The Hint from the Bond Exchange Filing
According to the risk factors part of Chesapeake Energy Corporation (NYSE: CHK)'s recent filing of their bond exchange SEC filing on Dec. 2, proved reserves are calculated using 12-month trailing commodities prices. At the end of Q3 the numbers resulting from this trailing average was $59.21 per bbl of oil and $3.06 per mcf of natural gas, resulting in a PV of its proved reserves of $7.1 billion. Furthermore, the filing estimates that the prices used to reevaluate its proved reserves at year end will decrease to $50.68 for oil and $2.60 for gas. The filing indicates that based on these estimates the company will take a hit on the PV of its proved reserves by "$2.9 billion in the 2015 fourth quarter" and adds that "Such decrease is likely to be a significant factor in the amount of impairment recorded as of December 31, 2015." In other words, the $2.9b would probably not be the full impairment.
How could we estimate the full impairment? This is problematic because out of Chesapeake's $17.7 billion in long term assets, only $7.1 billion are being singled out here. I expect that this is the biggest source of impairment for the company for Q4, so I wouldn't extrapolate out and say that the hit would be more than double the given $2.9b. But I can't help but think that some of the other assets will take a hit as well. I would guess the hit will be somewhere in the neighborhood of $4.5b. This also seems to correlate roughly with how the impairments have hit in the previous two quarters under similar declining commodities prices.
This $4.5b hit comes from an important assumption: the prices of $50.68 for oil and $2.60 for gas. Oil and gas have not performed well since the filing, but since the calculations use data from the first day of each month and the filing takes into account Dec. 1 prices, $4.5b seems like a reasonable number for the headline hit.
The Light Side: Bond Exchange and Efficiency Gains
On the other hand, the result of the bond exchange is that it gives the company an immediate one-time boost in the other direction. This boost is about $1.5 billion. And what about lower costs, better technology, improved infrastructure (e.g., new pipeline(s) out of Marcellus), and improved efficiency? Since this deserves an article of its own, I won't go into the details here. The main tenor of the last few quarters has been that costs have indeed gone down, new infrastructure is in the works, etc., but the problem is that these have not been enough to combat severely falling prices. Hence we still saw huge impairment hits and the inability to make a profit despite the lower depreciation costs which follow those hits. (Not that this is the company's fault. Without the company's efforts in these areas, the company wouldn't have a chance of surviving in the current environment.) These efforts will be vital for the long term viability and strength of the company, provided it can survive the next 2 years… or however long oil and gas remain low.
Extrapolating Beyond the Headline Hit
So we are looking at a $4.5b hit mitigated by a $1.5b gain from the bond exchange, resulting in a net impairment of $3b for 2015 Q4, bringing the company's equity down from $4.8b to $1.3b.
However, to get to a more accurate valuation of the company and its prospects (and a target price for the stock), we need to start by considering the current commodities situation. This involves looking into the future(s) rather than the past. Natural gas futures are currently around $2.5 for 2016 and $2.80 for 2017, and oil futures are about $41 for 2016 and $46 for 2017. So perhaps $2.70 for gas and $45 for oil are appropriate for valuing Chesapeake's assets. These numbers are 4% up for natural gas and 11% down for oil compared to the $2.60 gas and $50.68 oil numbers which Chesapeake used for their valuation. Since oil is a larger percentage of revenues than natural gas (66% vrs 34% according to the Q3 10-Q) I estimate this as another hit of $0.5b which Chesapeake actually deserves to take. This leaves it with a meager $0.8b in equity.
Valuing the Stock
Valuing a stock normally involves evaluating the company's earnings potential. But when a company is near bankruptcy, the company's equity and liquidity become very important. Hence I will present a model valuing the stock based on my updated estimate of their equity. I keep in mind several considerations in creating my valuation model. First, the company is likely to continue losing money in Q4 2015 and Q1 2016 in addition to impairment hits because the commodity prices are below the prices they use to value their assets (especially oil). So the situation in the short term is bleak. In light of this, the company now has a very high bankruptcy risk because of its debt burden (hence most of the bonds trade between 30 and 60 cents on the dollar). Second, even if the company doesn't go bankrupt, there is a high risk of dilution event(s) especially if a deal needs to be struck with bondholders of upcoming bond expirations (e.g., in 2017). Third, the company's preferred shares have face value of $3b which have advantages over the common shares in most scenarios.
To come to a sort of simplified model for valuing , I suggest four scenarios:
(1) The company goes bankrupt, and the shares become worthless.
(2) The company squeaks by with the help of significant dilution event(s).
(3) The company squeaks by without any major dilution.
(4) The company recovers and thrives due to an unexpected recovery in commodities prices.
This simplified model allows you to fill in your own numbers based on your thoughts about the likelihood of these scenarios and how you think CHK will be valued under these scenarios. (When estimating a value for CHK in a scenario, remember that you are estimating an expected value or average value, since there is still a range of possibilities under each scenario.)
In scenarios 2 and 3 I estimate that the preferred shares retain a market value of about 60% of face value, and thus retain about $1.8b of equity. In scenario 2 I can't imagine valuing the (current) common shares at much--I assign them $.8b. In scenario 3 I value the common at $1.5b. In scenario 4 I value the common at $13b and the preferred at 95%. I assign probabilities of 50%, 20%, 20%, and 10% respectively to these scenarios. This leaves an expected value for the common at .2*.8+.2*1.5+.1*13 = $1.76b or $2.64/share. Discounting 10% for the risk involved yields a final valuation or target price of $2.41 for CHK. Meanwhile, the preferred shares come out with expected value of .2*60+.2*60+.1*95 = $33.50/share, and after discounting 10% for risk yields a valuation or target price of $30.45 for Chesapeake Preferred (CHK.PD).
Conclusion: the common shares are overvalued, but the preferred shares are undervalued.
Disclosure: I am/we are long CHK.PD.
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.
Additional disclosure: I am considering adding to my position in CHK.PD and/or buying Chesapeake Energy Corporation Bonds in the next 3 days.