Markets

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Chesapeake Energy is not a name you associate with “winner” these days. “Doomed," perhaps; “survivor” if you’re feeling generous (or own the stock.) But “winner?"

Believe it.

Winning?
Source: Bloomberg

Sometime early this year, Chesapeake did something that many others had stopped doing: It bought its own bonds. Specifically, it bought $60 million worth of convertibles that mature in 2037 for 53 cents on the dollar. It is hard to know exactly when, but it happened before the struggling oil and gas producer filed its annual 10-K form. The debt was trading around that level at the very beginning of January, so maybe Chesapeake rang in the new year with a trade. If it did, it's been a good one.

Turning Lead Into Gold
Indexed price performance
Source: Bloomberg

For a company like Chesapeake, which just pledged everything down to the paper clips to get a new lifeline from lenders, buying back debt in the open market isn't just about enjoying a nice gain when the market turns. It's about doing something that the E&P sector -- Chesapeake very much included -- hasn't always won plaudits for: Using cash rationally.

Investors have largely accepted by now that repairing balance sheets, rather than growing at all costs, is the priority for Chesapeake and its ilk. Paying $32 million to retire $60 million of debt cuts net debt by $28 million. It also relieves the burden of paying interest on that debt. Granted, in this case the coupon was only 2.5 percent, but every little bit helps. Incidentally, the fact that an E&P company like Chesapeake was ever able to issue 30-year debt at 2.5 percent tells you exactly how this industry got into trouble.

Yes, $60 million is small beer in the context of net debt that stood at almost $10 billion at the end of last year. Again, though, this is about rational use of cash. It is a fair bet that no drilling opportunity, no matter how good, could net Chesapeake a theoretical 44 percent return in the space of three months. In this commodity environment, even the yield-to-maturity of 8 percent that the bonds offered when it likely bought them doesn't look bad.

Will it save the company? On its own, no. That will take the blocking and tackling Chesapeake is already doing in terms of taking its borrowing capacity to the limit, plus -- and this is the wildcard -- a sustained recovery in oil and gas prices. Just this week, rival producer Energy XXI succumbed to bankruptcy. That company had retired almost $740 million of debt in the opening weeks of 2016 for less than 1 cent on the dollar plus some accrued interest, its last quarterly filing showed.

What's more, the very gains made recently in Chesapeake's bonds close off the trade for now. If that were based on the company truly being through the worst of its problems, that would be a good thing. But while Chesapeake has gotten some breathing room, anyone mapping out a clear pathway of liquidity through the company's debt repayment schedule over the next few years should remember that plenty of optimistic investors were doing the same thing for coal-mining companies a few years back -- and that didn't turn out so well.

Essential Oil
Indexed price performance
Source: Bloomberg

Despite its recent gains, the high-yield energy market remains a dangerous place for investors. The recent rally depends not just on fickle oil prices. As fellow Gadfly Lisa Abramowicz wrote here, energy makes up a large component of passive high-yield funds, so the sector's sinking bonds get lifted by the tide whenever money floods back into junk. And this March saw the biggest inflow to such funds since October 2011, according to Morningstar.

Chesapeake at least has a strategic rationale to trade in this stuff. What's your excuse?

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net