Chesapeake Energy: Drilling Its Way Out or Selling Off Assets?

The business and political news in Washington for the past few days has been the huge trading losses incurred by the banking investment giant JP Morgan Chase. How could this happen? Why did it happen? Who will take the blame? Of course, in Washington, the issue is what is the role of government to regulate business behavior? Interesting stuff. However, there in a better story out there. It involves Chesapeake Energy, the second largest natural gas producer in the country.

By way of background, Chesapeake Energy Corporation headquartered in Oklahoma City is a natural gas and oil exploration and production company. It also provides substantial marketing, midstream, drilling and other oilfield services. As of December 31, 2011, the Company owned interests in approximately 45,700 producing natural gas and oil wells producing around 3.5 billion cubic feet of natural gas equivalent per day, net to its interest. That is a lot of hydrocarbons.

 The sharp drop in natural gas prices have put Chesapeake in a squeeze and have led the company to pile up debt, with long-term liabilities of $13 billion used to finance a flurry of land acquisition and drilling.

 

 The company’s stock, which has lost about half its value over the last year, continues to drop, down about 6 percent again to today at abound $14.50 per share

CHK Price Range, Past 5 Years

Minimum	11.32	Dec 5 2008
Maximum	69.40	Jul 2 2008
Average	29.35

 Exploration of oil and gas is quite capital intensive. It requires money to do the geophysical and geological work, money to buy acreage and drilling and completion of the wells. Of course, there is risk involved as not every well spud contains recoverable economical quanities of hydrocarbon. If a well can produce, there is a waiting time to lay pipeline and, of course, the price of the commodity is subject to the vulgarities of the market. It can take years to recover investment from cash flow.

In order to finance operations-because of the delay and the amount of cash flow need to continue expansion-companies will often borrow against the reserves discovered in the ground. The borrowings are usually plowed back into exploration.  This is done to create new reserves and to replace producing reserves that are being depleted.

Problems occur when the merry-go-round of drilling, borrowing and cash flow from operations get out of sync. For example, poor drilling results can mean reserves are not replaced which diminishes the reserve base used as collateral. Since the values of reserves are based on prices of the underlying asset, price drops can cut the borrowing base.

More problems occur when drilling get too far ahead of cash flow and supporting the borrowing base. Banks and investors will and can only loan so much based on the collateral reserves. This was a frequent issue during the 1980’s as exemplified by Penn Square Bank, Continental Illinois Bank and others who made awful and even fraudulent lending decisions to dubious companies based on trumped up and non-existent reserves.

When it all goes bad and the squeeze is on, companies often want or must sell their reserves. More money to keep drilling.  The sale diminishes the reserve based and the vicious cycle can get out of hand, a spiral downward. This is what may be happening to Chesapeake. 

The company announced it is raising a new $3 billion unsecured bridge loan aimed at buying time in order for them to sell valuable assets. That is a red flag to me, and the market seems to confirm it. I have no special knowledge of their situation but I have seen this before and once a company gets too far out of cash flow, tries to drill its way out of a financial bind, faces a depressed commodity market and then has to sell assets, it can end up messy.

In addition to the asset sales, it has been disclosed by the company that Chesapeake sold a 10-year volumetric production payment, or V.P.P., which requires it to deliver natural gas at a future date in exchange for cash upfront. Creative but again a red flag.

Chesapeake Energy has been a very successful company and a pioneer in shale and other tight sand gas exploration. It has also been financially aggressive but now is facing divesting itself of the very assets it needs to support its activities. I would be very cautious here but when the gas prices come back, Chesapeake will be in a position to benefit if it can maintain its producing base.