Will Financial Discipline Help This Energy Company?

Chesapeake Energy is fighting an uphill battle to get rid of its massive debt while growing its production.

Vladimir Zernov
Vladimir Zernov
Nov 12, 2013 at 1:24PM
Energy, Materials, and Utilities

After amassing a very large debt position, Chesapeake Energy (NYSE:CHK) decided it was time to be conservative. Chesapeake began to cut its leverage by selling some of its assets. In addition to that, the company focused on growing its oil production, as natural gas prices remained low. These measures helped Chesapeake gain as much as 57% this year. However, the future of the company is still unclear.

Oil production will fall in the fourth quarter
Chesapeake stated that it expects fourth quarter oil production to drop by 9,000 barrels a day. As growing oil production was one of the main sources of investor confidence, this announcement was not a positive for the company.

Chesapeake mentioned several reasons for this drop. First, the company stated that third-quarter production in the Eagle Ford was above the normal rate. Second, several oil-producing assets were sold. Third, heavy rains in South Texas in October affected Eagle Ford production rates.

Less oil production is clearly bad for Chesapeake. The market favors liquids-rich players like EOG Resources (NYSE:EOG), which is the largest leaseholder in the Eagle Ford with 639,000 net acres. EOG is also the largest Eagle Ford producer with 460 net wells. What's important given the low natural gas prices, oil is 78% of EOG's total production. Despite the fact that EOG is up 42% this year, it still trades at a decent 18x forward P/E.

Chesapeake might be willing to follow the path of Cabot Oil & Gas (NYSE:COG), which complements its 200,000 net acres dry gas position in the Marcellus Shale with 62,000 net acres in the Eagle Ford. Cabot added a second rig to its Eagle Ford program in August.

The debt problem remains
Now let's turn to Chesapeake's main problem – its $12.7 billion debt. The company sold assets for $4.2 billion so far this year, but it will have to sell more. Chesapeake boasts that it has $5.2 billion of liquidity, but if we dig deeper, we find that $4.2 billion of this liquidity consists of undrawn credit revolvers.

The company is sure it will not have to engage in any kind of a fire sale of its assets. However, Chesapeake will have to pay $1.66 billion of debt as soon as 2015. This payment will be followed by a $500 million payment in 2016 and a huge $4.3 billion payment in 2017.

I think that it's the 2017 payment that investors should focus on. Time is running out fast, and, currently, Chesapeake does not have an investment grade rating. This means higher rates should the company choose to refinance its debt.

Chesapeake states that it does not have to issue new equity. The most important point is the fact that it does not have to do it now. Share dilution is almost always bad news if the proceeds are going toward debt repayment instead of growth projects.

Bottom line
Chesapeake trades at a reasonably attractive 12x forward P/E, but the company has significant long-term risks. Recent developments were good, but they might be already priced in. It will be a difficult task to grow production when the company has to sell assets. The situation with production at the Eagle Ford is an example of such risk. Investors should also keep in mind the possibility of share dilution.

All in all, I believe that Chesapeake must demonstrate more improvements to become a conviction buy.