Moody's Investors Service on Wednesday downgraded Chesapeake Energy Corp., as well as its midstream and oilfield services units, to "negative" from "stable" because first quarter results pointed to "an even larger capital spending funding gap for 2012" from low natural prices but also because of a planned increase in spending.
"The negative outlook reflects the escalating execution risk of Chesapeake's plan for funding its large capital spending budget, rising leverage metrics and accompanying liquidity concerns," said Moody's Vice President Pete Speer. "The company's already diminished cash flows are vulnerable to further declines in natural gas prices, and it remains dependent on completing asset sales and other financing transactions with third parties to maintain adequate liquidity and fund its transition toward higher liquids production."
Fitch Ratings on Friday cut Chesapeake's credit rating 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."
Recent disclosures about CEO Aubrey McClendon's personal financing transactions to fund his participation in the Founder Well Participation Program "have raised conflict of interest questions and reflect poorly on Chesapeake's corporate governance," said Speer. "These issues further confirm our existing views regarding the CEO's dominant role at Chesapeake and his strong influence on the company's risk appetite and growth objectives. This influence is reflected in the company's aggressive financial policies and complicated structure, which are incorporated into our ratings."
However, if an ongoing Securities and Exchange inquiry, shareholder litigation or the board of director's audit committee review of the CEO's personal financing transactions raise "additional issues or adversely effects the company's execution of its funding strategy then there could be negative ratings implications," said Speer.
According to Moody's, Chesapeake's funding gap "could continue to rise" if natural gas prices continue to decline, which would lower earnings and increase its compliance risk with bank credit facility debt covenants in the second half of this year. So far this year, Moody's estimates that Chesapeake has raised close to $4 billion through a bond offering and planned monetization transactions.
"We view volumetric production payments and the recent subsidiary preferred stock transactions as debt and therefore the company's debt (reflecting Moody's adjustments) has increased to approximately $23.6 billion at March 31, 2012 from $19.2 billion at the beginning of the year. Consequently, debt/proved developed (PD) reserves and debt/average daily production have increased to around $12.30/boe and $35,700/boe, respectively, at March 31, 2012."
Moody's also is concerned that Chesapeake's leverage metrics "could remain elevated or continue to increase," said Speer. For Chesapeake to reverse the rise in leverage metrics and maintain adequate compliance headroom with its credit facility covenants it has to execute on a plan to meet most of its remaining funding needs through asset sales, reduce its reported debt and continue to grow its production volumes, he noted. "If the company has to instead rely more heavily on debt funding then its leverage metrics could remain at levels inconsistent with its current ratings."
Chesapeake has a "very large proved reserve and production scale, big acreage positions in multiple basins across the U.S., low operating costs and successful execution through the drillbit," noted Speers. "The company is among the largest independent exploration and production companies rated by Moody's, with reserve and production scale comparable much higher rated investment grade exploration and production companies." In addition, he said the company has acreage positions in many oil and wet gas plays "that are very attractive to both peers and financial investors and a strong track record of completing its planned monetization transactions."
"Liquidity issues or further increases in leverage metrics could result in Chesapeake's ratings being downgraded...In order for the ratings to be upgraded Chesapeake's leverage metrics have to decline significantly and its liquidity will have to substantially improve and be less reliant on monetization transactions. Debt/average daily production, debt/PD, and retained cash flow/debt approaching $25,000/boe, $9/boe and 35% on a sustainable basis could result in a ratings upgrade to Ba1."
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