TEXT-S&P cuts Chesapeake Energy Corp. to 'BB-';otlk neg

Tue May 15, 2012 9:49am EDT

Our issue-level rating on Chesapeake's senior unsecured notes is 'BB-' (the same as the corporate credit rating on the company). The recovery rating is '3', which indicates our expectation for meaningful (50% to 70%) recovery in the event of a payment default.

Rationale

The downgrade reflects mounting turmoil stemming from revelations that underscore shortcomings in Chesapeake's corporate governance practices, covenant concerns, and the likelihood Chesapeake will face an even wider gap between its operating cash flow and planned capital expenditures than we had previously anticipated.

Chesapeake's financial performance during the quarter ended March 31, 2012, was very weak, hurt by not only depressed natural gas prices but also lower natural gas liquids prices and wider market price discounts in certain regions. Moreover, in conjunction with its first-quarter earnings announcement, Chesapeake lowered its guidance for liquids production during 2012-2013 to reflect the impact of various asset monetization transactions on production. At the same time, the company increased its guidance for capital spending in 2012 to $11.6 billion to $13.1 billion from the previously indicated $10.9 billion to $12.4 billion, although it has lowered its spending plans for 2013 to a still-daunting $9 billion to $10 billion. (This guidance encompasses well costs on proved and unproved properties, acquisition of unproved properties, and investment in oilfield services and midstream assets.) Based on our estimates and price deck assumptions (including natural gas price of $2.00 per British Thermal Unit in 2012, $2.75 in 2013, and $3.50 thereafter), we expect Chesapeake's negative free cash flow to total over $16 billion during 2012 and 2013.

Moreover, since April 26, 2012, when Standard & Poor's lowered the ratings on Chesapeake to 'BB' from 'BB+' and placed the ratings on CreditWatch with negative implications, there has been a series of additional revelations about personal transactions undertaken by Chesapeake's CEO, Aubrey McClendon, that pose potential conflicts of interest. For example, it has been reported in the media that Mr. McClendon co-headed a hedge fund that operated during 2004 to 2008 and took positions in commodities produced by Chesapeake.

On April 26, the company announced that its board of directors is reviewing financing arrangements between Mr. McClendon and any third party that has had a relationship with the company in any capacity--reversing its prior stance that the board was not responsible for reviewing personal transactions of Mr. McClendon. However, the willingness of the board to act independently of management is still unclear. Although the board and Mr. McClendon announced on May 1 an agreement to terminate the controversial and unusual Founder Well Participation Program (FWPP), the termination is not effective until June 30, 2014. Under the FWPP, Mr. McClendon can, before the beginning of each year, elect to take a working interest (up to 2.5%, subject to certain restrictions) in all of the wells Chesapeake drills during that year. Recent press reports have revealed that Mr. McClendon has obtained loans to fund his investments under the FWPP from third parties (such as EIG Global Energy Partners LLC) who, at the same time, were also significant participants in financing transactions with Chesapeake.

Turmoil resulting from these developments--and from potential revelations resulting from the board review--could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and aggressive ongoing capital spending. Chesapeake's production is heavily skewed toward natural gas, and natural gas prices are severely depressed. Chesapeake is in the midst of an extensive repositioning of its business mix, placing more emphasis on production of crude oil and natural gas liquids (collectively, liquids). The company's excellent drilling record and large acreage positions in the most promising North American liquids-rich basins afford confidence about its ability to make this transition.

To help fund its planned investment, Chesapeake has stated that it is targeting sales of proved and unproved properties and monetization of oilfield services, midstream, and other assets totaling $11.5 billion to $14.0 billion in 2012, and $5.5 billion to $6.5 billion in 2013. Chesapeake is asset rich, and it has been adept at structuring varied and innovative transactions to generate funds, including outright asset sales, formation of joint ventures (JVs), issuance of securities by a royalty trust and by newly formed subsidiaries, and issuances of volumetric production payment (VPP) obligations. However, Chesapeake's ability to continue executing such transactions on favorable terms depends largely on capital market receptivity. From our analytical perspective, some of the company's actions to raise funds dilute the benefit of debt reduction, which it is also pursuing. Based on our price deck, we anticipate that coverage metrics over the next two years will be weak even for the revised rating--with adjusted debt to EBITDA approaching 6x in 2012 and remaining above 5X in 2013 --before Chesapeake's liquids production increases sufficiently to offset the effect of persisting depressed natural gas prices.

The ratings on Chesapeake Oilfield Operating LLC and Chesapeake Midstream Partners L.P. are constrained by our ratings on Chesapeake, given the extent of Chesapeake's ownership control over these entities and the close business ties between Chesapeake and these entities. Over time, we could raise the ratings on Chesapeake Midstream Partners L.P. above those on Chesapeake Energy if it achieves greater customer diversity and remains committed to conservative financial policies. However, given the large list of future drop-down candidates from Chesapeake, we do not anticipate any ratings separation in the near term.

Liquidity

We view Chesapeake's liquidity as "less than adequate," under our criteria, since ready sources of liquidity are likely to be exceeded by uses over the next two years, and the company's primary credit facility affords limited downside protection. To maintain liquidity, Chesapeake is highly dependent on its ability to monetize assets or complete additional capital markets transactions. In our assessment of Chesapeake's liquidity, we take account the following:

-- The company typically holds only a relatively modest amount of unrestricted cash--$438 million as of March 31, 2012.

-- Borrowing availability under its $4.0 billion senior secured revolving facility (maturing 2015) totaled approximately $1.5 billion as of March 31, 2012. Chesapeake also maintains a $600 million midstream credit facility (maturing 2016), with $112 million of availability as of March 31, 2012, and a $500 million oilfield services facility, with $278 million of availability as of March 31, 2012.

-- Chesapeake recently announced that it had entered into a $3.0 billion unsecured loan facility, maturing on 2017, with proceeds to be used to repay borrowings under the company's existing corporate revolving credit facility. Borrowings may be repaid at any time this year without penalty, and Chesapeake has stated it intends to do so, out of asset sale proceeds. This transaction was costly for Chesapeake: it carries an initial variable annual interest rate through Dec. 31, 2012, of LIBOR plus 7.0%, which is currently 8.5%, given the 1.5% LIBOR floor in the loan agreement. Subject to certain limitations, the interest rate would step up to a fixed rate of 11.5% if the loan is not repaid by May 11, 2013.

-- Although this $3 billion debt issuance enhances near-term financial flexibility, we believe there is a risk of constraints on Chesapeake's ability to draw on its corporate credit facility. Among other maintenance financial covenants under the facility, there is a reported total debt to lagging-12-month EBITDA limit of 4.0X. We believe that if EBITDA remains at the weak level of the first quarter ($838 million) or worse, as we anticipate, without a significant reduction in reported total debt from the level at March 31, 2012 ($13.1 billion), Chesapeake could breach this covenant within the next three quarters.

-- We expect Chesapeake's cash flow from operations to be relatively meager compared with planned capital spending over the next two years, although, at least in theory, we believe that planned capital spending could be reduced significantly beyond the next two to three quarters in the face of financial distress.

-- Chesapeake is pursuing various initiatives to monetize assets, and it has stated that it has received strong interest from prospective buyers of its Permian Basin assets and from potential JV partners at its Mississippi Lime holdings. The company has stated that it expects to complete these two transactions in third-quarter 2012.

-- Debt maturities are manageable. Apart from the expiration of its three credit facilities during 2015 to 2016, maturities of senior unsecured notes total $464 million in 2013 and $1.265 billion in 2015. Also, $395 million of convertible senior notes are putable in 2015.

Recovery analysis

See our recovery report on Chesapeake Energy Corp., published Feb. 15, 2012, on RatingsDirect.

Outlook

Maintenance of the rating depends on the success of the company's efforts to lessen its reliance on natural gas while completing asset monetization transactions sufficient to fund the portion of capital expenditures not covered by internal cash flow and while containing any increase in financial leverage. We assume that Chesapeake will eventually benefit from a significant further increase in its liquids output, enabling adjusted debt to EBITDA to decline to 5.0x or lower in 2014. We could downgrade the company if we foresee that leverage is unlikely to be 5.0x or lower in 2014. On the other hand, we could stabilize the rating on Chesapeake if the company adopted a more conservative growth strategy and financial policies, reduced leverage to less than 4.5X, and took actions to address shortcomings in its corporate governance practices that were sufficient to satisfy its various stakeholders.

Related Criteria And Research

-- Chesapeake Energy Corp., April 20, 2012

-- Standard & Poor's Lowers Its U.S. Natural Gas Price Assumptions; Oil Price Assumptions Are Unchanged, April 18, 2012

-- Key Credit Factors: Global Criteria For Rating The Oil And Gas Exploration And Production Industry, Jan. 20, 2012

-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011

-- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009

-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009

-- Volumetric Production Payments (VPPs) For U.S. Oil And Gas Exploration And Production Companies, Jan. 30, 2009

-- Corporate Ratings Criteria 2008, published April 15, 2008

-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

Ratings List

Downgraded; Off CreditWatch; Outlook Action

To From

Chesapeake Energy Corp.

Corporate Credit Rating BB-/Negative/-- BB/Watch Neg/--

Chesapeake Midstream Partners L.P.

Corporate Credit Rating BB-/Negative/-- BB/Watch Neg/--

Chesapeake Oilfield Operating LLC

Corporate Credit Rating BB-/Negative/-- BB/Watch Neg/--

Downgraded; Off CreditWatch

To From

Chesapeake Energy Corp.

Senior Unsecured BB- BB/Watch Neg

Recovery Rating 3 3

Preferred Stock B- B/Watch Neg

Chesapeake Midstream Partners L.P.

Senior Unsecured BB- BB/Watch Neg

Recovery Rating 4 4

CHKM Finance Corp.

Senior Unsecured BB- BB/Watch Neg

Recovery Rating 4 4

Chesapeake Oilfield Operating LLC

Senior Unsecured BB- BB/Watch Neg

Recovery Rating 4 4

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