I’ve been trying to warn investors to stay away from Chesapeake Energy (NYSE:CHK) stock for some time now. I haven’t done so because I dislike Chesapeake. Nor do I necessarily have any beef with the oil and gas sector (though it has its challenges at the moment).
Rather, the problem is simple. I don’t believe CHK stock has any value. Bankruptcy has loomed as a potential outcome for years now. The risk became even clearer last year, when Chesapeake first issued a so-called “going concern” warning.
The news has only become worse since then. Oil prices crashed during the coronavirus pandemic, and haven’t recovered their losses. Natural gas now is fading as well. At these prices, Chesapeake’s acreage simply is worth far less than its debt.
In fact, it’s worth much, much less. Some Chesapeake bonds are trading at as little as four cents on the dollar. And the equity is behind those bonds in a restructuring.
As I’ve written before, the math for Chesapeake stock simply doesn’t work. The only it way could work is if energy prices soared — and Chesapeake had time to benefit. But it’s becoming increasingly clear that, unfortunately, time is up for Chesapeake. And that means there’s still more downside ahead for CHK stock.
Optionality
The issue is not that Chesapeake’s business has no value. The issue is that its business is worth less than its debt.
To be fair, that doesn’t necessarily mean CHK stock is worth zero right now. A rough example is instructive. Assume a business is worth $1.2 billion. It has $1.5 billion in debt. The equity value can’t be less than zero — though, as we learned this year, oil futures can amazingly go negative — but in this example, it seems clearly to be zero.
But that $1.2 billion figure isn’t set in stone. Things change. The business can become more efficient. External conditions can improve. The $1.2 billion figure assigned by the market is based on what we know now. From that point, there are a range of possible outcomes.
That means this company, which seems insolvent on its face, still has some equity value. After all, there might be, say, a 20% chance the business is worth $2 billion in a year instead of the current $1.2 billion. Perhaps, like Chesapeake, it’s a wildcatter, which can benefit if energy prices soar.
If there’s a chance of that kind of rebound, there’s some value in the equity, even if it’s just a high-risk, high-reward option. In this (admittedly rough) example, the equity value should be about $100 million. (The equity is worth $500 million 20% of the time.)
Put another way, just because debt is greater than assets right now, that doesn’t mean a stock is worth zero right now.
The Problem for CHK Stock
That rough example would seem to apply to Chesapeake. Certainly, its assets are worth less than its debt right now. Indeed, it’s exceedingly hard to argue otherwise.
As I’ve noted before, Chesapeake’s own analysis at the end of 2019 suggested its properties were worth roughly $9 billion. That’s less than the company’s debt net of cash.
But the news is actually even worse. That analysis used oil prices of $55.69, with natural gas at $2.58. Crude now is at $40, and natural gas below $2.
Chesapeake’s assets are simply not worth its debt. They’re not even close.
Again, that on its own doesn’t mean CHK stock has no value. Oil and gas prices could rise. Chesapeake could expand its reserves. The properties were worth $9 billion by one estimate at the end of last year. That doesn’t mean they’re worth $9 billion forever.
The problem for Chesapeake, however, is that it needs time for any sort of bull case to play out. Most importantly, it needs energy prices to bounce back.
But Chesapeake, or at least its shareholders, don’t have much longer to wait for that bounce.
Bankruptcy Looms
Last week, Chesapeake skipped interest payments on two of its bonds, according to a Form 8-K filed with the U.S. Securities and Exchange Commission. That basically starts the clock. Chesapeake has a 30-day grace period from June 15, the day those interest payments were due.
That’s not enough time to change anything. It thus is exceedingly likely that Chesapeake’s move started the bankruptcy process. Credible reporting suggests that Chesapeake is positioning for a restructuring.
Now, some Chesapeake bulls might argue that even in a bankruptcy the stock still has value. Hertz (NYSE:HTZ) rallied after its own filing, though the bounce was illogical and most of the gains have faded.
Whiting Petroleum (NYSE:WLL) shareholders appear to be getting some sort of equity in that company’s restructuring. And rallies in names like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) show recovering investor sentiment toward energy stocks.
But those are all different stories. Again, investors need to look to the bond market. Unsecured debtholders are senior to shareholders in a restructuring. And those claims are being valued at literally pennies on the dollar.
If bondholders don’t get a recovery, equity holders most likely get zero. That’s the outcome toward which Chesapeake is heading — and it’s an outcome that’s arriving soon.
Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. The power of being “first” gave Matt’s readers the chance to bank +2,438% in Stamps.com (STMP), +1,523% in Ulta Beauty (ULTA) and +1,044% in Tesla (TSLA), just to name a few. Click here to see what Matt has up his sleeve now. Matt does not directly own the aforementioned securities.
