Equity markets right now are pricing Chesapeake Energy (NYSE:CHK) for an eventual bankruptcy. In pre-market trading, CHK stock is changing hands for less than 24 cents per share.
That kind of price, and that kind of trading, might attract some investors looking for a lottery ticket stock. It shouldn’t. Barring an absolute miracle, Chesapeake’s stock is headed to zero.
The plunge of the shares has led bulls to look for someone, or something, to blame. But the selloff isn’t a matter of investors panicking amid fears of the coronavirus. It’s not being driven by short sellers. It’s not even, really, due to the proposed reverse split of the shares.
Nor is it even necessarily the fault of Chesapeake’s current management. To be sure, the company’s CEO, Doug Lawler, and his team haven’t done a great job. Last year’s acquisition of Wildhorse Resource Development hasn’t worked out.
But they have played the hand they were dealt. Chesapeake spent the 2000s loading its balance sheet with debt in a huge gamble that oil and natural gas prices would rise.
Instead, they’ve fallen.
At its core, Chesapeake’s situation is that simple. The gamble hasn’t paid off. And after Wednesday’s fourth-quarter earnings report, it looks like Chesapeake is just about out of time for its luck to turn.
The Q4 Results Don’t Look That Bad
On its face, the Q4 report this week hardly seems like enough to justify such a sharp selloff. Chesapeake’s Q4 EPS actually beat analysts’ average estimate. Its 2020 guidance doesn’t appear to be materially negative. Indeed, Chesapeake still is targeting positive free cash flow for this year.
But investors are, and should be, skeptical about the guidance. At the end of 2018, Chesapeake predicted that its free cash flow would improve in 2019. Instead, its cash burn (when measured as cash flow from operations less drilling and completion costs) widened from $118 million in 2018 to $557 million last year.
Lawler said on the Q4 earnings call that the “going concern” warning that tanked CHK stock after November’s Q3 results would not be present in the company’s Form 10-K filed with the SEC. And he emphasized that Chesapeake, for now, had enough liquidity to stay solvent through at least 2021.
It’s fair to argue that if an investor was willing to pay 50 cents per share for Chesapeake’s stock earlier this month, she should be happy to own it at 24 cents now. But it’s possible that the report simply led some of those investors to realize their mistake.
Reality Hits Home
There’s one piece of news that contradicts the optimism coming from Lawler on the earnings call. As part of its 2020 plan, Chesapeake is looking to sell land.
Indeed, the company is looking to raise $300 to $500 million through “non-core” asset sales. That move alone highlights just how precarious the company’s situation is, for several reasons.
First, trying to sell land now is a desperate move. Valuations across the energy sector have been absolutely hammered as crude oil prices have dropped below $50 and natural gas has dipped under $2. Even Exxon Mobil (NYSE:XOM), despite its diversification efforts, trades at a 15-year low. Chevron (NYSE:CVX) stock has fallen off the table. Pure-play producer Apache (NYSE:APA) has lost over 25% of its value just since last month’s highs.
That is the definition of a buyer’s market. Only a desperate company would try to sell land in this environment.
Second, those sales simply won’t move the needle on the company’s debt load. Chesapeake’s debt load rose over $700 million in 2019 alone. The company still has nearly $9 billion of dent outstanding. In a best-case scenario, those sales would eliminate 6% of its current debt.
But the news also crystallizes the vicious cycle in which Chesapeake finds itself. It has to grow its earnings to support its debt in the short-term and pay it off over time. Yet it also has to cut its costs and sell assets, simply to keep from burning more cash.
It’s impossible to do both. Its 2020 guidance actually shows that fact. Its target of positive free cash flow seems like good news. But Chesapeake has significant price hedges in place. According to the Q4 release, the company has 76% downside oil price protection at a price near $60. while 39% of gas production is hedged.
Those hedges aren’t available at current price levels. And so, in this environment, Chesapeake is still functionally unprofitable. Hedges can get the company through 2020, presumably. Once 2021 arrives, however, barring a massive spike in oil and natural gas prices, it will resume burning cash and its lenders may well run out of patience.
There’s a near-term problem, however. Lawler highlighted the company’s liquidity of $1.4 billion at the moment, most of which comes from additional money that the company can borrow.
On the call, Chesapeake management argued that the company’s asset base (which backs that facility) was large enough to keep that availability intact. The pressure, as CFO Nick Dell’Osso noted, comes from the leverage ratio (debt to earnings before interest, taxes, depreciation, and amortization, or EBITDA).
How will that get fixed? Asset sales, even if executed, would modestly reduce its debt. The company’s EBITDA, based on current oil and gas price levels, is headed for a significant decline in 2021. Once Chesapeake violates its agreements with its banks, there’s likely no way out for it.
The Math Doesn’t Work for CHK Stock
I argued before the company’s Q4 results were released that Chesapeake needed a miracle to avoid a restructuring. With energy prices even lower, that’s all the more true.
In the meantime, the shares may rally from time to time. The company’s shares nearly doubled from their November lows, after all. When a company’s shares trade below $1, they can make big moves. Even J.C. Penney’s (NYSE:JCP) stock doubled in a number of months last year.
But the only thing that can save Chesapeake is a massive increase in oil and natural gas prices. Even as the company has shifted its production toward oil, particularly via the Wildhorse deal, it still gets 44% of its revenue from natural gas. Those prices are at multi-year lows and show no signs of budging.
In that context, it’s worth returning to the 10-K. As Lawler noted on the call, the company’s land is worth $9 billion. Indeed, a so-called PV-10 analysis (which estimates the current value ofits proved energy reserves) values its proved reserves at $9.015 billion.
But that analysis uses 2019 pricing inputs, including oil at $55.69 and natural gas at $2.58. The West Texas Intermediate oil price is $46.10. The Henry Hub natural gas price, a common benchmark, is $1.73.
Those reductions don’t mean that the value of the company’s land has dropped by 25% or so.
Instead, they suggest that the value of the company’s land has collapsed because energy prices will stay “lower for longer.” Land that maybe is worth $5 to $6 billion now is trying to support debt that is nearly $9 billion.
That math doesn’t work. It only can if crude oil and, particularly, natural gas soar. But lenders are getting nervous, meaning Chesapeake is running out of time. That’s why CHK stock keeps falling and why it almost certainly won’t stop until $0.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.