This week, Durig looks at an energy company that is making the transition from its historical focus on natural gas to be more focused on oil production. Chesapeake Energy (NYSE:CHK) has been making strides this year to transition towards a more oil focused production portfolio. Chesapeake has already increased oil in its production portfolio from 17% in 2018, to 24% as of the end of the second quarter. The company estimates it will exit 2019 with oil representing 26% of its production. Oil is a higher margin product, so Chesapeake is already seeing the fruit of its decision.
- Chesapeake recorded record oil production in Q2 of 122,000 barrels of oil per day.
- Adjusted EBITDAX increased 18.1% year-over-year.
- Cash from operating activities increased by 9.3% over Q2 2018.
- The company projects its oil production will grow by double digits in 2020 with roughly the same amount of capital spend.
Chesapeake’s very short-term, 2021 bonds, couponed at 6.125% are now trading at a slight discount, giving them a competitive yield-to-maturity of about 9.5%. With what looks like a successful transition to a more focused oil producer, these bonds make a fantastic addition to Durig Capital’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio, the aggregated performance of which is shown below.
Chesapeake Energy’s Second Quarter 2019 Results
Chesapeake Energy has spent most of 2019 transitioning from a mostly natural gas producer to focusing more on oil production. With that in mind, the company had good things to report in its second quarter results. It has dedicated its capital expenditure budget on growing its oil production and in its second quarter, the company recorded more revenue from oil than from natural gas.
- Oil revenues for Q2 were $786 million and natural gas revenues were $668 million. In fact, Chesapeake had record oil production of 122,000 barrels of oil per day, indicating year-over-year growth of 36%, and a record oil mix of 25%.
- Second quarter adjusted EBITDAX improved by 18.1% over Q2 2018, growing from $518 million to $612 million.
- Cash from operating activities in Q2 totaled $397 million, up from $363 million a year ago.
- The company reduced cash operating expenses consisting of production, gathering, processing and transportation (GP&T) and general and administrative expenses by $57 million when compared to the prior year quarter
- Chesapeake is projecting to grow its oil production in 2020 by double digits on roughly flat year-over-year capital expenditures.
Doug Lawler, Chesapeake’s President and CEO commented on the company’s strategy moving forward. “As we formulate our initial 2020 plans, we expect to allocate more capital to oil growth areas, with less capital going toward our gas assets. As a result, with an approximately flat capital program to 2019, we project our 2020 oil volumes will show double-digit percentage growth over 2019, while our gas volumes will show a double-digit percentage decline, yet our projected adjusted EBITDAX remains approximately the same at 2019 levels using today’s lower NYMEX strip pricing and current hedge position. We look forward to driving further value from our scale, diverse portfolio and capital discipline in 2020 and beyond.”
About the Issuer
Headquartered in Oklahoma City, Chesapeake Energy Corporation’s (CHK) operations are focused on discovering and developing its large and geographically diverse resource base of unconventional oil and natural gas assets onshore in the United States. The company has recently been focusing its development efforts in three of its oil producing properties, including the Eagle Ford, Powder River Basin and Brazos Valley properties.
Extending Maturities and Improving the Balance Sheet
Chesapeake has taken action to extend its debt maturities as well improve its balance sheet through a recent exchange of senior notes and preferred shares for common shares. Earlier this year, the company exchanged approximately $919 million of new, 8.0% senior notes for roughly $884 million aggregate principal amount of its 2020 and 2021 Senior notes. Chesapeake currently has remaining maturities in 2020 and 2021 of $301 million and $294 million respectively.
Earlier this month, the company exchanged roughly $588 million of its senior notes and preferred shares for its common shares. Ultimately, Chesapeake retired a portion of its debt and preferred stock at a significant discount and more importantly, reduced its annual dividend and interest payments by approximately $35 million.
Recent Oil News
With the recent attacks on Saudi Arabia oil production facilities a few weeks ago, oil markets reacted with initial price increases as many feared a decrease in global oil supply due to Saudi’s impaired ability to produce and market oil in the global marketplace. However, some reports coming out of Saudi Arabia in the past few days are indicating that the country has almost fully recovered to its pre-attack levels of oil production. However, these reports are being met with some skepticism, as the damage to Saudi’s facilities was extensive. Whatever the case, oil prices have begun to readjust toward pre-crisis levels.
The continuing trade war with China also has spilled over into the oil industry. Beginning September 1, 2019, China began levying a 5% tariff on U.S. oil imports. It remains to be seen how this will ultimately affect domestic oil production and sales, but most predict that this will decrease the amount of oil the U.S. exports to China. As the supply of oil produced by the U.S. has been increasing, finding another market / buyer the size of China may be challenging for the U.S. especially amid rumors of a global slowdown.
Interest Coverage and Liquidity
Interest coverage is an important metric for bondholders as it is an indication of the issuer’s ability to service its existing level of debt. For its most recent quarter, Chesapeake Energy had operating income of $278 million and interest expense of $175 million for an interest coverage of 1.6x. In terms of liquidity, as of June 30, 2018, Chesapeake had approximately $1.6 billion available under its credit facility, along with $600 million under the Brazos Valley credit facility.
The risk for bondholders is whether Chesapeake can ramp up its oil production fast enough to replace its decreasing natural gas production. The company is investing heavily in its oil producing assets and so far, oil production and revenues have increased. And the company has projected significant increases in oil production in 2020 and 2021. If this holds true and the price of oil remains somewhat stable around current pricing, Chesapeake will move closer to being free cash flow positive and be able to pay off or refinance any upcoming debt maturities.
Chesapeake’s revenues are derived from the sale of natural gas as well as oil, so price fluctuations of these commodities is also a risk. Commodity prices can react to both market forces as well as national and international politics, and predicting the movement of commodity prices is difficult at best. A drop in prices could affect Chesapeake’s ability to produce adequate cash flow to meet its operational needs.
Generally, there is reduced risk for investors who invest in Durig’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio due to its diversification across many bonds and industries, as compared to the purchase of individual bonds. Historically, the FX2 Portfolio has significantly outperformed when compared to portfolios where investors have chosen bonds individually. Durig currently holds this bond in its FX2 Portfolio.
In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.
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Summary and Conclusion
Chesapeake is making the move to oil. As natural gas prices sit near their lowest levels of the past year, this energy company has decided to focus on higher margin oil. So far, the move looks like its working. Chesapeake expects to exit 2019 with oil representing roughly 25% of its total production mix. That’s a company record. The company’s rising star in its portfolio, Brazos Valley is expected to be cash flow positive by the end of the year and has lowered its projected break-even to around $39 / barrel since earlier this year, a sure money maker at current oil prices. Chesapeake’s 2021 bonds are now trading at a slight discount which still gives an attractive yield-to-maturity of about 9.5%. Although Durig has profiled higher yielding bonds in the recent past, this roughly 9.5% yield still exceeds the current yield investors get from a similar duration U.S. Treasury by far. In light of Chesapeake’s successful oil transition and the attractive 9.5% yield-to-maturity, these 2021 bonds have been marked for addition to Durig Capital’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio.
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TD Ameritrade Advisors
We have now started offering our highly successful Fixed Income 2 (FX2) Portfolio, our Dividend Aristocrats 40 Portfolio, and our Income Aristocrats Portfolio to clients of other Registered Investment Advisors through segregated accounts at TD Ameritrade Institutional. Please ask us to learn how this might work for you and your current advisor.
Issuer: Chesapeake Energy, Inc.
Bond Coupon: 6.125%
Rating: B2 / B+
Price: ~ 96.0
Yield to Maturity: ~ 9.50%
Durig Capital provides investors with a specialized, transparent fiduciary service at a very low cost. Our FX2 (Discretionary Management) Portfolio over time has greatly outperformed our FX1 (Non-discretionary) Portfolio, giving significantly higher (at times double) the returns of FX1. Our professional service enables access to a broad spectrum of bond, high yields, and lower price points that are often found in less efficient markets, but not evidenced in many bond services. Most of our client accounts are custodied in their own name at TD Ameritrade Institutional, a large discount service provider that is SPIC insured, or at Interactive Brokers. We have now started offering our highly successful FX2 service to clients of other Registered Investment Advisors through segregated accounts at TD Ameritrade. Please ask us to learn how this might work for you and your current advisor.
Disclosure: Durig Capital and certain clients may hold positions in CHK’s February 2021 bonds.
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Randy Durig, Durig Capital, Inc.
A Registered Investment Advisor