Forbes Predicts Chesapeake Running Out Of Options

The Dim Outlook For Chesapeake Energy

The highly leveraged shale gas champion is burning cash, selling assets and running out of options. 

Chesapeake Energy CHK +1.8% is in pretty bad shape. Shares are down 67% in the past 12 months, to $8.70 today. The last time Chesapeake traded at such a low range was in 2003. Its equity market cap is less than $6 billion. Think this looks like a bargain? Only if you’re really bullish on oil and gas prices. On the contrary, if oil and gas stays low for a couple more years it is hard to see how Chesapeake’s equity is worth anything at all.

Chesapeake’s earnings report last week provided no comfort. The company started 2015 with $4.1 billion in cash. It ended the first half with $2 billion. That’s half its cash evaporated in six months. During that time Chesapeake did not buy or sell any assets. It reduced its capex levels by about 40% over last year. So that cash burn rate pretty well represents the sorry state of its underlying business.

This highly leveraged company is becoming even more leveraged. In the first half, total debt net of unrestricted cash increased from $7.4 billion to $9.5 billion. As profitability has collapsed, net debt has risen to more than 6 times annualized Ebitda. In normal conditions 4x is considered rich. This is worrisome for a company that will need to refinance $5 billion in debt over the next five years.

Part of the problem is a huge glut of gas and liquids in the Utica and Marcellus, where there’s not enough pipeline capacity to evacuate it all out to market. Chesapeake has curtailed production in both regions. But that won’t solve the bigger problem. According to analyst Kevin Kaiser at Hedgeye, Chesapeake is caught in a “midstream stranglehold.” It is contractually obligated to pay fees to pipeline giant Williams Companies for its dedicated capacity. Most of Williams’ contracts with Chesapeake are on a “cost of service” mechanism, which guarantees Williams a return on its investment in building out pipelines. Chesapeake has to pay a certain amount whether it uses all the pipeline capacity or not. The less it uses, the higher Chesapeake ends up paying per unit of volume.

It’s a set-up that would work in a world of higher commodity prices and ever increasing volumes. According to Chesapeake’s February 2012 investor presentation, when the company entered into these pipeline contracts it was anticipating that in 2015 it would be enjoying $6 per mcf natural gas and $100 oil and annual ebitda of more than $10 billion. Instead, this year’s ebitda will be more like $2 billion.

According to Kaiser’s analysis, Chesapeake’s midstream pipeline expenses, at about $1.70 per mcf (or the oil equivalent) are the highest in the entire industry. In the Midcon region Chesapeake was paying 64 cents per mcf to move gas in 2012. But because gas prices have gone so low, it stopped drilling there. Now it’s paying an estimated $1.20 per mcf to move gas there. All told, Chesapeake’s payments to Williams amount to about $1.9 billion a year, according to its quarterly report. “It will take multiple years to play out, but we believe that CHK equity is ultimately a zero,” wrote Kaiser in his June report.

Chesapeake would love to renegotiate contracts with Williams, but the pipeline giant has very little incentive to play ball. Williams paid more than $8 billion to acquire its control of Access, the pipeline division that Chesapeake spun off in exchange for more than $4 billion in emergency cash back in 2012. Many of Chesapeake’s contracts with Williams carry terms of more than a decade.

Alan Armstrong, CEO of Williams, said on his quarterly conference call that he’s open to “win-win” solutions with Chesapeake. “In terms of restructuring, certainly, they take the lead on that and we try to provide support and find win-win ways where they can add volumes that help offset some of those obligations.”
Chesapeake could gain some traction by selling off assets where it’s stuck in tough contracts with Williams, or making joint ventures with other operators that can add their volumes to fill out Williams’ pipes.

Chesapeake has already tightened its belt a lot. CEO Doug Lawler has cut costs, slashed capex and improved drilling efficiency. Last month he announced that Chesapeake would suspend its dividend, saving $240 million a year.

Lawler will have to keep trying to sell off whatever acreage is attractive to buyers. In October 2014 Chesapeake sold acreage in the Marcellus and Utica to Southwestern Energy SWN +5.92% for $5.4 billion. At the beginning of the third quarter Chesapeake sold assets in Oklahoma to private equity backed FourPoint Energy for $1 billion. Lawler will need to orchestrate a lot more asset sales to make ends meet. The company says it has ample liquidity thanks to an untapped $4 billion revolving line of credit. That line may well shrink when banks do their fall borrowing base redeterminations.

Why not try to sell the whole thing? Please. Chesapeake’s big equity holders, Southeastern Asset Management and Carl Icahn (each with about 10% stakes), would like to convince the market that’s possible, but who would want to buy a business with such poor underlying performance and lots of overhead when they can just cherrypick off the decent pieces? If you’re a deep pocketed oil and gas major you’d be better off acquiring any number of healthier operators. Cowen & Company analyst Charles Robertson, Jr. notes that Cimarex Energy XEC +2.5%, with its low leverage and world-class position in the Permian Basin is “one of the easiest acquisition targets” for the majors.

Further complicating Chesapeake’s outlook is the ongoing legal trouble related to alleged underpayment of royalties. In the first half Chesapeake agreed to pay a $119 million settlement in a class action brought by Oklahoma landowners who said the company bilked them on royalty payments. Chesapeake says that litigation over similar allegations continues in Texas, Louisiana, Ohio, Pennsylvania and Arkansas and that the Dept. of Justice has subpoenaed information relating to Chesapeake’s royalty payments. The company says “losses are reasonably possible” but that “we are currently unable to estimate an amount or range of loss.” What potential acquirer would want to take on that open-ended liability?

This is a company that hasn’t been able to live within its cashflow at any time in the past decade, even when oil prices were above $100. It has generated more than $16 billion in cash from asset sales since 2012, but is more highly leveraged than ever. Unless oil and gas prices recover significantly in the months ahead Chesapeake will continue to sell assets and shrink smaller and smaller until it eventually runs out of cash and runs out of options.

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