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Chesapeake Energy Singing the Same Tune Amid Skepticism


Although Chesapeake Energy's (CHK) language has changed in terms of the assets it will sell to close a large funding gap, the company is not changing its tune: When it comes to executing on asset sales, forget about a hiccup or two and bet on Chesapeake Energy CEO Aubrey McClendon to prove that all of his detractors are worrywart Chicken Littles.

Skepticism has mounted on how Chesapeake Energy can engineer asset sales to escape a liquidity crisis. The skepticism hit a crescendo late last Friday afternoon when Chesapeake disclosed in a 10-Q filing the fact that asset sales could be delayed due to the risk of breaching debt covenants. Sales of producing natural gas and oil properties could adversely affect the amount of cash flow the company generates and the use of those producing assets as collateral in debt agreements.

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After shares tumbled to a 52-week low on Friday afternoon, and after an 8 p.m. press release on a Friday night from Chesapeake announcing $3 billion in emergency Wall Street credit funding, McClendon said in a Monday morning conference call that the company won't be challenged to raise billions in needed capital.

Chesapeake Energy said the company won't monetize its Eagle Ford shale assets this year in a planned $1 billion volumetric production payment, and its oil field services IPO may be pushed out to 2013 instead of 2012. However, the company said it still expects to raise billions through the sale of its Permian assets and a joint venture in the Mississippian Lime to meet the funding gap and maintain its debt covenants.

While the conference call dredged up all of the issues related to liquidity that have long trailed Chesapeake, shares of the embattled oil and gas giant received a lift on Monday morning when the Wall Street Journal reported that activist investor Carl Icahn could build a stake in the company. Shares were up roughly 7% at midday, making up for half of the Friday freefall. On Monday's call, Chesapeake Energy was happy to fuel that speculation. "We wouldn't be surprised if Carl became a large shareholder," said CEO McClendon.

The company is still in 2012 race to restore its liquidity, and investor confidence.

McClendon said during the conference call that the firm's biggest deals "remain on track." He also said that the $3 billion unsecured loan from its investment bankers Goldman Sachs (GS) and Jefferies (JEF) will give the company the financial flexibility to sell between $9.5 billion and $11 billion of non-core assets and transition its energy portfolio towards oil, amid a decade low in natural gas prices.

The company said the potential delay in asset sales relates just to its $1 billion Eagle Ford monetization. "We have chosen to at least temporarily suspend the sale of Eagle Ford VPP," said Chesapeake Energy CFO Nick Dell'Osso. "We do not expect to have covenant issues this year," he added. The company still expects to sell its Permian Basin and Missippian assets by the third quarter, but if those aren't completed by September, it might breach debt covenants.

The delay of the Eagle Ford monetization alone drummed up concerns about Chesapeake's liquidity. "[For] year-end debt to not exceed $12bn (4x $3.0bn), then asset monetizations must reach at least $5.0bn," noted Citigroup (C) analyst Robert Morris in a note to clients. "Without any asset sales, CHK would be non-compliant with its revolving bank credit facility at year end unless spending was cut sharply."

The dropping out of the Eagle Ford VPP also implies that Chesapeake now has to find other assets within its portfolio to sell at a time when it has no choice but to sell and had zeroed in on the Eagle Ford deal as one of the keys to its short-term cash raising plan.

The Wall Street loan also comes at a steep rate -- and if not paid back within the same year -- those terms become even more costly to Chesapeake. The $3 billion facility from Goldman and Jefferies is higher than the last debt deal Chesapeake raised in February, which was at 6.75%. The new debt deal is set at an interest rate of 8% if paid back this year, and would see its rate go as high as 11.5% if not paid back until after May 2013, when lenders would be able to exchange the existing debt for a higher rate instrument.

Meanwhile, CEO McClendon tried to turn investor focus back to the other planned sales, as well as the company's ability to always find something to sell and execute on it, saying that large buyers have been to Chesapeake's Permian basin operations for deal diligence, and adding, "Identifying assets to sell around here is perhaps the easiest thing we can do around here."

A slew of Monday analyst downgrades keyed in on details in the 10Q filing and showed less confidence in McClendon's long-time ability to keep the banks at bay and raise cash in deals. JPMorgan (JPM) cut its price target to $10 from $15, citing a possible delay to its planned Eagle Ford VPP sale. "We think Chesapeake still is not particularly cheap relative to other E&Ps and is in a difficult financial position," wrote Joseph Allman. Tudor Pickering cut its outlook on shares to "hold" from "accumulate," while UBS (UBS) cut Chesapeake's price target to $16 from $20 and Stifel Nicolaus cut its share outlook to $25 from $29.

Chesapeake's largest shareholder, Southeastern Asset Management, which has recently become more vocal about the company's issues, cited the looming VPP as one reason to not panic about the company's ability to make ends meet and return value to shareholders.

In a letter to McClendon, Hawkins changed his shareholder status to "activist" but said he was optimistic about Chesapeake's asset divestiture plans. "We applaud current management efforts to do an Eagle Ford VPP, sell the Permian assets and do a Mississippi Lime JV at a time of good oil prices."

Oil and gas company debt agreements are typically based on a ratio involving balance sheet strength and proven reserve levels. Chesapeake's cash flow and proven reserve levels are facing two headwinds: (1) any asset sales that lead to lower levels of cash flow from producing assets and lower level of proven reserves; (2) the low natural gas pricing environment. Chesapeake suggested on the call that proven reserves aren't an issue because natural gas assets being impaired due to the uneconomic environment for drilling are "non-cash" charges. However, the hit to cash flow and EBITDA as a result of low-priced natural gas would be compounded by asset sales and that could cause bank debt issues.

During the most current quarter, Chesapeake reported that the combination of high spending and reduced cash flow as a result of low natural gas prices required that it increase long-term debt, net of unrestricted cash, by approximately $2.4 billion to $12.6 billion to fund spending, while cash available declined to $2.4 billion from $3.1 billion. Bloomberg calculates that Chesapeake has outspent cash flow in 19 of the past 21 years.

Last Wednesday, Moody's (MCO) downgraded Chesapeake Energy's rating outlook from stable to negative, citing funding gap and the impact of CEO Aubrey McClendon.

"The negative outlook reflects the escalating execution risk of Chesapeake's plan for funding its large capital spending budget, rising leverage metrics and accompanying liquidity concerns," Pete Speer, Moody's vice president, said in the statement.

Southeastern Asset Management recently wrote in a letter to CEO Aubrey McClendon that the company should consider sale offers and push forward with its asset divestiture program. "We urge the board to be open to any offers to acquire the whole company," Southeastern Asset Management CEO Mason Hawkins wrote in a letter to Chesapeake on Monday.

Chesapeake's financial deterioration also comes amid revelations about McClendon's potential conflicts of interest related to his stewardship of the second biggest US oil and gas driller after ExxonMobil (XOM). A Reuters investigation reported that McClendon had run a $200 million commodities trading hedge fund that may conflict with his role at a leading oil and gas exploration and production company.

In April, Reuters published an investigation of McClendon's personal loans using his stake in Chesapeake wells as collateral. On Friday, the Wall Street Journal said that the company has saddled itself with about $1.4 billion of previously unreported liabilities called volumetric payment plans.

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