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Pay Close Attention to Chesapeake Energy Corporation (CHK)

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Chesapeake Energy Corporation (NYSE:CHK)Note: This post has been amended to more accurately explain EXCOs suitors.

On July 5, Chesapeake Energy Corporation (NYSE:CHK) announced that it has entered into a definitive agreement to sell its assets in the Northern Eagle Ford Shale and Haynesville Shale to EXCO, a subsidiary of EXCO Resources Inc (NYSE:XCO). In return for the sale, Chesapeake Energy Corporation (NYSE:CHK) would receive approximately $1 billion, of which approximately 90% will be received upon closing. The transaction is expected to close in the third quarter of the ongoing fiscal year. Another interested party was SandRidge Energy Inc. (NYSE:SD).

Some background

The mere sale of assets by Chesapeake Energy Corporation (NYSE:CHK) is no indication of any imminent problem. The company has been divesting assets aggressively in the last year. Since Carl Icahn, the activist investor, has bought a 7.56% stake in the company (which he later upped to 8.9%), he has been imploring various strategies to reduce spending and cut debt. He believes, and rightfully so, that the company’s massive level of debt has a strong negative impact on its equity value. At the end of 2012, for example, the company had a cash shortfall of about $10 billion. This has caused shares to remain depressed. As of the most recent quarterly report, Chesapeake Energy Corporation (NYSE:CHK) has a total of $24.5 billion of total liabilities, of which $13.5 billion is classified as long-term debt and $5.8 billion is short-term debt. For comparison, the company’s total market cap is only $13.8 billion, roughly a half of its total liabilities. This is why a debt reduction plan, like the one outlined by Icahn, is definitely in place.

Other troubled rivals

The danger of accumulating debt in boatloads isn’t unique to Chesapeake; debt has been troubling a few of its peers in the gas and oil industry. All of these companies possess massive debt and similarly massive assets. When pushed against the wall to meet pending bond payouts, such companies are likely to dispose of otherwise lucrative assets. This will hinder the profitability of these companies and will have a direct impact on shareholders.

You can try to spot the next troubled candidate by carefully reviewing balance sheets. Take SandRidge Energy Inc. (NYSE:SD), for example. This energy company has equity valued at $2.9 billion with total debt almost twice that amount. With assets worth almost $10 billion, SandRidge’s shareholders face a possible liquidation that will hurt the company’s share price.

Chesapeake Energy Corporation (NYSE:CHK), despite its heavy debts, has an edge over its rivals. It’s regarded as a highly efficient gas operator. The industry’s average cost to find and develop a gas well stands at roughly $3 per mcf. Chesapeake spends only $2.20 per mcf, while SandRidge pas roughly $3.30 per mcf.

In contrast to the trio, EXCO Resources Inc (NYSE:XCO), the company that just acquired the Eagle Ford assets from Chesapeake Energy Corporation (NYSE:CHK), is in a different financial situation. It has $1.8 in total equity value and $1.3 billion of net debt, of which only $192 million is classified as current liabilities. This allows the company to be much more flexible with its financials than the other three.

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