Chesapeake and SandRidge Alum Tom Ward Just Admitted How Bad The Energy Exploration Business Model Really Is

Those of you who follow the energy exploration and production industry probably know Tom Ward very well. He co-founded Chesapeake Energy with the late Aubrey McClendon in 1989 and later left to start SandRidge Energy in 2006. With Chesapeake struggling mightily these days (there were whispers of a bankruptcy filing earlier this year and shares trade below $4, down from an all-time high of $74 back in 2008) and SandRidge having filed bankruptcy just this month (Ward was fired as CEO in 2013), Ward’s two companies are wonderful examples of how the need to grow via debt financing can cripple energy exploration firms. Undeterred, Ward founded Tapstone Energy in 2013 as act number three.  Tapstone’s web site reads “Tapstone Energy: A Tom Ward Company.” I’m sorry, but given Ward’s track record that’s quite humorous.

I just saw Tom on CNBC discussing the current state of the domestic energy market and one of his comments was very instructive for energy investors. He said the industry’s “dirty little secret is that you cannot spend within cash flow and grow production.”  This comment was following his assertion that lack of access to capital was the real hindrance to the industry right now because banks “want you to spend within cash flow.”

I guess banks only want to lend money to energy companies that can operate at free cash flow break-even at a minimum. This is very logical of course, as it means that the profits from the oil and gas sold can cover the interest payments due to the banks. I find it amusing that Ward is in a way criticizing the banks for being so strict so as to want to ensure they can be repaid.

But the “dirty little secret” comment is most important in my view. What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.

This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.

I wish I had heard this comment many years ago, as it might have allowed me to realize a lot sooner just how bad of a business model most independent energy producers are employing. What is amazing is how many people continue to want to invest aggressively in the sector.

Oil Slump Shines Light on Weakness of Fracking Business Model

It remains to be seen if the U.S. is in the midst of a popping bubble in shale oil and gas exploration, or if a temporarily supply glut will merely be a bump in the road, but the last couple of years have served to shine a light on what should be alarming for those who continue to be bullish on the equities of fracking companies.

The biggest crack in the long fracking investment thesis has to be the amazing lack of free cash flow generated by these companies. When oil prices were hovering around $100 per barrel investors were content with capital expenditures that far exceeded operating cash flow in the name of “growth.” Leading frackers like Continental Resources (CLR), Pioneer Natural Resources (PXD), and Range Resources (RRC), among others, borrowed billions of dollars in order to continue acquiring land and drilling for oil and gas. As long as in-ground reserves increased, investors did not worry much about negative free cash flow or the lack of material dividend payments or debt repayment. They simply valued the companies based on the value of their millions of barrel of reserves.

Such events are not that surprising during a boom, but the strangest thing is what happened after oil prices cratered. At current prices, the fracking companies are rushing to slash operating costs and focus only on their lowest cost wells in order to bring cash operating costs per barrel down as low as possible. Doing so allows them to continue to service their debt and wait for commodity prices to turn around (at least for those companies with above-average acreage and manageable leverage).

What I find so disturbing is what has happened to the cash flow statements of these fracking companies during this transition away from rapid growth and towards operational efficiency; most of them are only able to operate at free cash flow breakeven, at best. The economics of fracking are so poor that even when you are supremely focused on minimizing operating costs and extracting from only your most productive wells, you still cannot generate free cash flow. And yet, these circumstances are exactly when you would expect profits to be highest (again, your best wells operating at the lowest possible cost). Simply put, the economics of fracking for low-cost producers should be very strong right now, but they are not.

What does this say about the fracking business model? Why should investors be putting their money into these stocks?  If you care at all about the quality the businesses you invest in, and you judge quality at least to some degree by how profitable the model is, this energy cycle should be very illuminating. If the best companies in the industry cannot generate material free cash flow today, then when?

The pipeline stocks look better and better to me every day.

Full Disclosure: No positions in CLR, PXD, and RRC at the time of writing, but positions may change at any time

The Oil Shale Revolution Is A Double-Edged Sword

Back in the old days falling energy prices were a clear incremental tailwind for the U.S. economy. Some economists even went as far as to argue that low gasoline prices were the equivalent of a tax cut for consumers, but that line of thinking never made sense to me. After all, a tax cut implies that you have more money in your pocket, but when gas prices go down you have the same amount of money. You are simply able to reallocate some of it away from gas and into other things, as your total spending stayed the same.

Then the shale revolution came to the U.S. and technological advances resulted in states like Colorado, Ohio, Pennsylvania, and North Dakota having large slices of their regional economies linked to oil production. The tide shifted and the U.S. economy now was tied to oil production as opposed to simply consuming oil imports from Canada and the Mideast. When oil prices were high that was a good thing, but now that oil has cratered from $100 per barrel to below $30 we can clearly see the other side of the double-edged sword.

To understand why the stock market is reacting so much lately to falling oil prices, we simply have to think about the ripple effects now that we have so many more domestic oil producers. Most of these shale firms are relatively new companies that borrowed billions of dollars to acquire land and start drilling. Their business models were predicated, in most cases, on oil prices of $75-$100 per barrel. Once prices dropped below $50 certain companies no longer could produce oil profitably. As prices have continued to fall, more and more companies fall into that category. Very, very few can make money sub-$30 per barrel.

So what happens in this scenario? Frankly, many smaller oil companies will not survive. Without profits they will not be able to pay the interest on their debt (let alone the principal), which causes multiple problems. Most importantly for investors and financial markets, as debts go unpaid lenders will lose a lot of money. The energy sector owes tens of billions to banks and investors who hold their corporate bonds. Much of that debt is held in mutual and exchange traded funds, so the losses will accrue from the biggest banks all the way down to small investors. And without knowing how low oil prices will fall, and for how long it will stay there, there is no way to know exactly how many companies will survive and how much debt will go into default. That uncertainty is impacting financial markets today, this month especially.

The other issue worth mentioning is why exactly oil prices have not been able to stabilize after so many months of decline. The problem of excess supply is not self-correcting as quickly as many might have thought (the cycle looks like this: high prices result in too much drilling, prices fall due to oversupply, production is curtailed due to unprofitable prices, supply comes down to balance the market, low prices spur demand, prices stabilize and rebound).

For these shale companies want to hang on as long as they can, they simply need to keep paying the interest on their debt. If their debt does not come due for another 2-3 years, the companies can continue to sell oil at prices above their cost, so long as they have a little runway left on their bank credit lines and they can generate enough cash to cover interest payments. The reason we have not seen many oil-related bankruptcies yet is simply because very little of the debt has come due. But that time will come, and as long as oil prices remain low the banks and other lenders will not shell out any more money. Only then will companies stop producing, which will start to bring the supply/demand picture back into balance.

Coming back the stock market specifically, it is important to note that the non-energy sector is doing just fine (S&P 500 companies actually grew earnings in 2015 if you exclude the energy sector). Lenders will take some losses on their energy loans, but the size of that market is small relative to the rest of the economy. For that reason, it is fair to say that the current stock market correction is sector-specific and not indicative of a widespread, systemic problem (unlike in 2008 when banks were in danger of closing, this time they will simply take losses on a part of their loan book).

For comparison purposes, today’s situation reminds me very much of the dot-com bubble that peaked in early 2000. As was the case with oil in recent years, back then there was a bubble in one sector of the domestic economy (tech and telecommunications). While it caused a recession in the U.S. the problem was contained to that one area, which allowed for a relatively swift recovery. In fact, S&P 500 corporate profits peaked in 2000 at $56 before falling by 30% to $39 in 2001. Earnings began to rebound in 2002, got back to even in 2003, and hit a new all-time record of $67 in 2004.

The goods news is that this time around things should turn out considerably better because the energy sector peaked at 15% of the S&P 500 index in 2014, whereas the tech and telecom sectors comprised 30% of the S&P 500 in 1999. Therefore, energy should have only about half of the impact compared with the technology sector 15 years ago. Even as oil prices collapsed in 2015, S&P 500 profits only fell by 6% from their peak. While that number could certainly get a bit worse if oil stays at current prices for the duration of 2016, there is a floor in sight; in terms of market value the energy sector today only represents 6% of the S&P 500.

Contrarian Opportunity of the Moment: Oil Stocks

You may remember back in 2008 there was a debate about whether financial market participants (“speculators”) and the billions of dollars they moved around every day were impacting prices to such an extent that it severely widened the gap between what was “real” in the world and what the markets were supposedly telling us. Efficient market believers want us to think that the market always reflects reality and things rarely get off track. As we saw in 2008, however, market prices often did not accurately gauge the underlying fundamentals of the financial industry. Many companies were in trouble, no doubt, but when pretty much every single asset is mis-priced at the same time, there are clearly instances where the short-term traders have overcome the system regardless of what the underlying fundamentals truly are.

I am not saying that today’s oil market is anywhere near as mis-priced today, but when the price of a barrel of oil fetches $100 in late July and then in December drops to $58, when very little in the world has changed during the interim, investors need to ask themselves if the daily ebb and flow of the capital markets, and the computers that largely control that flow these days, is materially impacting the price action we are seeing in the oil market.

Is the U.S. energy production boom helping contribute to a temporary glut of oil? Yes. Has the supply-demand picture shifted so much that $58 oil reflects the true balance between supply and demand in the end markets for crude oil? I suspect probably not. Now, if $100 per barrel was the “wrong” price based on supply and demand then you can certainly argue that prices should have come down quite a bit. But when prices drop so quickly and then the fall accelerates lately as it has, I have to think financial “speculators” and short-term hedge fund traders are controlling the near-term price quotes.

CRUDE OIL PRICES HAVE DROPPED BY 43% IN LESS THAN 6 MONTHS

oil-july-dec

If you think we will look back a year or two from now and think $58 oil was a bargain, as I do, then now is the time to think about increasing exposure to the sector. Below are some of the names I like along with their current quotes (long all except EOG as of this writing).

Mega-cap integrated dividend payer: BP PLC (BP) $36

Large cap E&P growth: EOG Resources (EOG) $86

Small cap E&P growth: Halcon Resources (HK) $1.95

Pipeline infrastructure: Enlink Midstream (ENLC/ENLK) $29/$25

 

First Carl Icahn, Now Former Warren Buffett Co-Manager Lou Simpson Invests in Chesapeake Energy

Corporate activist investor Carl Icahn timed his 6% investment in natural gas driller Chesapeake Energy (CHK) almost perfectly earlier in 2011, buying in the low 20’s and selling in the mid 30’s a few months later after extracting a publicly announced debt reduction plan out of management. Now, with the stock back down to prices even lower than where Icahn originally bought, Lou Simpson (former GEICO executive and Warren Buffett number two investment manager at Berkshire Hathaway (BRK)) has bought 200,000 shares in the energy producer.

Simpson, long considered to be a possible Buffett successor despite only a small age difference, retired from Berkshire in 2010 but remains active as a director on three public company boards of directors. Chesapeake is one of the three and the latest. Interestingly, in recent months Simpson has sunk more than $5 million of his own money into Chesapeake stock, at prices in the high 20’s. This is a rare move for Simpson, who typically does not make moves in the public eye like this. As a director though, he must update his holdings in Chesapeake whenever changes are made. I find this move especially telling because in the case of the other two public companies he is involved with, he has largely been given stock options in return for his service, whereas direct open market purchases are rare for him. Often times new directors make small investments (say, a few thousand shares) to show public support, but Simpson has made two separate purchases of 100,000 shares each, for more than $5 million in total.

Now, some may point out that Simpson is worth a heck of a lot of money, so $5 million to him may be peanuts relatively speaking. And I can’t argue that point, but given Simpson’s investment savvy, coupled with the fact that he has not done this with the other companies he serves, I think it is worth noting and is likely due to his belief that the stock is actually quite attractive.

CHK shares, as mentioned previously, are down a lot in recent weeks, as natural gas prices have sunk to $3 and the company continues to spend more on exploration and production than it brings in (to the detriment of equity holders), but it is now even cheaper than it has been previously. And given that Icahn was very successful with his first investment in CHK, I would not be surprised if he got back in, now that the stock price has given back all of the gains he booked, and more. Chesapeake investors, myself included, have been frustrated a lot in recent years, but these recent buys by Lou Simpson strengthen the case that giving up now might be a mistake.

Full Disclosure: Long shares of CHK at the time of writing, but positions may change at any time

BP, Goldman Sachs, Google, and FinReg… What a Day!

Today is the kind of day that investment managers such as myself love; lots of resolutions on multiple issues that have been holding back certain companies, stocks, and industries. Let me tackle each one briefly.

BP: While it is nice to see the ruptured well capped without any oil spewing out, we have to keep things in perspective. This is a test, this is only a test. The well has been capped for only a couple of hours and leaks could still surface, not to mention the fact that the pressure could further damage the well. Hopefully the relief wells can be paired with this latest cap to finally put a stop to the oil leak, but it is too early to say and the rally in BP shares today (up 3 points) will easily vanish if any issues arise.

Goldman Sachs: News of a $550 million settlement with the SEC is great news for investors. Most were assuming a $1 billion fine to ensure they avoided a fraud charge but it came in at half that amount. Goldman reports earnings Tuesday and the numbers have been ratcheted down a lot due to a weak trading environment early in the second quarter. With the bar set so low, they could surprise on the upside, but the stock is getting a nice bump from the SEC deal, so any further move higher may take some time to develop. I still see GS as the premier firm in the space and earnings should climb back later in the year, which is why I will still be holding the stock for clients.

Google: The stock is down after revenue for the second quarter came in a bit higher than estimates but profits fell short on higher expenses. The company is back in acquisitive mode so free cash flow is on the decline. Without a new, clear growth engine (I am not convinced yet that Android app sales will fit the bill, but they are promising) I would not be willing to pay a premium for the stock. With 2011 earnings estimates around $31-$32, putting a 15 P/E on that gets you to $475 per share, right where the stock is trading after-hours. Color me neutral at these levels.

FinReg: Now that this bill has passed the Senate, we can finally stop hearing about it so much. The banks will see their margins on certain financial products squeezed temporarily (overdraft protection, for instance, is now opt-in, not automatic), but banks will always find ways to recoup the lost income in other ways (free checking accounts, for instance, may become less common in the future). The negative talk today was that the banks and investors are worried because the bill gives regulators a lot of power in forming new rules and this adds to uncertainty. This argument baffles me. Regulators already have the power to make new rules to deal with issues they discover in the marketplace. The bill gives regulators oversight over a few more areas of the financial services industry, but the idea that giving them the power to make rules is a new and overly aggressive idea is simply wrong. That has always been the role of regulators! Now we just need them to do their job, and frankly, that is the part that always seems to let the American people down. I have no reason to think anything will be different this time around.

Full Disclosure: Long shares of BP and GS at the time of writing, but positions may change at any time.

BP Stock Reacts Well as the Obama Administration Helps Craft Framework for Spill Cost Outlays

Once the decline in BP plc (BP) stock reached 20% after the Gulf spill I was in the camp that felt that BP’s stock price drop was overdone given the oil giant’s financial strength. However, as the oil has continued to gush despite repeated efforts to stem the flow, BP shares have continued to fall, which at its worst levels amounted to a market value loss of 50% or $95 billion. While my initial nibbling in the stock was premature (I, like many people, figured BP would have better success containing the well after 2 months of trying), I still believe the stock market reaction has been excessive.

Thus far on this blog I have resisted providing specific financial projections to back up such an assertion, due mostly to the fact that the oil continues to pour out of the ruptured well, making the potential liability unlimited and unknowable. That said, Wednesday’s meeting between the Obama Administration and BP executives was helpful for value investors looking at BP. During the meeting they were able to agree on a timetable for cash outlays to cover the spill’s economic damages, which gives us a lot more clarity as to the financial impact on BP in the coming months and years.

As a result, I will run through some of these numbers and show why I still believe that BP can survive this spill somewhat easily, simply due to the size and financial strength of the entire company. We must remember that BP is one of the world’s largest and most profitable companies (we are not dealing with accounting games at Enron or 30x leverage at Lehman Brothers).

Let’s start with the costs of the containment efforts and the clean-up of the oil. So far BP has spent $1.75 billion in the two months since the Deepwater Horizon rig exploded. Industry experts expect this run-rate of expenses (about $1 billion per month) to drop once the well has been capped (evidently undersea robots drilling with diamond studded saws are pretty costly), but to be extremely conservative I have been assuming that the containment/clean-up costs continue at $1 billion per month through 2011 before the drop. This equates to $12 billion per year in containment and cleanup costs as a conservative estimate.

The White House and BP agreed Wednesday to a $20 billion escrow account to be used for economic claims from businesses. BP has announced it will pay $5 billion into the fund this year and an additional $1.25 billion each quarter beginning in 2011, until the $20 billion has been fully funded. This comes to $5 billion per year for 2010 through 2013.

It is also important to understand that BP will be subject to additional fines and penalties under the U.S. Clean Water Act, based on how much oil ultimately is determined to have been spilled into the ocean. Because the oil continues to flow from the broken well, this aspect of the cost equation is still unknown, as is the exact daily flow rate. Current estimates are 35,000-60,000 barrels per day. If we assume the oil flow is completely stopped by September 3oth (the current expectation is sometime in August) and a penalty of $4,300 per barrel is assessed, these fines could amount to about $30 billion. However, those fines and penalties will likely be fought over in court and therefore the amount will be unclear for a while. Still, because of this unknown liability, I likely will not be buying more BP stock until the well has been capped completely.

The question for investors, obviously, is whether or not BP can afford these projected costs. We are talking about $17 billion per year in containment, clean-up, and damages, plus fines. Let’s look at some of their first quarter 2010 financial metrics to get an idea of their financial capacity:

Operating Cash Flow: $7.7B     Capital Expenditures: $4.3B     Free Cash Flow:  $3.4B     Dividends Paid: $2.6B

The dividend has been scrapped for now, so we can expect that BP’s ongoing operations will generate about $14 billion per year in free cash flow. However, we must keep in mind that these costs are pre-tax figures. BP paid about $8 billion of income taxes in 2009 and all spill costs will be able to be used to offset operating profits and therefore save the company billions in taxes. On an after-tax basis, $17 billion in annual spill costs comes out to an adjusted figure of about $12 billion of cash outlay. As you can see, BP should be able to handle these clean-up costs without dramatic capital expenditure reductions (they have announced a 10%/$2 billion annual reduction in capex).

Additionally, BP has said they have about $10 billion in available credit facilities and also expect to divest $10 billion of assets over the next 12 months. Undoubtedly that money will be used to help pay the penalties and fines that it will ultimately be forced to pay, as well as serve as a cushion if claims come in higher than $20 billion or the well gets worse rather than better. Unlike some energy firms, BP has a very strong balance sheet, with $8 billion of cash and a debt-to-capital ratio of 20%, at the low end of their 20-30% target range. As a result, the company could take on up to $17 billion in new debt and still be within that range.

Finally, we cannot forget that BP only owns 65% of the ruptured well. They will almost certainly ask Anadarko (APC) and their other partners to foot their portion of the bill, although we can expect the court system to play a major role in that process.

All in all, the financial strength and size of BP makes it possible for the company to use normal business activities and a bit of financial management to pay for the spill. Even using an aggressive estimate $50 billion in total spill-related costs over the next few years should not force BP into dire financial straits. Not only that, but the last Exxon Valdez spill claims were settled quite recently, about 20 years after the accident occurred. Even if costs are higher than current estimates and take longer to resolve, BP should be okay given that the company brings in about $30 billion per year in operating cash flow.

I figured it would be helpful to go through these figures because some people on Wall Street have been talking about BP being forced into bankruptcy due to the Deepwater Horizon disaster. Barring some unforeseen, unexpected, or simply unheard-of developments, it certainly seems that BP’s reputation will be hurt far more from this spill than their finances will be. Obviously things can change, but these are the kinds of numbers I have been looking at in recent weeks and I think they are very interesting, even if one has no interest in bottom-fishing in BP stock. Less aggressive investors might want to look at BP bonds, which recently yielded between 8 and 10 percent in the 1 to 5 year maturity range.

Full Disclosure: Peridot Capital had a small long position in BP stock at the time of writing, but positions may change at any time

BP Stock Drop Hits 50%, Market Value Loss Reaches $94B as Panic Ensues

Shares of BP are getting clobbered again today, down to about $30 per share, or 50% since the rig explosion in late April. Today’s worries are being attributed to two stories. First, talk of a dividend suspension is not exactly new and even if the company did suspend dividends, or as I have suggested, paid out a BP stock dividend rather than cash it should not have any impact on the stock price (shares are not valued off of dividend yields, only cash flows). Also today the New York Times wrote about a possible pre-packaged bankruptcy for BP:

“But all those numbers don’t account for the greatest possible threat: a jury verdict against BP. Such a verdict might push the cost of the spill into the hundreds of billions. If that happened, even BP might buckle.

This outcome might seem far-fetched right now. But on Wall Street bankers have already coined a term for it: “the Texaco scenario.” In 1987, Texaco was forced to file for Chapter 11 because it could not afford to pay a jury award worth $1 billion to Pennzoil. That award had been knocked down by a judge from a whopping $10.53 billion.”

Talk about instilling fear into the market. The New York Times forgot to mention that shareholders did not get wiped out in the Texaco bankruptcy, as they normally do in Chapter 11 proceedings. It simply was a restructuring move. BP has now lost half its value, a stunning $94 billion, since the oil rig they were leasing exploded on April 20th. The dividend yield now sits at 11%, even though it seems unlikely BP will ignore political pressures and actually continue to pay out cash to shareholders while oil is still flowing into the Gulf.

As is often the case, the stock market has now entered full blown panic mode with BP stock. It is pretty crazy to watch all of this play out. I can understand if people don’t want to touch BP stock with a ten foot pole, but I am sitting tight on a small long position in client accounts, as I don’t really see how one can argue a $94 billion market value loss is warranted here.

Full Disclosure: Peridot Capital was long BP in select client accounts at the time of writing, but positions may change at any time

Given Its Financial Strength, BP Should Pay Its Dividend in Stock Rather Than Cut It

The main reason value investors may be willing to take a stab at BP plc (BP) stock after a nearly 40% drop since the rig explosion is their financial strength. BP earns about $20 billion per year and has a net debt to capital ratio of less than 20%. Combine very profitable operations and a strong balance sheet with plenty of borrowing capacity and you can see why even an ultimate liability of $15-$25 billion over the next several years could be absorbed by the company.

Given that these situations usually turn out to be buying opportunities, I have begun to accumulate small positions in the stock for some of my clients, even though I admit the ultimate financial impact is unknowable at this point. The company’s financial strength coupled with the $70 billion market value loss so far give me enough of a cushion to take a position so long as it is part of an otherwise diversified portfolio.

With the failure of the “top kill” procedure and news that relief wells likely will not be completed until August, there are renewed worries about the sustainability of BP’s dividend, which at $3.38 per share ($10.6 billion) annually stands at about 9.25% right now. Given that BP’s operations are still throwing off tons of cash and the company has only spent about $1 billion in the first five weeks of this disaster, cutting the dividend does not seem like a necessary step to take from the cash preservation perspective. Still ,with political pressures mounting, BP may not want to pay out billions of cash to shareholders until this spill is under control.

I think that makes sense from a PR perspective,  but BP should really consider paying out their dividend in stock rather than choosing to cut it for PR purposes. Such a move would succeed in padding the company’s cash hoard (which stood at $8 billion as of March 31st) and silence any critics who would be angered if the company paid out cash to shareholders before fixing the hole and paying for the cleanup. After this spill is contained, BP’s underlying profitability will be unchanged and any dividend cut would be reversed anyway. Some banks shifted to stock dividends in late 2008 and early 2009 and it worked very well. Such a move would both silence the critics and preserve precious cash, but the shareholders would not be completely left out in the cold. It simply makes more sense to do that rather than take on more debt and pay interest on the additional borrowings or sell certain assets that are the key to BP’s future success.

Full Disclosure: Peridot Capital was long BP at the time of writing, but positions may change at any time.

Chesapeake Energy Swaps One Type of Capital for Another, Creating Little Shareholder Value

Last week Chesapeake Energy (CHK) announced a plan to increase shareholder value over the next 24 months by reducing the company’s net debt by $3.5 billion over that time. By doing so, the company hopes to attain an investment grade credit rating, something that has been out of the firm’s reach as it has accumulated a sizable debt load as a result of growing the company into one of the largest natural gas exploration and production companies in the United States. The plan is being sold to investors as a way to increase CHK’s stock price but it appears to me that they are simply issuing one form of capital to repay another.

Chesapeake’s plan has two prongs, so to speak. First, the company expects to raise $5 billion from a combination of asset sales and preferred stock issuances in order to repay $3.5 billion of senior debt. This would reduce the company’s net debt position from just under $12 billion to about $8.5 billion. The remaining $1.5 billion in funds will be used to expand the company’s oil exploration activities, as crude oil prices have rebounded far more quickly than natural gas prices in recent quarters (CHK currently has about 90% of its reserves in natural gas).

On the face of it, this plan does look promising for shareholders. Reducing net debt will boost equity value in the absence of any dilution from the capital raises. Unfortunately, on Tuesday afternoon Chesapeake announced that it has raised a total of $1.7 billion from the sale of new 5.75% convertible preferred shares. Typically convertible preferred is attractive from a corporate standpoint because it tends to carry very low interest rates (in exchange for having equity-like upside from the option to convert into common stock). However, since this new preferred stock is costing CHK 5.75% per year in interest, it hardly looks like a way to boost shareholder value.

In fact, Chesapeake has also announced that it is using most of the proceeds from the new preferreds to redeem $1.334 billion of senior debt. This debt carries interest rates of between 6.875% and 7.5% with maturity dates ranging from 2013 to 2016. As a result, CHK is replacing $1.3 billion of senior debt (average interest rate: 7.2%) with $1.7 billion of convertible preferred stock (interest rate: 5.75%). How is this helping shareholders? The interest on the new preferred will actually cost CHK $98 million per year, more than the annual interest payments ($96 million) paid out on the senior debt they are retiring! Not surprisingly, Wall Street has yet to cheer these announcements with a higher stock price.

Now to be fair, there are some marginal benefits associated with this capital swap, which I am sure the company would point out if asked. First, if Chesapeake does get a credit rating upgrade over the next two years as a result of this plan, it could possibly see a small decrease in the interest rates it needs to pay on future borrowings.  Second, CHK is extending the average maturity schedule of its debt by replacing senior notes due to mature over the next six years with convertible preferred shares that come with no maturity date.

These small benefits aside, this type of capital exchange is not likely to help equity holders. Few people are going to be overly impressed by debt reductions accomplished by issuing other forms of capital to replace them (and in this case, raising more new capital than the amount of the senior debt repayments). If Chesapeake really is serious about increasing shareholder value, they are going to have to use free cash flow from operations to reduce their debt load.

A big reason the stock price has lagged, aside from the fact that natural gas prices are in the tank right now, is because the company insists on using all of its profits (and more oftentimes) to continue to grow the company. As borrowings have grown, even increases in production and operating cash flow have not been enough to increase shareholder value. In fact, consider the data below, which I compiled from CHK’s 2009 annual report.

Although the company has grown its oil and gas production and operating cash flow, it has taken a lot of new debt and common equity raising to accomplish these growth objectives. Not surprisingly, equity holders have reaped a negative benefit despite CHK being a much larger company today than at the end of 2005. This latest plan to increase shareholder value seems to me to just be more of the same. The company likes to say it is trying to increase shareholder value, but does not go anywhere far enough to actually make it happen.

Full Disclosure: Peridot Capital was frustratingly long shares of CHK at the time of writing, but positions may change at any time