I Don't Think Chesapeake's Debt Is Safer Than Its Shares Any Longer

| About: Chesapeake Energy (CHK)

Summary

Previously, replacing Chesapeake shares with Chesapeake debt was kind of a no-brainer.

While such replacement worked, increasingly the whole proposition is looking shakier.

In this article, I explain why Chesapeake's unsecured debt is no longer that safe.

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Previously, in my article titled "You Can't Expect An Acquisition To Save Your Distressed Company Or Its Shares", I stated that holding Chesapeake Energy (NYSE:CHK) debt was a good solution for those wanting to be exposed to CHK, when compared to holding CHK shares.

The rationale was that CHK debt would have less downside if CHK did go bankrupt, and would have similar or larger upside in most scenarios where it didn't.

This Rationale Is Changing

There are several reasons why the previously-stated rationale is changing. At the time, I gave as an example CHK's 6.125% 2021 bond. This bond traded at 25 cents on the dollar. Now consider the following:

The Bond Went Higher

This bond now goes for 36 cents on the dollar, and it paid a coupon as well. Ignoring the coupon, the bond went up ~44%. This more than kept up with the stock, which went from $2.99 to $3.75, or up ~25%. The bond thus kept with the promise of providing upside.

However, as it provided upside, less upside remained. Hence, the price going up reduced the debt attractiveness (from an upside perspective).

This Bond Is Unsecured And Junior In Practice

Now, this is actually a bit interesting, because the bond in question is classified as being Senior (to other unsecured and junior claims).

However, here's the problem. Each time CHK issues any new indebtedness or renegotiates past indebtedness, it has to throw the creditors a bone. And this bone, as it were, is always direct security - that is, pledging assets as collateral for the new or restructured debt. So now that "Senior" bond is actually behind:

  • The $4 billion credit line which CHK will slowly be drawing upon.
  • The exchanged debt (from 2015's debt exchange), with this debt actually also being behind the $4 billion credit line.
  • Any further debt exchanges, like the recently-rumored 1.5-lien debt.

This constant bumping backwards in line for the "Senior" debt makes such debt less and less likely to share meaningfully on any recovery if default takes place. Hence me calling it "Junior in practice". This means that the downside protection in case of a default is looking less and less certain.

The April 15 Borrowing Base Redetermination

Come April 15, CHK's $4 billion credit line will come up for a borrowing base redetermination. Now, natural gas prices have evolved unfavorably and CHK's PV-10 took another hit during Q1 2016. This hit (when disclosed) likely brought PV-10 below $4 billion.

It thus seems likely that the borrowing base redetermination will either bring a reduction in the credit line's size, a severe increase in collateral, or both. The worst possible event would actually be the credit line retaining its $4 billion size with all of CHK's producing assets securing it (see "This Just In" below).

What this means for the bond I had given as an example, again, is that yet fewer assets will be available to provide it recovery in the event of a CHK default.

"This Just In"

The article above was written before this development took place -- I actually had to re-submit the article again with this addendum.

The development is that CHK announced that its borrowing base redetermination has kept the credit line at $4 billion. Along with other changes, the PR states that further security was given to the credit line as predicted above, however it doesn't state just how much security was given. Given the changes, it wouldn't surprise that the collateral will now extent to all or nearly all of CHK's producing assets.

This development doesn't change the thesis written above. In fact it reinforces it.

Conclusion

Due both to CHK's unsecured debt trading higher and it increasingly losing its place in line for a claim on CHK's assets, I can no longer say that CHK's debt is a good way to get exposure to CHK with similar upside to the shares, and a lot lower downside. It would seem that in the event of default, CHK's "Senior" but unsecured debt could actually see very little in the way of recovery.

This would happen because the $4 billion credit line would have first dibs on nearly all of CHK's assets, and even if something was left after that (which still seems likely, I must say), then recently-exchanged debt would have second dibs, along with any future exchanged debt. CHK's senior debt, once very cheap, would now be looking like junior debt - only having a go at CHK's assets after $6 billion or more of secured claims tried to be paid in full by auctioning those assets off.

Furthermore, with those debts having precedence on all producing assets, there might not even be a viable entity after default. Such an entity, on which equity could be issued in exchange for senior debt, would need producing assets. Both of the secured debtholder classes ahead of the senior unsecured debt would be incentivized to sell assets for just enough to make good on their own claims. In other words, they'd be incentivized to sell those assets cheap to get deals done quickly.

In short, I can no longer say CHK's senior unsecured debt is a no-brainer replacement for holding its stock. It's not that I like the stock either, but before this was an easy decision - now it isn't, any more. I wouldn't hold either (unsecured debt or stock).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.