Exerpt from May 1, 2012 Issue of the Powers Energy Investor
Far and away the most powerful company in the shale gas revolution of the past decade has been Chesapeake Energy. The company, led by charismatic CEO Aubrey McClendon, has been an early stage participant in virtually every major shale gas play in the U.S. currently under development. The company’s business model for capturing acreage in shale gas plays is very simple: once there is an inkling that a play might be commercial, pay top dollar for all available acreage, crank up the hype machine touting how the recent discovery is one of the biggest and most important fields in the world, attract a latecomer—usually a foreign operator that is new to the shale business—to chronically overpay for access to the exciting play (often through an upfront cash payment and drilling carry), rinse and repeat. The strategy works fantastically well as long as new discoveries continue to be made, gas prices remain at levels that at least hold out hope for a positive rate of return and there is an unending supply of fools willing to overpay for access to largely unproven acreage. Over the past year, however, CHK’s business model has broken down. The company’s shares continue to break to 52-week lows and the company has a funding issue—financial speak for the company is running out of money. While it was able to farm-out a portion of its Utica Shale assets in Ohio to France’s Total last year—this is remarkable given the accounting errors that resulted in Total receiving significantly less revenue from their Barnett Shale joint-venture—CHK has largely run out of prospective acreage to farm-out.
More recently, the revelation that McClendon has borrowed $1.1 billion over the past three years from a private equity group (EIG), also a lender to the company, to participate in its founder’s well program, has created quite a stir in the financial press. While I do not see anything outright illegal about one of Chesapeake’s financing sources lending to McClendon, the practice certainly calls into question CHK’s corporate governance policies. According to Bloomberg, the SEC has begun an informal investigation into the matter. Shareholders are furious over the indebtedness of the CEO to one of its lenders and analyst Phil Weiss of Argus Research—a longtime critic of the company who has had a ‘sell’ on the company for some time—has called for the firing of the McClendon and the replacement of board of directors (BOD). I find it unlikely that McClendon will get fired or the BOD will quit, but, given the numerous corporate governance issues that have plagued the company over the past five years (such as McClendon’s egregious pay package), I am certain the company’s upcoming annual meeting will be very interesting.
In this article I will take a hard look at the company’s reserve booking practices, its convoluted balance sheet, the practicality of its plan to become an oil-focused company and whether it can withstand today’s low natural gas price environment, which it played a big role in creating. Additionally, I will look at the outlook for the U.S. natural gas market over the next few years now that CHK is financially impaired, perhaps mortally. Lastly, I will look at the impact a potential bankruptcy of America’s second largest natural gas producer would have on supply and prices.
The best place to begin any analysis Chesapeake Energy is its balance sheet. According to the company’s 10-K filing, as of 12/31/2011, CHK had 15.5 tcf of proven natural gas reserves and 545.5 million barrels of oil or a total of 18.78 trillion cubic feet equivalent (tcfe). The reserves have a combined value of $19.8 billion when future production cash flows are discounted at 10 percent using 2011 average strip pricing of $4.12 per thousand cubic foot (mcf) and $95.97 per barrel before adjustments. (page 15 2011 10K) In other words, despite the company’s marketing efforts to fool the analyst community into thinking the company is becoming oil-focused, fully 82 percent of the company’s year-end 2011 proven reserves were natural gas. I assign no value to the company’s unproved reserves due to the highly speculative nature of much of its unproven acreage and its aggressiveness in booking proved reserves. Digging deeper into the make-up of the company’s reserves, we see that 8.7 tcfe of the company’s reserves, 46 percent, are classified as proven undeveloped reserves, or, as they are referred to within the industry, PUDs. As I document in my upcoming book, the PUD reserve category was completely bastardized following the SEC Oil and Gas Modernization Act which went into effect on December 31, 2009. Faced with huge reserve write-downs after the dramatic fall-off in gas prices in 2008, the shale gas industry heavily lobbied the SEC to move from allowing one PUD location for each producing well to allowing an unlimited number of PUD locations per producing wells, as long the PUD locations are drilled within the next five years using existing technology.
I have long viewed the Modernization Act as a way to allow shale gas operators to capitalize on the manufacturing model myth—all acreage is created equal and each well will produce similar results—that Art Berman and others have thoroughly discredited. In every shale gas play under development, we have seen outstanding wells drilled near poor wells or even dry holes. By allowing more than one PUD per offsetting developed location, the SEC allowed CHK and others to book far more proven reserves than prior to the change. In fact, the 2009 SEC Modernization Act came to be known within the industry as the “Petrohawk Act” since it allowed Petrohawk Energy, now part of BHP, to massively increase its proven reserves at the end of 2009. I believe the SEC did the investment community a huge disservice by changing the reserve booking rules before the manufacturing model was proven (which it never will be) since it muddied waters on the success of shale plays and allowed for the aggressive booking of proven reserves that are farther from a producing location.
But I digress. According to the CHK’s 10K, for the company to convert a portion of its already booked 8.7 tcfe of PUD reserves into proven developed producing (PDP) locations within the 5-year limit, it has stated that it intends to spend $2.3 billion in 2012 and $2.5 billion in 2013. In other words, the company must spend $2.3 billion this year or in all likelihood it will be forced to take a proven reserve write down. It should be noted that PUD conversion drilling is not the only drilling that will be required for the company to continue as a going concern. CHK also must continue to drill thousands of wells into its recently acquired leaseholds prior to expiry to keep the leases in good standing over the next few years.
A second reason CHK may be faced with severe financial distress in the near future is its substantial debt load and other immediate financial obligations. According to page 115 of the company’s 10K report, CHK had $11.1 billion in debt of which $1.7 billion was a revolving line of credit. I arrived at this figure by adding back the $490 million discount on its senior notes, that were trading below par at year-end, to the company’s 2011 year-end debt balance of $10.6 billion. Additionally, as of the end of last year, the company had $3 billion in convertible preferred stock with a 5.75 percent coupon. To top is all off, the 10 volumetric production payments or VPPs (a financial transaction where CHK receives funds upfront and the counterparty receives gas production over a period of time) the company has entered into since 2007, that have generated $6.4 billion for the company, are also a form of debt (link). It should be noted that CHK is responsible for all costs associated with the delivery of the production for its VPPs (see page 33 of 2011 10K). When the off-balance sheet debt (i.e. VPPs) and preferred issues are added to the company’s existing $11.1 billion of on-balance sheet debt, CHK’s has a whopping $20.5 billion of financial obligations.
Given such a high level of indebtedness, CHK debt is rated junk and will be for the foreseeable future. According to a note put out by Moody’s analysts Peter Speer and Stephen Wood in February, for the company to qualify for an upgrade from its current status of Ba2 to Ba1, the highest non-investment grade level, the company would have to improve its liquidity levels materially and reduce its reliance on assets sales. Reducing its reliance on asset sales is unlikely since they have been an integral part of the company’s strategy for years. I also see little prospect for the company to increase its liquidity.
Additionally, the company’s credit default swaps (CDS)—the coalmine canary of every highly leveraged company—recently touched their highest level since October 2009. It now costs approximately 500 basis points per year to insure CHK debt (link).
On the surface, it would not appear that a company with 18.8 tcfe of proven reserves with a PV10 value of nearly $20 billion and $20 billion in debt is in danger of bankruptcy. However, Chesapeake’s financial problems center around the gap between the amount it will need to spend to grow its oil production, meet interest and dividend payments, hold its leased but undrilled acreage and funds it will generate this year from operations, selling additional debt and equity, and asset sales. Several analysts have termed the difference in available funds and funds coming from cash flow and asset sales as the “funding gap”. Let’s take a closer look at the funding gap since it is central to the discussion of the company’s solvency.
According to the company’s April presentation and its 2011 10K, CHK is likely to spend money on the following during 2012 (when ranges were given I used the midpoint):
Development Drilling: $6.25 billion
Exploration Drilling: $1 billion
Land Acquisition: $1.4 billion
Mid-Stream Build out: $3 billion
Interest & Dividends: $1.13 billion
General and Admin.: $500 million
Total Cash Outflow: $13.28 billion
Below are what I believe are reasonable assumptions on the amount of cash the company is likely to generate in 2012:
Cash from Oil and Gas Production: $4 billion
Asset Sales: $6 billion
Total Cash Inflow: $10 billion
2012 Cash Shortfall ~$3 billion
While CHK management has projected the company will generate between $4.5 and $5.2 billion in operating cash flow, I see the company’s cash flow expectations as overly optimistic. Fully 75 percent of 2012 production is expected to be natural gas that is nearly completely unhedged and selling at approximately $2 per mcf currently. According to the company’s April presentation, the company assumes it will be able to grow its average daily liquids production from approximately 86,000 barrels a day to 150,000 barrels per day in 2012. Growing average liquids production 57 percent over the course of a year is not going to be easy given the high decline rate—over 50 percent on recently drilled wells—on virtually all of its liquids production. I believe a more realistic average production rate would be 130,000 barrels of liquids per day. This rate of liquids production would generate approximately $2.37 billion of cash flow (Assuming $50 per barrel netbacks). Funds from its gas production and its mid-stream assets will generate approximately $1.3 billion in cash this year.
The $64,000 question surrounding CHK is its ability to monetize additional assets. While the company has already sold off $2.6 billion of Mid-Continent assets in 2012, CHK has a long way to go to reach its goal of between $8 to $10 billion in asset sales. To achieve this, the company plans to sell outright its Permian Basin assets where it has 1.5 million acres and joint venture its Mississippi Lime play that straddles the Kansas/Oklahoma border where it has 2 million acres. While I have not seen the marketing books for either of these assets, I find it unlikely that the properties will meet the company’s sale expectations, given the early stage nature of the Mississippi Lime play and the low quality and high abandonment liabilities of the Permian assets.
While CHK’s material funding gap in 2012 will likely be met through the sale of additional debt securities, a further draw down on its line of credit or the sale of more preferred shares, the company is a long way from solid financial footing. There are several catalysts that could send the company into a tailspin. For example, should oil prices drop to $80 a barrel for any length of time before natural gas prices rebound to more than $4 per mcf, the company will be in severe financial distress. Additionally, should borrowing costs rise to unmanageable levels or lenders simply refuse to lend at any price, CHK will be forced into restructuring.
It is difficult to overstate the impact Chesapeake’s financial problems will have on the North American natural industry over the next few years. Given that the company has not been able generate free cash flow (cash flow from operations minus capex) in the decade it spent chasing shale gas plays and is now spending additional billions on oil development, it is not unreasonable to expect to see a material drop (up to 50 percent) in the company’s natural gas production by the beginning of 2014. Given that the company is expecting a 32 percent decline rate on its existing properties in 2012 and a further 20 percent drop in 2013 (page 14 2011 10K) and more than 85 percent of its development spending in 2012/2013 will be on liquids projects (page 15 April presentation), look for the company’s gross operated gas production to drop from 6.3 bcf/d (3.27 net) in 2011 to approximately 3.5 bcf/d gross (1.85 net) by the beginning of 2014. With many of the best locations in its Barnett, Haynesville and Marcellus gas plays already drilled and the need to spend virtually all of its available capital (as well as some it does not have) over the next three years to hold recently acquired oil leases, there is no scenario where the company will ever produce as much gas as it did in 2011.
Having America’s second largest natural gas producer as well as its most reckless destroyer of shareholder capital almost completely walk away from the shale gas business is a great indication that today’s natural gas price bubble is on the verge of popping. CHK has not made any money by drilling shale wells—and neither have virtually any of its peers—and now the dumb money has run out. This means the re-balancing of North American natural gas storage is going to accelerate and natural gas prices will head much higher. Other analysts are now starting to see the how unsustainable current prices are. JP Morgan analyst Joe Allman recently predicted in a note to clients that U.S. prices could hit $4 per mcf by November 2012 due to a massive reduction in capital spending.
Though investors in natural gas focused companies have been through a very difficult period over the past couple of years, the opportunities to invest in high quality gas producers have never been better. The investment community saw both Ultra Petroleum and Southwestern Energy, two of the lowest cost and best-positioned gas producers in North America, as darling stocks only a few years ago. Both companies have great management teams, project inventories and return on capital employed. Now, both are trading near multi-year lows though they have the same management teams, lowered their costs and added to their prospect inventories. Yet nobody cares. This is how markets work. However, eventually somebody will care and the hardened survivors of the natural gas bubble will provide spectacular returns for investors willing to position themselves in these contrarian plays.
Recently uber investor Jeff Gundlach of DoubleLine Funds likened natural gas to gold in 1997. Gold got crushed in 1997, due largely to the Bre-X scandal and the world’s infatuation with tech stocks, and proceeded to have two more bad years until finally bottoming in 2000. Gold has been up 11 straight years since. Natural gas prices peaked in 2008 and have had three very poor years. It now appears gas is poised for a long and profitable rally.