Despite the Plunge in Oil, Chesapeake Energy Gets Back on the Track to Investment Grade

10/23/2014 5:39 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Given the severe drop in oil, it should come as no surprise that this natural gas giant plunged too, but MoneyShow's Jim Jubak thinks its back in the debt reduction game, based on recent news of a sell agreement and the possibility of getting an investment grade bond rating.

The rout in oil and natural gas prices-and in the prices of oil and natural gas industry shares-leaves investors with two big related-but not identical-questions.

How low will oil and natural gas prices go?

And what companies will be hurt the most-and which might actually manage to come out in strong positions-when prices stop falling?

The consensus is that oil and natural gas prices are headed still lower. Global demand doesn't look likely to rebound significantly in the short-term. Global supply shows no signs of falling. And projections are calling for a warmer than average winter in the United States. All that suggests that the $80 a barrel level for US benchmark West Texas Intermediate won't hold. (The closing price for December 14 delivery was $80.53 on October 23.) And that natural gas prices are headed below $3.50 per million BTUs. (Closing for November 14 delivery was $3.66.)

And I don't think a drop in oil below $80 or natural gas below $3.50 is necessarily the end of the damage. The Saudis, the swing producer in OPEC, seem determined not to cut production now and have indicated a determination to hold onto market share even if they have to see oil prices decline for another six months or more.

It's no wonder that with prices for oil and natural gas headed down, down, down, the share prices of oil and natural gas producers have plunged too. Shares of US natural gas giant Chesapeake Energy (CHK), for example, tumbled to $17.49 on October 14 from $29.61 on June 23. That's a 42% drop. (I bring up Chesapeake Energy as my example because it is (painfully) a member of my Jubak's Picks portfolio. As of the close on October 23, I have a 0.95% loss on that position since I added it to the portfolio on June 7, 2013.)

But Chesapeake has staged a small but significant rally beginning on October 15 and accelerating on October 16. In those two days, the stock moved up 18.9%.

The cause of the rally?

Not a radical shift in the dynamics of oil and natural gas supply and demand. Despite a move up in oil and natural gas prices at the end of the week, the fundamentals still look dismal.

Instead, the stock moved up on a huge improvement in company's ability to manage through the downturn without suffering lasting damage.

This was the year that a previously dangerously overleveraged Chesapeake Energy was supposed to see cash flow cover capital spending. Asset sales went to pay down debt and greater financial discipline was going to produce that milestone this year: the company would not have to borrow more money (and increase its debt load) in order to develop all the acreage that it had leased.

But the drop in natural gas prices threatened to-at best-delay that goal and-at worst-send the company back down the path to the leveraged bad old days.

Which is why the stock rallied so strongly on the October 16 news that the company would sell natural gas and oil shale fields on 413,000 acres of the Marcellus and Utica shale formations to Southwestern Energy (SWN) for $5.4 billion. This will be Southwestern Energy's first major step into oil shale production after focusing almost exclusively on natural gas. (Wells that are included in the deal produce 56,000 barrels a day of oil and natural gas liquids. That will increase Southwestern's reserves by about one-third.) Which may be why Southwestern was willing to pay a premium for the assets above what industry analysts thought Chesapeake could get in the current weak market. (I've seen estimates that put the premium as high as 50%.)

And, suddenly, Chesapeake is back in the debt reduction game. The day after the announcement of the deal, both Moody's Investors Service and Standard and Poor's issued positive outlooks on Chesapeake. With the deal leading to a lower net debt to cash flow ratio for the company, both ratings companies look likely to give Chesapeake's debt an investment grade rating before too long.

The company's improving balance sheet had let it move up to the top junk bond rating at both Moody's and S&P. And now the financial markets are anticipating that this latest asset sale will put Chesapeake over the top. For example, Chesapeake's unsecured bonds maturing in March 2023-and originally issued with a 5.75% coupon-climbed in price on October 16 and 17 to show a yield of just 4.72%.

It would be an amazing result if Chesapeake came out of this horrendous drop in oil and natural gas prices with a stronger balance sheet and an investment grade bond rating. But that does look possible.

That development wouldn't prevent the company's shares from falling along with the rest of the sector but it would mean that Chesapeake would be in a great position to expand production (and maybe even acquire assets-without increasing its leverage-of course) when the bearish cycle for energy prices ends.

I'll hold onto these shares on that improving balance sheet and its potential in the next bull cycle for energy.

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