Tuesday, May 11, 2010

Chesapeake, Liquids and Buzzwords

Chesapeake Energy's public relations department was a flurry of press releases and buzzwords yesterday.  First, the company announced that it has struck a deal to sell $600 million preferred stock to two Asian investors. That press release was written by lawyers to the letter of the SEC regulations.  A second press release trumpeted Chesapeake's "Strategic and Financial Plan to Increase Shareholder Value and Reduce Debt."  That one was written by the folks in the Investor Relations department to please Wall Street.

The "strategic" plan calls for Chesapeake plans to raise up to $5 billion to pay off $3.5 billion of debt and invest $1.5 billion in "liquids-rich plays."  Everyone is talking about the liquids these days, especially when talking to Wall Street analysts.  Unfortunately for Chesapeake it has to further extend itself financially to pursue these projects.

To raise $5 billion, Chesapeake first will sell preferred stock to two big Asian investors, Temasek, the Singapore sovereign wealth fund, and Hopu Investment Management, a Beijing-based firm.  Chesapeake has the potential to sell another $500 million of a similar security to other Asian investors within 30 days.  Chesapeake is also looking at domestic investors for a private placement of equity.  Second, Chesapeake will sell 20% of its Marcellus Shale ownership entity, Chesapeake Appalachia LLC, in the next 3-12 months.  Presumably this is 20% of the 67.5% left after the JV deal it struck with StatoilHydro in 2008.  CEO Aubrey McClendon suggested this might bring in up to $2 billion.  Third, the company will create more E&P joint ventures and "monetize" (a.k.a. sell) certain unnamed but assuredly "non-strategic" assets.  (Actually, the release suggests the "monetization" of Haynesville midstream and gathering infrastructure as an option.)

The main goal for Chesapeake is to reduce $3.5 billion debt.  I'm a conservative guy, so debt reduction is always a good thing in my book.  One of the first things one learns in finance courses in business school is that a company is constantly striving to find the optimum balance of debt and equity.  The answer is different for every company. Even with all of the billions the company has earned selling bits and pieces of its gas plays, Chesapeake still has a lot of debt, so the balance is still out of whack on the debt side.  As a result, the company has decided to sell more equity (potentially diluting shareholders) and sell assets to re-balance the equation.  The ultimate goal is to gain investment grade debt rating and therefore increase shareholder value. 

Whether selling stock and assets to pay down debt "increases shareholder value" is yet to be seen.  I also wonder if a company that nearly outspends its annual operating cash flow every year is ever eligible for an investment grade rating. 

The secondary goal is to raise $1.5 billion to spend on liquids projects that are all the rage these days.  With natural gas prices stuck in the doldrums, gas-centric E&P companies have seized on targeting "liquids-rich" plays for oil and NG liquids, both of which have stronger commodity prices than natural gas.  As one might expect, Chesapeake's commitment to liquids is decidedly not half-assed.  The company hopes to be operating 50 rigs in liquids-rich plays in 12 months (up from 21).

The emphasis on liquids is a good move given the current economics, but companies run the risk of a wild goose chase of spending lots of capital on the next "it play."  I think many companies learned hard lessons in the Haynesville Shale, but I still get the feeling that E&P companies are working too hard to please Wall Street analysts. 

I read EOG Reources' recent first quarter earnings announcement last week and there was not a single mention of a natural gas play.  The three minor references to natural gas were in conjunction with oil production.  True, EOG was an early promoter of adding liquids to the mix, but in 2009 the company's production volume was 78% natural gas!  There was no mention of the Haynesville Shale, where the company currently runs 13 rigs.  You had to dig deep in the company's PowerPoint presentation to find the one Haynesville slide.

With the heightened focus on liquids, these producers are capitalizing on the fact that the ratio of gas to oil prices has broken the historical band in oil's favor.  They also are counting on the "new new" ratio continuing well into the future.  Are they chasing the latest fashion trend or making shrewd long-term decisions?

I'm a gas fan, so maybe I'm a little bitter to see the spotlight shift away from natural gas when it has finally entered the national stage.  These companies need to do what they can to survive and thrive and maybe the liquids push is the right way to go. Only time will tell.

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