Is Chesapeake the New Enron? Or Unfairly Targeted?

house of cardsTake a few days off, and the news comes fast and furious. Big, complex stories are not what blog sites like MDN are usually geared for, but we have a big, complex story to deal with: Chesapeake Energy. In case you’ve missed it in the business pages, a new “controversy” has erupted over Chesapeake’s financial situation. They carry a heavy debt load, and with the commodity price of natural gas at 10-year lows, Chesapeake CEO Aubrey McClendon is doing new deals (it seems) almost weekly in a bid to keep the money coming in to the company to fund continuing exploration and production.

Some of the Chesapeake deals are of the joint venture nature as in “give us money and you’ll get part of the profits from this set of wells in this particular shale play,” and other deals sell off company assets outright, like the announcement on Monday that Chesapeake is spinning off its Oilfield Services, Inc. division into a separate company and will float an initial public offering (IPO) hoping to raise more than $850 million in cash (see this Chesapeake press release).

The Oilfield Services IPO seemed to be the straw that broke the financial analyst camel’s back. A very intense scrutiny began. Leading industry publication NGI’s Shale Daily (an advertiser on MDN) ran a story looking at the deal. Part of that story contains an analysis that shows Chesapeake’s long-term debt load is more than Exxon Mobil’s long-term debt, and Exxon is 32 times bigger in market capitalization than Chesapeake:

According to data compiled by NGI’s Shale Daily, Chesapeake also is holding more total net debt than integrated producer ExxonMobil. At the end of 2011, Chesapeake’s total debt was $13.3 billion net, excluding minority interests, and $14.5 billion net, including minority interests. By comparison, ExxonMobil at the end of 2011 carried $4.37 billion net debt, excluding minority interests, and had $10.7 billion net debt, including minority interest. The figures excluded off-balance sheet debt items, including pipeline take-or-pay contracts, as well as volumetric production payments. In addition, ExxonMobil’s market capitalization currently is 32 times that of Chesapeake’s.(1)

The Shale Daily story ran yesterday, April 18th. The same day, Reuters released a six paragraph story that took direct aim at McClendon. It starts this way:

Aubrey McClendon, the CEO of Chesapeake Energy Corp, has borrowed as much as $1.1 billion over the last three years against his stake in thousands of company wells – a move that analysts, academics and attorneys who reviewed loan documents say raises the potential for conflicts of interest.

The loans, which haven’t been previously detailed to shareholders, are used to fund McClendon’s operating costs for an unusual corporate perk that offers him a chance to invest in a 2.5 percent interest in every well the company drills. McClendon in turn is using the 2.5 percent stakes as collateral on those same loans, documents filed in five states show.(2)

Oy vey, this is where it gets complicated to follow for us average Jims. McClendon has a deal with the company he founded—a company that is now a public company with shareholders and a board, people he must answer to. The deal was/is he personally gets a 2.5 percent ownership interest in every well the company drills. Hey, he started the company, he took the risks, and he’s the one with the chutzpah to make it all work. So he should be rewarded in any way he can negotiate—no complaints about that. But he is using his ownership interest in those wells as collateral for loans, and those loans are used to fund the drilling of those same wells. In a sense, he is leveraging his personal ownership stake to help fund the drilling. Or think of it this way, the underlying asset—the well—is being put up for collateral twice. Investors in Chesapeake’s joint ventures are giving Chesapeake money to drill those wells and have a “claim” against the wells—the wells are collateral for the investors in the jv’s. But then, other companies invest by making a loan to McClendon and theoretically have a claim against the same wells. Kind of a second mortgage if you will, and they are second in line in their claim, via McClendon’s 2.5 percent stake.

Yeah, headache time trying to get the little gray cells wrapped around this. If MDN understands this correctly (and that’s a big IF!), Chesapeake’s wells are being “mortgaged” twice, to different parties. And given that McClendon’s personal loans against the “second mortgage” total a whopping $1.1 billion, that’s where whispers of “Enron 2” and “house of cards” come into play. None of this would likely matter if the price of natural gas was not so low. At current historically low price levels, Chesapeake, like other natural gas drillers, is having a hard time being profitable. There’s a risk that they won’t be able to pay back their loans, and if they can’t, it puts the asset (the wells) at risk.

A story from the Pittsburgh Post-Gazette that appeared on Sunday, March 25, looks at how McClendon is mortgaging his 2.5 percent interest in wells in West Virginia, and how it may affect landowners:

An affiliate company owned by Chesapeake Energy CEO Aubrey McClendon is mortgaging its stake in West Virginia oil and gas leases, making Brooke County farmland part of a billionaire’s portfolio built to profit on the promise of future drilling.

The affiliate company — Jamestown Resources — has entered into mortgages with a global investment group to raise funds against untold portions of its holdings in West Virginia. Jamestown Resources is owned by Mr. McClendon, who also owns a personal stake in every well that Chesapeake drills.

The mortgaging gives Mr. McClendon the opportunity to raise cash now on the promise of drilling at a time when the industry is scaling back production and waiting for natural gas prices to rebound. Meanwhile, the practice is never disclosed to the landowners whose property it concerns, although it is filed in the Brooke County Courthouse alongside their leases.

It’s a win-win situation for Mr. McClendon: Drill a profitable well, and the loan is easily paid off and well profits go to Oklahoma City-based Chesapeake. If the well doesn’t produce or isn’t drilled, the only collateral jeopardized is oil and gas interests in Brooke County.

"What Aubrey does with his own investments is separate from what the company does," said Bob Brackett, a senior analyst at New York-based Sanford C. Bernstein & Co. LLC. "But Aubrey as the CEO is willing to take big bets, and he’s consistent with his own money."

The mortgages can be bundled and traded, not unlike how home mortgages have been on Wall Street.

Since landowners do not have to be informed about the mortgaging practice, it’s hard to gauge just how common it is. Chesapeake says this is standard procedure for such transactions. P. Nathan Bowles Jr., an oil and gas attorney in Charleston, W.Va., who served as trustee on some Jamestown mortgages, agrees it’s a standard strategy.

"It’s not uncommon at all. It is used whenever somebody wants to leverage their investments," Mr. Bowles said. "When it comes to oil and gas, somebody might go to a lender and say, ‘I have these leases, I’m experienced in the business … so I’d like to borrow money to finance the drilling and I’ll pay you back as this oil or gas is produced.’ "

Chesapeake calls this everyday business, saying it’s taken mortgages out on holdings for the 23 years it’s been operating.

While the recent mortgages are taken out against stakes held in each individual oil and gas lease, the borrower — in this case Mr. McClendon — presents the entire package of interests to EIG Global Energy Partners, a Washington, D.C.-based energy investment company, in order to secure the total loan.

"In the end, the package is put together and it is like a person saying ‘I will mortgage my house and my farm and my summer home to secure the same loan,’ " Mr. Bowles said.

Jamestown is able to secure this loan on the promise that Chesapeake will continue to drill as it has for years. In 2010, Chesapeake’s daily production rate averaged approximately 2.8 billions of cubic feet equivalent (bcfe), an increase of 14 percent from 2009.

But what if the wells leveraged for cash up front don’t produce?

"The debt’s still there. The borrower is still required to pay off the debt," Mr. Bowles said. "So how else can the borrower do that if they didn’t have the money to drill in the first place?"(3)

Notice the reference to how McClendon’s loans are bundled and sold, “not unlike how home mortgages have been on Wall Street,” referencing the financial melt-down of 2008. A not-so-subtle comparison. The drilling industry certainly doesn’t need one of its most visible spokesperson’s, McClendon, to go down in scandal. But financial stability, honesty and transparency are vital to public confidence. Chesapeake, to be fair, loudly protests and says it has done nothing wrong and that shareholders have known of, and approved, McClendon’s deal of receiving 2.5 percent ownership in all wells drilled. They further say that his personal loans (totaling $1.1 billion) don’t adversely impact the company and don’t put the company or its wells at risk. Yesterday they issued this rather terse press release:

Chesapeake Energy Corporation General Counsel Henry J. Hood issued the following statement in response to recently published media reports: “The Founders Well Participation Program (FWPP) has been in place since the company’s founding and was reapproved by shareholders by a wide margin in 2005. The terms and procedures for the program are clear and detailed in every proxy for all shareholders to see. Mr. McClendon’s interests and Chesapeake’s are completely aligned. In addition, there are numerous third-party participants in the company’s wells, including some of the largest energy companies in the world, that monitor the actions of the company through a number of processes, including well audits, reporting, governmental filings and hearings, participation in development plans and marketing of production. The suggestion of any conflicts of interest is unfounded.”

Hood also added, “The Board of Directors is fully aware of the existence of Mr. McClendon’s financing transactions and the fact that these occur is disclosed in the proxy. Additionally, the total amount of his cost obligations and revenue attributable to the FWPP for each year are detailed in the proxy. The FWPP fully aligns the interests of Mr. McClendon with the company and the Board of Directors supports this program as does the majority of its shareholders.”

Please visit for more information regarding the company’s disclosure on this topic.(4)

On the web page, Chesapeake does an extensive Q&A and responds to multiple charges and points raised by Reuters and others. In that Q&A, Chesapeake says that McClendon’s 2.5 percent share and the loans he secures against it does not put the wells at risk. In other words, the investors in McClendon’s “second mortgage” cannot “foreclose” on the wells if McClendon can’t pay them back. Here is one of the questions and Chesapeake’s answer:

Q: The loan agreements show that Mr. McClendon has pledged his oil, gas and land interests, and well-related equipment as collateral. The loan agreements also show that he has pledged his interests in hedging contracts, geological and business data, and intellectual property as collateral. Because of the scope of collateral pledged and the potential difficulty in dividing or valuing Mr. McClendon’s share of the collateral in the event of a default, oil and gas attorneys and analysts who reviewed the loan documents say it is likely that Chesapeake would become entangled in any legal dispute that may arise. What is Chesapeake’s response to that view?

A: Chesapeake does not agree with this assertion. Chesapeake has an operator’s lien on the proceeds, equipment and leases that is superior to any lender’s rights. Chesapeake also has rights of set-off and controls the payment of Mr. McClendon’s proceeds on wells operated by the company. The company does not have an interest in the other related assets (such as Mr. McClendon’s personal business data and hedging contacts) and Mr. McClendon does not have an interest in the company’s related assets. As a result, each party’s interest in its own property would be unaffected by any dispute between the other party and a third party. The rights of a third-party operator would be identical to Chesapeake and the rights of a third-party working interest owner would be identical to Mr. McClendon.(5)

Let’s bring it all back to center. Here’s the situation: McClendon has taken out a lot of loans, over $1.1 billion, against his personal interest in the company’s wells, and he’s using those loans, along with other deals that he does, to keep the company going. Chesapeake argues it’s savvy business practice and all above-board. Detractors say it’s risky at minimum, and borders on fraudulent at the other end of the scale. Chose your metaphor. The blood is in the water and the sharks are now circling. The first blow has been landed. What will happen next? That’s the question.

Chesapeake’s stock, as of yesterday, hit a new 52-week low. Investors are nervous. Some believe loans on top of loans equals a house of cards, and some even say it resembles what happened with Enron. MDN does not believe this is an Enron-like situation, but MDN is no financial expert either. This is all vitally important for landowners because Chesapeake is the second largest natural gas producer in the U.S. and thousands of landowners in the Marcellus are signed with Chesapeake. If the company, because of this situation, becomes unraveled, the drilling of Chesapeake’s wells and their leases won’t go away—someone will own them—but what about royalty checks and lease payments? Will they be delayed?

Important? You bet it’s important, and MDN will keep an eye on this developing (and complex) story.

If any of our sharp MDN readers have additional information they can add, please leave a comment.

(1) NGI’s Shale Daily (Apr 18, 2012) – Oilfield Services Business Next Financial Windfall for Chesapeake? (trial subscription required to view)

(2) Reuters (Apr 18, 2012) – Exclusive: Chesapeake CEO took out $1.1 billion in unreported loans

(3) Pittsburgh Post-Gazette (Mar 25, 2012) – Chesapeake Energy CEO quietly mortgaging his stake in West Virginia leases

(4) Chesapeake Energy (Apr 18, 2012) – Chesapeake Energy Corporation General Counsel Henry J. Hood Issues Statement

(5) Chesapeake Energy (accessed Apr 19, 2012) – Chesapeake Statement