Overview -- U.S. natural gas producer Chesapeake Energy Corp. has announced that it is negotiating an early termination of the Founder Well Participation Program (FWPP) after revelations about the CEO's personal transactions revealed shortcomings in the company's existing corporate governance practices. The board is currently reviewing financing agreements between the CEO and third parties. -- Turmoil resulting from these developments could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and continuing aggressive capital spending. -- We are lowering our corporate credit and senior unsecured debt issue ratings on Chesapeake to 'BB' from 'BB+', and lowering the ratings on two affiliates--Chesapeake Oilfield Operating LLC and Chesapeake Midstream Partners L.P. -- We are placing all these ratings on CreditWatch with negative implications. Rating Action On April 26, 2012, Standard & Poor's Ratings Services lowered its ratings on Oklahoma City-based Chesapeake Energy Corp., including the corporate credit rating to 'BB' from 'BB+', and lowered ratings on two related entities--Chesapeake Oilfield Operating LLC and Chesapeake Midstream Partners L.P. At the same time, we placed all these ratings on CreditWatch with negative implications. Rationale The downgrade and CreditWatch placement reflect our view that recent revelations about personal transactions undertaken by Chesapeake's CEO relating to the company's unusual FWPP underscore shortcomings in Chesapeake Energy Corp.'s corporate governance practices. Under the FWPP, Chesapeake's CEO, Aubrey McClendon can, before the beginning of each year, elect to take a small (up to 2.5%, subject to certain restrictions) working interest in all of the wells Chesapeake drills during that year. Recent press reports have revealed that Mr. McClendon has obtained loans to fund his investments under the FWPP from third parties (such as EIG Global Energy Partners LLC) who, at the same time, were also significant participants in financing transactions with Chesapeake. Mr. McClendon has also at times sold his interests in certain fields, in conjunction with asset sales by Chesapeake. We believe these transactions heighten the potential for unmanaged and unmonitored conflicts of interest, or the perception thereof. Under the terms of the FWPP, there has been no effective mechanism to protect against conflicts of interest, in our view. Indeed, Chesapeake has previously stated that the company does not review or approve financings of Mr. McClendon's personal assets, including his FWPP interests. It is our understanding that Mr. McClendon has also been under no obligation to disclose his dealings with third parties which also have lending, investment, or advisory relationships with the company. Chesapeake today has announced that its board and Mr. McClendon have committed to negotiate the early termination of the FWPP, which otherwise would have expired at the end of 2015. The company also announced that the Board is reviewing financing arrangements between Mr. McClendon (and the entities through which he participates in the FWPP) and any third party that has had a relationship with the company in any capacity. The board has also confirmed that it did not previously review, approve, or have knowledge of the specific transactions engaged in by Mr. McClendon or the terms of those transactions. In our view this represents a significant governance deficiency. Turmoil resulting from these developments--and from potential revelations resulting from the board investigation--could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and aggressive capital spending. Chesapeake's production is heavily skewed toward natural gas, and natural gas prices are severely depressed at this time. Although hedge-related gains had been an important support to Chesapeake's earnings and cash flow in recent years, the company terminated its natural-gas related hedge positions in late 2011. Chesapeake is in the midst of an extensive repositioning of its business mix, placing more emphasis on production of crude oil and natural gas liquids (collectively, liquids). The company's excellent drilling record and large acreage positions in the most promising North American liquids-rich basins afford confidence about its ability to make this transition. However, Chesapeake faces very large external funding requirements to sustain the aggressive planned investment needed to effect its strategic shift. In its investor presentation dated April 17, 2012, Chesapeake gave guidance of total investment of $10.9 billion to $12.4 billion in 2012, and $10.5 billion to $12.3 billion in 2013. This guidance encompasses well costs on proved and unproved properties, acquisition of unproved properties, and investment in oilfield services and midstream assets. Based on our estimates and price deck assumptions (including natural gas price of $2.00/btu in 2012, $2.75 in 2013, and $3.50 thereafter), we expect Chesapeake's funds from operations to total only $3.4 billion to $3.8 billion in 2012 and $5.4 billion to $5.8 billion in 2013, implying massive internal funding shortfalls. To help fund its planned investment, Chesapeake has stated that it is targeting sales of proved and unproved properties, and monetization of oilfield services, midstream, and other assets, totaling $10 billion to $12 billion in 2012, and $4.0 billion to $6.5 billion in 2013. Chesapeake is asset rich, and it has been adept at structuring varied and innovative transactions to generate funds, including outright asset sales, formation of joint ventures (JVs), issuance of securities by a royalty trust and by newly formed subsidiaries, and issuances of volumetric production payment (VPP) obligations. However, Chesapeake's ability to continue executing such transactions on favorable terms depends largely on capital market receptivity. From our analytical perspective, some of the company's actions to raise funds dilute the benefit of debt reduction, which it is also pursuing. Based on our price deck, we anticipate that coverage metrics over the next two years will be weak even for the revised rating--with debt to EBITDA higher than 5x and EBITDA of less than $4 billion in 2012 and less than $5 billion in 2013--before Chesapeake's liquids production increases sufficiently to offset the effect of persisting depressed natural gas prices. CreditWatch As part of our CreditWatch review, Standard & Poor's will take account of the conclusions of the board's investigation; the terms under which the FWPP is terminated; Chesapeake's ongoing capital-raising initiatives; and potential changes to its growth strategy, financial policies, and governance structure. At this time, we cannot rule out further ratings downgrades of more than one notch; for example, if we believe that asset monetization actions will fall short of plans and that offsetting actions won't be taken to preserve liquidity and limit the increase in financial leverage. The ratings on Chesapeake Oilfield Operating LLC and Chesapeake Midstream Partners L.P. are constrained by our ratings on Chesapeake, given the extent of Chesapeake's ownership control over these entities, and the close business ties between Chesapeake and these entities. Over time, we could elevate Chesapeake Midstream Partners L.P. ratings above those of Chesapeake Energy if it achieves greater customer diversity and remains committed to conservative financial policies. However, given the large list of future drop-down candidates from Chesapeake, we do not anticipate any ratings separation in the near term. Related Criteria And Research -- Standard & Poor's Lowers Its U.S. Natural Gas Price Assumptions; Oil Price Assumptions Are Unchanged, April 18, 2012 -- Key Credit Factors: Global Criteria For Rating The Oil And Gas Exploration And Production Industry, Jan. 20, 2012 -- Chesapeake Energy full analysis, dated April 20, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009. -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Corporate Ratings Criteria 2008, published April 15, 2008. -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Downgraded; On CreditWatch To From Chesapeake Energy Corp. Corporate Credit Rating BB/Watch Neg/-- BB+/Negative/-- Senior Unsecured BB/Watch Neg BB+ Recovery Rating 3 3 Preferred Stock B/Watch Neg B+ Chesapeake Oilfield Operating LLC Corporate Credit Rating BB/Watch Neg/-- BB+/Negative/-- Senior Unsecured BB /Watch Neg BB+ Recovery Rating 4 4 Chesapeake Oilfield Finance Inc. Senior Unsecured BB/Watch Neg BB+ Recovery Rating 4 4 Chesapeake Midstream Partners L.P. Corporate Credit Rating BB/Watch Neg/-- BB+/Negative/-- Senior Unsecured BB/Watch Neg BB+ Recovery Rating 4 4 CHKM Finance Corp. Senior Unsecured BB/Watch Neg BB+ Recovery Rating 4 4