Chesapeake Bondholders Don't Share In The Oil Rally Enthusiasm

Summary

• The price of oil has rallied this week, leading to bullish moves on energy stocks.
• Chesapeake's bonds continue to sit at lows at around 5% of par, indicating that the negative near term future for the stock is getting more ominous.
• Investors who are insistent on a turnaround for CHK should buy the bonds and sell the stock.

Over the past couple of weeks, I have written two articles on Chesapeake Energy Corporation (NASDAQ:CHK). In the first article, I predicted that Chesapeake's bond prices signaled the end is near for the stock. In the second article, I used the recent restructuring of Whiting Petroleum Corporation (WLL) as an example to show that even in the best case scenario, CHK stock was overvalued.

Oil has been in rally mode this week, propping up oil and gas peers and temporarily halting CHK's decline in stock price. However, Chesapeake's bond prices suggest that there is absolutely no reason to be bullish on CHK equity. My advice to investors who insist on speculating on a turnaround for the company remains the same. They should buy the bonds and sell the stock. The stock is nothing more than an expensive trading vehicle and an easy shorting opportunity upon any spike.

Data by YCharts

Bond prices sink amid bankruptcy filing

Hours after my second article was published, a report came out from Reuters stating that CHK was preparing a bankruptcy filing. Chesapeake held discussions with creditors about debtor-in-possession financing of up to $1 billion and is considering skipping out on a $192 million interest payment. This report resulted in the bonds cratering in price, with little recovery even as the price of oil has increased this week.

Source: Morningstar

All bonds are now trading well below 10% of par. Even the bonds maturing this year have fallen from approximately 20% of par to just over 5% of par, leading to ridiculous yields to maturity of over 3,000%. The potential debtor-in-possession financing is the main driver of this price decline. As outlined in my previous article, there is approximately $3 billion in debt between a term loan and a revolving credit facility in addition to the $6 billion face value worth of publicly traded bonds.

Source: CHK's 2019 annual report

The publicly traded bonds are junior to the term loan and credit facility, so that $3 billion must be settled in any bankruptcy proceedings before these bonds get a penny. If a DIP financing is undertaken, that loan would sit senior to all other outstanding debt. That would mean Chesapeake would have $4 billion in senior debt instead of $3 billion. Combine that with the company likely to skip out on the interest payment due in August and the bonds have sunk to the point where $6 billion in face value trades at around $300 million.

Under a DIP financing and court overseen bankruptcy procedure, a restructuring of second lien bonds similar to that of WLL becomes greatly impaired. It is highly unlikely that CHK common and preferred stockholders will receive any payout.

If you're bullish on CHK, buy the bonds and sell all forms of stock

Given the dire situation it's in, a purchase of any kind of Chesapeake security is a highly risky proposition. But the bonds clearly present the best risk-to-reward trade-off right now.

At 5% of par on average, the bonds have a combined $300 million valuation. At $15, the common stock has a $150 million valuation. At $3, the preferred stock has an $18 million valuation. If a restructuring took place, the bonds would likely receive in excess of 90% of new equity but currently only represent about 64% of the combined valuation of these three classes of securities. Buying the bonds assumes the new equity would hold greater than $300 million in value. But if the new equity failed to hold on to that value and the bonds declined, that just means the existing stock performed even worse. Conversely, if the new equity did really well, the bonds would return multiples back to their investors before current equity holders broke even.

The restructuring scenario is more of an exercise than anything. With the looming bankruptcy and DIP financing, I believe that the equity is headed to essentially zero. I have closed off my previously disclosed put option position on CHK. It's difficult to say how long the stock could remain on life support so it's always wise to take option profits when you have them. However, if the stock has another dead cat bounce before the inevitable crash to pennies, I believe that becomes an ideal opportunity for shorts and a must-sell gift for longs.

Analyst’s 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.