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Chesapeake Still Roiling; S&P Downgrades

The tribulations at Chesapeake Energy Corp. proved to be a rerun of the week before, with the stock price ticking lower, more shareholders publicly voicing their disapproval, another credit ratings agency downgrade and the board of directors announcing yet more changes. However, CEO Aubrey McClendon said last week he was confident several planned property sales this year would plug a funding gap estimated at $10 billion.

"We will get our asset sales done," he told energy analysts during an early morning conference call last Monday to start the week.

The conference call, hastily called the previous weekend, was to explain a $3 billion term loan that Chesapeake had secured late on May 11, at the start of the weekend. However, by Tuesday Chesapeake affirmed that the unsecured loan from Goldman Sachs Bank USA and affiliates of Jefferies Group Inc. already ha been increased to $4 billion, "based on strong investor demand" and 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 rapidly escalating revolving debt. The loan carries an initial variable annual interest rate through Dec. 31 of the LIBOR (London Interbank Offered Rate) plus 7%, which was 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 plans to use asset sales proceeds to repay the loan in full before the end of this year. It said it currently has more than $4.7 billion of liquidity "including unrestricted cash on hand and available borrowing capacity under its revolving bank credit facilities."

The loan could be completely paid off with one big asset sale: the Permian Basin portfolio, which some think could fetch up to $8 billion. The data room opened earlier this month and buyers already are lined up. Anadarko Petroleum Corp., a long-time Permian player, is said to be interested in the properties, which abut some of its leasehold.

The third leg of the company's monetizations, a planned volumetric production payment (VPP) in the Eagle Ford Shale, has been shelved, McClendon said during the conference call. The VPP was to have given Chesapeake an estimated $1 billion in proceeds and it was "a key element of our 2Q2012 financial plan." Basically, a VPP gives the buyer a share of a leasehold's produced oil or gas in exchange for an upfront payment. While it gives the seller upfront cash, it delays the producer's output over a period of time, since that is directed to the buyer.

However, Chesapeake already has 10 VPPs in place for some of its onshore leaseholds, in which it has publicly disclosed that it has received $6.4 billion. The Wall Street Journal reported earlier this month that Chesapeake has about $1.4 billion of unreported liabilities over the next decade associated with the VPPs, beginning with $300 million this year and in 2013.

Instead of participating in another VPP, "we've identified other assets that are noncore to the company that will enable us to reach...our [sales goal] for the remainder of the year," McClendon said. "We also plan to sell sufficient noncore assets in 2013 to make sure we are well funded next year, as we complete our natural gas-to-liquids transition and reach our goal of being free-cash-flow positive in 2014.

"Believe me, Chesapeake's management team is very, very focused on getting this funding gap issues behind us once and for all and as early as possible.We will sell sufficient assets in 2013 to make sure we are well funded next year and reach our goal to be cash flow positive and get our funding issues behind us once and for all."

This year Chesapeake is "moving from asset capture to asset harvest," McClendon noted. Over the past seven years the company has participated in an "asset resource revolution," but the transition to more liquids plays, begun two years ago, "has not been easy with gas prices at 10-year lows."

There is "no CEO more determined or motivated than I am," he told analysts. "I understand fully where we are, where we've been and where we are going."

On Tuesday Standard & Poor's Ratings Services (S&P) slashed the corporate credit rating 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.

Sprinzen was not 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.

"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.

"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."

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."

Late Thursday shareholders were urged by a group of New York City pension funds to vote against the only two board members up for reelection this year for failing to monitor financial activities of CEO Aubrey McClendon.

The City of New York Office of the Comptroller, which represents pension funds that control 1.9 million shares of Chesapeake, said in a letter to shareholders that it opposes the reelection of Oklahoma State University President V. Burns Hargis and former Union Pacific Corp. CEO Richard K. Davidson. Both also serve on Chesapeake's audit committee.

"We are particularly disturbed by the audit committee's failure to review, approve or disclose Mr. McClendon's personal loans secured by company wells," wrote New York City Comptroller John C. Liu, who oversees the $122 billion pension fund. Liu also criticized McClendon's right to invest in every well the company has drilled, noting that "his investment time horizon, risk appetite and liquidity needs may conflict with those of the company."

Chesapeake shareholders previously have overwhelmingly voted in favor of McClendon's sole participation in the Founder Well Participation Program, which is to be scuttled in 2014.

Chesapeake currently has a nine-member board, and only a few stand for reelection every year, as required under Oklahoma law, where the company is incorporated. Chesapeake backed the board reelection structure as an "essential takeover defense," which some believe makes it less vulnerable to outside interests.

Liu also asked shareholders to support the pension funds' proposal that would require Chesapeake to include board candidates nominated by large shareholders, arguing that it would make the company more responsive. In its response Chesapeake said the proposal would encourage "the wrong type of board responsiveness" and give power to special interests.

According to regulatory filings, several large hedge funds and investment firms have sold most or all of their positions in Chesapeake since the beginning of this year, including S.A.C. Capital Advisors LP (91%), Millennium Management LLC (86%), Fidelity Management & Research Co. (59%), Two Sigma Investments LLC (98%), Adage Capital Advisors LLC (57%), and Highbridge Capital Management LLC (100%).

On Friday after the markets had closed the board adopted a new compensation arrangement for outside directors, reducing compensation by 20% and eliminating the use of fractionally owned aircraft for personal travel. Under the new arrangement, which took immediate effect, outside directors are to receive total annual compensation of $350,000, comprised of $100,000 cash and $250,000 equity, which the board said was "at or below the average director compensation of the company's peers."

Chesapeake's annual meeting is scheduled for June 8. However, several shareholders have filed a federal lawsuit asking for an injunction to postpone the meeting until Chesapeake discloses more information on McClendon's compensation and third-party debts. A hearing is scheduled for May 30.

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