter the symbol, select how many shares you wish to buy, and the trade is executed almost instantly for a minimal fee. And several brokers have made investing in foreign common stocks just as simple and transparent.

But just because common stocks are the most popular and straightforward investment doesn’t mean they’re the sole, best way to make money. In fact, thanks to the recent credit crunch and a wave of hedge fund liquidations, the corporate bond and preferred markets are offering some of the most compelling opportunities of the past decade.

The attraction is simple: Investors can earn yields in the 7 to 11 percent range purchasing preferred and corporate bonds issued by energy firms. And there’s a kicker: These securities offer plenty of upside as the broader stock market and commodity prices recover. In a sense, bonds and preferreds offer a way of playing the long-term upside in the energy patch–and generate solid income while you wait.

Consider the chart below for a closer look at what’s happening in the corporate bond market today.

This chart shows the difference between the yield on a basket of 10-year corporate bonds for US industrial companies rated BBB and the yield on the 10-year government bond. Bloomberg created the index of BBB yields and offers historical data going back to 1991.

Most investors are familiar with bond ratings provided by companies like Standard & Poor’s and Moody’s. These ratings are meant to help investors assess the risk that a particular issuer will default on their bonds; in theory, the higher the rating, the more financially secure the firm.

An obligation rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

Another way of looking at BBB-rated firms is that this is the lowest rating still considered investment grade. Firms with a rating lower than BBB are called high-yield or junk bonds. 

As you can see from the chart above, for most of the past seven years, 10-year corporate bonds rated BBB have offered a yield roughly 1.25 to 2.25 percent higher than US Treasuries of a similar maturity. One useful way to think of this spread is that it’s a sort of risk premium: The higher the spread, the higher the return investors are demanding to accept the risk of holding BBB-rated bonds rather than risk-free Treasuries.

It’s obvious what’s happened over the past six months; yield spreads have exploded to unprecedented levels of around 5 percent. That’s more than double the average level of the 2001 through 2007 period. In fact, here’s the same chart on a monthly basis offering a longer-term look at the BBB yield spread.

This chart shows just how unusual this spread looks right now compared to long-term historical norms. The current spread between BBB-rated bonds and Treasuries is the highest it’s been in 17 years and is around triple the average spread since 1991.

As I noted on the financial blog At These Levels earlier this week, there are a number of reasons this spread has exploded to unprecedented levels. One is certainly that the major credit rating agencies have lost a great deal of credibility lately, with good reason. Moody’s and S&P assigned high credit ratings to mortgage-backed debt securities that ultimately proved to be shaky investments. And the agencies also failed to offer much of an early warning of several high-profile bankruptcies this year; for example, Lehman Brothers was still assigned an investment grade A rating by S&P right up until it filed for bankruptcy.

And there are some clear potential conflicts with the way the ratings agencies are run; for one thing, companies wishing to have their debt rated actually pay the agencies to evaluate their creditworthiness. That leads to a potential conflict of interest; companies want to have their debt assigned a high rating because this makes it more appealing to some classes of investors and lowers the cost of the credit. Meanwhile, the agencies are obviously keen to please their customers, and investors want to have a handle on their risks. These interests aren’t necessarily aligned.

At any rate, whether you believe credit ratings have merit or are a complete sham, the fact is that the market has lost some faith in these agencies. There’s certainly some doubt about whether firms rated BBB are actually stable. That uncertainty means investors are demanding a higher risk premium to own corporate bonds rather than Treasuries, partly explaining the rising spreads.

This is also why investors can’t rely solely on ratings from the agencies; bond investors must do their own fundamental evaluation of a company, just as they would when buying the common stock. We can’t assume that because it’s a bond, it’s safe.

And just as with most stocks, institutional liquidations have had an impact on the bond and preferred stock markets. Hedge funds and other institutional traders are major players in the corporate bond market. As I explained with reference to MLPs in the November 5 issue, hedge funds have been facing large redemption requests from their investors in recent months thanks to the slump in the broader market. To meet those requests, institutions have been selling off their portfolios to raise cash. Selling off their corporate bond holdings alongside stocks has pushed yields broadly higher.

Finally, rising yields in the corporate bond market is a direct symptom of the credit crunch that infected stocks this fall; obtaining credit simply has become more expensive. Check out the chart below for a closer look.

The TED Spread is a convenient measure of health in global credit markets. This spread is the difference between the yield on three-month US Treasuries and the three-month London Interbank Offered Rate (LIBOR).

LIBOR is a measure of the interest rates banks charge one another for loans. Meanwhile, the three-month Treasury is effectively a risk-free rate–there’s essentially no risk that the US Treasury will default on these short-term debt obligations. Similar to the BBB yield spread I outlined above, the TED Spread is a risk premium; the spread measures how much risk is priced into the interbank loan market.

It’s clear from this chart that the TED Spread, represented by the yellow line, exploded to the upside in September following Lehman Brothers’ bankruptcy. The reason was that banks were simply afraid to lend to one another because they doubted the financial stability of other financials and hoarded cash.

But it wasn’t just the interbank market that locked up; banks were also reluctant to lend to companies in other industries. Banks were looking to hold cash, not lend it out. You can clearly see that as the TED Spread began to spike, the yields on BBB-rated corporate bonds (the white line) also began to accelerate to the upside; yields on the Bloomberg BBB Industrial Bond Index spiked from 6.5 percent in late summer to highs near 9 percent in late October. These charts are inextricably related.

The other point to note is that although the TED spread has normalized significantly, the yield on BBB-rated bonds hasn’t fallen. The TED Spread has fallen mainly because of concerted action by global governments to pump capital into the financial system. This has eased fears of stability in the interbank market.

I expect the yields on BBB-rated debt to eventually follow suit. Financially stable firms will likely be able to access the credit markets, though debt will almost certainly cost more than it did a year ago. Bottom line: I don’t expect the spread between BBB-rated yields and Treasuries to revert to 1.5 to 2 percent immediately, but the current level of more than 5 percent is totally excessive.

Undoubtedly some of the firms rated BBB in the index above deserve to be rated junk and trade with yields above 10 percent. But the result of liquidations and indiscriminate selling is that the bonds and preferred shares of financially and fundamentally sound energy firms have been hit alongside the weak firms.

Investors are throwing out the proverbial babies with the bathwater in the bond markets, just as in the stock market.

Back to In This Issue.

For most individual investors, buying bonds and preferreds won’t be quite as easy as buying common stock.  The corporate bond market historically has been geared to institutional traders, not retail investors. In addition, the terminology used is different and finding information is more difficult.

But there are some major advantages inherent in these complexities. Chief among those is that the bond market is less crowded; investors who take the time to understand the terms of a particular issue will often find they can earn higher yields with less risk than in stocks.

In this issue I’ll offer all the information you need to purchase bonds from your broker along with exact recommendations.

Any modicum of added effort is definitely worth it; adding a few bonds and preferreds to your portfolio can offer more stability during periods of market turmoil, along with a consistent income stream. And, as I noted above, the corporate bond and preferred markets represent extraordinarily good value at current levels.

Finally, buying into the bond market is a lot easier than it once was. Over the past few years, most major retail brokers have added bond trading to their list of services, either online or by telephone. Even better, it won’t cost you much more in commissions to buy a bond than a stock.

Here’s a brief primer on buying and understanding bonds and preferred shares.

This bond primer shouldn’t be considered comprehensive. My purpose is to give subscribers unfamiliar with the bond markets a basic rundown of some the terminology and quirks that are inherent in the bond market. Those with experience in the bonds can safely ignore this section. 

Corporate bonds are simply debt securities issued by companies. Investors who buy bonds are lending cash to companies in exchange for regular interest payments and, ultimately, the repayment of their loan principal.

Unlike stocks, bonds don’t represent ownership in a company. However, bond investors always get paid before common stock investors. For example, companies that pay dividends to common shareholders can suspend those dividends for any reason at the option of the board. In most cases, companies can’t suspend interest payments on their bonds.

Moreover, in the event of bankruptcy, bond investors are able to recoup their investment before common shareholders. Bond investors have the first claim on a company’s assets. Common shareholders only get paid after all bond and preferred shareholders have recouped their investment.

Bonds are typically identified by their coupon and maturity. The best way to illustrate is with an example; let’s examine the Chesapeake Energy 7 5/8 Percent Bonds of 07/15/13 (CUSIP: 165167BY2).

These bonds are issued by Chesapeake Energy (NYSE: CHK), the largest natural gas focused exploration and production (E&P) firm in the US. These bonds mature on July 15, 2013; Chesapeake must repay the full principal amount of the bonds on that date. Finally, 7 5/8 is the coupon rate of the bonds, expressed in percentage terms. In this case, Chesapeake is promising to pay 7 5/8 percent of the face value of the bonds each year as interest. 

Most corporate bonds are issued with a par value of USD1,000. Therefore, a single Chesapeake bond would pay 7 5/8 percent of USD1,000 per year, equivalent to USD76.25 per year in interest. Of course, on maturity on July 15, 2013, the full USD1,000 principal of the bond would also be repaid. But most corporate bonds pay interest semiannually; the Chesapeake bonds would pay USD38.125 per bond every six months on July 15 and Jan. 15 of each year.

Also, notice the CUSIP number I’ve noted in parentheses after the bond name. “CUSIP” stands for Committee on Uniform Securities Identification Procedure; for practical purposes, the CUSIP is a unique identification number that any broker can use to look up a particular bond, preferred or common stock. Some brokerages, such as Interactive Brokers and E*Trade, allow you to input CUSIP numbers into their systems directly to look up a particular bond. In other cases, you’ll have to phone in and give your broker the CUSIP over the phone.

A few other complications are worth noting. First, check out the chart below of the Chesapeake bonds.

The chart above shows the trading of the Chesapeake bonds going back to mid-2006. A few things are worth noting. First, the traditional quotation for bonds is as a percentage of par value; the Chesapeake bonds are trading at 88, equivalent to USD880 on a USD1,000 par value bond. As you can see, these bonds traded around par or higher up until this fall, when the bonds plunged to as low as the high 70s before recovering.

When you buy a bond you must pay the seller what’s known as accrued interest. For example, the Chesapeake 7 5/8 bonds pay interest on July 15 and Jan. 15. The holder of the bond on those dates will receive the entire semiannual coupon payment of USD38.125 on a USD1,000 bond regardless of how long that holder has actually owned the bond.

But let’s assume I decide to purchase the bond today, Nov. 19. The seller last received a coupon payment July 15; however, they’ve held the bond for a total of 124 days since that last coupon payment. Therefore, the seller is owed 124 days’ worth of interest on the bond. As the buyer, I’ll receive the entire Jan. 15 coupon payment; therefore, I must compensate the seller for his portion of the coupon.

The convention in the corporate bond market is to assume there are 30 days on each month and 360 days per year. In this case, the seller has owned the bond for a total of four months and four days since their last coupon; this corresponds to 124 days by convention (four months times 30 days plus four days). Because there are 180 days (360 days divided by two) in each semiannual coupon period, the seller is owed 68.9 percent of a coupon payment (124 divided by 180). That works out to roughly USD26.26.

If you decide to buy the Chesapeake bonds and your broker quotes you a price of 88, you’ll pay about USD906.25 per USD1,000 in face value of bonds purchased. This consists of USD880 for the bond and USD26.26 in accrued interest. Your broker will handle all these calculations for you, but it helps to understand the mathematics behind the price.

Sometimes you’ll hear the price of the bond that doesn’t include accrued interest, the clean price. The full price of a bond including accrued interest is, as you might have guessed, called the dirty price.

Back to In This Issue.

When researching or buying bonds, one of the most common numbers you’ll hear quoted is the yield. There are actually many different ways to calculate yield.

The current yield is simply the annual coupon payment divided by the price of the bond. Let’s use the Chesapeake 7 5/8 bonds again as an example.

These bonds are currently trading at a price of 88 or USD880 per USD1,000 in par value. The important point to note is that the amount of the coupon payment is fixed regardless of the price of the bond in the secondary market. In other words, this bond will pay USD76.25 in two annual installments each year regardless of whether you happen to purchase the bond at 110 or at the current quote of 88.

This explains why the yield on a bond varies inversely with its price. Put more simply, that means that when the price of a bond rises, its yield falls.

For example, let’s assume you buy the Chesapeake 7 5/8 bonds at 100. The current yield on those bonds would be 7 5/8 percent, or 7.625 percent.

But let’s assume you decide to purchase the bonds now at a price of 88. You’d still receive the very same USD76.25 per USD1,000 in face value of bonds. But you’d be buying USD1,000 in face value of bonds for just USD880. That means your current yield would be 8.665 percent (USD76.25 divided by USD880). Because the price of the bond dropped from 100 to 88, the yield rose about a percent from 7.625 percent to 8.556 percent.

The current yield takes into account only one source of return from buying a bond–the annual coupon interest payments on that bond. A more commonly quoted yield measure is yield-to-maturity (YTM). Yield-to-maturity takes into account three potential sources of return: coupon payments, capital gains at maturity and coupon reinvestment. This measure assumes you hold the bond to maturity. The actual calculations behind this yield are quite complex, but the basic concept isn’t.

Imagine you purchased a single USD1,000 face value Chesapeake 7 5/8 bond for 88 on Nov. 19, 2008. Your total dirty price (including 126 days accrued interest) would be USD906.69.

Between now and the bond’s July 15, 2013, maturity, you’d receive a total of 10 coupon payments of USD38.125 each, totaling USD381.25. This is your coupon income. This is the only source of return considered in the current yield calculation.

But YTM calculations assume that you’re able to reinvest those cash flows over time and earn a further return. The Street convention is that you’re able to reinvest your coupon payments at an interest rate equal to the YTM on the bond you’re buying. Again, the calculations here are a bit complex, and most traders use a computer or a yield table to calculate these figures; suffice it to say that by reinvesting interest coupons, you’re able to earn another USD109.43.

This USD109.43 is the reinvestment return. Note the quirk here: The YTM calculation assumes you’re able to reinvest your coupon payments as you receive them at the same interest rate. This is by convention; however, it may not be completely logical. After all, prevailing interest rates and bond yields vary wildly over time–you may or may not be able to reinvest your coupons at an equivalent rate.

The final component of the return on your bond would be capital gains. In this case you paid USD906.69 on your bond, but on maturity you’d be paid the full USD1,000 face value. That means you’re making an additional USD93.31 in capital gains on the bond when it matures.

In total, making the above assumptions, you’d pay USD906.69 for the bonds and receive a total of USD1,490.68 between your purchase data and maturity. That’s a total profit of USD583.99.

These calculations give you an idea of what cash flows are considered in a calculation of yield-to-maturity. The YTM calculations also take into account when those payments are received–because money has time value payments received today are worth more than coupon interest received two or three years from now.

To make a long story short, if you plug these figures into a yield calculator or look it up on a yield table, you’ll find that the yield-to-maturity on this bond equals about 10.98 percent. This is the most commonly quoted yield you’ll encounter in the corporate bond market; most brokers’ Web sites offer calculators for determining the YTM on a bond.

Back to In This Issue.

Callable Bonds. Some bonds are callable by the issuer. This means the firm issuing the bonds can redeem the issue prior to the maturity date on the bonds. The dates and prices at which a particular bond can be called are detailed in the prospectus.

The Chesapeake bonds I’ve been using as an example in today’s issue are callable bonds. In this case, they’re callable at any time prior to the maturity of the bond. However, these bonds have what’s known as a make-whole provision. To call the bonds, Chesapeake would need to repay the face value of the bonds (the full par value) plus a special additional make-whole amount.

The make-whole payment is typically a calculation based on the preset value of future debt payments under the bond. But what’s important is that this make-whole amount is a sort of punitive fee the issuer must pay to call the bonds. In many cases, as is the case for Chesapeake, this make-whole payment would be prohibitively expensive at the current time and can be safely ignored.

That said, call provisions vary. Some bonds are callable only on specific dates and at specific prices.

Putable Bonds. A put provision is basically the opposite of a call provision. A put gives the bond owner the right to force the issuer to redeem their bonds.

The Chesapeake 7 5/8 bonds aren’t putable; however, Chesapeake does have some putable bonds, including the Chesapeake Energy 2 3/4 Percent of 11/15/35 (CUSIP: 165167BW6). These bonds currently trade around 73, and holders can require Chesapeake to buy back the bonds for a price of 100 on Nov. 15 of the following years: 2015, 2020, 2025 and 2030.

Sometimes you’ll hear the term poison put. This is a form of takeover defense that some companies use to discourage acquirers. Essentially, it’s a put provision in a company’s bonds that allows the bondholders to redeem their bonds at par in the event the firm is acquired. This increases the cost of buying a firm–the acquirer must be ready to meet bond redemption requests from holders who exercise their put options.

Convertible Bonds. Convertible bonds are a favorite with hedge funds. These bonds allow the holder to convert their bonds into a certain amount of common stock according to some schedule. In a sense, converts are traditional bonds attached to a call option on the issuer’s stock. Converts allow investors to participate in the potential upside in the issuer’s stock while receiving coupon interest payments on their bond.

The Chesapeake 2 3/4 bonds highlighted above are putable and convertible. The conversion price of the bonds is set forth in the prospectus as USD39.07 per share. Because the face value of a bond is USD1,000, that means you can convert a single bond into 25.5951 (USD1,000 divided by USD39.07) shares of Chesapeake Energy common stock; this number is known as the conversion ratio.

The prospectus, Chesapeake Form S-3 Registration Statement 2.75 Percent of 2035 Convertible Bonds, also sets out when a holder can convert their bonds into stock. In this case, holders can convert their bonds

prior to November15, 2033 during any calendar quarter…if the closing sale price of our common stock for at least 20 trading days during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than 125 percent of the Conversion Price.

That language sounds a bit complex; suffice it to say these bonds are only convertible when the common stock is trading at a large premium to the USD39.07 conversion price. There are also other provisions in the prospectus allowing the bonds to be converted if and when Chesapeake decides to call the bonds or in the event of certain transactions such as acquisitions.

The prospectus also offers criteria for adjusting the conversion price and conversion ratio of the bond. Examples of when the conversion price would be adjusted include: stock splits, when the common pays dividends exceeding USD0.065 per quarter, and if Chesapeake is acquired.

A few additional metrics and concepts are valuable when evaluating convertible securities. First, consider the conversion premium of the bond. To illustrate, let’s use the above-referenced Chesapeake convertible as an example. If you purchase the bond at its current price of 73, you’d be paying USD730 per USD1,000 face value bond. That said, the conversion ratio is a fixed 25.5951 shares per bond regardless of where the bond is trading in the secondary market.

Based on your purchase price of USD730, you could covert your bonds when possible under the terms of the prospectus at an effective price of USD28.52 per share (USD730 divided by 25.5951). Because Chesapeake common shares are currently trading around USD21, the conversion premium is nearly 36 percent (USD28.52 divided by USD21). Another way to think of the conversion premium is that it’s the amount the stock would need to appreciate before conversion becomes an attractive option for you.

Check out the chart below for a closer look at the conversion premium over time.

The lower pane of this chart shows the conversion premium for these convertible bonds over time. As you can see, up until late September the premium ranged between roughly 0 and 20 percent. It has since exploded to the upside.

Typically, I’d start to worry about buying a convertible with a premium that deviates from historical norms by a large amount, as it makes it less likely that the stock can rise enough to make conversion worthwhile. In this case, there are a few major reasons for this premium explosion.

First, the volatility of the stock market and Chesapeake common stock has exploded in recent weeks; this makes it more likely that the shares can rally enough to make the conversion worthwhile. Second, Chesapeake has been the subject of near-constant acquisition speculation. Traders may be using the converts as a means of playing the potential for a takeover speculation.

Another factor to consider is the yield sacrifice. Convertible bonds trade with a lower yield to maturity than regular corporate bonds; investors are willing to accept a lower yield in exchange for the upside provided by the convertible.

I’ve used two Chesapeake bonds extensively as examples above, one convertible, the other not convertible. The yield-to-maturity of the non-convertible bond is over 10.9 percent against less than 8 percent on the convertible. Therefore, you’re giving up about 3 percentage points worth of yield.

Preferred Shares. Preferred shares bear some similarity with common stock and some with bonds. Preferreds typically offer a guaranteed dividend that’s calculated as a percentage of some par value, just as for bonds.

Unlike bond interest payments, however, failure to make preferred dividend payments can’t force a firm into bankruptcy. In addition, many preferred shares are cumulative preferreds, meaning that missed dividend payments must eventually be paid back in full. In addition, the prospectus for preferred issues may specify other punitive actions when a firm forgoes a preferred dividend.

Most preferred stock has no voting rights, unlike common stock. However, in the event of bankruptcy, preferred shareholders rank above common stockholders in getting paid back their investment.

Just as with bonds, preferreds can offer other specific features such as convertibility. The prospectus for the individual issue typically offers all those details.

Back to In This Issue.

Bond and Preferred Buys

In picking individual bonds and preferreds, I attempted to choose issues that are widely traded and available from most of the big retail brokerage houses. In most cases, I recommend a particular bond but offer multiple alternate buy recommendations. If your broker is unable to find the bond I recommend, I consider these alternatives to be broadly equivalent.

Note that every broker’s system for looking up and entering orders on bonds and preferreds is a bit different. For example, via Interactive Brokers you can look up the Chesapeake convertible preferreds I highlight below by typing in the symbol “CHK PRD” or the CUSIP number. Other brokers denote the preferred using the symbol “CHK_prd.” If you can’t figure out how to enter the symbol, simply call your broker and ask–they’re going to get the commission, so they should be more than happy to oblige.

I recognize that getting information on bonds can be a bit more difficult than for stocks. Look for updates and ongoing coverage in TES via Flash Alerts and future issues.

I’ve highlighted Chesapeake Energy on several occasions, most recently in the August 20, 2008, issue, The Natural Gas Boom, and the September 3, 2008, issue, Unlocking Shale.

Chesapeake is the largest natural gas producer in the US and has built impressive positions in America’s largest and most prolific unconventional natural gas fields.

I explain unconventional gas in the September 3, 2008 issue at great length for those unfamiliar with the term. Unconventional fields are gas reserves that can’t be produced using traditional drilling technologies. To produce these fields effectively, companies employ two key techniques: horizontal drilling and hydraulic fracturing.

Horizontal drilling is a simple and largely self-explanatory concept. These are wells drilled sideways underground. Natural gas and oil don’t exist underground in some giant cavern or lake. Rather, hydrocarbons are found trapped in the pores and cracks of a reservoir rock. These rock formations lie in layers, and certainly not all layers contain economic quantities of oil or gas. By drilling horizontally through productive layers of rock, producers can vastly increase the productivity of their wells.

Hydraulic fracturing is a bit more complex. Most unconventional plays have plenty of gas in place, but the reservoirs lack permeability. That means that there are pores and cracks within the reservoir rock that are holding gas or oil, but those pores aren’t well connected. Since the pores aren’t connected to one another, there’s no way for the gas to flow through the rock into a well.

Hydraulic fracturing involves pumping a liquid into the reservoir under tremendous pressure; this actually cracks the rock, creating cracks for the gas to flow through the formation and into a well. In short, fracturing improves the permeability of the field.

Producers also introduce what’s known as proppant–typically sand, sand coated with resin or ceramic material–into the fracturing fluid. As the name suggests, the proppant actually enter the cracks caused by the fracturing and holds–or “props”–those cracks open. This prevents the newly formed cracks from closing as soon as pressure is removed.

Although some unconventional fields have been known to exist for decades, most weren’t extensively developed until after 2000 because horizontal drilling and fracturing techniques weren’t readily available and cost-effective. But producers have garnered a great deal of experience in these plays over the past few years; gas production growth from unconventional plays has soared.

In fact, it’s safe to say that US unconventional gas reserves are among the most exciting plays in energy today. Five years ago, most pundits were talking about the need to build more US natural gas import capacity. But thanks to the boom in natural gas production from unconventional plays, there’s now serious talk of exporting US gas abroad or harnessing gas as a transportation fuel. The US is likely to overtake Russia as the world’s largest producer of natural gas within the next five years.

I offer a detailed rundown of the largest and most important unconventional oil and gas plays in the US in the September 3 issue. There are six major plays to keep an eye on: the Barnett Shale of Texas; the Haynesville Shale of Louisiana; the Marcellus Shale of Appalachia; the Fayetteville Shale of Arkansas; and the Woodford Shale of Oklahoma. For a detailed explanation of each of these plays, see the September 3 issue.

Here’s a rundown of Chesapeake’s positioning in each play.

Barnett Shale. Chesapeake is the No. 2 producer in the Barnett Shale near Fort Worth, Texas, and has about 315,000 acres of leasehold in the region, 280,000 of which is located in what’s considered the ore of the play.

Chesapeake’s production from the region has soared more than 37 percent over the past year, and it’s currently looking to boost production to 670 MMcfe/d by the end of this year and 920 MMcfe/d by the end of 2009.

That said, Chesapeake appears to be moderating its activity in the region in favor of other plays; most producers have said the Barnett will probably see peak production in 2009 or 2010. Next year, Chesapeake is looking to have 33 rigs operating there.

Woodford Shale. The Woodford Shale is the smallest and highest-cost play of the six unconventional plays highlighted above. Chesapeake sold off its Woodford assets earlier this year to BP (NYSE: BP) and XTO Energy (NYSE: XTO) for more than USD2 billion. At the time of the sale, Chesapeake’s Woodford Shale assets accounted for only about 2 percent of proved reserves.

Fayetteville Shale. Chesapeake is the second-largest player in the Fayetteville Shale play in Arkansas. The company has 415,000 acres in the core of the play and production of 145 MMcfe/d.

The Fayetteville is a fast-growing, low-cost play, and Chesapeake plans a significant expansion in its drilling activity in the region. The company has secured 375 MMcfe/d of capacity on the Fayetteville Express pipeline that’s being built by Proven Reserves Portfolio holding Kinder Morgan Energy Partners (NYSE: KMP) and Energy Transfer Partners (NYSE: ETP).

All told, Chesapeake plans to boost its output in the play to 165 MMcfe/d by the end of 2008, 260 MMcfe/d by the end of 2009 and 300 MMcfe/d in 2010.

Better still, I like Chesapeake’s strategy of monetizing the value of its Fayetteville Shale play. In August, the firm announced a deal to sell a 25 percent stake in its Fayetteville play to BP for USD1.9 billion. That USD1.9 billion price tag is a combination of cash and an agreement by BP to cover drilling and production costs. The deal retains Chesapeake’s exposure to the red-hot and exciting Fayetteville play while allowing it to earn some cash in the process.

Marcellus Shale. The Marcellus Shale is a large shale gas deposit located in Appalachia. The heart of the play is in Pennsylvania and West Virginia, although the formation covers a wider area, ranging up into New York.

Chesapeake is the No. 1 player in the Marcellus, with close to 1.8 million acres of leasehold. Current production is only 15 MMcfe/d; however, there’s plenty of growth to come, and Chesapeake plans to see production of 130 MMcfe/d by the end of 2010.

The main problem with Marcellus right now is that the core region lacks significant infrastructure to handle all the gas that could be produced; this will delay the big run-up in Marcellus production for a few years. But make no mistake about it: Marcellus is a promising play and will get developed in time.

The longer-term nature of Marcellus makes Chesapeake’s recent deal in the region even more attractive. Just last week Chesapeake announced yet another joint venture to sell a 32.5 percent interest in its Marcellus Shale acreage to Norwegian energy giant StatoilHydro (NYSE: STO) for a total price of USD3.375 billion. Based on that price, Chesapeake’s remaining Marcellus acreage is worth more than USD7 billion.

In addition to acreage, Chesapeake has also agreed to a strategic alliance with StatoilHydro to develop unconventional reserves outside the US. Chesapeake’s expertise in developing unconventional reserves in the US could prove useful in finding and putting similar reserves into production overseas. This deal allows Chesapeake to retain ownership in its Marcellus acreage while monetizing and extracting immediate value from this long-term play.

Haynesville Shale. The Haynesville Shale is the crown jewel of Chesapeake’s shale empire. The heart of this play is located in western Louisiana just east of the border with Texas. Several producers estimate that the Haynesville could be the largest unconventional gas play in the US, five times or more the size of the current No. 1, the Barnett Shale.

This is certainly a view that’s been backed up by recent drilling results from Chesapeake and Gushers Portfolio holding PetroHawk (NYSE: HK), the two most aggressive players in the Haynesville. Chesapeake’s most recent two wells are producing upwards of 25 MMcfe/d combined–wells producing over 10 MMcfe/d are extremely rare in the US. And PetroHawk recently announced a series of impressive wells in its acreage as well.

Chesapeake is No. 1 in the Haynesville, where it currently has 14 rigs drilling. Current production is 50 MMcfe/d, and Chesapeake believes it could grow that more than tenfold to 615 MMcfe/d by the end of 2010.

Chesapeake also announced a joint venture deal in the Haynesville early in the third quarter. The firm sold 20 percent of its Haynesville acreage to Plains Exploration and Production (NYSE: PXP) for more than USD3.3 billion.

Few would argue with Chesapeake’s unparalleled acreage position in America’s hottest shale plays. The major negative argument concerning Chesapeake is that to build this asset base, it’s had to issue lots of stock and take on considerable debt. Chesapeake’s total debt has risen from less than a billion dollars at the end of 1999 to about USD11 billion at the end of 2007. Shares outstanding have ballooned from about 95 million at the end of 1999 to 460 million at the end of 2007.

All this debt and equity capital was necessary to allow Chesapeake to buy productive assets; the company’s asset base and productive capacity has grown alongside its debt and equity issuance.

But the current market isn’t forgiving. One of the main reasons that Chesapeake’s bonds have fallen from their summertime levels is that investors in both the stock and bond markets have become totally afraid of debt. In some cases this makes sense, however I don’t see Chesapeake’s debt position as a problem.

Now that the company has amassed its acreage in America’s key shale plays, Chesapeake is moving from a strategy of grabbing assets and acreage to a strategy of generating free cash flow.

Chesapeake has no immediate needs to access credit markets. The company’s credit line doesn’t mature until 2012, and it has no senior notes maturing until 2013. Even better, at its analyst day in mid-October and its more recent earnings release, Chesapeake offered more details on its financial position.

Specifically, the company has scaled back its drilling plans in light of weak gas prices. The company hasn’t reduced drilling in promising, low-cost reserves such as the Haynesville. Rather, Chesapeake’s activity cuts have mainly centered on higher-cost conventional plays that just aren’t particularly profitable at current prices. The result: Chesapeake reduced its planned expenditures on drilling by around USD3.7 billion over the next two years.

Meanwhile, Chesapeake is well hedged. Roughly 73 percent of remaining 2008 production is hedged at an average price of more than USD9 per million British thermal units (MMBtu). A total of 67 percent 2009 and 42 percent of 2010 production is hedged at prices averaging USD8.65 and USD9.81, respectively. Thus, even a further near-term drop in gas prices would have a modest impact on Chesapeake’s revenues and ability to generate free cash flow.

Overall, Chesapeake believes it will be able to generate sufficient cash flow over the next few years to meet its capital spending plans and pay down its debt.

Bottom line: With an unrivalled acreage position in America’s fastest-growing shale plays and a solid financial position, Chesapeake looks like an outstanding play as an independent firm. Chesapeake also remains a tempting takeover target for a host of international integrated oil companies.

As noted earlier, several producers have already shown considerable interest in Chesapeake; the company has closed joint venture deals with BP, Plains Exploration and Production and Norway’s StatoilHydro.

Finally, Chesapeake has also put together a number of so-called volumetric production payment (VPP) deals. Under such a deal, Chesapeake sells the rights to a certain pre-set volume of natural gas, produced from a certain number of wells over a certain time period. VPPs don’t cover all the production from a particular area, just production from specific underground formations and wells. VPPs offer Chesapeake a way to sell off some of its production from more mature plays and realize a big, up-front cash payment.

Although Plains is too small to acquire Chesapeake, both BP and StatoilHydro are potential buyers. Both have expressed interest in acquiring a position in America’s fast-growing unconventional gas plays. And both firms have expressed direct interest in Chesapeake by partnering with the firm in joint ventures.

Chesapeake is currently trading at less than six times projected 2009 earnings, the lowest valuation for the stock since its 2002 lows. Meanwhile, concerns over Chesapeake’s debt position are way overblown given its strong hedging position and the cash it’s receiving from joint venture and VPP deals. Chesapeake stock could easily fetch USD40 in an acquisition.

I’m adding the Chesapeake Energy 4.5 Percent Convertible Preferred D of 12/31/49 (NYSE: CHK D, CUSIP: 165167842) to the Wildcatters Portfolio. This convertible preferred pays a USD4.50 annual dividend in four installments on March 15, June 15, Sept. 15 and Dec. 15.

Based on the current price, the preferred offers an annualized yield of roughly 7 percent. Holders of the convertibles can exchange their preferred shares for 2.265 shares of Chesapeake common stock at any time.

Because of the convertible option, the preferred tends to track the basic performance of Chesapeake’s common shares over time. In fact, the preferred topped out over the summer at more than USD170 when Chesapeake was trading north of USD70 per share. The preferred has since declined alongside the common stock.

Currently, the conversion premium on the preferreds is about 36 percent. This is somewhat higher than historical norms but well off the 50 percent plus conversion premium levels witnessed earlier this fall. As I discussed earlier in today’s report, the main reason for that higher-than-normal conversion premium is rising volatility in the stock and the growing potential for a takeover offer.

If I’m correct about gas prices and Chesapeake’s fundamental positioning, the preferred should give you the benefit of that appreciation. The stock could easily double from current levels, making the convertibility option in the preferreds highly attractive. In the meantime, you’re collecting a more than 7 percent yield on your investment.

Chesapeake can force the mandatory conversion of this preferred starting on Sept. 15, 2010, but it can’t do that unless the price of Chesapeake’s common stock exceeds the conversion price of USD44.154 by 130 percent for 30 consecutive trading days. With Chesapeake’s stock currently around USD21, mandatory conversion isn’t an issue at the current time.

Furthermore, if Chesapeake is acquired by another firm, there are provisions designed to benefit preferred holders. Specifically, the conversion price for Chesapeake’s shares is adjusted to equal the market price of the common stock. Put simply, this will allowed preferred holders to benefit from upside in Chesapeake’s common stock if it’s acquired.

Buy Chesapeake Energy 4.5 Percent Convertible Preferred D of 12/31/49 under USD68.

In addition to this preferred stock, Chesapeake has a handful of other preferreds outstanding. Most are highly illiquid, although the Chesapeake Energy Preferred E (Symbol: CHK E; CUSIP: 165167818) sees considerable trading action from time to time.

This preferred is a mandatory convertible–it will convert to stock on June 15, 2009. That means that unlike the Preferred D series, holders have no option in the matter.

The par value of this preferred is USD250. If the stock is trading below USD29.0376 per share, you’ll receive 8.6095 shares of Chesapeake common stock. If the common stock is trading above USD34.845, you’ll receive 7.1745 shares of common on conversion. And if the stock is trading in between these two threshold prices, you’ll get a conversion price of USD34.85 per share.

The current yield on the Preferred E is higher, at 8.63 percent. However, the Preferred E doesn’t have much time left before it converts, so the price will increasingly reflect the value of the conversion option. It currently trades at USD180, roughly a 27 percent premium to conversion value; Chesapeake Energy Preferred E is a bet that Chesapeake common will trade above USD25 by next June. I don’t think that’s a bad bet, but I prefer the stability of the Preferred D.

I’m also adding the Chesapeake Energy 6 3/8 Bonds of 06/15/15 (CUSIP: 165167BL0) to the Proven Reserves Portfolio as a buy under USD81.

These are standard Chesapeake bonds with a current yield of 8.8 percent and a yield-to-maturity of 12.7 percent. Here’s a chart of the bonds over the past few months.

Source: Bloomberg

As you can clearly see, these bonds have been hit over the past few months for the reasons I outlined earlier in this report. This offers investors a chance to lock in some impressive yields. As the credit markets continue to normalize and gas prices firm, I see these bonds trading back toward 100. These bonds will pay coupon interest on June 15 and Dec. 15 each year.

These bonds area callable based on the following schedule:

• After 12/15/09 at 103.188
• After 12/15/10 at 102.125
• After 12/15/11 at 101.063
• After 12/15/12 at 100

I chose this issue because it’s among the more liquid bonds Chesapeake has. Here are some alternates if you can’t locate this specific issue.

Buy Chesapeake Energy 6 7/8 Bonds of 01/15/2016 (CUSIP: 165167BE6) under USD82. These bonds have a yield-to maturity of 12.5 percent and a current yield of 9.3 percent. They’re callable starting 01/15/09 at a price of USD103.438; the call price gradually steps down each year to 100 after 01/15/12.

Buy Chesapeake Energy 7 1/2 Bonds of 09/15/13 (CUSIP: 165167BC0) under USD88. These bonds offer a current yield of 9.3 percent and a yield-to-maturity of 12.9 percent. They’re callable starting 09/15/08 at a price of USD103.75, gradually stepping down to USD100 after 09/15/11.

Buy Chesapeake Energy 6 5/8 bonds of 01/15/16 (CUSIP: 165167BN6) under USD86. These bonds offer a current yield of 8.6 percent and a yield-to-maturity of 11.5 percent. They’re callable beginning 07/15/10 at a price of USD103.313, stepping down to USD100 after 07/15/13.