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TEXT-S&P cuts Chesapeake Energy rating to 'BB'
April 26, 2012 / 6:45 PM / in 6 years

TEXT-S&P cuts Chesapeake Energy rating to 'BB'

Overview	
     -- U.S. natural gas producer Chesapeake Energy Corp. has announced
that it is negotiating an early termination of the Founder Well Participation 	
Program (FWPP) after revelations about the CEO's personal transactions 	
revealed shortcomings in the company's existing corporate governance 	
practices. The board is currently reviewing financing agreements between the 	
CEO and third parties.	
     -- Turmoil resulting from these developments could hamper Chesapeake's 	
ability to meet the massive external funding requirements stemming from its 	
currently weak operating cash flow and continuing aggressive capital spending.	
     -- We are lowering our corporate credit and senior unsecured debt issue 	
ratings on Chesapeake to 'BB' from 'BB+', and lowering the ratings on two 	
affiliates--Chesapeake Oilfield Operating LLC and Chesapeake Midstream 	
Partners L.P. 	
     -- We are placing all these ratings on CreditWatch with negative 	
implications.	
	
	
Rating Action	
On April 26, 2012, Standard & Poor's Ratings Services lowered its ratings on 	
Oklahoma City-based Chesapeake Energy Corp., including the corporate credit 	
rating to 'BB' from 'BB+', and lowered ratings on two related 	
entities--Chesapeake Oilfield Operating LLC and Chesapeake Midstream Partners 	
L.P. At the same time, we placed all these ratings on CreditWatch with 	
negative implications.	
	
Rationale	
The downgrade and CreditWatch placement reflect our view that recent 	
revelations about personal transactions undertaken by Chesapeake's CEO 	
relating to the company's unusual FWPP underscore shortcomings in Chesapeake 	
Energy Corp.'s corporate governance practices. Under the FWPP, Chesapeake's 	
CEO, Aubrey McClendon can, before the beginning of each year, elect to take a 	
small (up to 2.5%, subject to certain restrictions) working interest 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. Mr. McClendon has also at times sold his interests in certain 	
fields, in conjunction with asset sales by Chesapeake. We believe these 	
transactions heighten the potential for unmanaged and unmonitored conflicts of 	
interest, or the perception thereof. Under the terms of the FWPP, there has 	
been no effective mechanism to protect against conflicts of interest, in our 	
view. Indeed, Chesapeake has previously stated that the company does not 	
review or approve financings of Mr. McClendon's personal assets, including his 	
FWPP interests. It is our understanding that Mr. McClendon has also been under 	
no obligation to disclose his dealings with third parties which also have 	
lending, investment, or advisory relationships with the company.  	
	
Chesapeake today has announced that its board and Mr. McClendon have committed 	
to negotiate the early termination of the FWPP, which otherwise would have 	
expired at the end of 2015. The company also announced that the Board is 	
reviewing financing arrangements between Mr. McClendon (and the entities 	
through which he participates in the FWPP) and any third party that has had a 	
relationship with the company in any capacity. The board has also confirmed 	
that it did not previously review, approve, or have knowledge of the specific 	
transactions engaged in by Mr. McClendon or the terms of those transactions. 	
In our view this represents a significant governance deficiency.	
	
Turmoil resulting from these developments--and from potential revelations 	
resulting from the board investigation--could hamper Chesapeake's ability to 	
meet the massive external funding requirements stemming from its currently 	
weak operating cash flow and aggressive capital spending. Chesapeake's 	
production is heavily skewed toward natural gas, and natural gas prices are 	
severely depressed at this time. Although hedge-related gains had been an 	
important support to Chesapeake's earnings and cash flow in recent years, the 	
company terminated its natural-gas related hedge positions in late 2011. 	
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. 	
	
However, Chesapeake faces very large external funding requirements to sustain 	
the aggressive planned investment needed to effect its strategic shift. In its 	
investor presentation dated April 17, 2012, Chesapeake gave guidance of total 	
investment of $10.9 billion to $12.4 billion in 2012, and $10.5 billion to 	
$12.3 billion in 2013. 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/btu in 2012, $2.75 in 2013, 	
and $3.50 thereafter), we expect Chesapeake's funds from operations to total 	
only $3.4 billion to $3.8 billion in 2012 and $5.4 billion to $5.8 billion in 	
2013, implying massive internal funding shortfalls.  	
	
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 $10 billion to $12 	
billion in 2012, and $4.0 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 debt to EBITDA higher than 5x and 	
EBITDA of less than $4 billion in 2012 and less than $5 billion in 	
2013--before Chesapeake's liquids production increases sufficiently to offset 	
the effect of persisting depressed natural gas prices.	
	
CreditWatch	
As part of our CreditWatch review, Standard & Poor's will take account of the 	
conclusions of the board's investigation; the terms under which the FWPP is 	
terminated; Chesapeake's ongoing capital-raising initiatives; and potential 	
changes to its growth strategy, financial policies, and governance structure. 	
At this time, we cannot rule out further ratings downgrades of more than one 	
notch; for example, if we believe that asset monetization actions will fall 	
short of plans and that offsetting actions won't be taken to preserve 	
liquidity and  limit the increase in financial leverage.	
	
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 elevate Chesapeake Midstream Partners L.P. ratings above 	
those of 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.	
	
Related Criteria And Research	
     -- 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	
     -- Chesapeake Energy full analysis, dated April 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	
     -- Corporate Ratings Criteria 2008, published April 15, 2008.	
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008	
	
Ratings List	
Downgraded; On CreditWatch	
                                        To                 From	
Chesapeake Energy Corp.	
 Corporate Credit Rating                BB/Watch Neg/--    BB+/Negative/--	
 Senior Unsecured                       BB/Watch Neg       BB+	
   Recovery Rating                      3                  3	
 Preferred Stock                        B/Watch Neg        B+	
	
Chesapeake Oilfield Operating LLC	
 Corporate Credit Rating                BB/Watch Neg/--    BB+/Negative/--	
 Senior Unsecured                       BB /Watch Neg      BB+ 	
  Recovery Rating                       4                  4	
	
Chesapeake Oilfield Finance Inc.	
 Senior Unsecured                       BB/Watch Neg       BB+	
  Recovery Rating                       4                  4	
	
Chesapeake Midstream Partners L.P.	
 Corporate Credit Rating                BB/Watch Neg/--    BB+/Negative/--	
 Senior Unsecured                       BB/Watch Neg       BB+	
   Recovery Rating                      4                  4	
	
CHKM Finance Corp.	
 Senior Unsecured                       BB/Watch Neg       BB+	
   Recovery Rating                      4                  4

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