Chesapeake Energy: The Credit Market Signals That The Distress Risk Is Now Remote

| About: Chesapeake Energy (CHK)
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The note offering fully resolves the most pressing liquidity requirements.

However, the divestiture program remains a necessity.

Ultimately, achieving a competitive capital productivity is Chesapeake’s biggest challenge that may be difficult to overcome.

Important Note: This article is not an investment recommendation and should not be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.

The terms of yesterday's $1 billion unsecured debt offering by Chesapeake Energy (NYSE:CHK) indicate that the credit market no longer views the recently troubled E&P operator as a distress risk. While the 8.00% coupon on the senior notes due 2025 with a standard unsecured high-yield structure is by no means low, it demonstrates investors' recognition that Chesapeake has come a long way addressing its liquidity challenges and reducing leverage to manageable levels. The offering was upsized.

In combination with the $450 million in gross proceeds from the asset sale in the Haynesville announced two days ago, the note offering provides nearly sufficient amount of cash to fund the maximum amount under the tender offer for the existing notes that the company launched concurrently.

The tender offer will be another major step by the company in terming out the nearest maturities. Even assuming the offer is undersubscribed, the remaining amount of debt coming due in 2017 and 2018 would be moderate and the remaining cash on hand can be used to defease the nearest maturities.

(Source: Chesapeake Energy, October 2016)

In essence, the note offering addresses Chesapeake's near-term liquidity requirements. However, it does not reduce the company's leverage challenge. In fact, the interest burden will increase on a pro forma basis.

On the leverage side, Chesapeake has made important progress, despite the very challenging market environment. Total leverage has declined by $1.8 billion since the end of 2014, despite the collapse in commodity prices and the company generating negative free cash flow.

(Source: Chesapeake Energy, October 2016)

While the debt reduction is meaningful, Chesapeake still has a lot of work to do before the balance sheet comes in proper shape. The amount of debt that the company can comfortably carry is ultimately determined by cash flow.

Assuming $2.3 billion in EBITDA in 2017 and applying the 2.0x leverage ratio indicated by the company as its ultimate target, the "comfortable" level of debt in 2017 would be in the $4.6 billion range, which requires an additional ~$4 billion reduction in debt. Obviously, accomplishing such a reduction in a short period of time would be impossible without a major core asset sale (which would reduce borrowing capacity), likely in combination with a sizeable equity offering.

It appears that for the time being, Chesapeake is pursuing gradual deleveraging, which may take some time. The choice is to a great degree determined by the market environment.

Given the improvement in the fundamental outlook for natural gas, Chesapeake has been able to monetize several natural gas assets at reasonable prices. The company has sold its Barnett holdings and the first Haynesville package. The sale of the second Haynesville area package should be imminent, and in my expectation, is likely to receive solid bids.

On the oil side, the situation is more challenging. Chesapeake has no shortage of oily assets that it could conceivably offer for sale. The company's portfolio includes large positions in the Eagle Ford, Utica, Powder River Basin and a vast, 1.1 million acre footprint in the Mid-Continent. The monetization of the STACK acreage was quite successful, despite the unfavorable macro environment. However, with oil prices continuing to struggle, it is difficult to see what marginal assets in the company's oil portfolio can generate proceeds commensurate with the debt reduction target.

It is clear, in my view, that Chesapeake's divestiture program will have to continue irrespective of the macro environment. However, in the absence of a strong recovery in oil prices, deleveraging via the A&D market will likely be a tedious undertaking.

Adding to the challenge is the significant budget deficit expected in 2017. Chesapeake has indicated that its outspend relative to operating cash flow will likely be in the $400-$600 million range next year (the slide below).

(Source: Chesapeake Energy, October 2016)

Despite the outspend, the company expects to post flat-to-declining production volumes.

(Source: Chesapeake Energy, October 2016)

While debt reduction remains an important priority for Chesapeake, the company's fundamental challenge is bigger. Chesapeake ultimately needs to demonstrate the ability to grow production at a competitive rate while spending within cash flow. Based on the guidance, the company is not quite at that point yet.

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The following slide shows Chesapeake's hedge position for 2017 as of October:

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