The announcement by Chesapeake Energy that it will sell several assets to raise $5bn to put toward paying down debt was warmly greeted by analysts who have been lamenting prospects for a sector under intense pressure by low US natural gas prices.
Indeed, Standard & Poor’s, the ratings agency, placed a BB rating on Chesapeake, BB senior unsecured issue ratings and B preferred stock issue ratings on CreditWatch with positive implications. Here is what Standard & Poor’s credit analyst Scott Sprinzen had to say:
We placed the ratings on Watch positive because Chesapeake today announced its plan to sell all of its Fayetteville Shale assets, as well as its equity investments in Frac Tech Holdings LLC and Chaparral Energy Inc. and that it plans to reduce its long-term debt through 2012.
Last week, Chesapeake agreed to sell to Cnooc, China’s largest offshore oil and gas producer, a stake in its US shale oil and gas holdings for up to $1.3bn. This is all part of Chesapeake’s plans to reduce long-term debt by 25 per cent in 2011-2012.
The reason for the excitement about a move to improve financials at Chesapeake is because the announcement comes amid a number of grim reports about the sector in recent weeks. One of the latest determined the US independents focused on natural gas production are “living on borrowed time” with plans to grow production 19 per cent year-on-year into an already glutted market.
That was the conclusion of a new report by Lazard Capital Markets, which just last week downgraded the key gas-focused exploration and production (E&Ps) companies – Chesapeake, Petrohawk Energy and Range Resources – to sell from hold. Eric Hagen, the Lazard analyst who wrote the report, had this to say:
We believe 2011 will be the breaking point, where producers run out of assets to sell to fund growth that is driven by spending 80 per cent more than discretionary cash flow. Natural gas E&Ps are living on borrowed time.
Raoul LeBlanc, director at PFC Energy, the consultancy, explains the US independents are rated by investors not only on the current price of the oil and gas they sell today, but also on the ability to grow reserves and production in the future. This has led to a growing number of deals such as Chesapeake’s to sell partial or entire acrage positions in US gas fields so these companies can afford to continue spending to acquire and drill acreage to grow their output and reserve base.
The resulting glut has pushed gas down to the $4 per mBtu of recent months, significantly down from the $13.69 per mBtu record reached in 2008. These companies know if they stop spending to wait for improved prices, he said, they will have no growth in reserves or cash flow with which to impress investors. More from Mr LeBlanc:
It is a classic prisoners’ dilemma: the industry is less profitable as prices slide, and that makes all the companies even more reluctant to surrender their growth story. That means they continue to forge ahead and drill new wells.
It is this issue that has kept US independents feeding an oversupplied gas market in 2010. “Reserves are the bedrock of E&P valuation,” says David Heikkinen, head of the E&P research team at Tudor Pickering Holt, the energy investment and merchant banking firm, in a new report. As the US independents prepare to report their 2010 financial results, Mr Heikkinen projects, as a group, they will reveal reserves growth of some 18 per cent year-on-year.
Yet Scott Gruber, senior analyst at Bernstein Research, the energy research firm, said in a new report that gas-focused E&Ps are outspending cash flow by about 50 per cent.
Both gas- and oil-focused E&Ps raised more than $20bn in capital in each of the past two years, but clearly a large portion was secured by the gas-leveraged companies to fuel their “excess spending”. And while equity investors appear far less inclined to provide additional funds, he said the appetite of debt investors will be key to continued capital inflows.
Mr Heikkinen adds:
The business continues to consume too much capital and many times destroys value in the pursuit of growth, capturing acreage and, most recently, chasing oil. Growth needs to be the outcome of efficient capital allocation, as opposed to the target.
Some see the announcement by Chesapeake at the start of the year to reduce debt by 25 per cent over the next two years, by spending less and selling assets, as the first good sign that things might change. It would reduce its growth rate to 25 per cent, from 30-40 per cent. The announcement followed a move by Carl Icahn, the activist investor, to increase his ownership in the company to about 5 per cent, from 2.5 per cent, in late December. He said the shares were undervalued and he was discussing ways to maximise shareholder value.
Jon Wolff, oil and gas analyst at Credit Suisse Securities, said most of the independents have a strategy focused on oil or natural gas liquids for the year ahead as companies from EOG to Devon to Chesapeake plan to cut capital expenditure on gas. US capital spending in gas across the sector is to be down 12 per cent this year despite an overall rise of 8-10 per cent in capital expenditure with the focus on liquids, he said.
Yet complicating this attempt to reduce gas production is that the liquids production results in “associated gas” that rises with the liquids. The US is literally overflowing with gas. Too bad Congress and the Obama Administration cannot see that it is in the nation’s best interest to encourage its use.