Will The Delay In Chesapeake Key Targets Risk Its Survival?

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Chesapeake Energy

Having pleased the market with its solid performance in the March quarter, Chesapeake Energy (NYSE:CHK) is in for a tough time ahead. While the US-based independent oil and gas company has made a remarkable progress in improving its deteriorating cash flow position and highly skewed balance sheet since last year, its latest annual shareholder meeting has left the investors disappointed and doubting its speedy recovery. At last week’s meeting, the management hinted at a slower improvement in its financial health, when it shifted the target of attaining cash flow neutrality in 2018 to 2020. In addition to this, earlier this year, Chesapeake had increased the lower range of its capital expenditure guidance, and maintained an aggressive production growth plan. In an environment where there is still uncertainty regarding the reversal of commodity prices, these targets are likely to prove to be detrimental rather than augment the company’s comeback. In this note, we briefly discuss each of these moves and their possible implications on the company.

See Our Complete Analysis For Chesapeake Energy Here

Chesapeake’s New Targets For 2020

CHK-outline-2

Source: Chesapeake’s Annual Shareholder Meeting, May 2017

Aggressive Production Targets And Increased CapEx To Weigh On Cash Flows
In anticipation of the recovery of the commodity markets, Chesapeake had announced its plans to grow its oil production by around 10% in 2017, and by 20% in the subsequent year. Overall, the company targets to expand its hydrocarbon production (adjusted for asset sales) by roughly 7% in the current fiscal, and 10%-15% in the following four quarters, driven by its assets Eagle Ford, Mid-Continent, and the Powder River Basin. In order to achieve these growth targets, the US-based company announced a capital budget of $1.9-$2.5 billion for the full year, which it recently increased to $2.1-$2.5 billion. Although an aggressive production and capital spending plan can provide an upside in a strong pricing environment, it is likely to further pull down the company’s profitability and cash flows in the current weak price environment.
Further, since the company’s cash flow position continues to be weak, it aims to use most of its divestment proceeds to repay its long term debt. This increases the possibility that the company might have to raise additional debt to meet its capital allocation plans. Raising more debt with an already highly levered balance sheet could prove to be taxing for the company, and is likely to weigh on its cash flows.

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Refinancing Debt To Delay Maturity 

In order to cope with the ongoing commodity downturn, Chesapeake has been working towards improving its highly levered capital structure. Over the last few quarters, the oil and gas producer has reduced its long term debt from $10.3 billion at the end of 2015 to $9.5 billion in the first quarter of 2017, using either the proceeds of its asset sales or by refinancing its debt at attractive rates. Given the success of this strategy, the company recently announced the private placement of $750 million of 8% senior notes due in 2027, which it plans to utilize to pare down its outstanding debt due in the 2020-2022 timeframe.

Although the move appears to be in line with its previous strategy, the terms of the proposed swap are far more unattractive than the previous issues. For instance, Chesapeake is replacing its debt due beyond 2020 with senior notes that bear an interest obligation of 8%. Firstly, the deal will only defer the maturity of its obligations, and not reduce the overall debt from the company’s balance sheet. Secondly, it is expected to increase the company’s annual interest expense notably, as cheaper debt is being replaced by expensive debt. This is likely to weigh on the company’s bottom line over the next few years. Finally, the company is redeeming some of its debt at a sizeable premium, implying that it will be able to pay down a lower amount of debt compared to what it will raise through the issue, which will marginally increase its debt.

Chesapeake’s Debt Schedule

CHK-outline-1

Thus, we figure that even though Chesapeake has managed to extend the maturity of its debt beyond this decade, it will be a strenuous task to retire $2-$3 billion of its debt and achieve its target of 2x Net Debt-to-EBITDA ratio by 2020. This is because the company has to rely on asset sales to repay its debt obligations, and there is a limited amount of assets that it can divest to maintain stable operations. Plus, the company has set a high capital spending plan for 2017 and beyond in order to meet its audacious production growth targets. Given the paucity of funds, the company might have to raise incremental debt to fund its capital requirements, which is likely to make it difficult for the company to achieve its targeted Net Debt-to-EBITDA ratio in the next couple of years.

Expansion Of Common Share Base Could Improve Liquidity

In the last week’s shareholder meeting, Chesapeake’s Board approved the expansion of its authorized share capital by $2 billion. This implies that the company is looking to dilute its shareholders’ equity with an aim to improve its liquidity. Expansion of the company’s shareholder base will provide the company an easier and much more effective way of correcting its excessively levered capital structure. To put things in perspective, the oil and gas player had a debt-to-capital ratio of around 40% in 2014, when the commodity slowdown began. At present, this ratio has shot up to nearly 115%, largely because of the company’s dwindling shareholders equity.

CHK-outline

Source: Google Finance; US Energy Information Administration (EIA)

Considering the weak cash flow position, this move will allow Chesapeake to raise additional funds to fulfill its capital needs, and prevent it from borrowing money in the form of debt. This would help the company to keep its long term debt under control, and achieve its leverage targets by 2020. The only caveat to the success of this move is the steady recovery of commodity prices over the next few months, so that Chesapeake is able to raise enough money through share issue, and reinstate investor confidence in its ability to survive the commodity slump.
In a nutshell, being an exploration and production (E&P) company, Chesapeake’s value, both present and future, is tied closely to oil and gas prices. Thus, none of its strategies are likely to work unless they are backed with the strengthening of the commodity markets.

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