Chesapeake Energy Could Finally Be Headed Into Ch.11 Bankruptcy – Chesapeake Energy Corporation (NYSE:CHK)

With reports that Chesapeake Energy (CHK) has retained restructuring advisors, many investors are expecting a Ch.11 bankruptcy filing in the near future. A stock price of only $0.19 usually screams that a bankruptcy is coming soon, but some are hopeful that an equity capitalization of about $370 million indicates that there is still some “rope” to work with. Unless there is an immediate sustained increase in energy prices, I doubt that the company can create a restructuring plan that will keep them out of bankruptcy court.

On March 16, Reuters reported that Chesapeake had retained Kirkland & Ellis and Rothschild & Co. Both are leaders in bankruptcy and restructuring. It is important to note a statement made in the article: “The company is studying its options and no debt restructuring move is imminent, the sources added”. It seems that they think they have time to negotiate a deal.

If they are planning to file for bankruptcy one would think that they would use 30-day grace periods instead of using much needed cash to pay interest due on April 1 (7% 2024 notes) and April 15 (4.875% 2022 notes). They may use the 30-day grace period to give them some flexibility negotiating an out of court restructuring or negotiate a RSA before filing for Ch.11.

Why Equity Capitalization Is So High

The current equity capitalization of $370 million is fairly high for a company about to file for bankruptcy. Often capitalizations are at least below $100 million prior to bankruptcy. Two factors have kept the stock price up: First, as of February 26, approximately 70% (including January and February) of estimated production was hedged for 2020. Oil is hedged at an average price $59.90 and natural gas at an average price of $2.76. Second, cash flow should cover interest expenses, maturing debt, and CAPEX (at a reduced level) in 2020.

The problem is what happens in 2021. The hedges for 2020 production were established when prices were much higher. The price charts below show how prices have plunged.

Crude Oil WTI Front MonthSource: NYMEX

The current forward strip prices indicate that 2021 could be a very difficult year.

Forward Strip Prices

NYNEX Light Sweet Oil Henry Hub Natural Gas

Year-2021

Jan. $31.70 2.625

Feb. 32.05 2.594

Mar. 32.50 2.494

April 33.725 2.254

May 35.75 2.217

June 33.30 2.261

July 34.65 2.301

Aug. 34.875 2.307

Sept. 35.125 2.291

Oct. 35.35 2.316

Nov. 35.625 2.376

Dec. 34.50 2.515

Year 2022

Jan. 36.05 2.623

Feb. 36.225 2.575

Source: Profitquotes.com

Too Much Debt

While Chesapeake has reduced long-term debt over the last few years, there is still too much debt. In addition, with having so many different note issues, it is more difficult to negotiate some type of restructuring deal than if there just a few. It becomes a classic case of “too many chefs in the kitchen”.

December 31, 2019

Source: 10-K

Recent Exchange Offers

Last December there was an exchange offer of $3.22 billion unsecured notes for $2.21 billion 11.5% senior 2lien notes due 2025. There was also a cash tender offer for $616.2 million 2025 notes for $1,000 (including a $50 early tender premium) in December.

On September 9, the company entered into a private exchange offer of 250.7 million shares for about $548 million notes and $40 million preferred stock. The value of the shares was $474 million using $1.89 price per share-the closing price on September 9. Prior to this exchange offer, the capitalization was $3.088 billion using 1.634 billion shares issued as of 2Q 2019. The current value for those 250.7 million shares is only $47.6 million using the latest CHK market price of $0.19.

All of these prior exchange offers were conducted when the market capitalization was much higher. With only a capitalization of $370 million, there is almost no equity “rope” to work with in a potential restructuring. There also isn’t any “extra” cash or assets that could be secured in new exchange offer.

Preferential Transfers

Another issue that could impact the timing of a potential Ch.11 filing and paying of interest on a specific debt issue is “preferential transfer”. For example, if the debt holders, who are effectively running Chesapeake, make payments on a note issue that they own a large percent of and soon thereafter file for Ch.11, other creditors may assert the interest payment was a “preferential transfer”. These creditors may demand a clawback of the cash paid and have the money put into the bankruptcy estate. Often it is general unsecured creditors who are receiving less than full recovery for their claims under a reorganization plan that assert preferential transfer actions against senior debt holders who are paid interest prior to a bankruptcy filing. The negatively impacted creditors could also include holders of notes whose interest payments would have been paid soon after the Ch.11 filing. Section 547 of the Bankruptcy Code covers preferential transfers. The look back period is 90 days (1 year for insider transactions).

If the negatively impacted creditors can show that Chesapeake was insolvent at the time these interest payments were made, they will demand the clawback of the cash paid on the interest payments. Insolvency is not a cut and dry definition and is often litigated. Strong cases could be made by both sides whether Chesapeake is currently insolvent or not.

Reverse Stock Split

Shareholders will vote April 13 to approve a reverse stock split ranging from 1-50 to 1-200. The board will decide the actual amount. The reverse split is needed to retain Chesapeake’s stock listing on the NYSE.

In an odd whist of events, holders of the $1.06 billion 5.5% Convertible Senior Notes due 2026 do not want a reverse split and do not want CHK to be listed on any exchange. As stated in the latest proxy, “If our common stock is removed from listing on the NYSE (and we are not eligible to become listed on other specified exchanges), holders of our 5.5% Convertible Senior Notes due 2026 (the “Convertible Notes”) would have a right to require us to repurchase their notes at par.” These notes are currently trading at huge discount from par. I doubt they would pay out that much cash. I would assume they would file for bankruptcy instead.

To many traders, including myself, a much higher priced CHK stock via a reverse stock split would them make much more willing to short CHK than shorting a penny stock. Often after reverse splits, the stock price drops as more traders short the stock.

A Possible Ch.11 Reorganization Plan

One of the problems when creating a reorganization plan for energy companies is the possibility of extreme commodity price changes during the Ch.11 process. Breitburn Energy, for example, was in bankruptcy for almost two years and because energy prices kept changing, the negotiated plans kept changing.

Currently, I would expect CHK shareholders to receive no recovery and the shares cancelled on the plan’s effective date. (Shares would still trade during bankruptcy process under a different ticker symbol.) There is just too much debt that has priority. I also do not see any need for “gifting” to shareholders and I don’t see a need to pay shareholders for “releases”.

Given the size and diverse asset base, it is not clear what a reorganization plan would be. I could see a number of different plans. My best guess at this point is that secured debt holders would select which assets they want in a new Chesapeake. It is possible they could do this via “credit bidding” for those assets.

The rest of the assets would be put into a different new company owned by the unsecured noteholders. The unsecured noteholder company could have a rights offer to raise needed operational cash and to pay part of the bankruptcy expenses. The rights offer would be backstopped by certain hedge funds and it would be used as a tool to get effectively a larger recovery for these select hedge funds than will be received by non-backstop noteholders. Many bankruptcy courts view new financing, including rights offers, as not being part of a recovery for a class of claim holders. The courts have ruled that it is just a means to raise capital. The rights offer could have a negative impact on non-backstop unsecured noteholders, especially retail holders if the rights offer is open to only accredited investors.

What I Am Expecting Regarding Current Negotiations

Since there is no short-term cash/liquidity needs, there is no rush to file for Ch.11 bankruptcy. The Reuters report even stated no debt restructuring move is imminent. They have time, but part of the problem is section 547 preferential transfer litigation, if they do eventually file for bankruptcy. A bankruptcy judge would decide the insolvency issue and that could be a problem. As many Seeking Alpha readers know from other bankruptcy cases, judges can be a wild card. The April 1 interest payment date is now the focus of many investors. Do they pay or use the 30-day grace period? The next date would be April 15. Beyond that there are other interest payments due and there is also the $208.6 million 6.625% note issue maturing August 15.

While they may the cash to pay their financial obligations in the near future, certain hedge fund holders of their debt may not want cash to go out the door. Often it is better to file before you absolutely have to because it gives you more flexibility in creating a viable reorganization plan.

My Prior Coverage Of Chesapeake

In August 2017 article, I was somewhat bullish on CHK because I was expecting some type of asset sales to reduce debt. For a number of reasons I covered in the article, I thought billionaire Phil Anschutz could be a likely buyer of Chesapeake’s PRB assets. While Anschutz did not buy their assets, he did greatly increase his holdings in the PRB area. In August 2018, Anschutz Exploration’s CEO gave a very positive presentation at an energy conference in Denver about their PRB activity. He, however, auctioned off part of his holdings in December 2019.

While I remained somewhat bullish on CHK, I did not buy any stock. My views dramatically changed when the company announced in October 2018 that they were buying WildHorse Resource Development for about $4 billion. The announcement of a large asset purchase instead of an asset sale to reduce debt/leverage made me very bearish. I immediately shorted CHK. (I closed my short positions when CHK traded below $1.00)

Conclusion

Unless energy prices soar in the near future, I expect Chesapeake to eventually file for Ch.11 bankruptcy. While some out of court restructuring plans may be floated by various stakeholders in the near future, the reality is that they just have too much debt and energy prices are too low to generate cash flow to pay interest and to pay CAPEX to maintain production. They need to greatly reduce debt. They may not file in the next few weeks, but I expect them to file before the notes mature in August.

I am not expecting any recovery for CHK shareholders under a reorganization plan. The recovery for unsecured notes is a real wildcard at this point. Retail unsecured noteholders need to pay very close attention to any proposed plans because potential rights offers may be open to only accredited investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may short CHK after the reverse stock split

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