Should Chesapeake Energy Trade Closer To $0?

About: Chesapeake Energy Corporation (CHK)
by: Small Cap Capital

Chesapeake's stock price recently decoupled from what its debt prices are implying.

Despite the temporary relief granted in conjunction with the reaffirmation of the borrowing base, Chesapeake's massive debt load does not justify the current residual equity value.

Even if you were to assume a little default risk and/or believe in a commodity price rebound, there are better commodity beta plays.

If there was a publicly traded equity security that the market knew was worth $0 -- or even had negative equity value from discounted cash flows or some other valuation methodology -- in theory the security should trade at or near $0. However, if the business has some cash flow to offset debt service costs for few months or so, in reality, the security will trade slightly above $0. That's because investors know that the company can kick the can down the road for the time being, and there is "option value" on the equity. As to how large this option value should be, that's largely a function of how much time the business has until it has to throw in the towel, and how big of an upside the business has when you reach or get past the inflection point.

Many E&P companies are currently in an analogous situation, trading on option value, with perhaps a few months or about a year left before they are forced to default (not covenant breaches that will get waived, but missing interest payments or failing to repay debt). But they potentially possess a large upside in equity if commodity prices rebound during such a time frame. Obviously, these companies have minimal equity value and their bonds are trading at impaired prices to reflect distress and theoretical liquidation values.

While I have monitored many E&P companies' stock prices as they plummet -- and many of them filed for Chapter 11 since mid-2014 -- Chesapeake Energy's (NYSE:CHK) story stands out given its gravitas (along with one of its key peers, Southwestern Energy (NYSE:SWN)). It was a company with a $20 billion market capitalization and an aggregate enterprise value of above $30 billion less than two years ago, and it is still the second largest natural gas producer in the U.S. Only now, its market capitalization is $4 billion, 80% below its peak, and has a corporate rating of Caa2/CCC.

Source: Yahoo Finance.

Despite the precipitous drop in value (~80% since its peak just two years ago), I actually think CHK's stock price is overvalued (both absolute and relative). CHK's stock price steadily declined from $30 in mid-2014 and broke the $10 mark in mid-2015. Then, it kept on falling until early February of this year when it announced it had hired Kirkland for restructuring (the stock price hit $1.50 after the announcement). Since then the company had a few announced asset divestitures and debt buybacks. And, most recently (April 11, 2016), it affirmed its borrowing base at $4 billion.

As a result of this reaffirmation, CHK pledged additional assets as collateral (essentially the entire company), postponed the next borrowing base redetermination until June 2017, and received a covenant relief (other than $500 million minimum liquidity). CHK now has a cash balance and an undrawn revolver of $4 billion as sources of liquidity. Major pressure points were pushed out to 2017, when its collateral coverage ratio of 1.25x kicks in (on March 31, 2017), and its senior secured leverage of 3.5x kicks in (in September 2017, dropping to 3.0x in 2018). The pressure gets magnified by maturing/puttable debt in 2017 of $1.6+ billion. Since the announcement of borrowing base redetermination, the stock price jumped 60%+ -- which implies $1.5 billion-plus of value in dollar terms.

Intrinsic value of the business aside, the big overhang around the going concern of the business just got pushed out to 2017 when the covenants come back into play, in addition to $1.6 billion-plus of debt maturity. Another red flag from a production point of view going into 2017 is CHK's decision to allocate 70% of its 2016 capital budget to reduce its DUC backlog (~50%, or ~240 wells). This improves capital efficiency in 2016 given that they are expected to only reduce average production by 200mmcf/d, with ~$1.6bn of capex.

But in 2017, capital intensity/efficiency positions will dramatically worsen in order to maintain similar production and leverage positions absent an upswing in gas prices. Lower production and higher capital intensity make CHK more levered to higher gas prices going into 2017. But even in a status quo environment, it also deteriorates CHK's operating netback position (CHK has a lot of take-or-pay firm commitments where they lose operating leverage when the volume drops).

Source: CHK Investor Presentation.

By now we have established that CHK equity is more or less an option value play, with about a year of time left to see if the market rebounds. Below are a few names that are trading more or less on "option value"; by no means is this an exhaustive list. Because I think most of the names below have a higher default risk -- at least from a timing point of view -- than CHK, they are not perfect comps either.

In any case, let's just gauge the order of magnitude of "option value" for this list of names. I have compiled market caps, enterprise values based on both market and book value of debt, and SEC PV-10 values of proved reserves as of Dec. 31, 2015, based on SEC standards. I have then compared trading values (both book and market) relative to the PV-10 values for both proved reserves and proved developed reserves. SEC reserve reports obviously have loopholes with respect to assumptions used in arriving at the PV-10 value -- the only reason why it sheds some light on comparability of value today is that the pricing deck used for the 2015 reserve report was $50.28/bbl for oil and $2.58/mcf for gas (current strip at ~$42/bbl and ~$2.50/mcf).

Also, you don't have to attribute much value, if any, to unproven reserves. That was not the case just a year or two ago, when drilling made economic sense. Again, these names all have varying degrees of default risk (both certainty and timing) and the metrics presented are only limited data points. Lastly, balance sheet and reserve values might not reflect debt buybacks/swaps or asset divestitures that might have occurred subsequent to the filing of the 10-K and 2015 SEC reserve reports.

Source: Capital IQ, company/market data, investor presentations, Bloomberg, and author's estimates.

CHK currently trades at 3.7x PV-10 of proved reserves at book value of debt and 2.5x at market value of debt, while the other names trade at 0.8x to 1.4x PV-10 of proved reserves at market value of debt. As per the SEC reserve report, CHK's proved reserves have a PV-10 value of $4.7 billion at an oil price of $50.28 and a gas price of $2.59. In addition, CHK effectively pledged its entire acreage and mortgage as collateral and was able to get a $4 billion borrowing base on its reserve based lending facility.

If you compare this to CHK's enterprise value of $17.3 billion (or $11.7 billion if you use market value of debt), CHK still faces an uphill battle from a collateral coverage point of view -- even if it obviated the risk of immediate default. With post-2018 maturity debt trading below 50 cents on the dollar, there is a clear decoupling in valuation between equity and credit market. (How do you attribute $4 billion of "excess" equity value for a company that has $13 billion of more senior security ahead of equity, when collateralizing the entire asset base yielded just $4 billion of borrowing base?)

Compare this to a company like Antero Resources (NYSE:AR), which is not distressed (debt trades at 97 cents and the company has less than 50% debt to cap vs. CHK, which has close to 80% debt to cap) and has had an industry-leading hedge book for many years. Even if you do not think CHK is a pure option value play, it will make you wonder if CHK is expensive in relative terms. AR is trading at 3.75x PV-10 of proved reserves and, on a hedged basis, it is trading at 2.0x PV-10 of proved reserves (AR's hedge book is too valuable to simply ignore even for comparison purposes).

Depending on how you look at it, you are essentially either paying the same or more to buy CHK than AR from a valuation metric perspective -- let alone adjusting for risk premium, asset quality, etc. Again, I do want to offer the caveat that PV-10 proved reserve value is not a precise proxy for the true net asset value of an E&P business. I just think it provides good point of reference for mature companies. Also, using the 2015 year-end report with a price deck similar to the current strip and in an environment where you are not attributing much value to future discovery makes it particularly useful, in relative terms.

Going back to option value (CHK aside), huge upside can be realized if commodity prices rebound. That's because the net asset value of an E&P company does not increase or decrease in a linear function, but more so in a step function. Locations that are not economic at a gas price of $2 become economic at $3, such that locations that you have booked in today's environment increase in value, but you are also booking "new" locations at $3. Hence, that's a step function, not a linear function.

In conclusion, I am not saying that CHK will file for Chapter 11 (it might, but at least not this year) nor am I saying that gas prices will stay at this level or go lower for a sustained period of time. (I am actually bullish on gas prices going into 2017, but that is a separate discussion.) I am merely saying that CHK is massively overpriced from an option value point of view. Even if you were interested in making a gas-beta trade, CHK is still not attractive in relative terms (the amount of catching up that needs to be done to have the current market value converge with net asset value is too steep).

Also, with respect to the divestiture strategy of CHK, incremental divestiture is helpful for liquidity and deleveraging, but it is only accretive from a collateral coverage point of view if you are getting value for your unproved acreage. I am not saying that CHK cannot squeeze out value for unproved acreage, but the fact that CHK is being forced to sell acreage in today's pricing environment also implies that the company will not be well-positioned to ride the up-cycle when the environment hits an inflection point.

If you were to trade on this idea and wanted to short CHK equity, I would do a capital structure pair trade with a near-term maturity bond. Or you could do a pair trade with a better gas beta name, such as EQT Corp (NYSE:EQT) or Antero. To state the obvious, you can have the perfect thesis, but commodity prices can affect your trade both ways when you are trading E&P names. Pair trades are prudent, in my opinion, unless you want a complete directional bet.

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.