Current Ratios During 1998 And 1997 example essay topic

Oil and Gas Industry Chesapeake Energy Corporation Firm Description Chesapeake Energy Corporation (NYSE: CHK), headquartered in Oklahoma City, Oklahoma, owns 1.1 trillion cubic feet equivalent (tcf e) of proved oil and gas reserves, one of the largest inventories of onshore U.S. natural gas {Chesapeake Annual Report, 1998, p. 1}. Recently, Chesapeake finished the transformation from an aggressive exploration company focused on developing short-reserve life, to a lower-risk, longer reserve life natural gas producer. Chesapeake's operations are focused on developmental drilling and producing property acquisitions. These operations are concentrated in three major areas: the Mid-continent, the onshore Gulf of Mexico and far northeastern British Columbia, Canada [Chesapeake Annual Report, 1998, p. 1]. Management Team Aubrey K. McClendon is Chesapeake's Chairman of the Board, Chief Executive Officer and Director.

Tom L. Ward is the President, Chief Operating Officer and Director. McClendon met cofounder Tom Ward in the 1980's. Both were independent oil producers; they teamed up in 1983 [Morgenson, p. 2]. They each have more than 16 years of experience in the oil and natural gas industry.

All other members of the management team have multiple years of experience in the industry. Competitive Environment Chesapeake has concentrated on expanding its holdings in natural gas since the company's incorporation in 1989. Chesapeake thinks that natural gas will be the fuel choice of the 21st century. The company has been highly competitive in both its exploration activities and efforts to increase its inventory of undeveloped leasehold land. This combination should enable Chesapeake to remain a competitive force in the energy producing industry. New technology in the oil and gas industry has made exploration and production more profitable.

This is key for the survival of American businesses that compete with OPEC and other foreign cartels that have very low production costs. New technology, including three-dimensional imaging, which has greater resolution than the previously existing technology, will enable Chesapeake to detect reserves more accurately. Also, horizontal drilling has enabled companies to drain more than one reserve at a time. With profits continuing to be squeezed within this industry, new technology is necessary to help American businesses compete on a global scale. Economic Climate The oil and gas industry is truly a global market. The industry boosted gains in 1999 from increased production efficiency and a decrease in the current supply. U.S. firms, along with OPEC, have voluntarily reduced their total production, which has increased the price.

OPEC currently supplies approximately 40% of the world oil production. If OPEC chooses to produce at a lower output, Chesapeake could easily increase production with its low production costs and huge reserves. Many other nations are emerging as competitors, such as the former Soviet Union and Latin American countries. The continuing increase in supply from other nations would potentially saturate the market, causing lower prices and lower profits. Demand is expected to rise only slightly more than two percent through the year 2005. The outlook for this industry is for increased competition domestically (from smaller companies) and internationally from emerging nations.

The U.S. has superior technology, which will help keep profits up as supply increases and demand remains relatively constant. Natural gas makes up 72% of Chesapeake's revenue. They usually sell the product to third parties and are not dependent on any one buyer. Less than 10% of their revenues are generated from two buyers. Governmental Regulations Operational and Labor Relations The oil and gas industries are subject to considerable government regulation.

These laws and regulations are primarily directed toward the handling and disposal of drilling and production waste products and waste created by water and air pollution control devices [Chesapeake 10-K, 1998, p. 10]. The oil and gas industry is accountable to numerous government agencies, including the Environmental Protection Agency, the Department of the Interior, the Department of Energy, the State Department and the Department of Commerce. Virtually every aspect of operations is subject to complex and ever changing regulations. The oil and gas industry is tightly regulated in regard to labor relations by government department and agencies, including the Occupational Safety and Health Association (OSHA) and the National Labor Relations Board (NLRB). Some states have their own state sponsored occupational safety plans, while the remainder must comply with federal OSHA regulations. Some of the topics covered under OSHA include personal protective equipment, hazardous communication (HAZ COM) and safety process training.

Chesapeake had 453 employees as of March 15, 1999. None of these employees were represented by organized labor unions. The company considers its employee relations to be good [Chesapeake 10-K, 1998, p. 13]. Unocal (NYSE: UCL) employed 7,880 people as of December 31, 1998, of which 575 were represented by various U.S. labor unions [Unocal 10-K, 1998, p. 12]. Both companies are subject to new laws and regulations regarding the environment and labor. Chesapeake and Unocal cannot predict what adverse financial conditions the new laws and regulations will bring.

However, short-term and long-term costs will increase as companies improve existing operations to become and remain compliant with government regulations. As a result, all companies in petro-chemical industries are experiencing tremendous difficulty operating profitable businesses. Several businesses have ceased operations as a result of increased regulation coupled with poor profit margins. Chesapeake is at a higher risk regarding this scenario since most of its operations are domestic.

Unocal, although a U.S. based company, operations are concentrated primarily overseas, and therefore experience increased leniency regarding environmental and labor regulations. Overview During the last two years, Chesapeake Corporation took a significant hit in terms of earnings, stock price and credit ratings. Positive 1996 earnings turned to a loss in 1997 and tumbled to a bigger loss of $10 per share in 1998. This earnings decline caused the stock price and credit rating to plummet. The company also faces a class action lawsuit stemming from alleged violations of federal securities laws.

Top management and directors are accused of using insider information to sell personal holdings in the company at artificially inflated prices. Chesapeake had very disappointing years in 1997 and 1998 as evidenced by the fall in the stock price. The company underwent a substantial repositioning to increase natural gas holdings and reduce risk. As a result of this repositioning, Chesapeake incurred considerable debt and is dependent on the market prices of oil and natural gas to increase, and in effect, improve profit margins. Additionally, in 1997, Chesapeake changed their fiscal year end from June 30th to December 31st.

As part of the repositioning, Chesapeake increased long term debt over $400 million to a total of $920 million, coupled with a short-term indebtedness of $25 million. This increased borrowing drastically reduced the company's ability to obtain additional financing. Standard & Poor's and Moody's placed Chesapeake on review with a negative outlook. The ability to meet obligations for this additional debt will depend on the production and financial performance of the company, market prices of oil and natural gas, and general economic conditions. Common Size Income Statement Analysis Chesapeake had an extremely large write-down of assets (impairment) as a result of reduced oil and gas prices during the past few years. This charge increased operating costs by over $1.2 billion during 1997-98 with 72% of that cost coming in 1998.

The asset write-down, combined with expense increases in production, marketing and interest, were the main contributors of total operating costs to be over three times total revenue. The result was 1998 EBIT of ($920) million, and a non-existent ROE, since the company had a net loss approaching $1 billion. Unocal's ROE was 5.9% in 1998 and 25.1% in 1997. The impairment cost reported by Chesapeake is questionable because of the very large amount that was charged. In perspective, Unocal with over $5 billion in property assets recorded an impairment charge of $97 million during 1998. If oil and gas prices rise in the near future, the impairment costs may be reversed giving the impression that the company is doing very well.

Future investors of Chesapeake equities should consider this fact prior to making any investment decisions. Common Size Balance Sheet Analysis Chesapeake had a $140 million reduction to both sides of the balance sheet. The repositioning of the firm focused on increasing inventory of natural gas reserves, the fuel of choice for the 21st century [1998 Annual Report, pg. 18]. Oil and gas properties nearly doubled from 1997 to 1998, totaling $2.2 billion. However, nearly $1.6 billion was depreciated, depleted and amortized.

Additionally, cash decreased nearly $100 million, short-term investments were liquidated, and paid-in capital exceeded $1.1 billion over the past two years to provide additional cash for purchases of gas reserves. As a result, total property, plant and equipment was 85% of total assets in 1998 compared to 77% in 1997. In comparison, Unocal's PP&E was 66% and 64% of total assets respectively. Long-term debt increased over $400 million in 1998, totaling $920 million compared to $510 million in 1997. The $920 million was 113% in relation to total liabilities and owners equity of $813 million.

In 1998, current liabilities were $131 million compared to current assets of $118 million. This resulted in a reduced current ratio of. 90 from a 1997 ratio of 1.42. The Unocal current ratios during 1998 and 1997 were 1.01 and 1.29 respectively. Cash Flow Statement Analysis Chesapeake has relied primarily on cash flow through financing activities during the past few years. Cash flow from operations was approximately $95 million in 1998 and $180 million in 1997, while cash flow from financing was $365 million and $278 million respectively.

Sales accounted for $378 million in 1998 and appear to be rising approximately 35% annually from 1996 and 1997. However, an accurate comparison is unavailable because of the change in the company's fiscal year end. Low oil and gas prices forced Chesapeake to borrow, sell equity, and liquidate short-term investments in order to continue operations and invest in oil and gas properties. The company is dependent on the rise of prices during 1999 to continue operations and provide shareholder wealth.

The company has several restrictions from being able to borrow additional funds. Additionally, the price of stock has dropped from a high of $34 in 1996 to a low of $. 63 in 1998. This has further reduced the company's ability to generate cash. Liquidity The current ratios for Chesapeake Energy are as follows: 1.00 (June 96), 2.03 (June 97), 1.42 (December 97), and.

90 (December 98). Current liabilities remained constant over this period, ranging from a high of 19% (June 96) to a low of 15% (June 97), with the current level at 16% of total assets. Extreme levels of change in current assets caused the current ratio to fluctuate drastically. Current assets declined from a high of $297 million (31% of total assets) to a current low of $117 million (15% of total assets). This decline in current assets caused the deterioration of the current ratio.

The acid test ratios are as follows: . 94 (June 96), 2.00 (June 97), 1.37 (December 97), and. 81 (December 98). As previously mentioned, current liabilities remained constant.

Net accounts receivable remained flat as a percentage of total assets: 9% in 1996, 7% in 1997 (Both June & December), and 9% in 1998. Marketable securities were sold off during the past three years, decreasing from 11% ($104 million) of total assets to zero. Cash decreased from 13% ($124 million) of total assets in 1997 (both June & December) to 4% in 1998. The combination of severe decreases in both cash and marketable securities are the reasons that the acid test ratio decreased so dramatically. The quick ratios are as follows: .

96 (June 96), 2.00 (June 97), 1.38 (December 97), and. 86 (December 98). As mentioned previously, current liabilities remained constant and current assets declined. As with the current ratio, the main reason for the deterioration of the quick ratio is the continued loss of current assets. The above ratios and the reasons for their poor trends indicate Chesapeake is currently in a liquidity crisis. This, in combination with the increased debt liabilities, is an extreme warning to both investors and management.

This condition also adds to the suspicion that assets are being sold off to fund current debt obligations. The firm's ability to meet its obligations with cash, as they come due, is approximated by the cash flow liquidity ratio. As previously mentioned, solvency improved and then deteriorated as indicated by the current and quick ratios. The trends are confirmed when looking at cash flow. From 1995 to 1997, Chesapeake's cash flow liquidity improved from 1.47 to 1.8. 1997 to 1998 showed a large drop in liquidity from 1.8 to 0.95.

The company's financial statement data gives an indication as to why. From 1995 to 1997, short-term solvency improved from 1.47 to 1.8. When looking at the data, cash from operations rose from $55 million in 1995, to $139 million in 1997. The 1997 rise was due to a change in the accounting period. During this same period, cash on hand rose from $56 million to $123 million and marketable securities rose from zero to $13 million. While cash was increasing, current liabilities rose from $75 million to $153 million.

Current liabilities doubled during this period, while cash flow increased 150%. The larger increase in cash flow, relative to short-term obligations, accounts for the improvement in solvency during the 1995 to 1997 period. During the 1997 and 1998 periods, liquidity deteriorated as shown by the decrease in the cash flow liquidity ratio from 1.8 to 0.95. The data indicates that cash from operations dropped approximately 32% to $95 million. When looking at the Cash Flow Statement, the large decrease in operating cash is mainly due to the large net loss incurred during the period.

At the same time, cash dropped 76% to $30 million while marketable securities fell to zero. Much of the cash appears to have gone to fund the company's payables and accrued liabilities. Current liabilities were reduced 15% to $131 million. The larger reduction in cash flow relative to current obligations accounts for the deterioration in short-term solvency. The cash flow data confirms that Chesapeake's liquidity suffered severe deterioration. A reduction in current liabilities is a good sign, but the little amount of cash generated and being used to fund current obligations is not enough.

Cash assets are being used to fund these obligations as well. Leverage In comparison to the industry debt ratio of. 31, Chesapeake ended with a debt ratio of 1.31 in 1998 compared to. 71 in 1997.

The long-term debt to total capitalization ratio increased from. 64 in 1997 to 1.37 in 1998, while the industry average was. 44. The tremendous increase in debt was attributable to significantly lower oil and gas prices during the past three years, and a failed drilling venture known as the Louisiana Trend. The company was forced to liquidate assets and take on a substantial amount of debt to meet operational expenses and increase oil and gas field reserves.

Chesapeake was added to the Standard & Poor's Credit Watch with negative implications [Yahoo Finance, Nov. 14, 1999] in December of 1998. The low price of fuel during fiscal years 1996 through 1998 was the primary reason for Chesapeake's troubles. The debt incurred has covenants restricting the company from seeking additional debt and from paying dividends to preferred stock holders. Principal on a large portion of the outstanding debt is not due until 2004 allowing the company time to improve operations. This will also give fuel prices a chance to rise, which is determinant to the company's survival. The industry average for times interest earned is 5.2, while Chesapeake's operating profit was ($856) million.

The ratio equated to well below zero in 1997 and 1998. In 1998, interest payments were more than $68 million. The financial leverage index could not be computed since there was not a return on equity. Chesapeake overextended their credit by substantially financing with debt and has jeopardized their ability to make obligated payments for their debt and fixed costs.

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