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Chesapeake Governance Questioned; Pickens Dumps Stock

The drip, drip, drip of discouraging news continued for Chesapeake Energy Corp. last week, beginning with a letter on Monday from the largest shareholder encouraging the board "to be open to any offers to acquire the whole company." The week ended with a regulatory filing by the company that it may delay some of the $14 billion in planned asset sales this year because low natural gas prices could stretch its ability to comply with credit covenants.

In the Form 10-Q filing with the Securities and Exchange Commission (SEC), Chesapeake detailed some of the financial issues it is facing over the coming months.

Shareholders bolted on the news, with more than 76 million shares trading hands Friday, versus a daily average of about 24 million. The stock lost 13.8% of its value in one day to end at $14.81 for the week.

Southeastern Asset Management Inc., holding 13.6% of the company's stock, had stepped in earlier this month to take an active role in overseeing the company after CEO Aubrey McClendon was dismissed as chairman (see NGI, May 7). Following reports of financial improprieties, the SEC (SEC) began an informal inquiry, and the Department of Justice is considering an investigating for possible price manipulation and fraud.

Southeastern Chairman O. Mason Hawkins urged the company in a letter "to take action in three areas: debt targets, management focus and strategic options. We do not think that managing to an arbitrary target like the '25/25 Plan' makes sense," referring to a plan to reduce debt by 25% and increase output by 25%. "On the production '25,' we would prefer that management simply focus on maximizing operational cash flow after capex [capital expenditures], instead of going for a volume growth target and spending significantly above maintenance capex currently to grow production to targeted levels." Of the plan to reduce debt by 25%, Southeastern is in favor of reducing debt but "we don't think that management needs to be managing to a specific target there either. This target has been twisted by some constituencies such that it is sometimes confused with debt maturities actually coming due rather than a worthy goal."

Chesapeake also should "accelerate monetizing any assets that are not core" to exploration and production (E&P), including the midstream and oil services assets "and/or any more E&P assets which are not overly reliant on depressed spot natural gas prices and where the company does not have a leading position."

A "second set of concerns" relate to management's focus "and the time spent on unproductive communications. We urge management to simply put their heads down" and get things done. "Sell-side conferences, media interviews with no hope of a fair hearing and meetings all over the U.S. with groups who may have only a casual interest but don't mind hearing the 'story' use valuable amounts of top management's time with no apparent benefit and plenty of misinterpretation detriment."

The last point "may be taken out of context, but is important: we urge the board to be open to any offers to acquire the whole company," said Hawkins. "We acknowledge that today's low market price is far below the company's net asset value [NAV] per share and would not encourage any action that would generate a lowball bid versus this NAV. We recognize the dangers of opening such conversations, which can sometime put a company 'in play' at an inopportune time. We therefore want to make clear that we would not support a bid, which might be a large premium to today's stock price but is meaningfully below NAV per share. However, we also don't want to use this large price-to-value gap as an excuse to refuse discussions with any potential acquirers who would be willing to pay a price today that recognizes the longer term value of the company."

Moody's Investors Service followed with a downgrade to "negative" from "stable" on the corporation and the midstream and oilfield services units in part because 1Q2012 results pointed to "an even larger capital spending funding gap for 2012" on low gas prices and because of a planned spending hike. "The negative outlook reflects the escalating execution risk of Chesapeake's plan for funding its large capital spending budget, rising leverage metrics and accompanying liquidity concerns," said Vice President Pete Speer. Fitch Ratings on May 4 also had downgraded the company on its "still aggressive" capital spending plan.

Recent disclosures about McClendon's transactions "have raised conflict of interest questions and reflect poorly on Chesapeake's corporate governance," said Speer. "These issues further confirm our existing views regarding the CEO's dominant role at Chesapeake and his strong influence on the company's risk appetite and growth objectives. This influence is reflected in the company's aggressive financial policies and complicated structure, which are incorporated into our ratings."

However, if the SEC inquiry, shareholder litigation or the board of director's audit committee review of the CEO's personal financing transactions raise "additional issues or adversely effects the company's execution of its funding strategy then there could be negative ratings implications," said Speer. The funding gap "could continue to rise" if gas prices continue to decline, which would lower earnings and increase its compliance risk with bank credit facility debt covenants in the second half of this year. So far this year, Moody's estimates that Chesapeake has raised close to $4 billion through a bond offering and planned monetization transactions."

The VPPs and other transactions are viewed by Moody's as debt, which puts Chesapeake's total debt with adjustments at about $23.6 billion at the end of March, versus $19.2 billion at the end of last year. "Consequently, debt/proved developed (PD) reserves and debt/average daily production have increased to around $12.30/boe and $35,700/boe, respectively," said Speer.

In a revised proxy filing with the SEC on Friday, Chesapeake reiterated to shareholders that it will introduce performance-based awards as part of McClendon's pay package this year. The variable annual pay plan was approved by the board in December after more than 40% of the shareholders voted against Chesapeake's executive compensation plan and said McClendon's was "too high." Last year the CEO's compensation amounted to around $17.9 million, and the year before he took home about $21 million.

The Wall Street Journal reported late Thursday that Chesapeake has about $1.4 billion of previously unreported liabilities over the next 10 years through its VPPs, which it called off balance sheet transactions, because the liabilities are unreported in the SEC filings. Most of the costs "will hit this year and next, at a time when the company needs to raise substantial cash to cover operating expenses and its move into the more lucrative oil business," the Journal noted.

Ten VPP documents filed by the company in county courthouses in four states were reviewed by the Journal, which the newspaper said showed Chesapeake's liability is "far larger than previously thought by investors and analysts; most of whose estimates were lower than $600 million." Based on the newspaper's calculations, the costs total $300 million in 2012, which Chesapeake confirmed, and $270 million in 2013. "Another roughly $800 million is expected between 2014 and 2022, the documents indicate."

Shareholder and gas proponent T. Boone Pickens told CNBC during an interview in Las Vegas on Thursday that he has sold his investment firm BP Capital's entire stake in the company, estimated at about $13 billion -- or about 9% of BP Capital's equity.

"I don't like the position he's in," Pickens said of McClendon. However, he said he "wouldn't count Aubrey out." Chesapeake's planned asset sales are wise and the company could be headed for better times, he told the network. McClendon "is a good friend" and "has done some innovative things."

As to how much Chesapeake might command in an outright sale, most energy analysts said the company's liability issues at this point make it difficult to determine. Trefis analysts last week estimated the general price at around $27.81/share, with net debt of $22.15/share. The higher price comes from its turn to more liquids growth, said analysts.

"For Chesapeake, oil production is 59.6% of the Trefis stock price estimate, and is the most important division." Natural gas production "is 36.9% of the stock price estimate, while marketing, gathering and compression make up 2% of the estimate. Service operations make up another 1.5%."Analysts noted that the producer owns interests in around 44,100 producing gas and oil wells that are currently producing about 2.4 Bcfe/d. It also is "has one of the most active drilling programs in the industry. In 2009, it drilled over 1,200 gross operated wells and participated in nearly 1,000 gross wells operated by other companies. The company's success rate was 99% for the wells operated by it and 98% for the wells operated by other companies."

A "weakness" is its "lack of presence outside the U.S.," said the analysts. "Though Chesapeake is the second largest producer of natural gas and a top 20 producer of oil and natural gas liquids in the U.S., it lacks international presence, unlike its major competitors like BP plc, ExxonMobil Corp., Chevron Corp., etc..."

Moody's Speer also commented on the strength of the assets in his analysis, noting that Chesapeake has a "very large proved reserve and production scale, big acreage positions in multiple basins across the U.S., low operating costs and successful execution through the drillbit...The company is among the largest independent E&P companies rated by Moody's, with reserve and production scale comparable much higher rated investment grade E&Ps." In addition, he said the company has acreage positions in many oil and wet gas plays "that are very attractive to both peers and financial investors and a strong track record of completing its planned monetization transactions."

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