In mid May, Standard & Poor's lowered Chesapeake Energy's (CHK) credit rating to BB-, a junk rating. This is exactly counter to Chesapeake's optimism earlier this year that it would be able to obtain investment grade ratings by the end of 2012. Since the current rating of BB- is three steps under investment grade, there seems to be little chance Chesapeake will exit 2012 with its coveted investment grade rating.
As Standard & Poor's noted in its decision, the battering Chesapeake stock is taking over Chesapeake CEO Aubrey McClendon's questionable business decisions and personal financial woes might make it difficult for Chesapeake to pay its debts. The lower rating will also make it more expensive for Chesapeake to service some of its existing debt, not to mention any further debt that the company takes on as it tries to return to profitability.
Just a week after accepting a $3 billion loan guaranteed by Goldman Sachs (GS) and Jefferies Group (JEF), Chesapeake increased the loan amount to $4 billion to avoid maxing out its revolving credit line. Its revolving credit line has an acceleration covenant that would trigger a default in its senior note indebtedness, which would trigger a second acceleration. The problem with taking on further debt is that these debts are secured by Chesapeake's assets, which could hinder the asset sales on which Chesapeake's future now seems to depend.
Aubrey McClendon continues to play the optimist in public, though remarks like his recent comment that Chesapeake's marketed 1.5 million acres in the Permian Basin are "the world's hottest acquisition" is doing less to calm investor calls for his resignation and more to push the demand for change. At this point it's clear that the sale of the Permian Basin assets is required in order for Chesapeake to meet its short-term obligations, so companies interested in this offer know that there is room to bargain since Chesapeake has little choice but to sell the acreage.
Annual Proxy Hints at Change
In its Proxy Statement for the 2012 annual shareholder's meeting, Chesapeake indicated that it was taking steps to address shareholder concerns regarding executive compensation. In addition to the previously announced early termination of the Founder's Well Participation Program, Chesapeake enacted a "prohibition on certain margining and speculative transactions," which may be a response to the revelation that from 2004 to 2008 McClendon was participating in hedging activities on company time that may have presented a conflict of interest to shareholders and his company. Also, moving forward, 50% of executive compensation will be directly tied to Chesapeake's performance if the proposed changes to the existing compensation plan are ratified by shareholder vote at the annual meeting on June 8.
Chesapeake's board is searching for a new Chairman of the Board to replace McClendon, who will step down once a new Chairman is appointed. This appointment is not required to be ratified by shareholders. Of the search, Chesapeake only indicated that it is "considering potential candidates…with no previous substantive relationship with Chesapeake and will be soliciting input from major shareholders".
A Positive Outlook in Sight
According to its first quarter earnings report, Chesapeake has $45.5 billion in total assets against $26.7 billion in liabilities. As of the first quarter earnings' filing, the fair value of Chesapeake's investments on natural gas and oil derivatives were $1.7 billion in the red. Its largest losses were on call options for oil, with a $1.3 billion mark down. In my opinion, continued unsuccessful derivatives trading may push Chesapeake's stock down past the point of a recovery. It is clear from these trading results that Chesapeake is not taking a realistic view of the current market for oil and gas, and it's also clear from the balance sheet Chesapeake does not have the cash to cover these losses. Yet this may turn out to be a positive thing for Chesapeake's shareholders.
Currently, Chesapeake shares are trading around $13, giving it a market cap of $8.70 billion. As of its first quarter earnings report, Chesapeake's assets after its liabilities were $18.9 billion, which includes assets and liabilities through Chesapeake's many variable interest entities, and currently there are 662 million shares outstanding. Using these simplified figures, Chesapeake would have a net asset value around $29 per share, or a true value twice its cap, at $19.1 billion. I think it would be ambitious for Chesapeake to hold out for much of a premium, considering much of its asset value is tied up in undeveloped and underdeveloped acreage as well as complicated trusts and partnerships, most of which center on the currently depressed natural gas market. So, which companies could afford a wholesale price on Chesapeake?
Chevron (CVX) is one possibility. At the end of the first quarter, Chevron was sitting on $18.8 billion in cash and cash equivalents. Chevron is a major player in liquid natural gas with its Australian Wheatstone project, and might be interested in the plays Chesapeake made towards liquid natural gas in the U.S. Also, as noted in its first quarter earnings call, Chevron will be open to spending its cash once some of its liquid natural gas and deepwater commitments reach 50% completion. Assuming Chevron can make that progress this year, I would say Chevron is a likely buyer for at least part of Chesapeake.
Exxon Mobil (XOM) is another company that could afford Chesapeake. According to its first quarter earnings report, Exxon Mobil was holding a similar balance to Chevron's, with $18.6 billion in cash and cash equivalents. Its first quarter earnings presentation also noted the company's continuing interest in unconventional assets based in the U.S., particularly Woodford Ardmore. I think it's fair to say that Exxon Mobil would be interested in further expanding its unconventional resource base at a discount, especially areas that are liquids rich, which a Chesapeake acquisition could provide.
Other companies that have interest in unconventional U.S. plays might not have the cash and asset balances to leverage a buyout of Chesapeake, but could come up with the cash to purchase select assets that Chesapeake is holding. These companies include ConocoPhillips (COP), Anadarko Petroleum (APC), and Apache (APA). All three of these companies currently have unconventional assets based in the U.S., where Anadarko and Apache are particularly dominant and ConocoPhillips is expanding. In fact, ConocoPhillips recently indicated that its planned $15 billion capital expenditures for each of the coming years will focus on U.S. shale plays, specifically the Eagle Ford, the Permian Basin, and the Bakken - three areas where Chesapeake has assets.
Given that Chesapeake admits it does not have the required cash to develop many of its properties and its high debt load, not to mention the problems surrounding its corporate governance that are hobbling its efforts to move forward, it is only a matter of time before Chesapeake is either dismantled or sold. With the discount at which shares are currently trading, Chesapeake may be a buy for those who can withstand the risk.