Fitch Affirms Chesapeake Energy's IDR at 'BB'; Outlook Revised to Stable

Fitch Ratings has affirmed all ratings for Chesapeake Energy Corporation (NYSE: CHK). The Rating Outlook is revised to Stable from Positive.

The Outlook revision reflects the reduced prospects of a positive rating over the next 12 months due to the impact of lower oil & gas prices on the company's forecasted cash flow and leverage profiles, as well as a general loss of debt reduction and capital structure simplification momentum.

Approximately $11.7 billion and $3.0 billion in unsecured debt and convertible preferred stock, respectively, are affected by today's rating action. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

Chesapeake's ratings reflect its considerable size with an increasingly liquids-focused production profile and proved reserves (1p) base, solid reserve replacement history, favorable liquidity position, and strong operational execution with ongoing improvements in drilling, stimulation, and completion techniques leading to competitive production and cost profiles. These considerations are offset by the company's levered capital structure, continued exposure to legacy drilling, purchase, and overriding royalty interest obligations, natural gas weighted profile that results in lower netbacks per barrel of oil equivalent (boe) relative to liquid peers, and weaker realized natural gas prices after gathering, transportation and basis differentials. Fitch recognizes, however, that Chesapeake has made significant progress towards its financial and operational deleveraging efforts since 2013. Further, Fitch believes realized prices could exhibit positive trends with Marcellus basis differentials steadily improving over the medium-term and, possibly, the formation of Barnett and Haynesville partnerships, as well as constructive discussions with its midstream partner.

The company reported year-end 2014 net proved reserves of nearly 2.5 billion boe and production of 707 thousand boe per day (mboepd; 29% liquids). This results in a year-end reserve life of just under 10 years. First quarter 2015 production was 686 mboepd (29% liquids) with declining quarterly trends anticipated with the sharp reduction in forecasted rig activity (14 rigs working by year-end 2015 vs. 65 rig average for 2014). The Fitch-calculated one-year organic reserve replacement rate was about 154% with an associated finding and development (F&D) cost of approximately $10.15 per boe. Fitch-calculated cash netbacks ($18.16/boe in 2014) have generally exhibited positive trends over the past five years with a compound annual growth rate of nearly 13% mainly due to the realization of production efficiency gains and reduced interest expense. However, materially lower unhedged realized prices during the first quarter of 2015 have had a considerable negative impact resulting in Fitch-calculated cash netbacks below $6/boe.

Balance sheet debt/EBITDA metrics strengthened year-over-year to 2.6x at year-end 2014 from 2.8x at year-end 2013 mainly due to lower debt levels following the spin-off of the company's oilfield services business (Seventy Seven Energy Inc.). Latest 12 month (LTM) metrics, however, demonstrate the early effects of lower price realizations with balance sheet debt/LTM EBITDA rising to over 2.9x. The Fitch-calculated debt/1p reserves and debt/flowing barrel have remained relatively steady quarter-over-quarter and were approximately $3.35/boe, and $19,300, respectively, as of March 31, 2015. Fitch's base case, assuming West Texas Intermediate (WTI) and Henry Hub prices of $50/barrel and $3/mcf, respectively, forecasts debt/EBITDA of over 5.4x in 2015. Upstream credit metrics are generally forecast to exhibit less variability, subject to reserve revisions.

HEIGHTENED CAPITAL EFFICIENCY, LIQUIDITY FOCUS IN WEAK PRICE ENVIRONMENT

Chesapeake, consistent with other North American independent E&P peers, is focused on ramping down drilling activity and preserving financial flexibility in 2015. The company plans to operate an average of 25-35 rigs in 2015, or approximately a 55% reduction year-over-year, and has budgeted capital expenditures of about $3.25 billion (guidance mid-point excluding capitalized interest). Spending and activity is front-loaded with Chesapeake estimated to exit 2015 with 14 rigs operating at a quarterly capital spending rate of approximately $450 million. While management expects production to grow modestly at 1%-3% in 2015 (adjusted for 2014 divestitures), the reduction in activity should negatively impact exit production rates. Liquids, in particular, are anticipated to exhibit heightened production pressure given the considerable cutbacks allocated to the liquids-rich Eagle Ford.

While management intends on more closely aligning cash flows from operations and capital expenditures by year-end 2015, Fitch highlights that Chesapeake remains subject to nearly $1 billion in common and preferred dividends, interest costs, and royalty payments, which is viewed as a considerable credit overhang. However, the company continues to exhibit strong operational execution with ongoing improvements that have enhanced the production and cost profiles with an ability to accelerate activity relatively quickly in a supportive pricing environment. Transactions executed in 2014 and, potentially, the anticipated CHK Cleveland-Tonkawa (C-T) divestiture in 2015 have and could further improve financial flexibility, though deleveraging momentum seems to be greatly reduced in the current weak oil & gas pricing environment.

FORECAST CASH FLOW METRICS WIDEN DUE TO WEAK PRICES AND DIFFERENTIALS

Fitch's base case projects that Chesapeake will be approximately $2.2 billion free cash flow (FCF) negative in 2015. Fitch notes that its FCF estimate considers over $400 million in common and preferred dividends. The Fitch base case results in balance sheet debt/EBITDA of over 5.4x in 2015 mainly due to weak oil & gas market prices and differentials. Debt/1p reserves and debt per flowing barrel metrics are forecast to remain solid at approximately $5.35/boe, subject to any revisions, and $20,850, respectively. Fitch's base case WTI and Henry Hub price forecast assumptions of $60/barrel and $3.25/mcf in 2016, respectively, suggest that Chesapeake will need to continue to take a measured approach to capital spending with a heightened focus on capital efficiency. The Fitch base case considers that the company continues to outspend operating cash flow in 2016, albeit at considerably lower levels, resulting in debt/EBITDA generally consistent with 2015 forecasted levels. Fitch estimates that, in a $70/barrel WTI and $3.50/mcf Henry Hub price environment in 2017, Chesapeake's balance sheet debt/EBITDA could decline to approximately 3.5x.

Chesapeake maintains a combination of swaps and three-way collars to manage cash flow variability and support development funding. Fitch recognizes that the company's three-way collar hedging strategy provides some upside potential, but exposes cash flows to adjusted spot prices in a weak pricing environment. Entering the year, management had hedged about 43% of expected 2015 oil and natural gas production. No oil and minimal gas volumes are currently hedged for 2016.

ADEQUATE LIQUIDITY POSITION AND ESCALATING MATURITIES PROFILE

Cash & equivalents were $2.9 billion as of March 31, 2015. Additional liquidity is provided by the company's recently modified and extended $4.0 billion senior unsecured credit facility due June 2020. There were no outstanding borrowings under the facility, as of March 31, 2015, with $15 million of the facility capacity used for various letters of credit. The revolver contains two one-year extensions and may be increased by $1.0 billion upon lender consent. While the credit facility is currently unsecured, the company would be required to provide collateral with facility availability subject to a borrowing base if its credit rating were to decline to 'BB-' or lower. Fitch's base case forecasts the company will end 2015 with approximately $1.9 billion in cash & equivalents, assuming any contingent convertible senior notes that are put to the company are refinanced with long-term debt.

The company has an escalating maturities profile with $396 million, $500 million, $2.2 billion, $1.0 billion, and $1.5 billion due in each of the next five years. These amounts include the $396 million, $1.2 billion, and $347 million in contingent convertible senior notes with holders' demand repurchase dates in November 2015, May 2017, and December 2018, respectively. Fitch believes, in the current oil & gas pricing environment, it is likely that the contingent convertible senior notes holders will exercise their demand rights for a cash repurchase given the five-year demand repurchase date schedule and considerable spread between the current stock price and conversion threshold.

FINANCIAL COVENANTS MAY BECOME PRESSURED

Financial covenants, as defined in the credit facility agreement, consist of a maximum net debt-to-book capitalization ratio of 65% and net debt/EBITDA ratio not to exceed 4x. The net debt/EBITDA ratio, under the terms of the credit facility, will not apply in any period in which Chesapeake's credit ratings are investment-grade. Other customary covenants restrict the ability to incur additional liens, make restricted payments, and merge, consolidate, or sell assets, as well as change in control provisions. The company is currently in compliance with all of its financial covenants, but Fitch's base case forecasts Chesapeake could approach and may exceed its net debt/EBITDA covenant at year-end 2015. Fitch views this possibility as manageable given management's track record and relationship with its lending group and our expectation that there will be no borrowings on the credit facility at year end.

OTHER CONTINGENT OBLIGATIONS AND LIABILITIES

Chesapeake does not maintain a defined benefit pension plan. Asset retirement obligations (AROs) increased to $447 million in 2014 from $405 million in 2013 principally due the addition of ARO liabilities in the ordinary course of business and revisions associated with expected costs and timing of settlement. Other contingent obligations, as of Dec. 31, 2014, totalled approximately $17 billion on a multi-year, undiscounted basis mainly comprising firm gathering, processing, and transportation agreements ($16 billion), drilling contracts ($502 million), and pressure pumping contracts ($466 million).

Natural gas price differentials have been and are anticipated to remain soft due to weakening Marcellus basis differentials and increased gathering and transportation costs, including higher minimum volume commitment fees under the company's economically challenged Barnett and Haynesville natural gas gathering agreements. Fitch recognizes that the company is pursuing production enhancements that increase estimated ultimate recoveries, extend production peaks, and reduce well costs per lateral foot to improve economics in the Barnett and Haynesville. Management believes that these operational improvements may encourage Barnett and Haynesville partnerships, in conjunction with constructive discussions with its midstream partner, helping mitigate minimum volume commitments creating some cost relief.

In addition to customary E&P contingent obligations, Chesapeake has nearly $2.1 billion in legacy drilling ($1.3 billion; CHK C-T and Granite Wash Trust) and liquids & natural gas volumetric production payments ($773 million/PV10 $630 million), as well as overriding royalty interest obligations ($392 million; CHK Utica and CHK C-T). Fitch considers these arrangements, among other off-balance sheet obligations, in E&P adjusted debt given the associated payment and operating cost arrangements. The Fitch-calculated E&P adjusted debt/EBITDA is forecast in the base case to increase from under 3.2x in 2014 to nearly 6.6x in 2015. Management has been attempting to reduce its exposure to these arrangements in an effort to improve and simplify the company's operational and financial obligations. These are generally anticipated to remain a credit rating overhang with management expecting a possible exit from CHK C-T ($1.2 billion) resulting in a forecasted base case E&P adjusted debt/EBITDA improvement to about 6.1x in 2015.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for the issuer include:

--WTI oil price that trends up from $50/barrel in 2015 to $60/barrel in 2016 and a long-term price of $75/barrel;

--Henry Hub gas that trends up from $3/mcf in 2015 to $3.25/mcf in 2016 and a long-term price of $4.50/mcf;

--Production growth of about 3% (adjusted for 2014 divestitures) in 2015, generally consistent with guidance, followed by modestly higher growth in the production profile thereafter given supportive pricing signals;

--Liquids mix declines to 27% in 2015 due to lower drilling activity, particularly in the liquids-rich Eagle Ford basin, with a continued focus on liquids thereafter;

--Differentials are projected to exhibit improving trends over the medium term due to some Marcellus basis tightening and, possibly, Barnett and Haynesville gathering cost relief;

--Capital spending is forecast to be $3.25 billion in 2015, consistent with guidance, followed by price-induced spending increases, but a generally more balanced capital program than historical levels;

--Active financial management assumed with the refinancing of maturities with long-term debt.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to a positive rating action include:

--Maintenance of size, scale, and diversification of Chesapeake's operations with some combination of the following metrics;

--Mid-cycle balance sheet debt/EBITDA around 2.5x-2.75x on a sustained basis;

--Balance sheet debt/flowing barrel under $20,000-$25,000 and/or debt/1p below $6.00-$6.50/boe on a sustained basis;

--Continued progress in materially reducing adjusted debt balances and simplifying the capital structure;

--Improvements in realized natural gas differentials.

Fitch does not anticipate a positive rating action in the near-term given the current weak pricing environment, but believes a positive rating action is possible over the medium-term.

Negative: Future developments that may, individually or collectively, lead to a negative rating action include:

--Mid-cycle balance sheet debt/EBITDA above 3.5x on a sustained basis;

--Balance sheet debt/flowing barrel of $30,000 - $35,000 and/or debt/1p above $7.50-$8.00/boe on a sustained basis;

--A persistently weak oil & gas pricing environment without a corresponding reduction to capex;

--Acquisitions and/or shareholder-friendly actions inconsistent with the expected cash flow and leverage profile.

Fitch does not expect a negative rating action in the near term given the steps taken by management to reduce capital spending to preserve the company's current liquidity position. Further Fitch recognizes Chesapeake's size and scale, relative to other high-yield E&P companies, provides considerable financial flexibility.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings and assigned Recovery Ratings as follows:

Chesapeake Energy Corporation

--Long-term IDR at 'BB';

--Senior unsecured bank facility at 'BB'/RR4;

--Senior unsecured notes at 'BB'/RR4;

--Convertible preferred stock at 'B+'/RR6.

The Rating Outlook was revised to Stable from Positive.

Fitch has also withdrawn Chesapeake's senior secured bank facility rating of 'BBB-' following its replacement with a senior unsecured credit facility.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 28 May 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosures

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=985872

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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