S&P Downgrades Chesapeake Energy (CHK) to 'B'; Removes Unsecured Debt Rating from CreditWatch Negative

Standard & Poor's Ratings Services lowered its corporate credit rating on Chesapeake Energy Corp. (NYSE: CHK) to 'B' from 'BB-'. The outlook is negative.

At the same time, we removed the senior unsecured debt rating from CreditWatch with negative implications and lowered it to 'CCC+' from 'BB-' and revised the recovery rating to '6' from '4'. The '6' recovery rating indicates our expectation for negligible recovery (0% to 10%). In addition, we lowered the rating on the company's senior secured debt to 'BB-' from 'BB+'. The recovery rating on the secured debt remains '1', indicating our expectation for very high recovery (90%-100%). We also lowered our rating on the company's preferred stock to 'CCC' from 'B-'.

"We have reassessed Chesapeake's business risk and have revised our assessment lower to fair from satisfactory, said Standard & Poor's credit analyst Paul Harvey. "We expect profitability to continue to suffer due to low natural gas and crude oil prices, compounded by very high costs related to its gathering and processing contracts," he added.

This offsets otherwise good operating costs and the benefits of scale typically provided for a company of this size. The downgrade also reflects our assessment of the risk that the current market conditions could make it more difficult to make large asset sales on favorable terms. Asset sales are an important contributor to available cash to support long-term liquidity. Although based on preliminary results of Chesapeake's exchange offer, outstanding debt should fall by about $1.5 billion, our financial risk profile assessment remains highly leveraged. Moreover, the tendered offer failed to significantly ease the upcoming need to address about $2.5 billion of debt maturities or puts through 2017.

The lowering of the senior unsecured debt rating reflects both the lower corporate credit rating, as well as lower recovery prospects following the increase in permitted junior-lien debt; up to $4 billion. We assess Chesapeake's business risk profile as fair. We consider Chesapeake's financial risk profile to remain highly leveraged, pro forma for the company's exchange offer. We currently assess Chesapeake's liquidity as adequate.

The negative outlook reflects our expectation that liquidity could significantly weaken during the next 12 months due to high negative free cash flows and potential negative borrowing base redeterminations. Chesapeake will face challenging industry conditions exacerbated by its high debt levels. Additionally, given uncertainty in natural gas and crude oil prices combined with weaker capital markets for the sector, we believe achieving large asset sales will be challenging. Finally, we expect financial measures to remain weak despite the expected reduction in debt following Chesapeake's recent exchange offer. FFO to debt will be below 8% and debt to EBITDA about 8x under our base-case assumptions.

We could lower ratings if we assessed liquidity as less than adequate, or inadequate to address 2017's maturities and puts. This could occur if negative free cash flow exceeds our base case forecast, or if the borrowing base is substantially lowered at the upcoming April 2016 redetermination. Given the need to address its 2017 maturities and putable debt, there is a heightened risk of additional exchanges. We could also lower ratings if Chesapeake pursued exchanges we assessed as distressed. Finally, we could lower ratings if we expected debt to EBITDA to be sustained above 9x, most likely if we expected natural gas prices to be sustained below $2.50/mmbtu.

We could return the rating outlook to stable if Chesapeake can address upcoming maturities and putable debt such that it is expected to preserve adequate liquidity while addressing 2017's refinancing needs. This could be in conjunction with a material asset sale, or a sustained improvement in natural gas and crude oil prices that reduce negative free cash flow. At the same time, we would expect financial measures to improve on a sustained basis such that FFO to debt was 8% or better and debt/EBITDA was below 7x. Both events are most likely to occur in conjunction with natural gas prices exceeding $2.75/mmbtu.

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