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Chesapeake's 'Mounting Turmoil' Cited in S&P Downgrade

Standard & Poor's Ratings Services (S&P) on Tuesday downgraded the corporate credit rating of Chesapeake Energy Corp. to "BB-" from "BB" and said the outlook was "negative." The ratings on related entities Chesapeake Midstream Partners LP and Chesapeake Oilfield Operating LLC also were cut because the units are so closely tied to the parent, S&P noted.

Chesapeake's recovery rating was set at "3," indicating that S&P's expectation for a "meaningful recovery" is 50-70% in the event of a payment default.

"The downgrade reflects mounting turmoil stemming from revelations that underscore shortcomings in Chesapeake's corporate governance practices, covenant concerns and the likelihood Chesapeake will face an even wider gap between its operating cash flow and planned capital expenditures than we had previously anticipated," said S&P credit analyst Scott Sprinzen.

The downgrade preceded news following market close that its new $3 billion term loan, closed on Friday, was increased Tuesday to $4 billion (see Shale Daily, May 15). The unsecured loan from Goldman Sachs Bank USA and affiliates of Jefferies Group Inc. was "based on strong investor demand," said Chesapeake. It was syndicated to a "large group of institutional investors and priced at 97% of par."

Net proceeds, estimated at $3.8 billion, are to be used to repay some of Chesapeake's revolving debt. The loan carries an initial variable annual interest rate through Dec. 31 of the LIBOR (London Interbank Offered Rate) plus 7%, which is currently 8.5%, given the 1.5% LIBOR floor in the loan agreement, the company said. (The LIBOR is the rate that a select group of creditworthy international banks charge each other for large loans.)

Chesapeake said it "expects to use a portion of the proceeds from planned asset sales to repay the loan in full before the end of 2012. Giving effect to the increase in the size of the loan, the company currently has more than $4.7 billion of liquidity including unrestricted cash on hand and available borrowing capacity under its revolving bank credit facilities."

Sprinzen was not as enthusiastic about Chesapeake's financial outlook, noting that its performance in the first quarter "was very weak, hurt by not only depressed natural gas prices but also lower natural gas liquids prices and wider market price discounts in certain regions." Because Chesapeake lowered its production guidance through 2013 -- and increased spending plans -- negative free cash flow is estimated to total more than $16 billion through 2013, he noted.

"Moreover, since April 26, when Standard & Poor's lowered the ratings on Chesapeake to 'BB' from 'BB+' and placed the ratings on CreditWatch with negative implications, there has been a series of additional revelations about personal transactions undertaken by...CEO Aubrey McClendon that pose potential conflicts of interest..."

For example, Sprinzen cited the hedge fund that McClendon co-headed from 2004 to 2008 in which he apparently took positions in commodities produced by Chesapeake. He also noted recent decisions by the Chesapeake board of directors, including its decision to review financing arrangements between McClendon and any third party with a relationship with Chesapeake "in any capacity -- reversing its prior stance that the board was not responsible for reviewing personal transactions of Mr. McClendon," along with an agreement to terminate the Founder Well Participation Program.

"Turmoil resulting from these developments -- and from potential revelations resulting from the board review -- could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and aggressive ongoing capital spending," said the S&P analyst.

To help fund its transitioning from natural gas to liquids and oil, Chesapeake plans to sell proved and unproved properties and monetize oilfield services, midstream and other assets totaling $11.5-14.0 billion this year, and $5.5-6.5 billion in 2013, Sprinzen noted.

"Chesapeake is asset-rich, and it has been adept at structuring varied and innovative transactions to generate funds, including outright asset sales, formation of joint ventures, issuance of securities by a royalty trust and by newly formed subsidiaries, and issuances of volumetric production payment obligations. However, Chesapeake's ability to continue executing such transactions on favorable terms depends largely on capital market receptivity.

"From our analytical perspective, some of the company's actions to raise funds dilute the benefit of debt reduction, which it is also pursuing. Based on our price deck, we anticipate that coverage metrics over the next two years will be weak even for the revised rating..."

The company's adjusted debt to earnings before interest tax and depreciation is "approaching 6X in 2012 and remaining above 5X in 2013 -- before Chesapeake's liquids production increases sufficiently to offset the effect of persisting depressed natural gas prices," Sprinzen said.

S&P analysts "could stabilize the rating on Chesapeake if the company adopted a more conservative growth strategy and financial policies, reduced leverage to less than 4.5X and took actions to address shortcomings in its corporate governance practices that were sufficient to satisfy its various stakeholders."

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