Bumpy Road Continues for Chesapeake Energy

bumpy road aheadAn update of the ongoing story about Chesapeake Energy and the disclosure that CEO Aubrey McClendon’s has borrowed over $1 billion to help cover drilling costs. Chesapeake’s stock has taken a hit, down 25 percent this month, heading for what may be its worst monthly performance since the global financial crisis in 2008 when the company’s stock ultimately slide 38 percent in a single month.

Energy analysts are at best nervous about the current situation:

“Chesapeake is walking a tightrope right now,” Mark Hanson, an analyst at Morningstar Inc. in Chicago, said in a telephone interview. McClendon “has shown a predilection to outspend, sometimes recklessly.”

Philip Weiss, an analyst at Argus Research in New York, said McClendon and the board should be fired.

A “credibility chasm” between Chesapeake’s management and investors will continue to overshadow the company’s operating performance and will weigh on the share price for at least the next 12 months, said Tim Rezvan and Ryan Mueller, New York-based analysts at Sterne, Agee & Leach Inc.*

The situation in brief: McClendon gets a 2.5 percent ownership stake in each well drilled by Chesapeake. But along with that ownership stake comes the responsibility to pony up money to help drill the well. The Chesapeake board says that giving McClendon a 2.5 percent stake in the wells is better than stock options and other forms of compensation because it more closely aligns McClendon’s interests with the interests of the company.

In order to get the cash to cover his portion of the drilling expenses, McClendon mortgages his share of the wells, using them as collateral, to get the money to help drill them. The problem is, natural gas prices are at 10-year historic lows, so his 2.5 percent “asset” is not worth as much as it once was, and it’s not as profitable as it once was. You can spend the fixed cost to drill a well, but if the profit the well returns is less (natural gas prices are down 55 percent from last year this time), you have less money to pay back the loans you used to drill it. So McClendon keeps borrowing to cover the difference between what he pays as his portion to drill the wells, and what he gets back as profit. However, McClendon keeps participating in the 2.5 percent wells ownership plan:

McClendon told the company’s board of directors in September he will participate again this year in the program that the company said lost him more than $600 million in the past three years, according to an April 20 public filing.

During the first quarter, McClendon had $88.1 million in net losses in the wells program after accounting for capital expenses, according to the filing. Full-year losses amounted to $315.3 million, $141.9 million and $116.1 million, respectively, for 2011, 2010 and 2009. The company also reported it cut McClendon’s compensation 15 percent last year to $17.86 million in response to shareholder concerns that he was overpaid.

McClendon now finds himself squeezed between gas prices close to a 10-year low and expanding commitments to fund his drilling costs, Hanson [analyst at Morningstar] said.

“There’s no question that if Aubrey had to come up with that money on his own there is no way he could,” Hanson said.*

In 2008 when the global financial crisis hit, investors called in their loans to McClendon and he had to scramble to cover them. Ultimately, the Chesapeake board gave McClendon an $87 million bailout loan at the time. Would they do it again now?

Prospects for another CEO bailout are slim, said Scott Sprinzen, a Standard & Poor’s debt analyst. Chesapeake is unlikely to “again provide what we view as amounting to extraordinary financial support” he said.*

What happens next? Both McClendon personally, and Chesapeake the company, will have to work hard to cover “massive internal funding shortfalls” this year that could reach $9 billion. Their favorite method of raising money is to use a volumetric production payment, or “VPP.” In a VPP, Chesapeake agrees to deliver a certain amount of natural gas over a specified period of time at a given price, in return for up-front cash. Chesapeake has done 10 such VPP deals since 2007 raising $6.4 billion in cash. Looks like they’ll be doing more of them this year.

One thing’s for sure: Never count Aubrey McClendon out. He’s battled back before, and if MDN were betting, we’d bet on McClendon to do it again.

*Akron (OH) Beacon Journal/Bloomberg News (Apr 23, 2012) – Chesapeake’s 25 percent decline linked to CEO’s overspending

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