Is It The Beginning Of Another Fall For Chesapeake Energy?

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Chesapeake Energy

Chesapeake Energy (NYSE:CHK), the second largest natural gas producer in the US, has been struggling to keep up with the commodity downturn over the last two years. The company’s stock, which traded at over $30 per share in mid-2014, touched a multi-year low of $1.59 per share in early 2016, when the crude oil prices slipped to under $30 per barrel. At that point, the company’s cash flows were declining, while the company had a large amount of debt on its books, which made investors understandably anxious. Although the oil and gas company made a drastic comeback in the latter half of 2016 by reducing its operating costs and refinancing its debt obligations, it appears to be facing some headwinds again. Apart from a disappointing performance in the December quarter of 2016, below we discuss some of the factors that we expect to put pressure on the company’s performance in the coming quarters.

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Increased CapEx To Weigh On Chesapeake’s Cash Flows 

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One of the key strategies that worked for Chesapeake in 2016 was the notable drop in its capital spending for the year. The company reduced its capital expenditures from $3.5 billion in 2015 to around $1.7 billion in 2016, a decline of more than 50% from the previous year. Since most of the capital expenditures were funded from the company’s asset sales, this reduction allowed the company to improve its liquidity. However, the anticipated recovery in oil prices, driven by the OPEC’s production cuts, led Chesapeake to reverse its capital allocation strategy for 2017. The company announced a capital budget of $1.9-$2.5 billion for the current fiscal year in order to support its optimistic production plans (discussed later).

Now, this move could have worked for the company, if the dynamics of the oil and gas market played out as predicted. Unfortunately, the spike in oil prices that began in December 2016 came to an end recently, as the commodity markets became volatile driven by the rise in US oil inventories and production. Further, the expected reaction of the OPEC members to the growing U.S. output caused further turbulence in the commodity markets, causing oil prices to slide from around $55 per barrel to under $50 per barrel again. Thus, the company’s plan to spend more than the last year in the current uncertain oil price environment could weigh on its already vulnerable cash flows and debt position.

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Delay In Achieving Its Net Debt-to-EBITDA Target By 2020

Due to the plummeting commodity prices, Chesapeake’s debt-to-total capital ratio went up from 38% in 2014 to over 80% in 2015. Also, the company’s Net Debt-to-EBITDA rose to more than 5x in 2015. Chesapeake aimed to bring this ratio down to 2x by 2020, by reducing or refinancing its long-term debt obligations. While the company’s persistent efforts helped it to bring down its debt number marginally in 2016, its deteriorating profitability has led to the erosion of its shareholder equity. Thus, the company’s books remain heavily skewed towards debt.

As the outlook of the commodity markets is uncertain, we expect Chesapeake’s profitability to remain relatively weak in 2017 and 2018. According to our estimates, the company’s EBITDA margin for its E&P operations will drop from 57% in 2016 to 42% in 2017. With lower profits, we believe that it will be difficult for the company to execute its capital spending plans for the year without raising additional debt. Raising more debt with an already highly levered balance sheet could be strenuous for the company. Further, if Chesapeake has to bring in new debt to finance its capital needs, it will become difficult for the company to achieve its target of 2x Net Debt-to-EBITDA ratio by 2020.

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Difficulty To Meet Its Production Growth Targets 

In 2016, Chesapeake’s overall production (excluding asset sales) stood at 232 million barrels of oil equivalent (BOE), which is roughly 7% lower compared to the previous year. In fact, the company’s crude oil production for the year dropped more than 21% to only 33 million barrels. Despite this sharp plunge in its output, the company aims to grow its oil production by approximately 10% in 2017, and by another 20% between 2017 and 2018.

Chesapeake’s production growth targets made sense considering the rally in oil prices backed by OPEC’s production cuts. However, as mentioned earlier, the situation has changed over the last month. With the increased volatility in the commodity markets and insufficient cash flows to finance the production growth, the company’s production plans may not be as easy to achieve.

Thus, we believe that the decision to increase its 2017 capital expenditure budget could weigh heavily on Chesapeake’s balance sheet, pulling down its valuation. It will take considerable efforts for the company to withstand the commodity slowdown and get things back on track.

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