Chesapeake CEO Loans Block Upgrade Aspiration: Corporate Finance

Chesapeake Energy CEO Aubrey McClendon
Aubrey McClendon, chairman and chief executive officer of Chesapeake Energy Corp. Photographer: F. Carter Smith/Bloomberg

Chesapeake Energy Corp. Chief Executive Officer Aubrey McClendon says the second-largest U.S. gas producer is on track to be in investment-grade shape by the end of this year. The bond market is pointing the opposite way.

Credit-default swaps tied to the Oklahoma City-based company’s debt surged to levels that imply it should only be rated B2, according to Moody’s Corp.’s capital markets research group. Moody’s Investors Service rates Chesapeake Energy senior unsecured debt Ba3, and Standard & Poor’s has it one step higher, BB+. The company had $10.6 billion of long-term debt at the end of last year.

The swaps soared this week after reports that McClendon, a company co-founder, has been using his personal 2.5 percent stakes in some Chesapeake Energy wells as collateral for loans that weren’t fully disclosed to shareholders. Credit markets are built upon trust between lenders and borrowers, and the jump in the swaps suggest that link may be breaking down for Chesapeake Energy.

The “loan scandal” has “severely tainted the company,” according to Marc Gross, a money manager at RS Investments in New York who oversees $3 billion in fixed-income funds, including Chesapeake Energy bonds. “There is no chance of an IG rating” over the next three years, he said. Chesapeake Energy is “more likely to get downgraded than upgraded,” and the investment-grade goal “shows that they are out of touch with reality,” he said.

Jim Gipson, a spokesman for Chesapeake Energy, declined immediate comment.

‘Materially Improve’

While Chesapeake Energy is seeking investment-grade metrics by year-end, a rating reflecting that may take several years, McClendon said April 18 during an Independent Petroleum Association of America investment conference in New York. The company’s $10.6 billion in debt is down from $12.6 billion at the end of 2010, according to data compiled by Bloomberg.

Peter Speer and Steven Wood, Moody’s analysts, wrote in a Feb. 13 note that for its corporate family rating to qualify for an upgrade to Ba1, the highest non-investment level, from its current Ba2, Chesapeake Energy’s leverage will have to decline from Dec. 31 levels and liquidity will have to “materially improve” with reduced reliance on asset sales. The company’s leverage as measured by debt to earnings before interest, taxes, depreciation and amortization ratio was 2.03, Bloomberg data show.

Credit-default swaps tied to Chesapeake Energy surged to the highest since October 2009 on April 18 after Reuters reported this week that the structure of McClendon’s personal loans wasn’t fully disclosed to shareholders and created potential conflicts of interest.

Never High-Grade

Swaps have never signaled the company should be considered high grade, according to Moody’s data that goes back to January 1999.

Credit-default swaps tied to Chesapeake Energy reached 4.9 percent upfront, according to prices from data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. That’s in addition to 5 percent a year, meaning it would cost $490,000 initially and $500,000 annually to protect $10 million of Chesapeake Energy’s debt.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

Chesapeake Energy’s $1.3 billion of 6.775 percent notes due March 2019 fell to 97 cents on the dollar from 100.75 on Feb. 24, to yield 7.33 percent at 11:21 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Lowered Outlook

The company’s bonds on average yield 6.79 percent as of yesterday, closer to the 6.99 percent of all junk-rated energy companies than the 3.6 percent of those in the investment-grade sector, according to Bank of America Merrill Lynch index data.

Shares of Chesapeake Energy, which is smaller only than Irving, Texas-based Exxon Mobil Corp. among U.S. gas producers, fell to $18 yesterday, down 9.8 percent for the week. The shares have dropped 19 percent this year through yesterday. The shares declined 0.9 percent to $17.83 as of 11:56 a.m. in New York.

Moody’s lowered its outlook on Chesapeake Energy to “stable” from “positive” on Feb. 13, citing weakening natural gas prices and the company’s capital expenditure plans outpacing cash flow, meaning it would need to sell more assets or tap capital markets.

Chesapeake Energy plans to issue shares in its hydraulic-fracturing business unit Chesapeake Oilfield Services Inc. to raise $862.5 million to repay debt, make a cash distribution to its parent company and for general corporate purposes, according to a prospectus filed April 16.

Personal Finances

Although McClendon’s personal finances won’t factor into debt analysts’ calculations, credit-rating firms are wary of the company’s debt load and its penchant for using forward commodity sales to raise cash for drilling, said Scott Hanold of RBC Capital Markets LLC.

“The complexity and the way they structure some of their transactions will work against them when they are seeking investment-grade,” Hanold, an equity analyst with a rating the equivalent of “hold” on the shares, said in a telephone interview from Minneapolis. “I’m not sure the credit-rating agencies see these things the same way Chesapeake does.”

The company has raised $6.4 billion since December 2007 through a series of so-called volumetric production payments, or VPPs, that require Chesapeake Energy to deliver a certain amount of gas or oil over a given period of time, in exchange for up-front cash. In the most recent transaction, Chesapeake agreed to sell Morgan Stanley 10 years of future gas output from a geological formation known as the Granite Wash for about $745 million, according to an April 9 statement.

‘There Is Fire’

“The credit-rating agencies regard these VPPs as off-balance sheet debt,” Hanold said. “The VPPs are a form of leverage that has to be taken into consideration.”

Shareholders are protected if McClendon, Chesapeake’s 52-year-old co-founder and chairman, defaults because the company holds first liens, an overriding claim, to the oil and gas that flows from the wells he used for collateral, General Counsel Henry J. Hood said April 18.

“Since Chesapeake is not a party to the loan documents, the liens and provisions do not reach Chesapeake’s intangible assets,” Hood said in an e-mailed statement. McClendon has had the right to buy stakes in Chesapeake wells since 1993, in an arrangement which requires the CEO personally to pay a proportionate share of drilling costs on those wells, Hood said.

McClendon ranks 359th on Forbes magazine’s current list of wealthiest Americans, with a net worth of $1.1 billion.

“At the very least this highlights weak corporate governance,” Gross said. “Worst case is there is an ongoing series of revelations that highlight a major breach in fiduciary duty. Sometimes when there is smoke there is fire.”


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