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Chesapeake Quarterlies Likely Big Draw This Week

April 30, 2012
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Chesapeake Energy Corp. is scheduled to report quarterly earnings late Tuesday, followed by a 9 a.m. ET conference call the following day that may draw a legion eager to hear from CEO Aubrey McClendon about what is taking place at undoubtedly the most tumultuous period in the corporation's history.

Faith in the leadership at the second largest natural gas producer in the United States fell last week, with many calling for McClendon and the board of directors to step aside as more information about the CEO's personal loans -- with or without the board's knowledge -- drew more scrutiny.

Chesapeake ended the week in regular trading at $17.72, up about 16% from its close on Thursday, with nearly 50,000 shares trading hands -- versus average volume of 18,500. The company a year ago was trading at around $35.75.

The week began with Chesapeake issuing its 2011 proxy statement on Monday, which laid out McClendon's sole participation in the Founder Well Participation Program (FWPP), an incentive put in place in 1993 and approved again by shareholders in 2005, that allows the CEO to buy a 2.5% stake in every well the company drills in a given year.

The proxy indicated that McClendon's cumulative spending under the FWPP had "significantly exceeded cumulative production revenues to date" because capital spending had risen year to year." McClendon has routinely taken loans to cover the costs of participation and operational upkeep, but his personal loans jumped to more than $1 billion in the past three years, and loans with corporate investor EIG Global Energy Partners and a predecessor firm were lambasted by analysts and investors (see NGI, April 23).

The board earlier this month indicated that it knew all about McClendon's personal loans, but on Thursday, it was backing away from that statement -- and it was working on ways with the CEO to end the FWPP.

Chesapeake said it wanted to "clarify a statement" from its original press release issued on April 18 by General Counsel Henry Hood indicating the board was "fully aware" of McClendon's financing transactions.

The press release, said the company, "was intended to convey the fact that the board of directors is generally aware that Mr. McClendon used interests acquired through his participation in the FWPP as security in personal financing transactions. The board of directors did not review, approve or have knowledge of the specific transactions engaged in by Mr. McClendon or the terms of those transactions."

The FWPP is scheduled to terminate in 2015. However, the board and McClendon "have committed to negotiate the early termination of the FWPP and the amendment to Mr. McClendon's employment agreement necessary to effectuate the early termination."

McClendon also agreed to "separately disclose supplemental information regarding the interests he has acquired" through the FWPP as of Dec. 31, 2011. In addition the board is "reviewing the financing arrangements between Mr. McClendon (and the entities through which he participates in the FWPP) and any third party that has had or may have a relationship with the company in any capacity."

After the company issued its statement, McClendon followed with his own, noting that he had received a $61 million pre-tax gain by selling some of the Chesapeake well interests last year. Loans were obtained through his control of three private companies -- Arcadia Resources LP, Larchmont Resources LLC and Jamestown Resources LLC. The companies held a combined $846 million in outstanding loans at the end of last year, McClendon said.

Reportedly, the U.S. Securities and Exchange Commission's Fort Worth, TX, office has launched an informal inquiry.

"Shame on the board," said Oppenheimer & Co. energy analyst Fadel Gheit. "This is a very unusual, very unorthodox privilege and they should have gotten rid of it long ago."

Canaccord Genuity energy analyst John Gerdes said the announcement to end the FWPP was "emblematic of a board imperative...to eliminate a perceived material conflict of interest." The perception "has created a 10-20% valuation discount in Chesapeake shares. That the board is taking steps to alleviate this discount should be viewed positively."

Standard & Poor's Ratings Services (S&P) responded late Thursday by cutting the credit ratings on the corporation and two related entities, Chesapeake Oilfield Operating LLC and Chesapeake Midstream Partners LP to "BB" from "BB+" and placed them on "CreditWatch with negative implications" because of the "recent revelations."

The ratings revisions "reflect our view that recent revelations about personal transactions undertaken by Chesapeake's CEO relating to the company's unusual Founder Well Participation Program underscore shortcomings in Chesapeake Energy Corp.'s corporate governance practices," said S&P credit analyst Scott Sprinzen. "We believe these transactions heighten the potential for unmanaged and unmonitored conflicts of interest, or the perception thereof."

The FWPP's terms offer "no effective mechanism to protect against conflicts of interest, in our view. Indeed, Chesapeake has previously said the company does not review or approve financings of Mr. McClendon's personal assets, including his FWPP interests. It is our understanding that Mr. McClendon has also been under no obligation to disclose his dealings with third parties which also have lending, investment, or advisory relationships with the company," said the S&P analyst.

The board's decision to negotiate an early termination to the FWPP and to review the CEO's loans with any third parties that have a relationship with the company "represents a significant governance deficiency," said Sprinzen.

"Turmoil resulting from these developments -- and from potential revelations resulting from the board investigation -- could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and aggressive capital spending."

The company has an "excellent drilling record and large acreage positions in the most promising North American liquids-rich basins" that "afford confidence about its ability" to transition from natural gas production to more liquids and oil output, the S&P analyst said.

"However, Chesapeake faces very large external funding requirements to sustain the aggressive planned investment needed to effect its strategic shift. In its investor presentation dated April 17, 2012, Chesapeake gave guidance of total investment of $10.9-12.4 billion in 2012, and $10.5-12.3 billion in 2013. This guidance encompasses well costs on proved and unproved properties, acquisition of unproved properties, and investment in oilfield services and midstream assets.

"Based on our estimates and price deck assumptions (including natural gas price of $2.00/MMBtu in 2012, $2.75 in 2013 and $3.50 thereafter), we expect Chesapeake's funds from operations to total only $3.4 billion to $3.8 billion in 2012 and $5.4 billion to $5.8 billion in 2013, implying massive internal funding shortfalls," said Sprinzen.

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