The Collapse of Chesapeake Energy
A Quick Background on Chesapeake Energy
Chesapeake was founded by Aubrey McClendo and Tom L. Ward in 1989, who led Chesapeake to become one of the pioneer companies in the US “Shale Revolution”.
On 15 June 2020, Chesapeake voluntarily skipped ~USD 13.5M in interest payments and was given a 30-day grace period, before it was considered in default. On 28 June 2020, Chesapeake filed for Chapter 11 bankruptcy.
So what exactly landed the company in today’s plight?
Let’s start from the shale oil industry
Shale oil is a form of high-quality crude oil that accounted for 63% of the total crude oil production in 2019 (EIA). Production and consumption of shale oil dates back to 1857 but the “Shale Revolution” only started in 2011. The revolution was propelled by hydraulic fracturing and horizontal drilling techniques, which sent shale oil production levels soaring seven-fold in less than a decade.
However, the industry took a heavy blow in March 2020, mostly due to the impacts of COVID-19. Production levels fell sharply from 8.32M barrels produced per day in March 2020 to just 6.60M in July 2020.
According to a Deloitte report, at USD35 per barrel for crude oil, 31% of Oil & Gas companies would technically be insolvent, and another 20% under financial stress. Prices of crude oil futures dipped below the USD35 level in early 2016 and plunged well below to -USD37.63 in April 2020.
As a result, the number of Oil & Gas corporations that filed for bankruptcies hit 32 as of July 2020, in contrast to 2019 which saw 42 bankruptcies over the whole year. The 32 companies (arranged by chronological order of date of bankruptcy filing) and their respective defaulted amounts are listed below
Zooming in on Chesapeake Energy
On the list, Chesapeake Energy Corporation is the second most debt-ridden company with ~USD 9B in debt outstanding.
As part of the Restructuring Support Agreement (RSA), Chesapeake secured USD 925M in debtor-in-possession financing under a revolving credit facility to fund their operations during the reorganization. In terms of exit financing, Chesapeake also secured USD2.5B in debt consisting of USD1.75B revolving credit facility and USD750M term loan, and lenders have agreed to backstop a USD600M rights offering. ~USD 7B of Debt will be eliminated through the RSA.
So what caused Chesapeake’s fall from grace?
There were three main factors that led to Chesapeake’s calamitous fall from their peak of USD27.5B market capitalization in 2008 to USD 2.2B in 2019.
Over-leveraged Capital Structure
Chesapeake had highly financially leveraged and the legacy debt was cited as one of the main reasons for the bankruptcy filing. As seen below, Chesapeake has the highest leverage in terms of Net Debt to EBITDA compared to their competitors.
Interestingly, Chesapeake was presented with an opportunity to reduce their debt levels following the sale of Marcellus and Utica Shale assets to Southwestern Energy in 2014. However, the management decided to put the USD5B to other uses, which turned out to worsen their financial position. 20% of the proceeds went towards repurchasing stocks, which eventually saw a dilution in value due to debt exchanges and an acquisition. Also, Chesapeake used a portion of the proceeds to develop new wells so as to grow production, but was not able to achieve any returns on their investment, eventually selling the wells off (The Motley Fool).
High costs
Chesapeake faced high sunk, fixed and variable costs. Generally in the Oil & Gas industry, Chesapeake’s drilling costs can be considered sunk costs since a portion of the drilled wells might be dry. In 2019, 4 of 419 of the wells drilled turned out to be dry wells, and the rest were productive.
Additionally, according to a report by Bloomberg Intelligence, Chesapeake needs to sell at unhedged prices of USD60/barrel or higher in order to cover production costs while generating free cash flows. However, Chesapeake’s 31 Dec 2019 prices barely scraped this level, at USD 59.16 per barrel according to S&P Capital IQ.
Capital flight towards clean energy alternatives
Despite the meteoric rise of the shale oil industry, it is common understanding that shale oil is a mere “bridge fuel” from the relatively environmentally harmful coal source to the end goal — clean and renewable energy (National Geographic). Resultantly, the Oil & Gas industry as a whole has been seeing capital flight in recent years with universities, public institutions and various cities including New York and London taking the lead in offloading fossil fuel investments from their portfolios (CNN).
The future of the Oil & Gas Industry
Short-term
Demand and prices of oil are likely to remain depressed especially while the pandemic is still ongoing and most employees are telecommuting. As such, we are likely to see more bankruptcies and further consolidation within the industry similar to the USD 5B acquisition by Chevron of Noble Energy in July 2020.
Medium-term
According to a McKinsey report, nearly two-thirds of surveyed respondents demand for climate change to be prioritized by governments post-economic recovery. The option to diversify into renewables is a costly one, as the typical return on renewables are 5–10%, in contrast to returns of 15–20% for upstream oil investments (S&P Global).
In this light, Oil & Gas corporations that have the ability and are willing to take a short-term hit on profits can start setting capital aside for renewable energy and will stand the highest chances of surviving the industrial shift. Moreover, the profitability gap is forecasted to narrow until projects create the equal value (FT).
Long-term
Taking a longer-term view, the Oil & Gas industry is likely to become a sunset industry as more capital is transferred to the clean energy sector, longer term contracts expire and consumers have sufficient time to make the switch.
Final remarks
Chesapeake landed in a position of bankruptcy due to both industrial and company factors. While a Chapter 11 Bankruptcy Filing may buy some time for Chesapeake to reorganize, Chesapeake will be living to fight another day especially if the firm does not keep costs low and flexible and boost efforts in diversifying into the clean energy sector.
