Chesapeake Energy: Expect Regular Heavy Sell-Offs

| About: Chesapeake Energy (CHK)


Chesapeake's stock is heavily influenced by the timing of debt swaps.

Chesapeake's shares underperformed during periods when debt swaps were executed, irrespective of fundamental or sentiment developments.

When natural gas rallied 24% during the most recent debt swap, Chesapeake only rose by 10% despite its high operating leverage.

You can't take advantage of these unpredictable sell-offs as you must know when management intends to execute the swaps.

Management will likely approve additional swaps in the future, so be prepared for short-term volatility.

Other than the fluctuation of natural gas (NYSEARCA:UNG) prices, I believe that there is another factor that has been heavily influencing Chesapeake Energy's (NYSE:CHK) stock. In a departure from my regular discussion about fundamentals, the phenomenon described today is more technical. There is still a fundamental cause, though it's not related to the company's cash flows or anything of the sort. What am I referring to? I am talking about the persistent pattern of heavy sell-offs during the numerous debt for equity swaps that the company has executed over the past few weeks.

Click to enlarge

Source: author's calculation

The table above illustrates the price movements during periods when the debt for equity swaps were executed. The start date denotes the date on which the swap arrangements began and the end date reflects the date on which the swap arrangements ended. NG denotes the front month of natural gas futures and XOP denotes the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP).

Theoretically speaking, Chesapeake's stock should closely track the performance of natural gas. I used XOP to gauge the market sentiment, which could disrupt the stock's relationship with its fundamental value driver (i.e. natural gas). For example, if XOP declines significantly, we can expect Chesapeake to fall as well even if natural gas rallies. As you can see, despite positive or neutral developments in fundamentals and market sentiment, Chesapeake's shares significantly underperformed in most cases.

We can visualize the information above in the graphs below:

Click to enlarge

Source: author's calculation

Click to enlarge

Source: author's calculation

The first graph shows the changes in Chesapeake's stock in the periods during which swaps were executed. The second graph compares Chesapeake's performance shortly after the first swap was executed for each respective period. Chesapeake underperformed in both studies. For example, when natural gas rallied 4.7% between May 5th and May 11th (per the 8-K filed on May 12th), Chesapeake inexplicably fell 30%. Chesapeake's performance was poor even when the market was rising. The June 8th bars in the first chart show that Chesapeake only rose by 10.4% when natural gas rallied by 24% and XOP rose by 7.2%. Leveraged companies like Chesapeake benefit much more from higher commodity prices than typical E&P players due to their operating leverage, especially when the change is significant (in this case it was 24%); yet Chesapeake's stock barely beat the industry ETF.


I believe that the underlying cause behind Chesapeake's performance during periods when swaps were executed is the fact that the new equity holders are likely to dump their new shares in the market immediately after the exchange. Fixed-income managers are often reluctant to hold equity securities (not their mandate), hence they will sell out of principle. I've also mentioned in my previous article concerning the swaps (read Chesapeake's Recent Slide Is Unwarranted) that the bond holders could have immediately increased the value of their holdings by engaging in the swaps, as the value of common shares were worth more than the market value of their bonds. This gives them another incentive to sell.

As we all know, as more sellers enter the market, the price goes down. This is especially true when the seller is trying to get out of the position at any cost. Considering that debt holders got an immediate "markup" by engaging in the swaps, it makes them even more likely to unwind their positions as quickly as possible to lock in the gains.

Your Takeaway

There is nothing you can do to take advantage of these downward swings as an outsider, as you can't predict when the management will execute more swaps. However, knowing the reason behind Chesapeake's underperformance will help you understand the stock's short-term movements better and be more emotionally prepared for any temporary slumps. Since the management is likely to conduct additional swaps in the future as the company deleverages, we will continue to see anomalies in Chesapeake's stock. Unfortunately, you don't get to verify it until after the fact (i.e. after the 8-K is filed).

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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.