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Chesapeake Results Disappoint; Largest Shareholder to Take 'Active' Role

Chesapeake Energy Corp. CEO Aubrey McClendon appeared to take it on the chin Wednesday, refusing to bow down to reports about the "unprecedented scrutiny" of the company and of himself in recent days, and promised shareholders that the management team is focused on becoming a U.S. oil-weighted giant. However, it's going to take some time, he said, especially because the turnaround has little operational support from its natural gas-weighted portfolio.

To successfully fund the transformation, Chesapeake has added more properties to its sales list, including estimable liquids-rich targets that it is chasing, McClendon told energy analysts and investors listening in to a conference call. The management team spent more than an hour discussing the first quarter performance, which earnings-wise failed to hit Wall Street's expectations on almost every level. In addition, the CEO has faced scrutiny on several levels in recent weeks, and on Tuesday was knocked from his perch as chairman of the board (see Shale Daily, May 2). However, the flamboyant industry cheerleader assured the listening audience that the "distractions" of the past few weeks should be taken in stride.

"I'm deeply sorry for all of the distractions of the past two weeks," he said. "There has been enormous and unprecedented scrutiny of our company, and of me personally. And a great deal of misinformation has been published and uncertainty created...Mother told you not to believe everything you hear and read for good reason..."

In addition the McClendon's management team, a representative from Southeastern Asset Management, Chesapeake's largest shareholder, was in attendance but didn't participate on the conference call. However, in a regulatory filing Southeastern, led by Mason, Hawkins, said it has converted its 13.6% stake in Chesapeake to "active" from "passive." The filing stated that Southeastern intends to "open discussions" with Chesapeake's management, board and third parties, but it did not specify what those discussions may entail.

Shareholders reacted strongly to the earnings news and Chesapeake's inner turmoil, sending the share price on Wednesday down by more than 14%, to end the day at $16.73 from $19.60 on Tuesday. Trading volume was above 139.6 million, versus average volume of 20.26 million.

Reuters Wednesday reported that McClendon ran a private hedge fund for at least four years, from 2004 to 2008, that traded in contracts for oil and natural gas and other commodities. It was suggested that the hedge fund, reportedly founded by McClendon and SandRidge Energy Inc. CEO (and Chesapeake co-founder Tom Ward), may have influenced McClendon's running of Chesapeake.

The charge, if true, could be far more serious than the earlier revelations of loans to backstop his share of a Founder Well Participation Program that gave McClendon the sole contractual right to receive a 2.5% stake in every well the company drills. Chesapeake announced early termination of the program Tuesday when they relieved McClendon of his duties as chairman. The issue is whether a CEO playing the market for himself might be neglecting his obligation to his shareholders to maximize company profits or might be profiting in his trading from advance market knowledge gained in his management position.

"A key issue in all of this is disclosure," said NGI's Shale Daily's Patrick Rau, director of Strategy & Research. "The [Securities and Exchange Commission] is a stickler about disclosing any perceived conflict of interest." Rau, a former Wall Street analyst, questioned whether there has been full disclosure, and if not, from whom was the company's compliance unit taking orders.

As to whether McClendon could have influenced the natural gas futures market, "it is generally believed that there is no insider information when it comes to commodities, because commodities markets are as close as it comes to being perfectly competitive. In perfectly competitive markets, all producers are price takers, and therefore cannot impact the price themselves. So while a producer couldn't impact the overall market, he might personally profit from advance information," Rau said. He stressed, however, that there has been no proof nor confirmation of the hedge fund allegations made by Reuters in its lengthy report Wednesday.

Another question is why have shareholders put up with a joint CEO/Chairman for so long. "A CEO should never be in charge of a board of directors. One of the main reasons for an independent board is to provide a check and balance on the CEO," Rau said. He also noted that because Chesapeake co-founder Ward could also have been involved in the hedge fund, "Look for investors to put SandRidge under a tight microscope in the weeks ahead."

Beyond the headlines, McClendon said he intends to focus on the company -- reducing debt and expanding liquids and oil production. Now the No. 2 gas producer in the United States, Chesapeake remains about 85% gas-weighted, and with prices hovering at $2.00/Mcf, it's been difficult and costly to finance the move to liquids targets, the CEO explained.

"This is the first significant earnings miss in many years and hopefully our last," said McClendon. "The positives are enduring and the negatives are short term in nature."

The company was unable to replace natural gas hedges last fall and paid dearly for it in the first quarter, with a loss of $71 million (minus 11 cents/share), which included a hedging loss of $167 million, versus a year-ago loss of $205 million (minus 32 cents). Excluding the one-time gains/losses in the recent quarter, earnings were 18 cents -- below Wall Street's 28 cents/share expectations. Revenues totaled $2.42 billion, higher than year-ago sales of $1.61 billion, but off of Wall Street's forecasts of $2.71 billion.

Despite voluntary gas well curtailments that were begun in February, daily production in the first three months actually rose 18% year/year to 3.658 Bcfe from 3.107 Bcfe. One reason for the gains in gas output was to prevent expiry on some of the leaseholds, said the CEO. Once the company has captured all of the leaseholds it needs to be held by production, it plans to keep gas production flat, he explained.

Chesapeake no longer is a big gas "driller" by any stretch of the imagination. In January 2011 Chesapeake had about 100 gas drilling rigs in operation in the U.S. onshore. In the first three months of this year Chesapeake had 50 gas rigs running, and today it's down to 38, said COO Steve Dixon. "In just 90 days, we'll be down to 12...That's a drop of 75%."

The company has been ramped up in liquids targets, running 172 rigs beginning late last year, and the "first quarter took the brunt of elevated drilling," said Dixon. But the liquids rigs already have "dropped by 18 to 154, and drilling during the year will drop to 125 by the third quarter."

Liquids output in the first quarter jumped 69% from a year earlier to 113,600 b/d, making up 19% of total production; liquids now comprise around 61% of the unhedged portfolio. However, output for 2012 is expected to be flat because of asset sales, Dixon explained. Once Chesapeake is more stable and is drilling more wells in 2013 and beyond, liquids output will escalate.

The company plans to sell outright its highly prospective Permian Basin portfolio, said McClendon. The virtual data room already is open; a physical data room is expected to be up and running within a week or so. Chesapeake could net $7-8 billion from its Permian properties, a hot target for liquids drillers.

Other property sales, including a portion of the Mississippi Lime, also are on the block, and two joint ventures still in the works for the Utica Shale, along with monetizations in the Denver-Julesburg (DJ) Basin and other areas.

"The selling impacts 2012 and 2013 guidance, but it doesn't do anything to our outer-year targets -- we'll simply drill more wells," said McClendon.

The fact that Chesapeake has attractive properties to sell is to McClendon's credit. The Chesapeake co-founder started as a landman, and is "really good at identifying and acquiring potentially lucrative acreage positions," Rau said. "Much of Chesapeake's value comes from its ability to beat its competitors to the latest greatest properties. If Aubrey were forced to step down as CEO, it could conceivably have a greater negative long-term impact than the current controversy."

The Eagle Ford Shale, however, remains a prime drilling target and will capture around one-third of the capital drilling budget over the coming two years, said Dixon. The producer also has hit on a promising, heretofore untapped oily target in the Powder River region of the Niobrara formation -- but not the DJ Basin, where Chesapeake hasn't had much luck, said McClendon.

Chesapeake plans to cut its debt load to $9.5 billion by the end of this year through monetizations of various kinds (asset sales, joint ventures and voluntary production payments) acknowledging that it may run short of money in 2013 if natural gas prices don't rise. The company to date has completed $2.6 billion of asset monetizations to date this year and management said it's on track to complete the $11.5-14 billion total for the year. At the end of March Chesapeake had $12.64 billion in debt, or 40% of its capital, on the balance sheet.

Even though production forecasts are flat, capital spending plans for 2012 are higher, bumped up to $7.5-8 billion from a target set earlier this year of $7-7.5 billion, because, as McClendon explained, moving from gas to liquids will take "front-end loading." In 2013, with more drilling and less upfront spending, the capital budget is set at $6.5-7 billion, down from $7.5-8.5 billion.

Chesapeake's shareholders have been a fickle bunch in the past few weeks, sending the stock price up by double digits and then down sharply, depending on the news of the day. The company's stock performance over the past year (per the closing on Tuesday) was down almost 42%, versus a median decline of 32.1% for peer companies (see chart). Chesapeake has the highest amount of absolute debt of all the companies listed, but its debt-to-capital ratio of 43.2% is in line with the group's median level of 43.4%.

However, that debt-to-capital figure only incorporates balance-sheet debt. To understand Chesapeake's true debt load versus the industry, one should consider the adjusted debt level, which is a combination of balance sheet debt and off-balance sheet obligations, such as transportation take-or-pay contracts and operating leases. Chesapeake's adjusted debt-to-capital ratio is 64.8%, well above the industry average of 54%. Chesapeake is not the only debt- and gas-heavy company to underperform in the market in recent months. As indicated in the chart, Quicksilver Resources, Exco Resources, Forest Oil & Gas, and Ultra Petroleum all have similar relative levels of adjusted debt to Chesapeake, but suffered even steeper declines in their stock prices.

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