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Chesapeake Laying Groundwork for 'Meaningful' Improvement, Says Moody's

Chesapeake Energy Corp.'s decision to launch a record $3 billion bond offering to help refinance debt drew positive remarks from two of the largest credit ratings agencies.

Burdened by over-buying on credit since the unconventional revolution began, Chesapeake's debt last year rose 6.47%, more than the average debt of 5.6% among its exploration and production peers, even with a bundle of asset sales, staff reductions and a pullback in some of its targeted operating areas, including the Permian Basin.

Proceeds obtained from the bond offering would be used to repay a term loan maturing in 2017, fund a debt tender offer due in 2016 and redeem 2018 securities, according to the filing with the U.S. Securities and Exchange Commission.

The second largest U.S. natural gas producer has been working overtime during the past two years to turnaround its operations to fund more oil and liquids prospects. However, that also takes time and money. Investor Carl Icahn, who helped reshuffle Chesapeake's board in 2012 and has a representative on it, has prodded the Oklahoma City independent to keep operations within cash flow by selling assets and installing more financial discipline.

Since Aubrey McClendon stepped aside as chairman and CEO, credit ratings services have been closely following the exploration and production (E&P) giant because investors lost interest and pushed the stock price down while creditors lined up. Thursday, Standard & Poor's Ratings Service (S&P) and Moody's Investor Services reacted to the latest bond offerings.

S&P kept its "BB-" issue-level rating on Chesapeake and issued a "3" recovery rating to the $3 billion senior unsecured notes. "Our '3' recovery rating on this debt indicates our expectation for a meaningful (50-70%) recovery in the event of a default," said credit analysts. "The 'BB-' corporate credit rating on Chesapeake Energy remains unchanged. The outlook is positive."

Completing the planned refinancings "would benefit Chesapeake's debt profile by extending maturities and lowering borrowing costs" and the ratings reflect a "satisfactory" business risk and "aggressive" financial risk assessment.

"Chesapeake Energy is among the largest E&P companies in the world," S&P said. "It operates in a number of the most productive U.S. basins, and its cost position is benefiting from various initiatives to improve operating efficiency. Its production remains weighted toward natural gas -- pricing of which remains relatively depressed -- but it has been meeting with success in boosting its production of oil and natural gas liquids."

Cash flow to leverage "is aggressive, owing to past growth-related investment that substantially exceeded internal cash flow. Over the past year, the company has brought capital spending more closely in line with operating cash flow, and management has articulated an objective of reducing debt substantially, in part through using the proceeds of planned asset sales."

S&P could raise Chesapeake's rating within the next year "if we came to expect that debt reduction through asset sales would be sufficient for the company to sustain debt...Based on our current expectations for oil and gas prices and Chesapeake's production levels and operating costs, this likely would entail debt reduction of at least several billion dollars." In the longer term, the rating also could be lifted if the E&P demonstrates more progress to improve operating efficiency, S&P said.

Moody's assigned a "Ba3" rating to the proposed offering and said the outlook remains stable.

"Chesapeake Energy is opportunistically refinancing certain debts to extend maturities and lower its overall interest costs," said Moody’s Pete Speer, senior credit analyst. "The company has greatly improved its capital discipline and is actively reducing its cost structure, laying the groundwork for meaningful improvement in its cash margins and financial leverage."

Chesapeake now has a $4 billion senior secured revolving credit facility, Speer noted. Moody's rating "incorporates the benefits of its very large proved reserve and production scale, sizable high quality acreage positions in multiple basins across the U.S., and competitive drillbit finding and development costs."

The rating has been restrained by Chesapeake's high adjusted debt levels and "structural complexity that are a legacy of its past aggressive growth and financial policies," he said. However, under the revamped management team, which was put in place in mid 2012, "Chesapeake has changed its strategic focus to rigorous capital discipline, continuous improvement in operating and drilling efficiency and reduced financial complexity. This change in strategy and financial policy has the potential to improve the company's credit profile in 2014."

If the independent were to achieve meaningful "adjusted debt reduction, reduce complexity, improve its cash margins and meet its production targets, then the ratings could be upgraded," Speer said. Retained cash flow (RCF)/debt, approaching 35% with leverage on proved developed (PD) reserves and average daily production sustained below $9.00/boe and $25,000/boe "could result in a ratings upgrade to Ba1...RCF/debt below 20%, debt/PD above $12.00/boe, or debt/average daily production above $35,000 could result in a ratings downgrade."

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