This year has been another challenging one for Chesapeake Energy ( CHKA.Q ). Shares of the energy company have plummeted more than 70% due to the continued turbulence in the oil and gas market. That's causing concerns that the company might not be able to keep managing its hefty debt load in the coming year.
Those worries have forced the company to shift its strategy for 2020, which was one of the key themes on its third-quarter conference call. Here's a look at why Chesapeake believes its new plan is the right one, given the current weakness in the oil and gas market.
Taking its foot off the gas
Chesapeake Energy initially offered its preliminary view for 2020 when it reported its second-quarter results in early August. At the time, the company expected that it would keep capital spending flat with 2019's range of $2.1 billion to $2.3 billion. That investment level would enable it to grow its oil production at a double-digit rate while its gas output would decline by a similar percentage. Earnings, meanwhile, would be about flat with 2019's level given where it expected oil and gas prices to be next year.
A lot, however, has changed since Chesapeake offered its initial view for next year. With oil and gas prices weakening, the company has had no choice but to adjust its spending plans for next year, which CEO Doug Lawler outlined on the third-quarter call. He stated:
Due to lower commodity prices, we have updated our 2020 forecast to reflect an approximate 30% reduction in our drilling and completion activity. ... We currently anticipate delivering flat oil production while utilizing 10 rigs to 13 rigs and project between $1.3 billion to $1.6 billion in total capital expenditures. We will continue directing the majority of our capital to our highest-margin oil assets, and our capital spend will ultimately be determined by commodity prices in 2020. Additionally, we expect to reduce our production and G&A related expenses by approximately 10%, continuing our track record of cash cost leadership. We believe this capital program, along with our strong projected finish to 2019 and continued capital efficiency improvements, will position us to target free cash flow in 2020.
As Lawler points out, Chesapeake has reduced its 2020 capital spending outlook by 30%. That's just enough money to keep its oil production flat, though its overall output will fall because it still expects a double-digit decline in its gas volumes.
One of the benefits of cutting spending next year is that it will enable Chesapeake to generate free cash flow. That's something the company hasn't done over the years as it has typically outspent cash flow to fuel growth. This approach has caused debt to pile up on its balance sheet.
The pressure is on to improve the balance sheet
By targeting to produce free cash flow next year, Chesapeake will have more financial flexibility to reduce debt. That's becoming an increasing priority for the company. Lawler noted on the call that the company is "fully aligned and focused on our strategic priorities of delivering higher margins, sustainable free cash flow, and further deleveraging our balance sheet to achieve a net debt-to-EBITDA ratio of two times." However, he also stated that "the volatile commodity price environment has pressured the speed and timing of accomplishing these goals." That's because the company's leverage ratio is getting dangerously close to hitting one of its financial covenants, given where oil and gas prices are currently projected to be next year.
Because of that, Chesapeake is not only cutting spending to free up some cash flow to reduce debt, but also exploring other ways to improve its balance sheet. CFO Nick Dell'Osso stated on the call:
We've been keenly focused on absolute debt reduction, and we've made great strides. We expect to continue to make strides using all the same levers that we have, cost discipline in all aspects of our business, asset sales, hedging prices as they rise, capital markets transactions, and of course, working very closely with our bank group, which we do on a regular basis. We could go out and seek a waiver at any time from our bank group, but at the moment we continue to be focused on the strategic levers that result in permanent debt reduction.
As the CFO notes, while the company could ask its lenders to ease its leverage covenant for 2020, its current focus is on permanently reducing its debt level. It has done that in the past through exchange transactions and asset sales, which is a trend it expects will continue in the coming year. It's already reportedly in advanced talks to sell its Haynesville shale assets for as much as $1 billion. That would go a long way to easing its near-term debt concerns, as a sale in that neighborhood could eliminate more than 10% of its total debt.
Expect another volatile year
Chesapeake Energy's stock has cratered this year due to concerns that weaker oil and gas prices could cause it to fall out of compliance with its lenders. The company, however, is working quickly to adjust and get out ahead of this potential issue. Not only is it cutting spending next year, but it's also looking at selling additional assets. Because of that, the company believes it can stay afloat. However, given its current challenges, next year will likely be another volatile one for its shares, which is why investors shouldn't buy Chesapeake's stock in hopes of a bounce-back in 2020.