Chesapeake Energy Corp., which took incoming fire from all sides last week, is taking more heat about its liquidity from credit ratings agencies and energy analysts than about CEO Aubrey McClendon's alleged financial indiscretions.
The No. 2 natural gas producer in the United States, which went on a buying spree over the past decade to scoop up big positions in emerging unconventional basins across the country, hit by low gas prices now is attempting to transform itself into a big oil and natural gas liquids producer.
Those big acreage acquisitions? They cost a lot of money, operating costs are high and gas prices are low. The transformation into an oil producer? It's required buying liquids-prone properties, moving gas rigs to new targets, redirecting personnel and equipment -- basically revamping the decade-long business strategy. And the sustained low gas prices have failed to provide any financial padding for the exchange.
Even though it needs to turn off the gas spigot, 1Q2012 gas output actually jumped 18% from a year ago because drilling was done to hold expiring leases, McClendon told energy analysts last Wednesday during a quarterly earnings conference call.
Meanwhile, capital expenditures (capex) for 2012 has been bumped up to "escape the gravitational pull" of low gas prices, he said. But -- and it's a big one -- more spending won't mean more output this year and it isn't likely before late 2013 or 2014 because Chesapeake has put up for sale a long list of assets to pare its debt -- many once prime targets for liquids drilling.
An outright sale is planned for the highly prospective Permian Basin portfolio, which could net $7-8 billion. The virtual data room already is open; a physical data room is expected to be up and running within a week or so. Other sales are to include a portion of the Mississippi Lime, and two joint ventures still in the works for the Utica Shale, along with monetizations in the Denver-Julesburg (DJ) Basin, as well as yet another volumetric production payment for the Eagle Ford Shale, which would take away some of the output planned in the near-term for that liquids-heavy area.
"The selling impacts 2012 and 2013 guidance, but it doesn't do anything to our outer-year targets -- we'll simply drill more wells," McClendon told analysts.
Despite all of the noise in the quarterly report, "The positives are enduring and the negatives are short term in nature," said McClendon, who was ousted as chairman last week but retains his CEO post (see separate story).
The company was unable to replace natural gas hedges last fall and paid dearly for it in the quarter, with a loss of $71 million (minus 11 cents/share), which included a hedging loss of $167 million, versus a year-ago loss of $205 million (minus 32 cents). Excluding the one-time losses earnings were 18 cents -- below Wall Street's 28 cents/share expectations. Revenues totaled $2.42 billion, higher than year-ago sales of $1.61 billion, but off of Wall Street's forecasts of $2.71 billion.
Despite voluntary gas well curtailments begun in February, daily production in 1Q2012 actually rose 18% year/year to 3.658 Bcfe from 3.107 Bcfe. One reason for the gains in gas output was to prevent expiry on some of the leaseholds, said the CEO. Once the company has captured all of the leaseholds it needs to be held by production, it plans to keep gas production flat, he explained.
Chesapeake no longer is a big gas "driller" by any stretch of the imagination. In January 2011 Chesapeake had about 100 gas drilling rigs in operation in the U.S. onshore. In the first three months of this year Chesapeake had 50 gas rigs running, and today it's down to 38, said COO Steve Dixon. "In just 90 days, we'll be down to 12...That's a drop of 75%."
Liquids output is higher; the company began running 172 rigs late last year, and the "first quarter took the brunt of elevated drilling," said Dixon. But the liquids rigs already have "dropped by 18 to 154, and drilling during the year will drop to 125 by the third quarter."
The fact that Chesapeake has attractive properties to sell is to McClendon's credit. The Chesapeake co-founder started as a landman, and is "really good at identifying and acquiring potentially lucrative acreage positions," said NGI's Patrick Rau, director of Strategy & Research. "Much of Chesapeake's value comes from its ability to beat its competitors to the latest greatest properties. [Even] if Aubrey were forced to step down as CEO, it could conceivably have a greater negative long-term impact than the current controversy."
Chesapeake's shareholders have been a fickle bunch in the past few weeks, sending the stock price up by double digits and then down sharply, depending on the news of the day. Chesapeake has a high amount of absolute debt compared to some other E&P companies, but its debt-to-capital ratio of 43.2% is in line with others.
However, that debt-to-capital figure only incorporates balance-sheet debt. To understand Chesapeake's true debt load versus the industry, one should consider the adjusted debt level, which is a combination of balance sheet debt and off-balance sheet obligations, such as transportation take-or-pay contracts and operating leases. Chesapeake's adjusted debt-to-capital ratio is 64.8%, well above the industry average of 54%. Chesapeake is not the only debt- and gas-heavy company to underperform in the market in recent months. Quicksilver Resources, Exco Resources, Forest Oil & Gas, and Ultra Petroleum all have similar relative levels of adjusted debt to Chesapeake, but suffered even steeper declines in their stock prices.
Besides the asset sell-off, Chesapeake needs higher gas prices in 2013 -- McClendon admitted as much during the conference call -- or it likely will face liquidity problems, which are a much bigger concern than the CEO's travails, said analysts.
Fitch Ratings on Friday revised Chesapeake to "negative" from "stable" because of its "still aggressive capital spending program for 2012 in a very weak natural gas environment. The company's 2012 spending plans remain essentially unchanged in terms of magnitude and will create a large funding gap between cash flow from operations and capital spending and leasehold acquisitions, which is expected to be filled mostly from proceeds from asset sales and various monetizations.
"Given the size of this gap (estimated by Fitch to be approximately $10 billion for 2012) Fitch believes that the company's credit quality is likely to come under pressure."
Because of weak gas prices, operating cash flow before changes "was just $910 million" in 1Q2012, Fitch noted. "The difference between this and amounts spent during the quarter for capital expenditures and leasehold acquisition led to an increase in long-term debt of approximately 23%, from $10.6 billion at year-end 2011 to approximately $13 billion at March 31, 2012."
Long-term debt plus noncontrolling interests jumped 29% to $15.46 billion at the end of the quarter from $11.96 billion at the end of 2011. "Given the weak natural gas pricing environment, there exists the potential for a shortfall or delay in some of the expected proceeds from the remaining planned asset sales and monetizations this year."
Even though Chesapeake made it "clear that 1Q would be higher than the remainder of the year due to time required to ramp down spending, these levels leave relatively little room in the next three quarters for the company to stay within its full year capex guidance. Fitch anticipates the company will be sharply free cash flow negative over the next three years."
CreditSights debt analyst Brian Gibbons said he continues to have "substantial concerns about management's credibility and the company's financial transparency, aggressive spending program, myriad funding strategies and asset execution sales risk...Near-term liquidity risk is clearly high given the timing of the company's spending and its asset sale receipts."
Canaccord Genuity's John Gerdes cut his price target by 25.7% to $26 on concerns about liquidity, not corporate guidance. And because the company remains 85% weighted to gas, "historically low natural gas prices will provide headwinds...for the near future," said Wells Fargo Securities analysts. Chesapeake has a substantial portfolio of prospects to monetize, but the gas assets will be a drag.
If it can hold on through low gas prices, Chesapeake remains a compelling story because of its broad and deep portfolio, said BMO Capital Markets' Dan McSpirit, who upgraded the company to "outperform," because it's about "peak negativity and getting the house in order."
Chesapeake has underperformed its peers more than 20% since the beginning of April and there was no ignoring the reasons why, said McSpirit. However, "what remains is a company with a deep and wide asset base, and one that has fundamental value, in our opinion.
"Yes, the company continues to wildly outspend cash flow ($7.9 billion in 2012 on our numbers...yes, the company's cash flows are still largely tied to natural gas prices (unhedged in 2012 and 2013), although aggressive capital shifts to develop oil and liquids-rich assets should yield higher margin growth in future periods. Yes, the monetization of assets, whether in the form of a joint venture or an outright sale, is necessary to close the gap.
"All this is known and, we believe, largely reflected in the price today," said McSpirit. "We believe the risk-reward at current price levels presents an attractive opportunity for investors looking to venture out on this risk curve...This trade qualifies as high octane, but again that's the point. We believe...shares could better reflect the underlying asset value once the smoke clears, one way or another. This upgrade is not about handicapping the likelihood of a change in management, but about a change in market sentiment."
Describing Chesapeake "as high risk at this juncture is unhelpful for investors; however, it is equally unhelpful to portend any change in our view of the fundamental underlying value," wrote Bank of America analysts on Thursday. "More helpful, perhaps, is to reassess a stressed valuation case that acknowledges an inflated risk premium..."
The Bank of America team cut its 2012 earnings estimate to 75 cents from $2.01. "However, when the dust settles we fully believe successful execution of Chesapeake's transition from gas to liquids positions the shares [as] one of the most opportunistic value plays of the large cap U.S. oils in 2012."
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