CHICAGO–(BUSINESS WIRE)–Fitch Ratings has downgraded Chesapeake Energy Corporation’s (Chesapeake; NYSE: CHK) Long-term Issuer Default Rating (IDR) to ‘B-‘ from ‘B’. The Rating Outlook remains Negative. A full list of rating actions is provided at the end of this release.
The downgrade reflects the heightened liquidity risk given the prospect for a lower and longer price recovery profile. The current rating also reflects the potential for low hydrocarbon prices to negatively impact the company’s plans to raise liquidity through asset sales and could also have an unfavorable impact on the next round of borrowing-base redeterminations. This increases the prospect that the company might more quickly and heavily rely on its revolving credit facility to fund upcoming debt maturities and Fitch’s projected free cash flow (FCF) deficit, which could compound borrowing base and bank support risks. Fitch recognizes, however, that the company still has considerable unencumbered assets that could be pledged to help support the secured credit facility if there are material negative borrowing-base revisions.
The Negative Outlook considers heightened asset sale execution risk, as well as the potential for further deterioration of the company’s FCF profile. Fitch continues to expect the company will use its large, diversified asset base to manage its near- and medium-term operational and financial obligations, currently providing a limited margin of safety at the ‘B-‘ level. Fitch also continues to believe that there is an adequate amount of capital looking to be deployed for M&A. This view is supported by Chesapeake’s recently announced $700 million (net $500 million after repurchase of three Volumetric Production Payments [VPPs]) in asset divestitures closed or under signed sales agreements, as well as the size and volume of other E&P market transactions over the past few quarters. The company is targeting an additional $500 million to $1 billion in asset sales during 2016.
KEY RATING DRIVERS
Chesapeake’s ratings reflect its considerable size with the potential for more liquids-focused production, substantial asset base, and strong operational execution and flexibility with ongoing improvements leading to competitive production and cost profiles. Fitch views the company’s focus on completion activities, instead of drilling, in 2016 positively. This more closely aligns current capital spending with production and, as a consequence, cash flows. The company’s recent guidance highlights these effects with a year-over-year 50%-67% drop in drilling and completion capital spending resulting in a production decline of 0%-5%, adjusted for asset sales.
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. In the near term, the sharp drop in U.S. natural gas prices linked to a strong El Nino weather pattern will continue to weigh on the company. Fitch recognizes, however, that Chesapeake has made significant progress in its financial and operational deleveraging efforts since 2013, including the recent secured debt exchange and completed midstream transportation renegotiations which have the potential for further savings.
The company reported year-end 2015 net proved reserves of over 1.5 billion boe, which is a year-over-year reduction of approximately 39% mainly due to price-related reserve revisions. Production also decline around 4% year-over-year to approximately 679 thousand boe per day (mboepd; 28% liquids) in 2015 from nearly 707 mboepd (29% liquids) in 2014. The reserve revision and production decline resulted in a year-end 2015 reserve life of just over six years.
Fitch estimates Chesapeake’s balance sheet debt/EBITDA to be approximately 4.8x for the year ended 2015 compared to 2.6x at year-end 2014 demonstrating the impact of lower hedged price realizations. The company’s debt/1p reserves metrics, as calculated by Fitch, increased nearly 40% to around $7.50/boe at year-end 2015 from approximately $5.40/boe at year-end 2014 mainly due to negative price-driven reserve revisions. Debt/flowing barrel metrics, however, declined to over $16,500 at year-end 2015 from about $18,800 at year-end 2014 reflecting the reduction in balance sheet debt offset by moderate production declines. Fitch’s base case currently forecasts debt/EBITDA of 8.0x-8.5x in 2016. This assumes the completion of an additional $750 million (total $1.25 billion for 2016) in asset sales limiting the need for credit facility borrowings. Upstream leverage metrics are projected to remain relatively steady through 2016.
Fitch’s key assumptions within the rating case for Chesapeake include:
–Base case WTI oil price that trends up from $35/barrel in 2016 to a long-term price of $65/barrel;
–Base case Henry Hub gas that trends up from $2.25/mcf in 2016 to a long-term price of $3.25/mcf;
–Production of approximately 622 mboepd in 2016, generally consistent with mid-point of guidance, followed by a price- and cash flow-linked production profile;
–Liquids mix declines to 25% in 2016 due to lower drilling activity with activity focused on completions, 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 $1.25 billion in 2016, consistent with mid-point of guidance, followed by a price- and cash flow-linked capex profile thereafter;
–Asset sales of $1.25 billion assumed to be completed in 2016;
–Continued suspension of preferred and common dividends medium-term;
–No increase in long-term balance sheet debt assumed.
Positive: No upgrades are currently contemplated given weakening credit metrics associated with low oil & gas prices. Future developments that may, individually or collectively, lead to a positive rating action include:
For an upgrade to ‘B’:
Maintenance of size, scale, and diversification of Chesapeake’s operations with some combination of the following metrics:
–Mid-cycle balance sheet debt/EBITDA under 6.0x-7.0x on a sustained basis;
–Balance sheet debt/flowing barrel under $40,000 – $45,000 and/or debt/1p below $8.50 – $9.00/boe on a sustained basis;
–Continued progress in materially reducing adjusted debt balances and simplifying the capital structure;
–Improvements in realized oil & gas differentials.
To resolve the Negative Outlook at ‘B-‘:
–Asset sale execution that alleviates the company’s near-term reliance on its revolving credit facility to help fund FCF deficits;
–Improving oil & gas price environment and sufficient liquidity to help address escalating maturities profile;
–Mid-cycle balance sheet debt/EBITDA under 7.0x-8.0x on a sustained basis;
–Balance sheet debt/flowing barrel under $45,000 – $50,000 and/or debt/1p around $9.00-$10.00/boe on a sustained basis.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
–Mid-cycle balance sheet debt/EBITDA above 8.0x on a sustained basis;
–Balance sheet debt/flowing barrel over $55,000 and/or debt/1p above $10.00 on a sustained basis;
–An unwillingness or inability to execute asset sales, if necessary, to help address forecasted FCF shortfalls and debt maturities;
–A persistently weak oil & gas pricing environment that impairs the longer-term value of Chesapeake’s reserve base.
ADEQUATE NEAR-TERM LIQUIDITY POSITION
Cash & equivalents, as of Dec. 31, 2015, were approximately $825 million. Additional liquidity is provided by the company’s previously amended $4 billion senior secured credit facility due December 2019. There were no outstanding borrowings under the facility as of Dec. 31, 2015, with $77 million of the facility capacity used for various letters of credit. Fitch understands that the company has considerable unencumbered assets that could be pledged to help support the secured credit facility if there is a material negative borrowing base revision.
Chesapeake, as of Feb. 23, 2016, has hedged about 56% and 58% of its projected oil and natural gas production, or approximately 19 mmboe and 590 Bcf, at approximately $47.79/barrel and $2.84/mcf, respectively.
ESCALATING MATURITIES PROFILE
The company has an escalating maturities profile with approximately $260 million, $1.8 billion, $900 million, and $1.1 billion due in 2016 – 2019. These amounts include the effects of the recent exchange, open-market repurchases, and the $1.2 billion and $347 million in contingent convertible senior notes with holders’ demand repurchase dates in 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. Fitch also views the company’s open-market debt repurchases for approximately $240 million (at an average 5% discount) of the 3.25% senior notes due 2016 and about $60 million (at a 45% average discount) of debt due in 2017 favorably.
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% (35% as of Dec. 31, 2015), senior secured leverage ratio of 3.5x through 2017 and 3.0x thereafter, and an interest coverage ratio of 1.1x through first quarter 2017 followed by periodic increases to 1.25x by the end of 2017 (3.13x). 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 amended and increased its ability to incur junior lien debt to up to $4 billion from $2 billion. Any junior lien issuances could reduce revolver availability after April 15, 2016 (the first borrowing-base redetermination date).
FULL LIST OF RATING ACTIONS
Fitch has downgraded the following ratings:
Chesapeake Energy Corporation
–Long-term IDR to ‘B-‘ from’B’;
–Senior secured bank facility to ‘BB-‘/’RR1’ from ‘BB’/’RR1’;
–Senior secured second lien notes to ‘B+’/’RR2’ from ‘BB-‘/’RR2’;
–Senior unsecured notes to ‘B-‘/’RR4’ from ‘B’/’RR4’;
–Convertible preferred stock to ‘CCC’/’RR6’ from ‘CCC+’/’RR6’.
Additional information is available on www.fitchratings.com
Corporate Rating Methodology – Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 07 Dec 2015)
Dodd-Frank Rating Information Disclosure Form
Fitch Ratings, Inc.
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Chicago, IL 60602
Mark C. Sadeghian, CFA
Shalini Mahajan, CFA
Alyssa Castelli, New York, +1-212-908-0540