The rally may not last long, and it may have ultimately been inspired for the wrong reasons, but Chesapeake Energy (CHK) jumped as high as 17% Friday. Any oil/gas name capable of putting together that type of bullish thrust in this lousy environment deserves a closer look, even if the move wasn’t built to last.
You read that right — even after the intraday pullback Chesapeake Energy shares are currently up 5% Friday and up 36% from the new multi-year low it hit on Wednesday.
Is it possible we’ve truly reached the point where things literally can’t get any worse?
Why Is CHK Rallying?
The big move from CHK left investors scratching their heads.
There are two contributing factors, the biggest of which is news that Chesapeake Energy has decided to suspend the dividend its preferred stock is paying.
Preferred stock is more or less what it sounds like — a somewhat privileged class of shares that usually gets its share of corporate income after bondholders have been paid their interest but before common equity owners are given whatever’s left over after all the company’s non-optional bills are paid.
Dividends paid to preferred stock holders aren’t guaranteed (which is how Chesapeake Energy was able to suspend them), though it’s worth noting the company will resume dividend payments to preferred shareholders as soon as it feasibly can, and well before it resumes dividend payments to common stock owners.
Too good to be true? Not quite.
Debtors and bondholders still come before owners of preferred stock should the company be liquidated, yet common stock owners are more apt to fully participate in a company’s earnings growth. Dividend payments from preferred shares are generally capped.
With that being said, the common stock’s response to the news makes perfect sense. Chesapeake Energy is (if only temporarily) removing a nagging financial burden, boosting its overall liquidity at a point when liquidity is crucial.
The other reason CHK shares are rallying on Friday? Oil prices are soaring. Crude oil prices jumped 7% today against a backdrop of reports that the worst of the oil glut may be over. If that’s truly the case, the worst for Chesapeake Energy may also be over.
Crunching the Numbers
This isn’t the first time Chesapeake Energy has stopped paying shareholders as a means of retaining cash.
Last July, CHK suspended dividend payments to common stock holders, a decision expected to save approximately $240 million per year. The suspension of the preferred stock dividend is expected to save another $170 million annually.
The company has earmarked this particular savings, saying in Friday morning’s statement:
“Today’s decision to suspend our preferred stock dividends will allow the company to retain approximately $170 million of additional cash per year and use these funds to purchase debt at significant discounts in the near term. Given the current commodity price environment for oil, natural gas and natural gas liquids, we believe that redirecting this cash toward debt retirement provides better returns for the Company. We currently have senior debt securities trading at significant discounts, and we will continue to take advantage of that within the coming year.”
In simpler terms, it’s turning lemons into lemonade, buying its own bonds back while they’re cheap — depressed values stemming from concerns the oil and gas giant would struggle to survive the brutal oil market.
It’s not a bad idea, although it’s an idea that may have little impact. As of the most recent SEC filing, Chesapeake Energy is sitting on $11.1 billion worth of long-term debt. Putting $170 million toward the elimination of that debt — even at bargain prices — isn’t going to make a dent.
More plausibly, Chesapeake Energy is just trying to survive. It’s got $1.76 billion in the bank right now, but lost $12.6 billion over the course of the first three quarters of 2015. Though much of that loss was the result of non-recurring charges, cash is drying up real fast, and cash flow has been negative for three straight quarter.
Every penny counts from this point forward.
Bottom Line for Chesapeake Energy
It will be surprising if Chesapeake Energy actually puts a significant amount, if any, of the $170 million in question toward debt retirement.
It’s not legally obligated to do so, even though it voiced that premise as the plan for the savings. And, it wouldn’t really matter if Chesapeake Energy put all of that cash toward paying down debt — it’s only a drop in the bucket.
At this point, the only thing that would do CHK shareholders (preferred or otherwise) any real good is a recovery in oil prices and a return to profitability.
It’s possible, but that’s going to be a long, miserable road to travel, and Chesapeake Energy is still likely to run out of cash before it gets to the end of it.
Some sort of fundraising remains likely.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.