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What next for McClendon?

It’s becoming increasingly difficult to separate the misfortunes of Chesapeake Energy from those of its chief executive, Aubrey McClendon

The former chairman’s financial struggles are a reflection of Chesapeake’s own financial difficulties, amid revelations he leveraged personal interests in future wells to arrange $1.5 billion in personal loans.

Further allegations have emerged that McClendon ran his own hedge fund in the basement of Chesapeake’s Oklahoma City campus, trading in the commodities Chesapeake produces. The disclosures not only prompted a Securities Exchange Commission (SEC) investigation, they forced him to step down as chairman of the company over which he has held tight control since its inception in 1989.

As with Apple Computers, or Microsoft, Chesapeake was created in the image of its founder, and seems to have taken on traits of McClendon’s larger-than-life persona. Created with an initial investment of $50,000, Chesapeake went on to become the second-largest natural gas producer in the US after ExxonMobil.

Not content with leading a merely profitable company, in many ways McClendon aimed to transform the US energy market via the development of the country’s abundant shale-gas reserves.

He shrugged off his critics’ complaints that Chesapeake’s debt was too high, taking major acreage positions across Louisiana and Arkansas as he pushed to make Chesapeake the US’ dominant gas producer. The end, it seems, would justify the means – and the debt burden.

Falling stocks

In public McClendon was bullish about his strategy, saying market analysts did not factor in the company’s long-term goals when making calculations of Chesapeake’s net worth. But now, Chesapeake’s stock price is too low to allow it to continue making the kinds of deals that kept it growing. It can’t sell shares for fear of diluting a stock that is worth a fraction of its value at this time last year. On 17 May, shares closed at $13.55 on the New York Stock Exchange, down from a 52-week high of $35.75.

And Chesapeake is having trouble keeping the hedges that have allowed it to break even on its loss-making natural-gas production, resulting in a $71-million first quarter loss.

Even as Chesapeake was arranging financing to gain a $4-billion lifeline from Goldman Sachs, McClendon was scratching to come up with cash to fund drilling obligations under the company’s “founder’s programme” which grants him a 2.5% stake in every well Chesapeake drills. This commitment has proven to be a large personal liability for McClendon himself. According to proxy statements filed with the SEC on 11 May, McClendon’s share of Chesapeake’s wells generated $127 million in revenue, offset by $457 million in drilling costs, for a loss of $330 million.

Only now are investors becoming worried over potential conflicts of interest. Some have gone as far as to seek outright liquidation of the company

Thus it becomes a vicious circle; in order to get the revenue, McClendon must pony up his proportionate share of future spending. Likewise, Chesapeake must drill those wells to retain millions of acres of land it acquired at the height of the unconventional shale boom, or relinquish drilling rights.

Given the crash in North American natural gas prices – by McClendon’s own admission Chesapeake is responsible for 40% of US production growth – cash flows from existing wells are barely adequate to keep the treadmill turning.

With Henry Hub futures hovering at $2.74 per million British thermal units (Btu), a level that does not recoup the cost of production, the company has resorted to using volumetric pre-purchase agreements (VPPs) as a substitute to hedging. Since 2007 Chesapeake has raised more than $6 billion from VPPs, which are forward sales of future production and reserves.

Though they raise short-term cash, the sales are an impairment to future revenue. The Wall Street Journal said those agreements could carry $1.4 billion of undisclosed future liabilities the company claims it isn’t allowed to report under accounting rules. But on 14 May, Chesapeake cancelled a $1 billion VPP for Eagle Ford to avoid harming its credit lines.

VPPs also increase future capital burdens. Once again Chesapeake has to spend money to drill those wells whose production has already been paid for.

With no hedges in place, Chesapeake’s – and McClendon’s – revenue stream is exposed to North American spot prices. Gas dropped below $2/million Btu earlier this spring, the lowest in a decade. Even after recovering to $2.50/million Btu, present levels are far too low to satisfy the company’s need for cash to fund future capital commitments.

Chesapeake has tried to fill the hole with asset sales and joint ventures, but those partnerships also carry future spending commitments. “It takes money to make money,” McClendon told the company’s first-quarter conference call. The problem is that at present Chesapeake does not have a lot of liquidity, as almost its entire worth is locked up in the value of its sprawling assets.

It’s not the first time McClendon has faced a cash call. During the worst of the credit crunch in 2008 he was forced to sell 94% of his Chesapeake stock – at the time, he held 33.4 million shares – to cover short positions. His holding amounted to 6% of the company’s outstanding stock.

According to statements, McClendon now owns just 1.7 million Chesapeake shares, which are worth less than the outstanding obligations on his share of the company’s wells. With the exception of Chesapeake’s falling share price – down almost 63% in the past 12 months – his interests are absolutely aligned. Only now are investors becoming worried over potential conflicts of interest. Some have gone as far as to seek outright liquidation of the company.

On 7 May, Chesapeake’s largest shareholder, Southeastern Asset Management, wrote to McClendon to “urge the board to be open to any offers to acquire the whole company”, and to entertain discussions “with any potential acquirers who would be willing to pay a price today that recognises the longer-term value.”

It’s hardly a ringing endorsement from the firm that owns 13.5%, or more than 50 million of Chesapeake’s outstanding shares. It was further disclosed on 16 May that US industry stalwart T Boone Pickens sold Chesapeake shares in favour of rival Devon Energy. Shareholder activist Carl Ichan is also rumoured to be interested in re-taking a stake in the company. Ichan, who previously held 10% of Chesapeake, sold his stake in 2011. The Chesapeake boss welcomed the prospect of Ichan’s return, but pundits claim this would see McClendon leave the firm.

There is no doubt Chesapeake must restructure. The question is, what will a reformed Chesapeake look like – and will McClendon still be at the top.

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