The narrative from bulls has long been that Chesapeake Energy (NYSE:CHK) stock simply was, and perhaps still is, too cheap. That narrative never held much water, and in recent months it’s absolutely collapsed.
To be sure, CHK stock certainly looks cheap at Friday’s close of 56 cents. And there has been a bull case for the stock in recent years, despite its collapse to just one penny above a 20-year low reached late last year.
But the case for CHK was never based on the stock being cheap. As I’ve written in the past, the stock was a high-risk, high-reward leveraged bet on energy prices. The problem at the moment is that the risks have played out; barring a something close to a miracle, the rewards are unlikely to arrive.
Why CHK Stock Has Collapsed
For years now, the issue for Chesapeake Energy has been its substantial debt load. Under former chief executive officer Aubrey McClendon, Chesapeake borrowed and spent wildly to build up its acreage. At the end of the year 2000, Chesapeake had less than $1 billion in long-term debt. At the end of 2019’s third quarter, that figure had ballooned to over $9 billion.
That strategy worked well when oil and natural gas prices were soaring: CHK stock cleared $60 in 2008, and at its peak had risen 1,660% in a decade. Exploration and production companies are intrinsically leveraged bets on the price of their underlying commodities; Chesapeake amplified its model with financial leverage. As a result, shares soared along with the rise in energy prices.
And they’ve subsequently collapsed as those prices have fallen. Chesapeake stock now is down over 99% from its 2008 highs. Fundamentally, it’s not difficult to see why.
Chesapeake Energy Is Functionally Insolvent
CHK stock was already struggling ahead of the company’s third quarter report in November. Shares then fell off a cliff as the company disclosed a so-called “going concern” warning. That disclosure in the quarterly filing with the U.S. Securities and Exchange Commission cautioned investors that the company might not survive the next 12 months without a restructuring.
As Chesapeake management noted on the Q3 conference call, the disclosure largely was a technical matter. And indeed, the company announced a new $1.5 billion loan facility in early December. But that hardly means the company is out of the woods.
In fact, the long-term risk of bankruptcy remains exceedingly high. The company’s trailing twelve-month net leverage ratio is 2.97x, according to its most recent 10-Q filing with the SEC. In other words, Adjusted EBITDAX (earnings before interest, taxes, depreciation, amortization and exploration spend) is roughly one-third its debt load, less cash on the books.
Chesapeake is targeting a 2x figure. If the figure clears 4x by March 31, 2021, the company violates covenants on its debt — and potentially could be forced into bankruptcy, unless lenders waive those covenants.
There are three ways to improve the multiple. First, Chesapeake can sell assets. Those sales would reduce debt at a faster rate than EBITDAX, lowering the multiple. Second, EBITDAX can grow. And, third, debt can be reduced by free cash flow. The problem is that all three of these roads look reasonably closed off to Chesapeake at the moment.
How CHK Rebounds
The problem is that energy prices continue to fall. Most notably, natural gas futures are at their lowest level in almost four years amid predictions for a warm winter. Crude prices spiked briefly in late 2019, one reason why CHK stock saw a bounce in December, but those prices have pulled back amid the apparent resolution of tensions with Iran and fears of the spread of the coronavirus.
Chesapeake does have an unspecified portion of its 2020 production hedged, but if prices remain low, earnings are going to decline. But those earnings already don’t cover interest expense and capital expenditures. After Q3, Chesapeake targeted positive free cash flow in 2020, but the new, lower prices put that guidance at significant risk.
And so EBITDAX is unlikely to grow. Even if positive, free cash flow won’t be material enough at current strip pricing to materially affect debt. Asset sales are possible, certainly. But the company’s debt issues have reportedly stalled one such sale to Comstock Resources (NYSE:CRK). Lower prices reduce the value of other acreage. And after Occidental Petroleum (NYSE:OXY) saw its stock plunge after outbidding Chevron (NYSE:CVX) for Anadarko Petroleum, potential buyers will be paying close attention to price.
Chesapeake Is A ‘Hail Mary’ Play
And so the status quo simply isn’t good enough. Chesapeake Energy, including debt, is still worth roughly $10 billion. And there’s little evidence that in this energy price environment its assets are worth $10 billion. Many Chesapeake Energy bonds yield over 20%, which shows that debt markets, too, see a significant chance of restructuring — and not enough value in the business to make even bondholders whole, let alone stockholders.
That doesn’t mean Chesapeake Energy is going bankrupt in the next twelve months — or even the next few years. But even with CHK below $1, the equity here is valued at nearly $900 million. There is still room for downside ahead, even if shares don’t immediately head to zero.
So what saves Chesapeake at this point? Nothing beside a large, sustained increase in both oil and natural gas prices. That will add value to the company’s assets, allowing sales to pay down debt. That will allow CHK to finally return to consistently positive free cash flow.
Right now, the market isn’t betting on such a price increase: even a quality name like Exxon Mobil (NYSE:XOM) is at a multi-year low. It’s possible the market is wrong. It had better be for CHK to avoid hitting zero at some point.
As of this writing, Vince Martin has no positions in any securities mentioned.