Investors Are Betting Big Against Chesapeake Energy Corporation -- Are They Right?

Image source: Southwestern Energy.

Chesapeake Energy (NYSE: CHK) has been on a roller coaster ride this year. It took a nosedive to start the year, plunging more than 60% through the beginning of February. The stock has since recovered from that fall, and then some, and is up nearly 40% for the year thanks to an improvement in its finances, along with higher commodity prices. That said, some traders think the stock has run up too far, too fast, which is leading short-sellers to make a big bet that the stock is heading toward a correction. However, it is a dangerous gamblethat could come back to burn them if Chesapeake's outlook continues to improve.

A bold bet

According to the most recent data, short-sellers sold 115.75 million shares of Chesapeake Energy short as of the middle of August making it the sixth most heavily shorted stock on the NYSE. That represented 16.5% of its shares outstanding and was 21% higher than short interest at the end of July. That said, earlier this year traders sold more than 200 million of its shares short; the market is notquite as bearish on the company as it once was.

It is worth noting that Chesapeake's rising short interest is not a blanket bet on energy stocks. For perspective, fellow natural gas driller Southwest Energy's (NYSE: SWN) short interest is actually down 1.5% over the same time frame to 12.3% of its outstanding shares. Likewise, short interest in the SPDR S&P Oil & Gas Exploration ETF (NYSEMKT: XOP) is down 3.3%. Instead, traders clearly see the downside in Chesapeake Energy's stock.

Credit check

Fueling the rise in short interest is the company's bloated balance sheet, which was weighed down by $8.7 billion of debt as of the end of the second quarter. While that number is down by $1 billion since the start of the year, the company has a long way to go to before its finances are on solid ground. In particular, it has roughly $1.4 billion of maturing or putable debt in 2017 that it needs to address. While that number is down 38% since last September, it is an obstacle that short-sellers believe could weigh on the company's stock price in the short-term.

That said, Chesapeake Energy did recently secure a $1.5 billion five-year term loan that it intends to use to buy back near-termdebt maturities. However, that loan comes with a hefty price tag of LIBOR plus 7.5% whereas the company's maturing debt had interest rates that only went as high as 6.5%. The reason the interest rate on the term loan is so high is that Chesapeake's credit rating is near the bottom of the barrel. For example, while Moody's recently changed its outlook on Chesapeake's credit to positive, it maintained its credit rating at Caa2, which is extremely speculative. Meanwhile, S&P Global maintained its negative outlook and rates Chesapeake's debt at CC, which implies that there is a substantial risk that it could default on its debt within the next six months. These credit concerns are giving short-sellers reason to believe that a renewed wave of credit fears could weigh on Chesapeake's stock.

Why this bet could backfire

While Chesapeake's credit concerns remain elevated, it is hard to ignore the progress it made this year as well as what it has in the pipeline. Not only did the company secure the credit it needed to roll out its looming debt maturities, but it is in the process of selling addition assets. Overall, the company projects it will sell $2 billion in assets this year, which is up from its prior outlook to sell between $1.2 billion to $1.7 billion. It is already half way to that target, having sold $964 million through the end of the second-quarter and has a portion of its Haynesville properties on the market, which should enable it to reach its goal.

Further, the company's cash flow picture is vastly improving. Not only are oil and gas prices much higher than they were to start the year, but the outlook for both is bullish. Natural gas, in particular, is riding high causing Southwestern Energy to restart its drilling program and return to growth mode. Meanwhile, there's growing consensus in the oil market that the worst is over, given that demand continues to grow while supplies are projected to keep declining. On top of that, Chesapeake Energy renegotiated several midstream contracts, which are expected to boost its underlying cash flow by $200 million to $300 million in each of the next two years.

While Chesapeake Energy's credit concerns are not behind it just yet, it made substantial progress to address its most pressing issues. Further, there is clear visibility that it can make additional progress before the year is out. Because of that, I think short-sellers are making a dangerous bet. This stock could rocket higher if it sells more assets than anticipated or if commodity prices keep heading higher, which would quickly incinerate their bearish bet.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Moody's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.