Fitch Ratings has placed Chesapeake Energy Corporation's 'BB+' Long-Term Issuer Default Rating (IDR) and all issue ratings on Rating Watch Positive (RWP) following the announced acquisition of Southwestern Energy Company.

The Rating Watch reflects the reasonable valuation of the all-equity transaction, the conservative proforma capital structure and the increased scale of the combined company, which will be the largest North American natural gas producer and third-largest public producer globally.

The scale and metrics of the combined entity are commensurate with an investment-grade rating. The combined company will have very strong gas positions in the Marcellus and Haynesville plays.

Chesapeake will assume Southwestern's debt after closing the transaction. Fitch expects the combined entity to maintain a sub 1.5x EBITDA leverage after closing as well as strong liquidity and a back-end maturity profile.

The Rating Watch is expected to be resolved upon the completion of the transaction under the announced terms, which may take longer than six months.

Key Rating Drivers

Significant Natural Gas Assets: The scale of the combined entity is commensurate with an investment-grade rating. Combined reserves will approach 32 trillion feet of natural gas equivalent (Tcfe) and production will approach 7.9 billion cubic feet of natural gas equivalent per day (bcfe/d), making it the third-largest public global natural gas producer. Chesapeake will have 650,000 net acres in the Haynesville and 1.2 million net acres in Appalachia. At expected production levels the company has 15 years of drilling inventory.

Conservative Financial Policy: Chesapeake's conservative financial policy is a credit strength. The company is committed to a net EBITDA leverage target of less than 1.0x at $3 Henry Hub natural gas prices. To that end, CHK is funding the acquisition with equity and is focused on paying down debt to $4.5 billion (from $5.7 billion at close) over approximately two years. The company will continue to maintain a shareholder distribution policy that is linked to FCF with a modest fixed dividend, a variable dividend derived from 50% of FCF after the fixed dividend, and opportunistic share buybacks. Fitch expects that the company would revisit the shareholder distribution policy if natural gas prices remained less than $3 on a sustained basis.

Strategic Importance of Balance Sheet Strength: Chesapeake is highly committed to maintaining an investment-grade balance sheet following the Southwestern acquisition and Fitch expects the company to reduce total debt to approximately $4.5 billion over the next two years. An investment-grade capital structure is integral to Chesapeake's strategy as the company seeks to enter into long term liquified natural gas (LNG) supply agreements for up to 20% of its production. These agreements allow Chesapeake to sell at prices indexed to overseas LNG markets, which typically settle at higher prices than the Henry Hub (HH) natural gas benchmark.

Attaining and maintaining investment-grade ratings would enhance the company's ability to enter into agreements with counterparties that require investment-grade ratings. It would also enable Chesapeake to enter into the necessary long-term liquefaction contracts without having to post LCs.

Strong Forecast Metrics: Fitch forecasts sub-1.5x gross EBITDA leverage and positive FCF at its ratings case price assumptions with HH trending toward $2.75/thousand cubic feet (mcf) in the long term. Under Fitch's stress case price deck, Chesapeake's EBITDA leverage approaches 2.3x, which, while elevated, demonstrates reasonable capital structure resilience in a weak pricing environment that assumes gas prices of $2.25/mcf. Fitch forecasts EBITDA will range between $4.0 billion and $4.5 billion in its rating case and that the company will report positive FCF over the rating horizon.

Hedges Support Cash Flow Visibility: Chesapeake's commitment to hedging a portion of production provides downside protection to cash flows. Chesapeake maintains a policy of hedging 55%-60% of production for the next two quarters with production hedged declining 5%-10% in each subsequent quarter out to about two years.

LNG Supply Agreements: Although the LNG supply agreements that Chesapeake has entered into may allow the company to realize a price premium to Henry Hub, they'll increase fixed costs. These contracts enable Chesapeake to sell gas at prices indexed to LNG prices overseas; the two existing agreements, which begin in 2027 and 2028, are indexed to Japan-Korea LNG (JKM) prices.

Under the contracts Chesapeake commits to supply LNG at an export facility from the U.S., which will require Chesapeake to enter into fixed natural gas liquefaction contracts. The take-or-pay liquefaction contracts will expose Chesapeake to fixed charges that may be burdensome in periods with low differentials between Henry Hub and overseas LNG markets. In these instances, Chesapeake would likely not supply LNG, but would still be responsible for the liquefaction charges.

Derivation Summary

Following the close of the Southwestern transaction, Chesapeake will have production approaching 7.9 bcfe/d, which is significantly higher than peers EQT (BBB-/Stable; 5.7bcfe/d), Antero (BBB-/Stable; 3.5 bcfe/d), and Coterra (BBB/Stable; 4 bcf/d). PF netbacks as of third-quarter 2023 (3Q23) were $0.72/mcfe, which is better than EQT at $0.53/mcfe, in line with Antero at $0.79/mcfe and behind Coterra at $2.31/mcfe due to 28% of Coterra's production being liquids. The PF cash netback margin for 3Q23 for Chesapeake was 34%, which is stronger than EQT at 28% and Antero at 24% while again lagging Coterra at 63%. Proved reserves of the combined entity are 32.4 tcfe, which is larger than all peers with the closest competitor being EQT at 25 tcfe. EBITDA leverage is comparable with peers while FCF margin lags peers.

Key Assumptions

West Texas Intermediate of $78/barrel (bbl) in 2023, $75/bbl in 2024, $65/bbl in 2025 and $60/bbl thereafter;

Henry Hub of $2.80/mcf in 2023, $3.25/mcf in 2024, $3.00/mcf in 2025 and $2.75/mcf thereafter;

Production flat to up low single-digits post the acquisition;

Base interest rates applicable to the company's outstanding variable-rate debt obligations reflects the Secured Overnight Financing Rate forward curve;

Annual capex between $3.0 billion and $3.5 billion during the forecast;

Base dividend of $0.575/quarter;

Debt maturities paid down with cash in 2025 and 2026;

No share repurchases beyond 2023.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade:

Fitch expects to resolve the RWP upon completion of the contemplated transaction under the proposed terms.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade independent of the transaction:

A commitment to its stated financial policy resulting in post-dividend positive FCF generation through the cycle;

Netbacks maintained above or in line with IG-rated gas peers;

Midcycle EBITDA leverage sustained at or below 1.5x.

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade:

Failure to maintain a clear, conservative financial and operational policy;

A trend of negative FCF contributing to diminished liquidity or utilization of revolver commitment consistently above 50%;

Midcycle EBITDA leverage sustained over 2.0x;

Large creditor-unfriendly M&A;

Loss of operational momentum, with organic production trending below 3Bcfepd or materially increasing production costs.

Liquidity and Debt Structure

Strong Liquidity: PF for the acquisition, liquidity is provided by a $2.5 billion reserve-based revolver with full availability. This replaces CHK's existing $2 billion revolver and SWN's existing $2 billion revolver. With actual cash of $713 million at the end of 3Q23 and expected positive FCF the company maintains strong liquidity throughout Fitch's forecast.

Back-Weighted Maturity Schedule: Chesapeake's legacy maturity schedule had maturities in 2026 and 2029. The assumption of SWN's debt enhances this back-weighted structure as $2.35 billion of SWN's debt matures in 2030 and 2032.

Issuer Profile

Chesapeake Energy Corporation is a gas weighted U.S. onshore exploration and production company with operations in the Haynesville and Marcellus shales. Following the proposed acquisition of Southwestern Energy Corp. the company's PF production will rise to 7.9 bcfe/d.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

(C) 2024 Electronic News Publishing, source ENP Newswire