Credit worries intensify for embattled Chesapeake

Thu May 17, 2012 11:42am EDT

NEW YORK, May 17 (IFR) - Credit markets are signaling steadily growing concerns about troubled oil and gas producer Chesapeake Energy, raising pressure on the company to deliver on its strategy of planned asset sales.

The company's bonds, protection on those bonds and its shares have all been battered in recent months following a series of Reuters reports revealing potential conflicts of interest in loans extended by the company to Chief Executive Aubrey McClendon against personal stakes in the company's wells.

The reports have come as Chesapeake grapples with a 2012 funding shortfall of $9 billion to $10 billion as natural gas prices remain at their lowest in a decade. The company managed this week to tap the capital markets for a $4 billion bridge loan -- but investors are still worried.

"They need too large of an asset sale over too short of a time, otherwise they are going to have a liquidity crisis," said Marc Gross, portfolio manager at RS Investments' high-yield and floating-rate bond funds.

"All of the problems they are having today is because they didn't expect $2 gas, and it's hurting them a lot more than they are letting on. The company is under stress," he said.

The cost of insuring Chesapeake bonds against potential default jumped on Thursday after hedge fund manager T Boone Pickens dumped 71,000 of its shares.

Five-year credit default swaps were last trading 26 basis points wider at a record wide of 887, surpassing the previous historical wide of 828 seen in Jan, 2009.

That means it costs $887,000 a year for five years to insure $10 million of debt. Shares were down 19 cents at $13.85.

Shorter-term contracts are looking even more ominous, with one-year CDS close to 1,000, about double its level a week ago.

The one-year contract is less liquid than the five-year and can balloon wider or compress swiftly due to market technicals. But it is highly sensitive to the market's perception of credit risk.

SENTIMENT FADING FAST

The CDS price movement has been accompanied by an increase in net notional, or CDS positions, as measured by data provided by the Depository Trust Clearing Corp.

Data for the four-week period ending May 12 shows a more than 10 percent increase in dollar equivalent to about $1.3 billion, suggesting a rapid deterioration in sentiment and in risk aversion.

The company's CDS credit curves have dramatically flattened in the one-month period and several are now inverted, suggesting investors are even more fearful about what's ahead.

Standard & Poor's this week expressed concern about a covenant breach in the next three quarters as the company's debt levels climb. The company's loan covenants already state its debt cannot exceed 4 times its lagging 12-month EBITDA. Total debt as of March 31, 2012 was $13.1 billion, while EBITDA was weak, at $838 million.

S&P downgraded the credit to BB-, citing "increased funding risk stemming from weak internal cash generation and very heavy capital expenditures," alongside the revelations about the CEO's tangled personal financial transactions.

It was the second downgrade in three weeks and comes after Moody's a week earlier changed the outlook on its Ba2 rating to negative from stable.

"Their entire thesis has changed over the last couple of weeks," said Gross. "This was a company that said they had investment grade metrics and in the short term would be an investment grade company, and now they've been downgraded twice".

Philip Adams, credit strategist at GimmeCredit, agreed.

"This story would not have as much traction if natural gas was at $6 per million cubic feet and CHK was "A"rated and generating gobs of free cash flow," he said. "One of the consequences of being sub-investment grade is that spread volatility can be 'manic."

Chesapeake's bonds have been some of the most active and worst performing credits for the past several weeks. Chesapeake's benchmark 6.625% notes due 2020 traded at 90.50 today (Thursday), down two points from yesterday. Since May 1, the 6.625% notes have dropped over eight points.

"They are fading back to a mid high-yield company, so the class of investors changes," said Gross. "It's now a true high yield play, and with some hair on it, because of the investigations and disclosures, and Chesapeake has had to migrate into different hands."

Hedge fund and pure high-yield funds have replaced insurance companies and pension funds as holders of the debt as the notes get downgraded, forcing higher quality funds to sell out of the name.

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