Description

I recommend the purchase of Chesapeake Energy’s 6.5% senior notes due August 15, 2017.  I further recommend that a purchaser of the notes hold the notes until maturity, rather than participate in CHK’s offer to exchange the notes for 8% second lien notes due 2022.

Background.  CHK is the second-largest producer of natural gas and the twelfth-largest producer of oil and natural gas liquids in the United States.  CHK was co-founded by Aubrey McClendon, a VIC favorite.  During McClendon’s tenure, CHK followed a strategy of aggressive resource acquisition funded by debt, “creative financing,” and the occasional monetization of the acquired resources.  During the shale gas boom, CHK leased vast amounts of acreage in the Barnett Shale, the Fayetteville Shale, the Haynesville Shale, and the Marcellus Shale, and then drilled its acreage aggressively, with drilling often focused on holding leases rather than earning returns.  When the tight oil boom followed, CHK repeated itself, leasing large amounts of acreage in the Eagle Ford Shale, the Niobrara Shale, the Utica Shale, and portions of the Anadarko Basin in Oklahoma, and commencing major drilling programs in each of the plays.

The strategy left CHK with a lot of acreage, a lot of debt, and a cost structure burdened by VPPs, transportation commitments, and other financing commitments, leaving it ill-equipped to deal with a prolonged severe drop in energy prices.

CHK’s largest shareholders are Carl Icahn (11%) and Southeastern Asset Management (9%).  In 2012, Icahn and Southeastern worked together to reconstitute the company’s board of directors, and five of CHK’s nine board members are now designees of Icahn and Southeastern.  McClendon left CHK in April 2013, and in June 2013, Doug Lawler (a former Anadarko executive) became CHK’s chief executive.

Lawler has instilled cost discipline and an emphasis on returns-based drilling, and CHK’s operating metrics have improved significantly since his appointment.  Further, in late 2014, CHK consummated what, in hindsight, may have been a company-saving transaction, selling assets in the southern Marcellus Shale and a portion of the eastern Utica Shale (assets which contributed less than 8% of CHK’s production) to Southwestern Energy Company for net cash proceeds of nearly $5 billion.

Notwithstanding CHK’s improved operating metrics, cost discipline, and starting 2015 with over $4 billion in cash, the combination of onerous transportation commitments, a heavy debt load, and low energy prices have placed CHK in a precarious position.  The issue now facing CHK is whether energy prices will recover in time for CHK to avoid a restructuring.  For purposes of this write up, I don’t need to answer that; it is sufficient only that CHK’s restructuring, if any, occurs in 2018 or later.

Capital Structure.  CHK’s capital structure consists of a $4 billion first lien credit facility (which is currently undrawn and about which more later), $1.5 billion in proposed second lien notes being offered in exchange for CHK’s senior unsecured notes, $11.8 billion in senior unsecured notes, $3.1 billion (liquidation preference) of preferred stock, and common stock.

Enterprise Value.  CHK’s enterprise value is as follows:

Maturities.  CHK’s debt maturities are as follows:

Credit Facility.  In December 2014 (i.e., after the oil price crash), CHK replaced its $4 billion senior secured credit facility maturing in 2015 with a $4 billion unsecured senior credit facility maturing in 2019.  At the time, this appeared to be an endorsement of CHK’s asset value and new-found operating discipline.  In hindsight, it appears to be a failure by CHK’s lenders to acknowledge that the light at the end of the tunnel was an oncoming train.

In September 2015, with possible covenant breaches looming, CHK and its lenders modified the facility, converting it to a secured facility with a $4 billion borrowing base.  With the grant of collateral came looser covenants, as follows:  (1) so long as the facility is secured, there is no overall maximum leverage ratio (i.e., no maximum debt/EBITDA covenant); instead, there is a maximum first lien secured leverage ratio of 3.5 to 1 prior to December 31, 2017 and 3 to 1 after December 31, 2017, and (2) so long as the facility is secured, CHK must maintain a minimum interest coverage ratio (for all debt) of at least 1.1 to 1 prior to March 31, 2017, 1.15 to 1 prior to June 30, 2017, 1.2 to 1 prior to September 30, 2017 and 1.25 to 1 after September 30, 2017.

In addition, the amended facility permits up to $2 billion in second lien financing, a provision on which CHK is relying for the issuance of $1.5 billion in second lien notes in its proposed exchange offer.

Exchange Offer.  Earlier this month, CHK announced the commencement of private offers to eligible holders to exchange up to $1.5 billion of newly issued 8% senior secured second lien notes due 2022 for CHK’s outstanding (1) 6.25% euro-denominated senior notes due 2017, (2) 6.5% senior notes due 2017, (3) 7.25% senior notes due 2018, (4) floating rate senior notes due 2019, (5) 6.625% senior notes due 2020, (6) 6.875% senior notes due 2020, (7) 6.125% senior notes due 2021, (8) 5.375% senior notes due 2021, (9) 4.875% senior notes due 2022, and (10) 5.75% senior notes due 2023.

If the exchange offers are oversubscribed, the principal amount of each series of notes that is accepted is determined in accordance with stated “priority levels,” with notes with earlier maturity dates having higher priority levels and notes with later maturity dates have lower priority levels.  In addition, notes with earlier maturity dates receive a higher exchange price, while notes with later maturity dates receive a lower exchange price.  For example, the 6.25% euro-denominated senior notes due 2017 are offered 100 cents on the dollar if tendered by December 15 and 95 cents if tendered by December 31, and the 6.5% senior notes due 2017 are offered 97 cents (December 15) and 92 cents (December 31).  Conversely, the 5.75% senior notes due 2023 are offered 56.75 cents (December 15) and 51.75 cents (December 31).  CHK is incentivizing the tender of earlier maturities.

Projected Cash Flows and Covenant Compliance.

The projections are based on the following assumptions:

·         That CHK maintains flat production for 2016 and 2017.  Management states that capital expenditures of $2 billion per year are sufficient to maintain flat production.

·         That CHK achieves no further reduction in operating expenses.

·         That CHK realizes no additional capital efficiencies.

·         That CHK completes no asset sales through year end 2017.

·         That no 6.25% euro-denominated senior notes due 1/15/2017 are exchanged, and that 75% of the 6.5% senior notes due 8/15/2017, 75% of the 7.25% senior notes due 2018, and 67% of the floating rate senior notes due 2019 are exchanged.

For reference, consensus EBITDA estimates (per Reuters) are $2.393 billion for 2015, $1.779 billion for 2016, and $2.533 billion for 2017.

Cash Burn and Payment of Debt Maturities Through August 15, 2017.

It appears at first blush that there is not much cushion for the payment of the 6.5% notes in August 2015.  I believe, however, that the cushion is sufficient, for the following reasons:

·         The analysis assumes that none of the 6.25% euro-denominated notes are exchanged.  If, instead, 75% of the euro-denominated notes are exchanged, CHK will have $500 million in first lien credit facility capacity remaining after payment of the 6.5% notes in August, and will still have credit facility capacity remaining at year end 2017.

·         The analysis assumes that CHK completes no asset sales through 2017.  It is true that pricing for oil and gas assets is, to put it mildly, depressed.  Nonetheless, transactions are taking place and CHK does have assets to sell.  I believe it is reasonable to assume that, between now and August 2017, CHK can find $500 million to $1 billion of assets to sell.

·         Following the maturity of the 6.5% notes in August 15, 2017, CHK’s next maturity date will not occur until December 15, 2018.  In my view, CHK will exercise all available options to avoid defaulting on the 6.5% notes, seeking to buy time until December 2018.  This is especially probable since the outstanding principal amount of the 6.5% notes is likely to be relatively small.

Holding to Maturity is Preferable to Exchange Offer.  As stated in the introduction, I recommend that purchasers of the 6.5% notes do not exchange the notes for second lien notes.  The second lien notes are superior to the 6.5% notes only if CHK defaults on or before August 2017, something I believe to be unlikely.

In all other circumstances, the 6.5% notes are superior.  The notes are currently offered at $63.375.  If CHK avoids restructuring, the 6.5% notes provide a YTM of 38%, versus 18% for the second lien notes (assuming they are exchanged at the higher early tender price).  And if CHK restructures after 2017, holders of the 6.5% notes will have been paid at par in 2017, while holders of the second lien notes will be participating in a restructuring.

Redetermination of Borrowing Base.  The primary risk to the thesis is the possible redetermination of the borrowing base under the credit facility.  The borrowing base is currently $4 billion, and is based on the PV-9 of CHK’s proved reserves.

The first scheduled redetermination date is April 15, 2016.  Thereafter, the borrowing base is redetermined annually, on either June 15 or October 30 (I am not certain which date applies), and PV-9 is redetermined semi-annually, on June 15 and October 30.

As of September 30, 2015, CHK’s reported PV-10 was $7.138 billion.  CHK is projecting PV-10 to decline by at least $2.9 billion by year end, leaving a PV-10 of $4.238 billion at December 31, 2015.

PV-9 will of course be higher, and will be calculated on the lender’s price deck, which may result in the use of higher pricing.  Nonetheless, the cushion is not huge, and further sustained declines in energy prices could result in a reduced borrowing base, leading to an inability to use the facility to fully pay the 6.5% notes or to fund projected negative cash flow.

Bonus.  For those that can place the trade, I recommend the purchase of CHK’s 6.25% euro-denominated senior notes due January 15, 2017, and that purchasers not exchange these notes for second lien notes.  I believe it is reasonably certain that the 6.25% notes will be paid at par in January 2017.  Purchased at the current asking price of $70 provides a YTM of 44%.  Conversely, the second lien notes provide a YTM of 16% (assuming they are exchanged at the higher early tender price), with default risk post-2017.

For those looking for a place to park cash for the next three months, I recommend CHK’s 3.25% senior notes due March 15, 2016.  At $96, they provide a YTM of 20%.

Risks.

Redetermination of borrowing base.

Additional sustained decline in energy prices.

Equity-friendly actions taken at the expense of creditors.

Catalyst

Maturity of senior notes