The Chesapeake Energy (NYSE:CHK) stock price has seemingly found a bottom. Chesapeake Energy stock touched a 20-year low after earnings last month, and traded as low as 55 cents on Nov. 19. Including a 10% rally on Wednesday, however, shares since have gained 64%.
To some investors, that bounce might suggest that the market overreacted to the third quarter report. The company’s “going concern” warning grabbed the headlines after the release. Despite that warning, however, management insisted that the company’s balance sheet remained in decent shape. Moves since suggest that was the case. And with near-term liquidity worries minimized, if not yet erased, bulls might argue that there’s more upside ahead for CHK stock.
There is huge potential upside ahead if this works out. I’ve long thought Chesapeake Energy stock was an intriguing play for oil bulls, and called it a lottery ticket stock just last month. But investors need to be reasonable here.
The problem for CHK stock isn’t the media, and it isn’t short-sellers. Chesapeake has not delivered on its promises, and hasn’t proven it can deliver free cash flow. Until those two problems are fixed, all the company will be able to do is kick the proverbial can down the road. And, at some point, the ability to do so will come to an end.
Chesapeake Energy Gets Some Breathing Room
To some extent, the bankruptcy fears created by third-quarter earnings probably were overstated. The “going concern” warning is a technical measure. Covenants in the Chesapeake Energy credit facility are likely to be breached, but that doesn’t mean the company is going bankrupt. As Chief Financial Officer Nick Dell’Osso said on the Q3 conference call, “we could go out and seek a waiver [of those covenants] from our bank group.”
And in recent weeks, Chesapeake has firmed up its near-term financial footing. On Dec. 4, the company announced a new $1.5 billion term loan facility with loosened restrictions. It plans to buy some bonds back at discounted prices. And this week, the company announced it already has exchanged over $3 billion in debt. Chesapeake Energy stock rallied on both pieces of news.
Both moves give the company time to reduce debt, whether via free cash flow or via asset sales. Time matters, as it increases the odds of a much-needed spike in energy prices. At the very least, the moves over the past two weeks suggest that a near-term bankruptcy remains unlikely.
The Debt Problem for CHK Stock
The problem for CHK stock is that it’s not clear that bankruptcy fears drove all of the post-Q3 selloff. Even without a going concern warning, Chesapeake shares likely would have fallen anyway. The company generated $577 million in Adjusted EBITDAX (earnings before interest, taxes, depreciation, amortization, and exploration expense) in the quarter. Capital expenditures were $640 million.
And Chesapeake itself guided for a 30% reduction in capital expenditures in 2020. That’s not good news. Yes, it helps cash flow next year. But it also suggests that the company can’t drive positive return on investments in production. Meanwhile, cutting capex next year lowers operating cash flow in ensuing years. A company that has to pay off over $9 billion in debt needs that cash flow.
There was more to Q3 than the going concern warning. And just because Chesapeake can and likely will get through 2020 doesn’t mean CHK stock is a buy. The company needs to tackle that debt load at some point. Even after the news of the last few weeks, the bond market still is pricing in real risk on that front. An unsecured bond maturing in 2026, for instance, trades at 49 and yields over 19% to maturity.
That’s a yield that suggests a substantial risk of restructuring before the point. But it’s also a yield that itself undercuts the case for Chesapeake stock. Total return on that bond will be in the range of 200% in less than seven years if it’s repaid. Investors need to see enormous upside in the stock to choose the equity instead.
More to the Story
All told, there’s little evidence that the current CHK stock price is due to anything but real fears about the company’s viability. Chesapeake has a massive and potentially untenable debt load. Interest expense alone will near $700 million in 2019. Equity investors won’t see a dime until at least a large chunk of those borrowings are repaid.
Management continues to promise that the debt load will be tackled. No progress has been made. Free cash flow continues to be negative. Debt net of cash was $7.4 billion at the end of 2014, and will be in the range of $9 billion five years later. Chesapeake could look to asset sales, but if it can’t drill profitably (as witnessed by its capex reduction) on its acreage, buyers likely aren’t going to be lining up.
Trends in the sector as a whole add to that problem. Chevron (NYSE:CVX) took a huge writedown this week, though much of that related to offshore assets. Exxon Mobil (NYSE:XOM) still is hugging the lows. The optimism that greeted shale producers like Diamondback Energy (NASDAQ:FANG) and Pioneer Natural Resources (NYSE:PXD) after Occidental Petroleum (NYSE:OXY) acquired Anadarko Petroleum has quickly faded, and OXY stock touched a 14-year low recently. Chesapeake may have enough cash to get through 2020, but it will need much more soon. Investors wisely are asking from where that cash is supposed to come.
Chesapeake Energy Stock as a Call Option
Again, there are real, significant concerns here that go beyond November headlines. The balance sheet is a mess. Management has failed to deliver. Both need to change.
And at this point, there’s only way they will change — and only one pillar underpinning the bull case. Chesapeake Energy needs a large and sustained increase in oil and gas prices. While the balance sheet moves have helped CHK stock, so has a recent bounce in crude. Higher prices are essentially free money for Chesapeake at this point (whose cash taxes will be minimal). They also open up the possibility for acreage to become economic, providing either more free cash flow or proceeds from asset sales.
CHK stock thus is basically an out-of-the-money call option on those energy prices. Given the massive leverage, and a market capitalization under $2 billion, there are probably few stocks that will outperform if crude prices make a steep, sustainable rally. But it’s important to remember a key fact about call options: if the thesis doesn’t play out, investors wind up with zero.
As of this writing, Vince Martin has no positions in any securities mentioned.