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Chesapeake Liquidity 'Adequate,' Debt Offering Called 'Creative,' But Investors Not Convinced

Persistently weak oil and natural gas prices, combined with OPEC's decision last week to hold production steady, likely will reduce spending plans for many U.S. producers in 2016, but the debt-laden operators face even more pressure as they consider how to finance their go-forward plans.

Chesapeake Energy Corp. (CHK), the nation's No. 2 gas producer, last week joined a growing list of financially strapped operators offering an exchange for second and third lien notes, which have a higher priority in bankruptcy, to pare unsecured debt and extend  maturities due in 2022. CHK is far from alone, as exploration companies look for ways to remain viable until prices cooperate.

The proposed second lien by CHK would be a big market "test" about the flexibility of the credit markets not only for the producer, but the exploration and production sector in general, according to Jefferies LLC.

"If this creative structure proves successful, many companies may use it as a template," Jefferies analysts said. If Chesapeake is able to exchange the full $1.5 billion by the first tender date for the full amount of each issue, it may be able to redeem nearly all of the notes due in 2017-2018 ($1.7 billion of face value). This would leave it with $500 million in bonds that are due in 2016, which it likely would pay with cash on the balance sheet or by pulling on the undrawn $4 billion secured credit facility.

If the new issue were to be exchanged at par value, "this would add only a small amount of annual interest expense," estimated at around $5 million, but the notes likely are going to be sold at a discount, Jefferies analysts said.

Wunderlich Securities Inc. analyst Jason Wangler considers CHK's second lien offering a positive, but investors haven't thought so. The stock price fell sharply when the exchange was announced last Wednesday, showing "once again the negativity around the energy macro in general and CHK specifically."

CHK's share price to date this year has fallen about 70%; it fell by more than 30% in November alone. On Tuesday CHK closed at $4.40/share after opening at $4.05. In the past year CHK has traded for as much as $21.49/share to as low as $4.03.

"Overall, while the headline is poor as CHK is issuing debt, we believe that debt will ultimately lower the debt level of the company," Wangler said. The producer basically is "buying time" until it can get back to asset sales and other endeavors. "Recall CHK explained that pricing for assets in the current market are depressed, and as such it was slowing its asset sale strategy. This makes sense, but with a need to keep improving the balance sheet, the new debt does that. Further, it gives CHK more time to get back to that program assuming prices recover in the future."

CHK's heavy debt load has been a concern for years, but investors now appear more worried by the "distressed" exchange offer, Motley Fool senior energy analyst Matt DiLallo said. "The situation won't get any better until either commodity prices deliver a meaningful rally, or Chesapeake significantly repairs its balance sheet."

Credit ratings agencies have taken note as well. Fitch Ratings downgraded CHK to "BB-" from "BB," one step below investment grade, because cash flow, liquidity and leverage will be "notably weaker" than expectations." Moody's Investors Service last Friday downgraded the corporate family rating by three notches to "B2" from "Ba2," which moved all of the producer's debt further into junk-bond territory. However, Moody's speculative grade liquidity (SGL) rating was kept at SGL-3; SGL-5 indicates likely default.

"The ratings downgrade reflects Chesapeake's persistently weak cash flow and the corresponding rising default risk," Moody's Senior Vice President Pete Speer said. "Industry conditions are increasingly challenging for Chesapeake to complete asset sales of the scale necessary to reduce debt to sustainable levels."

The downgrade incorporates CHK's weak cash flow generation capacity relative to its debt levels and "rising downside risk to oil and gas prices in 2016," Speer said. "This weakening and uncertain outlook for prices increases the amount of debt reduction necessary to right size the capital structure while making large asset sales more difficult as buyers remain reticent."

Still, CHK has "adequate liquidity and very large proved reserve and production scale," with "sizable high quality undeveloped acreage positions in multiple oil and natural gas basins across the U.S., which provide a substantial inventory of potential assets to sell in a more supportive commodity price environment," he said.

CHK liquidity should remain "adequate" in 2016 because of its cash balance and borrowing availability on its credit facility, Speer said. At the end of September the operator had a cash balance of $1.4 billion with $4 billion available in its revolving credit facility. The cash and revolver should be enough to cover anticipated negative free cash flow and debt maturities next year.

"Chesapeake expects to complete $200-300 million of asset sales in this quarter, demonstrating that the company can still complete some asset sales to raise cash," Speer said. For the ratings to be upgraded, the company has to achieve substantial debt repayment and improve leverage metrics and liquidity to better weather commodity price liquidity, however.

CHK CEO Doug Lawler was named by DiLallo recently as one of the worst CEOs in the industry. Lawler took over in 2013 from co-founder Aubrey McClendon. DiLallo said he had "high hopes" for the company when Lawler came aboard.

"He was expected to bring financial discipline to a company that had a history of wild spending," promising disciplined capital spending to push the company toward top-quartile operational, financial and shareholder return performance" among its peer group. "Instead, he made a number of missteps, causing the stock to sink nearly 80% since he took the reins."

One of Lawler's "more notable blunders" was the early redemption this year of $1.3 billion of notes that were due in 2019. The company waited one month too long to tell investors of the planned redemption, costing the company millions in interest and penalties (see Daily GPIJuly 10).

"Making matters even worse was the decision to revert to the company's free-spending ways, with Chesapeake projected to burn through more than $2 billion in cash this year," DiLallo said. Some of the spending has followed low commodity prices, but "Lawler has pushed the company to grow its adjusted production by 6% to 8% this year, despite the fact that the oil and gas markets remain vastly oversupplied. Instead of leaving that incremental production in the ground, the company burned through more cash than it needed to this year, which is causing significant financial stress, with some of its bonds now trading at distressed levels."

Lawler "inherited a tough situation," DiLallo said, but "he hasn't engineered the turnaround many expected. Instead, his slip-ups have incinerated cash and shareholder value, which now has the company in a precarious financial position."

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