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Friday May 11th was an interesting day for Chesapeake Energy (NYSE:CHK) with the delayed filing of their 10Q. The stock was down over 15% intraday and closed down almost 14%. The main catalyst for this was the disclosure that selling certain assets may violate certain credit covenants. My question is, if they can't sell the assets they wanted to, where is the cash to fund their massive capex program going to come from? Their 10Q looks rather dire:

  • Current Assets: $3.9B
  • Current Liabilities: $6.7B
  • Unevaluated Properties: $17.6B (we will get to this later)
  • Cashflow from Operations: $274 MM
  • Q1 Drill & Complete (Net of carries) Capex: $2.5B
  • Q1 Land Acquisition (Net of carries) Capex: ~$1B
  • Q1 Midstream/Oilfield Services/etc Capex: $0.75B
  • Total Capex in Q1: ~$4.25B

There is quite the disparity between capex and cash from operations. They have said that capex was going to be front-loaded in the first quarter so we should annualize these numbers over 2012 to get a better idea of what is going on.

CHK is projecting total capex for 2012 will be $7.5-$8B on the D&C side, $1.6B on the land side, and $2.5B-$3.5B for their midstream, oilfield services, etc. The grand total is $11.6B-$13.1B. $11.6B in capex net of drilling carries is crazy for a company of their size. Look at some of the other independents' projected 2012 capex. Keep in mind these companies listed below are much larger than CHK:

Anadarko Petroleum (APC): $7B
EOG Resources (EOG): $7.5B

As a side note, these independents have only spent ~$2B in capex for Q1 2012. CHK has them doubled at roughly half the market cap.

Extrapolating cash from operations out over four quarters gives you $1.1B in cash coming in. Expected capex is 10 times cash from operations. They are looking at a $10B deficit. Some may counter that natural gas prices will rise and bring up cash from operations. This may be true, but even if you double cash from operations, they are still looking at a $9B gaping hole in their cash flow statement. Now, deficit spending is not something new to CHK, however, the company is in new waters this time with $13B in debt already and more importantly, being virtually unhedged on their major product, natural gas.

They announced in the 10Q that they will have to delay selling certain assets to avoid violating credit covenants. Which assets are they talking about? It had to have been something material. The only material assets they have specifically talked about selling was the Permian. The rest of their plan was to VPP the Eagle Ford and JV the Mississippian Lime. Selling out the Permian assets was a critical piece of their planned asset sales. If they can't sell that, or can't sell for awhile, where is the cash going to come from? The Eagle Ford VPP and Mississippian Lime JV, based on past VPPs and JVs, will probably bring in roughly $3B. Don't forget that a good chunk of this will be drilling carries from the JV which is spread out over a few years.

Speaking of drilling carries, Chesapeake has done multiple joint ventures that involve drilling carries. Drilling carries aren't even going to come close to saving them. They are mostly gone and the capex numbers above are net of drilling carries anyways. They only have $1.9B in drilling carries remaining. A few problems with these carries are that they are spread over a few years and the fact that over $500 MM of these carries are in the Niobrara, a play which has not worked out extremely well for CHK.

Stock issuance? After the beating they have taken, I don't think anyone is expecting an equity offering. Although, with current management, I would not rule out anything. Debt would go against their 25/25 plan to reduce debt to $9.5B by EOY. Assuming they get $3B for the VPP and JV and the Permian sells for a generous $8B, they are just cashflow neutral. They won't even be close to getting the current $13B in debt down to $9.5B.

Selling the Permian also sells one of the very things they are looking to increase: liquids. The "Western" portion is where the Permian Basin is located. This division provides 30% of the total liquids produced by CHK. You can also tell from the realized prices per region that this area is where most of the oil CHK produces is located. Realized prices are in the $8x range vs. the other areas where they are $6x. This is, in my opinion, one of the reasons CHK still does not break out oil and NGLs on their statements of revenue. The oil volumes are pitiful and they are planning on selling most of it.

All of this boils down to one thing...I think capex has to be cut dramatically. At some point CHK needs to take a look and see that they can't be spending double the capex of companies that are double the size of them. It's just not sustainable. Cutting capex brings huge problems when you have $18B in unevaluated properties on your balance sheet. O&G leases have terms and must be drilled to be retained. I think CHK is looking at asset writedowns anyway due to the way their asset valuations are calculated using trailing gas prices. They will be looking at even more writedowns on their $18B of undeveloped acreage as leases expire due to cutbacks in capex.

Is CHK a Ch. 11 candidate? There is a definite possibility they have liquidity issues. Their three revolvers are drawn down to the point of only having ~$2B remaining on them. The borrowing limits of two subsidiary revolvers were recently cut by the lenders. Current liabilities dwarf current assets by almost $3B. The difference in AP and AR eat up just about all of the cash on the balance sheet.

Obviously the company understands these issues due to the emergency Goldman loan late on Friday night. The terms of this loan should give you a good sign of the deteriorating credit worthiness of CHK. Earlier this year they placed ten year notes for 6.125% and seven year notes for 7%. The loan from Goldman is a five year loan at 8.5%. All of this to pay down a revolver that has an interest rate of a couple percent. Death spiral?

The issues with the Board and CEO are well discussed and I won't dig deep into them here. The issues are extensive and range from excessive director/CEO compensation to the CEO recklessly gambling with the company's cash flow hedges to the CEO running a hedge fund while running CHK. I think the shareholders would do well to install a new Board and new management with more realistic goals of what the company can accomplish. Reducing debt to $9.5B by EOY while filling the cashflow gap or expecting to be cashflow positive in 2014 are pretty lofty goals especially when cash from operations is only a measly $1B/yr. Management should take a look at what is actually achievable/sustainable and trim acreage and capex to meet. All of the assets in the world mean nothing if you can't drill them.

I personally think the company has some good potential if they take the right steps. The right steps are drastic and will probably hurt the egos of a few, but they are necessary. One of those steps includes showing the CEO the door. He is a loose wheel who brings about a new news story everyday which can give you an instant 15% haircut on your long position. Today it looked like a few big players are getting tired of the haircuts. The selling blocks were huge with some volume ticks showing 5 million shares traded within a minute or two. Another huge step needed is to cut the size of the company drastically. There's too much acreage. Sell it. Capex and cash from ops can't keep up.

On the opposite side, I don't think CHK is a good short candidate due to the fact that if the board were to wise up and show AM the door, I believe the stock would jump fairly high. It did a 10%+ jump when it was announced he was going to no longer be chairman. The jump from no longer being CEO should be much greater. I think it is best to sit this one out until some clarity is given on company direction.

Source: Where Will Chesapeake Energy's Cash Come From?