Chesapeake 22% Decline Seen Spurred by Personal Conflict

Chesapeake Energy Corp. CEO Aubrey McClendon
Aubrey McClendon, chairman and chief executive officer of Chesapeake Energy Corp. Photographer: F. Carter Smith/Bloomberg

Chesapeake Energy Corp. Chief Executive Officer Aubrey McClendon has been adding oil fields to his personal holdings faster than he can find cash to drill them. He’s steering the company down the same road.

Chesapeake, producer of more U.S. natural gas than any company except Exxon Mobil Corp., outspent its cash flow in 19 of the past 21 years while amassing millions of acres of drilling leases from the Rocky Mountains to Appalachia.

As the company moved to close this year’s projected funding gap with $12 billion in planned asset sales, investor criticisms of McClendon over a potential conflict of interest are stoking concern about the stability of the company. Chesapeake shares are down 22 percent this month, heading for the worst monthly loss since 2008, the last time McClendon’s personal finances intruded on company business.

“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.”

McClendon didn’t respond to e-mails seeking comment.

McClendon has been borrowing against personal stakes in thousands of company-operated wells to pay his part of drilling costs. Last week’s disclosures of the loans revived debate over financial management of a company already burdened with a $10.3 billion net debt load, more than twice the size of Exxon’s and the lowest price-to-earnings ratio of any independent U.S. energy producer.

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

Free-Falling Gas

McClendon’s loans and the use of his 2.5 percent stakes in Chesapeake wells as collateral are legal and present no conflict of interest, according to the company.

Chesapeake has lost more than one fifth of its market value since the end of March as questions about McClendon’s finances compounded plunging natural-gas prices. Gas for May delivery settled at $1.927 per million British thermal units on April 20, a 55 percent decline from a year earlier.

The last time Chesapeake’s stock performed this poorly was October 2008, after the global financial collapse triggered margin calls on McClendon’s personal investments.

To raise cash, he sold almost all his Chesapeake stock over a few days, accelerating a 38 percent plunge for the month. At the time, the board gave McClendon an $87 million bailout in the form of a special bonus and by purchasing his collection of 19th-century maps.

Plunging Shares

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.

Chesapeake rose 3.2 percent to $18 at the close in New York. Directors declined to comment or couldn’t be reached. McClendon was out of the country yesterday and unavailable for comment, according to Michael Kehs, Chesapeake’s vice president of strategic affairs. McClendon is chairman of the nine-person board.

The 52-year-old McClendon, who ranked 359th on Forbes magazine’s list of wealthiest Americans last year, has had the right to buy stakes in Chesapeake wells since 1993. The arrangement requires the CEO personally to pay a proportionate share of drilling costs on those wells.

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

Well Losses, Cut Pay

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.

The well-investment program aligns McClendon’s interests with the company’s more directly than the stock awards, bonuses and options used by other companies, Kehs, the Chesapeake vice president, said in an April 18 e-mail.

“Aubrey puts his money where his mouth is and has real skin in the game with every well we drill for our shareholders,” Kehs said.

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

Company Lien Protection

“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.

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

Chesapeake holds first liens on its wells, so if McClendon were to default on his loans the company is protected from losing assets, General Counsel Henry J. Hood said on April 18.

“Since Chesapeake is not a party to the loan documents, the liens and provisions do not reach Chesapeake’s intangible assets,” Hood said in an e-mailed statement.

Chesapeake had negative free cash flow of $8.547 billion in 2011, the 10th consecutive year that outlays exceeded inflows, according to data compiled by Bloomberg. Since 1991, the only years when the company posted positive free cash flow were 2000 and 2001. It’s paid its expenses with a combination of operating income, asset sales and loans.

Selling Future Production

One of Chesapeake’s favorite methods for addressing gaps between cash flow and capital spending has been an instrument known as a volumetric production payment, or VPP. The transactions are a type of forward commodity sale that require Chesapeake to deliver a certain amount of gas or oil over a given period of time, in exchange for up-front cash.

Without the proceeds from VPPs and planned asset sales, “massive internal funding shortfalls” this year could reach $9 billion, excluding the proceeds of asset sales and VPPs, Scott Sprinzen, the S&P analyst, said in an April 20 note.

“Chesapeake’s very aggressive push for growth in reserves and production has entailed investment that has substantially outstripped operating cash flow in recent years,” Sprinzen said.

Off-Balance Sheet Debt

The company has raised $6.4 billion through 10 VPPs arranged since December 2007. In the most recent such transaction, Chesapeake agreed to sell Morgan Stanley 10 years of future gas output from a geological formation known as the Granite Wash for about $745 million, according to an April 9 statement.

The VPPs are a form of off-balance sheet debt and shroud the company’s actual future liabilities, said Bob Brackett, an analyst at Sanford C. Bernstein & Co. in New York. Weiss of Argus said the VPPs demonstrate the company “continues to rely largely on financial engineering transactions to raise cash.”

Chesapeake defended the VPPs in the April 9 statement as a sound financial tool and a windfall for shareholders. The 10 VPPs enacted since late 2007 yielded about $4.65 per thousand cubic feet of gas, quadruple the company’s current costs to find and extract each thousand cubic feet, according to the statement.

The company’s 7.1 price-to-earnings ratio is the lowest among its peers and less than one-third the average for the group, according to data compiled by Bloomberg. The stock has 16 buy ratings from analysts, 16 holds and four sell recommendations.

Reasons to Sell

All of the sell recommendations predated last week’s disclosures about McClendon’s personal finances by at least three and a half months. Sanford Bernstein’s Brackett has been the longest-standing pessimist, maintaining his advice that investors dump Chesapeake stock since he initiated coverage 11 months ago.

“It’s the leveraged balance sheet, the joint ventures, the off-balance sheet debt, and now the most recent shoe to drop was corporate governance,” Brackett said in a telephone interview.

Investors who heeded Brackett’s advice to sell in May 2011 avoided a 40 percent loss.

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