Beware of the Dangers of Elephant Hunting: Chesapeake Energy Corporation (CHK)

In each case, it wasn’t necessarily the empire building that did these men in, but their timing in that pursuit. Take Kloppers’ pursuit of PotashCorp, which at nearly $40 billion would have made even Warren Buffett envious. The strategic rationale was smart because developing a new potash mine costs billions and could take up to a decade to complete. With an entry barrier that high, sometimes it’s better to buy than build. As the low-cost producer, picking off PotashCorp would vault BHP to the top in less time and with much less hassle. However, what he didn’t bank on was that Canada was fed up with losing jobs and strategic assets to foreign buyers. Of course, PotashCorp didn’t like the deal either, but that’s nothing a few more billion couldn’t cure.

That brings me to my next point, which is another page out of the “Book of Buffett.” Tell me if you’ve heard this one before: “Price is what you pay, value is what you get.” When in the context of commodity investments, the price you pay and the value you get depend solely on the future value of the underlying commodity. When McClendon was busy buying up acreage, he was snapping up that land for a fraction of what that future value turned out to be. That value though, is derived by the volatile price of natural gas. As the value of the underlying assets plunged so did his ability to fund growth by both debt and cash flow. The ensuing liquidity problem proved painful for investors. However, if gas prices had maintained their robustness we’d be praising McClendon’s visionary leadership instead of wishing him well as he departs.

Therein lies the biggest danger of elephant hunting: misjudging the outlook for the industry. That’s easy to do as commodities are known for their volatility and sensitivity to economic conditions. In hindsight, you can certainly say Rio’s deal for Alcan or BHP’s purchase of Petrohawk were both a stretch, but if the underlying commodities didn’t fall then these deals could have been considered a steal. As it turns out, the price paid was too much, and value was eroded instead of created. So while reading about the adventures of those on an elephant hunt are exciting, sometimes actually bagging one just isn’t worth all that effort.

The article Beware of the Dangers of Elephant Hunting originally appeared on Fool.com and is written by Matt DiLallo.

Fool contributor Matt DiLallo owns shares of BHP Billiton Limited (ADR). The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy.

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