Chesapeake Energy’s New Plan: Desperate Measures For Desperate Times

This article is available online at:
http://www.forbes.com/sites/christopherhelman/2012/02/13/chesapeake-energys-new-plan-desperate-measures-for-desperate-times/

This morning Chesapeake Energy announced a new financial plan that it hopes will allow it to raise the billions in cash it needs to keep drilling while still being able to pay interest on its $10 billion mountain of debt.

The company says it aims to raise $2 billion by spinning off assets from its service company and pipeline division. It expects another $2 billion from upfront sales of future flows from gas fields. And it earmarks another $6 billion or so from the sale of its largely undeveloped acreage in the oil-rich Permian basin. And for good measure, it will raise another $1 billion by issuing more senior debt. The $10-12 billion it hopes to raise is “substantially in excess of the difference between the company’s expected cash flow from operations and its planned capital expenditures.” Gosh I should hope so. Analyst Arun Jayaram at Credit Suisse pegs Chesapeake’s 2012 cash hole at $6 billion.

But with natural gas prices already at decade-long lows and set to go even lower in the months ahead, there’s no telling whether even Aubrey McClendon’s legendary financial finagling will be able to save the day.

Desperate times call for desperate measures.

Chesapeake Energy is in a bind. It’s the second-biggest natural gas producer in the country after ExxonMobil. But with natgas prices having fallen to their lowest levels in a decade ($2.40 per thousands cubic feet), Chesapeake isn’t generating enough cash.

Chesapeake has curtailed its drilling in some plays, and in January said it would shut in production of marginal gas fields. But the company has $10 billion in debt to service and is obligated to keep drilling wells on newer oil and gas leases in order to hold the land. Over the course of 2012, if gas prices were to stay where they are now, Chesapeake would face a cash shortfall of several billion dollars.

A gift for financial engineering is part of the genius of Chesapeake Energy Chief Aubrey McClendon. For years he has driven Chesapeake hard and fast to gobble up oil and gas acreage across the country. To keep his land machine running, McClendon has continuously raised more cash from joint ventures, spin offs and by issuing debt. This wouldn’t have been a problem if gas prices just cooperated by staying around $5 or $6 per thousand cubic feet. Yet Chesapeake and other drillers have found so much new gas that what used to look like a bonanza has now turned into a glut.

A couple years ago McClendon redirected Chesapeake to focus on oily, liquids-rich plays. First the Eagle Ford shale, then newer areas like the Mississippi Lime and Permian Basin. The idea was that while gas prices were low, the cash flow from the higher-value liquids would be enough to keep Chesapeake solvent.

It was a good idea, but not good enough. Before Chesapeake can start milking cash out of the liquids-rich fields it has to invest cash to drill wells. Cash it doesn’t have.

So what to think of Chesapeake’s plan? It starts with the creation of a “volumetric production payment” structure tied to its Texas Panhandle Granite Wash fields. These VPPs are a convoluted, but not unusual, structure whereby Chesapeake receives cash upfront (about $1 billion in this case) in exchange for delivering future volumes of oil and gas from the designated fields. Chesapeake insists that generally accepted accounting principles allow them to record these VPPs as a sale of assets, and they point out that investors in these VPPs have no recourse to the company if hoped-for production doesn’t pan out. But for all intents and purposes it’s like issuing debt that needs to be repaid in oil and gas instead of cash. Also, by selling these future flows at a time of record low gas prices, Chesapeake could end up leaving a lot of money on the table when/if gas prices were to rise in the future.

Then there’s the plan to create a new subsidiary to hold some assets in the Cleveland and Tonkawa plays of Oklahoma. Chesapeake plans to issue perpetual preferred shares (roughly $1 billion) tied to this acreage, and use the proceeds to develop it. The company recently did this same thing in the hot new Utica shale play of Ohio. Analyst Bob Brackett of Sanford Bernstein believes that both the VPP’s and the preferred shares tied to the new subsidiary should be viewed as debt because they tie the company into new long-term obligations, even though they won’t show up as debt on the balance sheet.

The next move involves selling joint venture stakes in the Mississippi Lime and Permian Basin plays of Kansas and Texas. These are areas that McClendon gobbled up acreage in to much fanfare in recent years because the reserves there contain far more oil. These were supposed to be long-term cash cows that balanced out uneconomic dry gas fields. Now Chesapeake says it would even consider a sale of its entire Permian position (which it thinks could fetch upwards of $5 billion).

A likely buyer is cash-rich BHP Billiton (which last year paid $4.75 billion for Chesapeake’s Fayetteville shale position), and which acquired a bunch of Permian acreage in its $15 billion buyout of Petrohawk Energy last year. CEO Mike Yeager told me recently that he’s looking at acquiring more acreage in the Permian.

For another couple billion, McClendon has said he intends to spin out Chesapeake’s drilling and oilfield services division as a standalone public company, and aims to drop down more pipeline assets into publicly traded Chesapeake Midstream MLP.

Lastly, there’s the intention of issuing another $1 billion in senior notes, which Chesapeake says will be used “to refinance or partially refinance” some of its $10 billion in debt.

Brackett is not impressed with the plan. As mentioned before, he sees the VPP and the preferred shares as just more debt with a different name stuffed in off-balance sheet pockets. The sales of oil-rich assets, meanwhile, would dramatically overturn McClendon’s stated efforts to more away from an overwhelming focus on gas. “This response is not a winning combination in our view,” writes Brackett, who instead perfers less indebted and more oily operators like EOG Resources.

Analyst Jayaram of Credit Suisse notes that big gaps between cash flow and required spending are nothing new for Chesapeake. The funding gaps amounted to $5 billion in 2007, $12 billion in 2008, about $4 billion in 2009, and more than $6 billion this year. So far McClendon has found ways to make ends meet while keeping hope alive that some day the price of natgas will turn around.

Over the years he has sold JV stakes and entire acreage chunks to the likes of Statoil, Total, Cnooc, Plains, BP, BHP Billiton and more.

At least some of them will be willing to invest again. In an interview this morning Blair Thomas, chief executive of private equity group EIG Global Energy Partners (which bought $500 million in preferred shares tied to Chesapeake’s recent Utica shale spin off) told me, “We hope to do more with them in the future.”

Of Chesapeake’s new plan, Thomas said, “It’s an ambitious agenda. But [McClendon] is one of the most remarkable value creators in the oil and gas sphere. People underestimate him at their peril.”

That said, Thomas doesn’t think the worst is over for natural gas drillers. Considering all the additional drilling that needs to be done to hold recently leased acreage, he thinks natural gas will go to $2. “We think there will be a nice opportunity in the the U.S. in the next 12 to 18 months to pick up assets on the cheap,” he says.

That means McClendon still has a lot of rabbits to pull out of his hat.

Chesapeake (CHK) shares were up 1.85% at midday, but are down 28% in six months.

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