Fitch Downgrades Chesapeake Energy's IDR to 'BB-'; Outlook Stable
The downgrade reflects Fitch's expectation that Chesapeake's cash flow, liquidity, and leverage profiles will be notably weaker than previously forecast due to persistently low oil & gas price realizations and heightened future reliance on asset sales to fund cash flow gaps. Another consideration is the company's increasingly limited ability to invest in its highest return assets in favor of operationally committed and shorter-cycle reserves. Fitch recognizes that Chesapeake's size and scale, relative to other high-yield E&P companies, provides considerable financial flexibility.
Approximately \\$11.7 billion and \\$3.1 billion in balance sheet debt and convertible preferred stock, respectively, are affected by today's rating action. A full list of rating actions follows at the end of this release.
KEY RATING DRIVERS
Chesapeake's ratings reflect its considerable size with an increasingly liquids-focused production profile and proved reserves (1p) base, solid reserve replacement history, adequate near-term liquidity position, and strong operational execution with ongoing improvements leading to competitive production and cost profiles. These considerations are offset by the company's levered capital structure, continued exposure to legacy drilling, purchase, and overriding royalty interest obligations, natural gas weighted profile that results in lower netbacks per barrel of oil equivalent (boe) relative to liquid peers, and weaker realized natural gas prices after differentials are incorporated. Fitch recognizes, however, that Chesapeake has made significant progress towards its financial and operational deleveraging efforts since 2013.
The company reported year-end 2014 net proved reserves of nearly 2.5 billion boe and production of 707 thousand boe per day (mboepd; 29% liquids). This resulted in a year-end reserve life of just under 10 years. Third quarter 2015 production was 667 mboepd (28% liquids) with declining quarterly trends mainly related to reduced rig activity. The Fitch-calculated one-year organic reserve replacement rate was about 154% for year-end 2014 with an associated finding and development (F&D) cost of approximately \\$10.15 per boe. Fitch-calculated third quarter hedged and unhedged cash netbacks were \\$7.11/boe and \\$2.29/boe, respectively. Unhedged cash netbacks have dropped 87% since year end 2014 mainly due to weakness in market prices and unfavourable differentials.
The increase in latest 12 month (LTM) balance sheet debt/EBITDA to approximately 3.9x, as of Sept. 30, 2015, compared to 2.6x at year end 2014 demonstrates the impact of lower hedged price realizations. Chesapeake's debt/1p reserves and debt/flowing barrel have remained relatively steady at approximately \\$5.37/boe, and \\$19,900, respectively. Fitch's current base case forecasts debt/EBITDA of about 5.4x in 2015. Fitch projects 2016 debt/EBITDA metrics will deteriorate more than previously expected.
HEIGHTENED CAPITAL EFFICIENCY, LIQUIDITY FOCUS
Chesapeake continues to focus on rationalizing drilling activity and preserving financial flexibility in 2015. The company is generally on pace to meet its operating rig target (14 rigs) by year end and has modestly reduced capital expenditures guidance with a mid-point around \\$3.25 billion (excluding capitalized interest). Meanwhile, production guidance has improved to 675 mboepd (mid-point), or 6% -8% year-over-year growth (adjusted for asset sales). Liquids, in particular, are anticipated to exhibit continued production pressure given the heightened rig allocation to the gas-oriented Haynesville (6 rigs at year end), Utica (2 rigs), and Marcellus (1 rig) plays. Management intends to further meaningfully reduce capital spending in 2016.
Chesapeake remains subject to approximately \\$800 million in preferred dividends, interest costs, and royalty payments, which is viewed as a considerable credit overhang. Fitch recognizes that the company recently eliminated its dividend (\\$234 million in 2014) and sold its CHK Cleveland-Tonkawa (CHK C-T) properties providing some cash flow relief and financial flexibility improvement.
CASH FLOW METRICS WIDEN DUE TO WEAK REALIZED PRICES
Fitch's base case projects that Chesapeake will be approximately \\$2.2 billion free cash flow (FCF) negative in 2015. Fitch notes that its FCF estimate considers nearly \\$300 million in common and preferred dividends. The Fitch base case results in balance sheet debt/EBITDA of about 5.4x in 2015 mainly due to weak oil & gas market prices and differentials. Debt/1p reserves and debt per flowing barrel metrics are forecast to remain largely unchanged at approximately \\$5.20/boe, subject to any price-induced reserve revisions, and \\$19,200, respectively.
Fitch's current 2016 base case assumptions (\\$60 WTI oil and \\$3.25 Henry Hub gas) results in balance sheet debt/EBITDA of approximately 6.4x, which is considerably higher than our previous estimate. Fitch also ran an alternative scenario assuming a relatively flat oil & gas price environment (\\$50 WTI oil and \\$2.75 Henry Hub gas) that resulted in weaker balance sheet debt/EBITDA leverage of over 9.7x. Fitch recognizes that additional non-core asset sales could be credit supportive.
Chesapeake maintains a combination of swaps and three-way collars to manage cash flow variability and support development funding. Fitch recognizes that the company's three-way collar hedging strategy provides some upside potential, but exposes cash flows to adjusted spot prices in a weak pricing environment. Favorably, the company has entered into some oil & gas hedges for 2016.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Chesapeake include:
--WTI oil price that trends up from \\$50/barrel in 2015 to a long-term price of \\$70/barrel;
--Henry Hub gas that trends up from \\$3/mcf in 2015 to a long-term price of \\$3.75/mcf;
--Production of 671 mboepd in 2015, generally consistent with guidance, followed by price- and cash flow-linked production growth;
--Liquids mix declines to 28% in 2015 due to lower drilling activity, particularly in the liquids-rich Eagle Ford basin, with activity focused in operationally committed and shorter-cycle gas-oriented plays near-term;
--Differentials are projected to exhibit improving trends over the medium term due to some Marcellus basis tightening and gathering cost relief;
--Capital spending is forecast to be \\$3.25 billion in 2015, consistent with guidance, followed by a more balanced capex profile thereafter;
--Non-core asset sales of \\$250 million assumed to be completed in 2016;
--No new long-term debt issuances assumed.
RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to a positive rating action include:
--Maintenance of size, scale, and diversification of Chesapeake's operations with some combination of the following metrics;
--Mid-cycle balance sheet debt/EBITDA under 3.5x on a sustained basis;
--Balance sheet debt/flowing barrel under \\$25,000 - \\$30,000 and/or debt/1p below \\$7.00 - \\$7.50/boe on a sustained basis;
--Continued progress in materially reducing adjusted debt balances and simplifying the capital structure;
--Improvements in realized oil & gas differentials.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
--Mid-cycle balance sheet debt/EBITDA above 4.5x - 5.0x on a sustained basis;
--Balance sheet debt/flowing barrel of \\$35,000 - \\$40,000 and/or debt/1p above \\$8.00-\\$8.50/boe on a sustained basis;
--A persistently weak oil & gas pricing environment without a corresponding reduction to capex;
--Acquisitions and/or shareholder-friendly actions inconsistent with the expected cash flow and leverage profile.
ADEQUATE NEAR-TERM LIQUIDITY POSITION
Cash & equivalents were nearly \\$1.8 billion as of Sept. 30, 2015. Additional liquidity is provided by the company's recently amended \\$4.0 billion senior secured credit facility due December 2019. There were no outstanding borrowings under the facility, as of Sept. 30, 2015, with \\$12 million of the facility capacity used for various letters of credit. Fitch's base case forecasts the company will end 2015 with approximately \\$1.1 billion in cash & equivalents assuming the contingent convertible senior notes that are expected to be put to the company are paid with cash-on-hand and the \\$200-\\$300 million in planned non-core asset sales are completed in 2016.
ESCALATING MATURITIES PROFILE
The company has an escalating maturities profile with \\$396 million, \\$500 million, \\$2.2 billion, \\$1.0 billion, and \\$1.5 billion due in each of the next five years. These amounts include the \\$396 million, \\$1.2 billion, and \\$347 million in contingent convertible senior notes with holders' demand repurchase dates in November 2015, May 2017, and December 2018, respectively. If oil & gas prices remain depressed in the medium-term, Fitch believes it is likely that the contingent convertible senior notes holders will exercise their demand rights for a cash repurchase given the five-year demand repurchase date schedule and considerable spread between the current stock price and conversion threshold.
MODIFIED FINANCIAL COVENANT PACKAGE
Financial covenants, as defined in the recently amended credit facility agreement, consist of a maximum net debt-to-book capitalization ratio of 65% (38% as of Sept. 30, 2015), senior secured leverage ratio of 3.5x through 2017 and 3.0x thereafter (no secured debt is currently outstanding), and an interest coverage ratio of 1.1x through Q1 2017 followed by periodic increases to 1.25x by the end of 2017 (4.7x). Other customary covenants across debt instruments restrict the ability to incur additional liens, make restricted payments, and merge, consolidate, or sell assets, as well as change in control provisions. The company also has the ability to incur up to \\$2 billion of junior lien debt. Any junior lien issuances could reduce revolver availability after April 15, 2016 (the first borrowing base redetermination date).
OTHER CONTINGENT OBLIGATIONS AND LIABILITIES
Chesapeake does not maintain a defined benefit pension plan. Asset retirement obligations (AROs) were approximately \\$442 million. Other contingent obligations, as of Dec. 31, 2014, totalled approximately \\$17 billion on a multi-year, undiscounted basis mainly comprising firm gathering, processing, and transportation agreements (\\$16 billion), drilling contracts (\\$502 million), and pressure pumping contracts (\\$466 million).
Natural gas price differentials have been and are anticipated to remain soft due to challenged Marcellus basis differentials and increased gathering and transportation costs. The recently executed fixed-fee gas gathering agreements with Chesapeake's midstream partner (The Williams Companies, Inc.) in the Haynesville and dry gas Utica are anticipated to provide some cash flow relief near-term. However, Fitch notes that the company will become subject to additional minimum volume commitments in mid-2017, which Chesapeake believes it can meet with approximately one rig per year. Fitch recognizes that the company continues to pursue production enhancements that increase estimated ultimate recoveries, extend production peaks, and reduce well costs per lateral foot to improve economics in the Barnett and Haynesville. Management believes that these operational improvements may encourage partnerships over the medium-term.
In addition to customary E&P contingent obligations, Chesapeake has roughly \\$1.1 billion in legacy drilling obligations (\\$264 million for the Granite Wash Trust) and liquids & natural gas volumetric production payments (\\$773 million/PV10 \\$630 million), as well as overriding royalty interest obligations (\\$234 million; CHK Utica). Fitch considers these arrangements, among other off-balance sheet obligations, in E&P adjusted debt given the associated payment and operating cost arrangements. The Fitch-calculated E&P adjusted debt/EBITDA is forecast in the base case to increase from under 3.2x in 2014 to over 6.0x in 2015. Management considerably reduced its exposure to these arrangements following the recent sale of CHK C-T (nearly \\$1.2 billion reduction to adjusted E&P debt). Additional improvements and simplifications would further alleviate the company's existing, non-core operational and financial obligations.
FULL LIST OF RATING ACTIONS
Chesapeake Energy Corporation
--Long-term IDR downgraded to 'BB-' from 'BB';
--Senior secured bank facility upgraded to 'BB+'/RR1 from 'BB'/RR4;
--Senior unsecured notes downgraded to 'BB-'/RR4 from 'BB'/RR4;
--Convertible preferred stock downgraded to 'B'/RR6 from 'B+'/RR6.
The Rating Outlook is Stable.
Fitch has also withdrawn the rating on Chesapeake Energy's term loan terminated in 2014.
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