My Problem with Chesapeake Energy's New Deal

Chesapeake Energy Corp. (CHK) Reports Preliminary Production & Reserves; Updates Haynesville Activity & Hedges; Announces $500 Million Senior Note Deal.

• 4Q08 Production:
  • 2.315 Bcfepd (92% natural gas). Up 2% sequentially and 14% year over year once you get everything on an apples to apples basis (adjusted for VPPs and asset sales )
  • This is just above the high end of the 4Q guidance of 2.23 to 2.27 Bcfepd.
• Reserves (preliminary)
  • Reserves grew 11% to 12.1 Tcfe (which is where they were at the end of 3Q and no doubt stalled from reaching 12.5 by a ceiling test writedown).
  • Reserve Replacement (new reserves added vs production and asset sales of 239%, this will be seen "as expected for them" and upper quartile among the large caps for 2008.
  • Writedown of $1.8 billion due to low year end oil and gas prices. This is non-cash and does not affect the reserves, simply an accounting rule they and all E&Ps are required to follow. The charge would have been smaller had this been 2009 when the new 12 month pricing rules go into effect. Not a big deal.
  • Finding & Development Costs:
    • Not given in the press release nor was final capital spending
    • but I’d bet the all in number is close to $3.50 per Mcfe (so-so)
    • and the drilling bit only F&D will be close to $1.50 per Mcfe (after impact of the reserve writedown)
    • F&D drillbit costs should fall substantially next year.
      
• Haynesvillle Shale Update: Bigger wells.
  • The average IP for the last seven wells is 16 MMcfepd, rising from the previous set of wells that were closer to 10 MMcfepd.
  • The last two wells which have been completed but not yet hooked to sales were 22 MMcfepd (its not clear if these two are included in the previous bullet).
  • Rig count in the play is now 20 with an average of 25 rigs expected for 2009 which is up a couple of rigs from their last update.
  • Potential well count implies net reserve adds of just under 600 Bcfe. That’s 25 rigs on average with a spud to spud time of 60 days (I think they can beat that), an 80% working interest (paying the equivalent of only 50%), a 25% royalty, and their middle of the road EUR estimate of 6.5 Bcfe 8/8ths.
    
  • Note: CHK entered JV with ETP to build the 178 mile, 42 inch, 1.25 Bcfgpd capacity Tiger Pipeline stretching to Carthage, Texas with an in service date of 2011.
• Hedges: Increasing Coverage
  • 2009:
    • 42% of expected production covered with swaps priced at $7.87,
    • 40% covered with collars with floors at $7.32,
    • minimal hedges subject to knockout swaps
  • 2010:
    • 37% with swaps at $9.44,
    • 12% with collars with floors at $6.41,
    • 241 Bcf (nearly a third of 4Q gas production) subject to knockouts. I for one think that’s smart, may go over like a lead balloon with analysts, but I really don’t see them being trigerred in 2010 (triggered in a range of $5.45 to $6.75 over the course of the year. )
• Cash at Year End: $1.75 billion (note that that is year end, not as of yesterday, and its also apparently not a net number…see next bullet)
• Announces $500 Million Senior Note Offering.
  • Would not be surprised to see this double in size as well, $500 mm seems to be a trial balloon.
  • Due 2015
• Use of proceeds: to repay the revolver (which they charged up to $1 billion just after the end of 3Q while that was still possible as the financial markets looked to be melting down).
  

• In A Nutshell:
  • Good to see their Haynesville wells improving; would like to see if they walk up the EUR’s to match as the 6.5 Bcfe type curve assumes lower initial production than what we are now seeing.
  • So if the debt deal is to pay down bank debt, the $1.75 billion listed in the cash and cash equivalents in the operations update is what, funny money? I kid because I love.
  • To me they are doing this because the debt window is open, at least temporarily, and the market has an appetite for high yield paper from gassy E&P names if HK’s deal last week is any indication.
  • CHK wants the flexibility, I "really" get that.
  • The market wants them to "really" live within cash flow. I don’t think they want to believe that.
  • I think they should have sold it as helping to pay for their share of the Tiger Pipeline mentioned above (although that may service to worry people about long term gas prices).
  • The problem I have with the deal is not really the deal itself. I mean, in this age of $50 billion here and $1 trillion there, the fact that we are swapping low cost revolver debt for high cost high yield debt (it will price well over 10%) should no long raise an eyebrow, right?
    
  • The problem I have with the deal is that it is CHK going back to the capital markets again. So soon. After another asset sale and another VPP made everyone feel it was safe to go back into the deep end of the shale, here we are again raising money.
    
  • After pointing out how much cash there is at hand and that no debt matures for 5 years…here we are again raising money.
    
  • After promising (again) to live within cash flow…here we are again raising money.
    
  • As you know, I’m a big fan of Chesapeake and I’m a shareholder.
    
    • I love their ability to buy acreage and later monetize it for 10x.
      
    • They never drill their best well at the beginning of the play so reserves rise and costs fall over time and that’s nice. I love the fact that they can get VPPs done through their clever friends at R&D for over $4 per Mcre in this climate.
      
    • But I’d like a little more thoughtfulness that even if your game plan isn’t growth for the sake of growth, and I know it's not, that sometimes it just doesn’t pay to produce an extra Mcfe because it’s there or to do a deal because you can, but that a promise is always a promise.

Comments

[Stone Fox C...:]

the other issue is that CHK is starting to have way too many moving parts. Wall St likes to invest in what they know and understand and CHK is at the point where its difficult to understand their capital structure, assets, and such.

Jan 28 01:38 PM

[BrotherMaynard:]

"The market wants them to "really" live within cash flow. I don’t think they want to believe that."

Excellent point. I think its a symptom of an ideologically driven CEO/management. This sort of denial is absolutely devastating for shareholders. Steve Jobs (i'm long aapl), John Mackey (WFMI), Bernie Ebbers, Sandy Weill are/were all ideologues...denying what needed to be done, in favor of what they wanted to be done...all at the expense of shareholders.

BBG reported that CHK was a bankruptcy risk

www.bloomberg.com/apps...

It uses the Z-score methodology and, like any model, can't capture the entire essence of what makes a business tick.

either way, what i'm annoyed about is how mcclendon won't elaborate on what happens to the PnL and balance sheet if these nat gas prices persist or even reach 2002 levels. Yes, we know eventually supply/demand must balance, but the fact that he isn't candid about the potential for lower prices and refuses to plan more than a few quarters ahead, is disconcerting, to say the least.

no position

Jan 28 01:53 PM

[budbro7:]

It's obvious the writer knows nothing about the oil and gas industry.

Jan 28 03:02 PM

[Mmarrkk:]

bud: gimme a break! a one line blast job mentioning no specifics or supporting information for your "comment"? Go out to Z's website and read a little bit. Then come back and site specific issues! Can't tell if you are a CHK supporter or CHK hater but at least put some meat in your comment before you insult someone!

Bro: CHK's bankruptcy potential is highly over rated. Looking at the value of the underlying assets Id say they are safe. Just gotta keep the spending reigned in for a while and focus on those 17 MMCF/day wells! of course, that doesn't help the price of gas and the demand/supply imbalance

Jan 28 03:13 PM

[natgas:]

how is the haynesville shale going to be benificial without a pipeline to market the gas, thus recieving huge infusions of cash. Plus, they will have alot of customers if the haynesville shale is as big as Aubrey thinks it is. I love CHK

Jan 28 03:28 PM

[Bill Herbert:]

>>Bro: CHK's bankruptcy potential is highly over rated. Looking at the value of the underlying assets - I'd say they are safe...<<

I agree, but I also think that CHK may be very volatile, as my view is that NG will soon drop to around $4, based on the fact that industrial demand has been crushed, and people are obviously conserving gas at home (i.e. keeping the thermostat low) and there is an enormous amount of gas being produced. This recent cold snap helps, but there will be 1700 BCF left in early April, and I don't know what will hold the price up.

I've made a TON of money on CHK the past six years, but now they have a more complicated situation, more risk, a really crappy economy to sell into, and no support from the oil or coal price. I love CHK too...but...

Look at what oil did today - with the market soaring and everybody high-fiving over the "Bad Bank" scenario, it got killed. Inventory rose over 6 MM barrels.

CHK will be a trader's dream over the next year or so, until the economy stabilizes. My strategy is to just buy the dips, and when it pops two or three bucks, sell covered calls, and forget about the dream of seeing the $30 range in the near future.

Jan 28 10:54 PM

[Mmarrkk:]

You may be right on the overall direction of nat gas pricing and CHK will follow that price curve. Trading it is a great idea. Also like the convertibles and the bonds. 9-10% per year is pretty darned good these days!

Jan 29 10:49 AM

[BrotherMaynard:]

"9-10% per year is pretty darned good these days!"

Keep in mind the notes were seniors (though, few can really borrow at reasonable rates with anything less than senior)

"Bro: CHK's bankruptcy potential is highly over rated. Looking at the value of the underlying assets - I'd say they are safe"

Still, I'd like to see CHK IR release some sort of stress test scenario showing what happens to their capital structure at $3 and $4 nat gas.

Jan 29 11:44 AM

[calvino:]

Z, come on! CHK has one problem. Aubrey McClendon. This is a destruction machine of shareholder value. He was on the Flying Baboon tv show on financial entertainment television, today actually bragging that his opening of Haynesville brought natty from thirteen down to four. Why would you do that to your investors Aubrey? You were hanging out on margin, did you never hear of supply demand curves. Turn down the taps a little Aubrey, save a little for the kids. Think of the little ones, maybe they will want a little natty for themselves. You don't have to pump it all out this year. Next year is ok also.

Jan 30 05:54 AM

[Anonymous A...:]

I like the analysis, barring a few quibbles. You make all the appropriate observations but fail to connect the dots, I think. You correctly noted that CHK operates in a way so as to smooth out the natural highs and lows of the natgas market. You also note that CHK continues to raise cash through several mechanisms (senior notes, VPPs, JVs, and mineral divestitures are a few that come to mind). This capital rush doesn't necessarily tell us that CHK is hemorrhaging cash and in danger of becoming insolvent. For example, CHK sits on trillions of dollars in proved illiquid assets. It's a pretty far-fetched scenario that sees the company having to leverage its physical assets to stay solvent, though. More realistic is this scenario:

Part I
-------
CHK tries to attenuate the highs and lows of the natgas cycle. We're unquestionably in a low period. As a result, CHK is sitting on a ton of supply. The best way to get your money's worth from that supply is by divesting it through non-traditional means (VPPs, JVs, etc.). All of the VPPs currently being floated (there have been two historically, and there are at least three more in the pipe) are in plays that are well past their prime. CHK can either continue to deplete the wells at market price, or it can find a better way to get its money's worth.

Part II
--------
CHK (actually Aubrey) is notoriously overzealous in the lease acquisition phase. They gobble up land and then sit on it, hoping the drilling schedule rolls around to a given lease before it expires. Selling off 25-30% in either the Marcellus, Fayetteville, or Haynesville in exchange for avoiding drilling costs, usually at a factor of 7-10x, is a no-brainer. CHK is/was over-invested in these areas in terms of leasehold, and they're correcting that position while earning a healthy profit.

In closing, I don't believe that CHK is in any kind of imminent danger, and they're certainly fine in the long-term. When your business model revolves around one commodity, you are more prone to wild swings in the market, and therefore wild swings in investor confidence.

Feb 02 03:41 PM