Chesapeake Energy Corporation — Q2 2018 Form 10-Q
Issuer note: The filing identifies Chesapeake Energy Corporation, not Expand Energy Corp. Reporting period: quarter and six months ended June 30, 2018; comparisons are with the corresponding 2017 periods. Amounts are in U.S. dollars unless noted.
Business context and reporting period
Chesapeake is an independent U.S. oil and gas exploration and production company. Its portfolio includes the Eagle Ford, Powder River Basin, Marcellus, Haynesville, Utica and Mid-Continent areas. Management emphasized debt reduction, funding capital spending from operating cash flow, and improving margins and efficiency.
Financial performance and position
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Total revenue | $2.255 billion | $2.281 billion | $4.744 billion | $5.034 billion |
| Income from operations | $30 million | $399 million | $308 million | $640 million |
| Net income (loss) attributable to Chesapeake | $(17) million | $494 million | $276 million | $634 million |
| Net income (loss) available to common shareholders | $(40) million | $470 million | $228 million | $547 million |
| Diluted EPS | $(0.04) | $0.47 | $0.25 | $0.59 |
- Q2 operating margin was approximately 1.3% (income from operations divided by reported revenue), compared with approximately 17.5% a year earlier. First-half operating margin was approximately 6.5%, versus 12.7%. Marketing revenue and expense are reported net in certain transactions following adoption of ASC 606, limiting comparability of reported revenue totals.
- Q2 production averaged 530,000 boe/day, essentially flat year over year; first-half production averaged 542,000 boe/day, up 3%. Adjusted production, which reflects assets sold, rose 8% in Q2 and 10% in the first half. Average sales price was $25.56/boe in Q2, up 14%, and $26.43/boe for the first half, up 13%.
- Reported oil, natural gas and NGL revenue was $982 million in Q2 and $2.225 billion in the first half, after derivative losses of $251 million and $368 million, respectively. Before derivative effects, product sales increased year over year, primarily from higher prices.
- Operating cash flow was $1.091 billion for the first half, compared with cash used of $58 million in 2017. Investing cash use was $643 million, including $979 million of drilling and completion costs; financing cash use was $450 million. Cash declined to $3 million from $5 million at year-end.
- At June 30, total debt principal was $9.706 billion, down 3% from $9.981 billion at December 31, 2017; carrying-value debt was $9.670 billion. First-half interest expense was $240 million, up from $188 million.
- Current assets were $1.240 billion against current liabilities of $2.873 billion; the working capital deficit was $1.633 billion, including $433 million of debt due or potentially puttable within 12 months. The $3.8 billion revolving facility had $506 million drawn, $183 million used for letters of credit and $3.096 billion of stated borrowing capacity. The company reported covenant compliance.
Material changes versus the prior comparable period
- Q2 shifted from substantial profit to a common-shareholder loss. Operating income fell to $30 million from $399 million, while commodity derivatives produced a $251 million loss versus a $200 million gain. Interest expense also increased.
- For the first half, operating income and net income declined, although operating cash flow improved markedly. The comparison includes a $417 million prior-period other operating expense, largely related to transportation commitments and an assignment payment, and prior-year gains on debt repurchases; 2018 included $139 million of investment gains.
- Chesapeake sold Mid-Continent properties, including Mississippian Lime assets, for approximately $491 million in the first half. It also sold about 4.3 million FTS International shares for net proceeds of $74 million and recorded $139 million of total investment gains related to FTSI.
- In Q2, the company spent $199 million to repurchase previously conveyed Utica overriding royalty interests and extinguish future conveyance obligations; the transaction generated a $61 million gain on extinguishment.
- A workforce reduction affecting approximately 13% of employees generated $38 million of first-half termination charges. Management said it expected annual cash cost reductions of approximately $70 million.
Outlook, risks, contingencies and unusual items
- Management targeted $2–$3 billion of debt reduction in 2018 and forecast capital expenditures, including capitalized interest, of $2.2–$2.5 billion, approximately 7% below 2017. It expected modest production growth from oil and gas assets, adjusted for asset sales.
- On July 26, 2018, after quarter-end, Chesapeake agreed to sell its Ohio assets for approximately $2.0 billion, with up to $100 million of contingent consideration tied to natural gas prices. Closing was expected in Q4 2018, subject to conditions and approvals; proceeds were expected to reduce debt. Completion and final proceeds were not assured.
- Management said available cash, forecast operating cash flow, revolver availability and anticipated Utica-sale proceeds were expected to fund planned capital expenditures, debt service and other obligations for the next 12 months, while cautioning that liquidity beyond that period was not assured. The revolver borrowing base could be reduced after the Utica sale.
- Commodity prices remain a major exposure. At June 30, derivatives had a net fair-value liability of $318 million; $298 million related to contracts maturing within 12 months. First-half derivative losses materially affected reported earnings. Hedging protects only a portion of production and may also limit upside.
- As of July 27, the company had posted approximately $203 million of collateral and could be asked to post approximately $468 million more; cash or letters of credit would reduce liquidity or revolver availability. Undiscounted gathering, processing and transportation commitments totaled $8.702 billion through 2035.
- Legal matters include an OOGC arbitration seeking unspecified, potentially material relief and a July 2018 HOOPP arbitration seeking rescission or $215 million plus other damages. Chesapeake said it would vigorously defend the claims. A tentative settlement of substantially all Oklahoma antitrust class actions was reached for an immaterial amount.
- Chesapeake recorded a $42 million impairment of other fixed assets in Q2 and had a full valuation allowance against its net deferred tax asset. It adopted ASC 606 using the modified retrospective method; the $8 million cumulative effect was not material, though some marketing transactions shifted from gross to net presentation.
Important facts for investors to verify
- Whether the Ohio/Utica sale closes on the anticipated terms and timeline, the net proceeds after adjustments, and the effect on debt and the revolver borrowing base.
- Debt maturities and put rights, refinancing needs, covenant headroom, and whether management achieves its $2–$3 billion 2018 debt-reduction target.
- Operating cash flow sustainability after commodity-price changes, hedge settlements, collateral needs, capital spending and preferred dividends.
- Production and unit-cost trends, especially the higher depletion rate and the effect of asset sales on future production and cash generation.
- Developments and potential exposure in the OOGC and HOOPP arbitrations, as well as the status of other legal and regulatory matters.
- Comparability of marketing revenue and expense after ASC 606 net presentation, and the effect of derivative gains or losses on reported results.