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SEC Tells Chesapeake, CEO to 'Retain Certain Documents'

Chesapeake Energy Corp. and CEO Aubrey K. McClendon were notified by the Securities and Exchange Commission (SEC) that the Fort Worth, TX, regional office has launched an informal inquiry and "requested that the company and Mr. McClendon retain certain documents," the company said after the stock market closed on Thursday.

The SEC said its inquiry, which Chesapeake received notice of on Wednesday, "should not be construed as an indication that any violation of the federal securities laws has occurred." The company and McClendon said they "intend to cooperate" in responding.

The announcement followed a jam-packed 48-hour news cycle, with U.S. Sen. Bill Nelson (D-FL) late Wednesday asking the Department of Justice to launch an investigation of Chesapeake for possible price manipulation and fraud. Beyond corporate governance, analysts also have begun questioning whether the producer will be able to get out from under smothering debt and stifling low gas prices without selling precious liquids-prone properties.

Nelson's request followed a report by Reuters, just before the first quarter earnings conference call, that McClendon may have run Heritage Management Co., a private hedge fund that traded commodities, for at least four years, from 2004 to 2008. Heritage listed Chesapeake headquarters as its mailing address (see Daily GPI, May 3). The report suggested that the hedge fund, apparently founded by McClendon and SandRidge Energy Inc. CEO (and Chesapeake co-founder) Tom Ward may have influenced McClendon's running of Chesapeake.

In a statement Sen. Bernie Sanders (I-VT) said the probe into Heritage raised questions about conflicts of interest and also about a lack of transparency into the derivatives.

"We now know that one of the wealthiest energy CEOs in this country was moonlighting as a major oil and gas speculator in the summer of 2008 when prices were skyrocketing," said Sanders. "Speculators, particularly CEOs of major energy companies, should not be allowed to make a fortune by jacking-up oil and gas prices in the energy futures market. It is time for federal regulators to do their job, obey the law, and crack down on excessive energy speculation as required by the Dodd-Frank Act. We also have got to prevent the obvious conflicts of interest that this report exposes and make our energy markets more transparent.

"Under current law, CEOs are required to let the public know when they buy and sell large shares of their own company's stock, but trading in energy futures and derivatives is kept hidden from the American public. This is simply unacceptable. The American people have a right to know this information."

Chesapeake lost almost 14% of its market value on Wednesday, but shareholders began to cautiously return on Thursday, with the stock price ending the day at $17.18, up 2.6%. Volume again was heavy, with more than twice the number of shares (46.47 million) trading hands, versus a daily average of 22.25 million.

McClendon was knocked from the chairmanship post on Tuesday; he remains CEO (see Daily GPI, May 2). Memphis-based Southeastern Asset Management, which owns 13.6% of the company and is the largest shareholder, plans to take an active role in the company going forward, said President G. Stanley Cates. Southeastern will be involved in the search for a nonexecutive chairman, he said.

"The bottom line is, there are positives and negatives of partnering with McClendon, as with anybody, and in our opinion the positives strongly outweigh the negatives, and the negatives have been very actively addressed," Cates said during a shareholder meeting.

Chesapeake's liquidity issues may be a much larger concern than McClendon's alleged improprieties. The No. 2 natural gas producer in the United States has been attempting to transform itself into a big oil and natural gas liquids producer, which has required the company to buy more acreage, move gas rigs and personnel and basically revamp its entire business strategy. On top of that transition, sustained low gas prices have failed to provide any financial padding for the exchange.

Chesapeake spent most of the past 10 years buying gas-weighted acreage across the United States, and even though it now is attempting to turn off the gas spigot, 1Q2012 gas production actually jumped 18% from a year ago because drilling had to be done to hold expiring leases, McClendon said Wednesday.

Meanwhile, capital spending for 2012 now has been increased. The CEO said Wednesday the budget has to be bumped up to "escape the gravitational pull" of low gas prices. However, more spending won't lift liquids output this year -- it will be flat because the company has put up for sale a long list of assets to pare its debt -- and the list includes some of the liquids targets it was planning to pursue, including the entire Permian Basin portfolio, a portion of the Mississippian Lime and another volumetric production payment in the Eagle Ford Shale.

Higher liquids output isn't likely before late 2013 or into 2014, once Chesapeake is able to fund more drilling -- and when gas prices hopefully are higher, McClendon told financial analysts. If gas prices don't strengthen, he admitted that Chesapeake likely will have liquidity problems in 2013.

Analysts appear not as concerned about McClendon's personal travails as they are about the company's financial outlook. Chesapeake has more than $13 billion of debt on its balance sheet, which it hopes to reduce to $9.5 billion by the end of this year, according to CreditSights debt analyst Brian Gibbons. The plan is "aggressive," he wrote in a report on Thursday. Chesapeake is facing a near-term liquidity risk because of reduced cash flow, he said.

"We continue to have substantial concerns about management's credibility and the company's financial transparency, aggressive spending program, myriad funding strategies and asset execution sales risk," wrote Gibbons. "Near-term liquidity risk is clearly high given the timing of the company's spending and its asset sale receipts."

Canaccord Genuity's John Gerdes on Thursday cut his price target on Chesapeake by 25.7% to $26 from $35 because of concerns about liquidity, not corporate guidance. "We are decreasing our price target $9...due to a lower '13-plus capital spending/production outlook, a lower oil composition, a narrower marketing margin and higher capital spending outside the corporation exploration and production business," Gerdes wrote.

Because Chesapeake remains 85% weighted to gas, "historically low natural gas prices will provide headwinds...for the near future," said Wells Fargo Securities analysts. The valuation range was set at $18.00 to $22.00, with a net asset value estimate of $49.83, using a "large discount" because of "near-term liquidity concerns" on low gas prices. Chesapeake has a substantial portfolio of prospects to monetize, but the gas assets will be a drag.

"Risks to our valuation range include sustained material weakness in commodity prices as well as the risk of a rising cost structure due to the company's active acquisition strategy," the Wells Fargo analysts said.

However, despite gas prices, Chesapeake remains a compelling story because of its broad and deep portfolio, said BMO Capital Markets' Dan McSpirit. He upgraded Chesapeake to "outperform" from "market perform," a change in rating that he said was about "peak negativity and getting the house in order."

Chesapeake, he said, underperformed its peers more than 20% since the beginning of April and there was no ignoring the reasons why. However, "what remains is a company with a deep and wide asset base, and one that has fundamental value, in our opinion.

"Yes, the company continues to wildly outspend cash flow ($7.9 billion in 2012 on our numbers...yes, the company's cash flows are still largely tied to natural gas prices (unhedged in 2012 and 2013), although aggressive capital shifts to develop oil and liquids-rich assets should yield higher margin growth in future periods. Yes, the monetization of assets, whether in the form of a joint venture or an outright sale, is necessary to close the gap.

"All this is known and, we believe, largely reflected in the price today," said McSpirit. "We believe the risk-reward at current price levels presents an attractive opportunity for investors looking to venture out on this risk curve...This trade qualifies as high octane, but again that's the point.

"We believe...shares could better reflect the underlying asset value once the smoke clears, one way or another. This upgrade is not about handicapping the likelihood of a change in management, but about a change in market sentiment."

Describing Chesapeake "as high risk at this juncture is unhelpful for investors; however, it is equally unhelpful to portend any change in our view of the fundamental underlying value," wrote Bank of America analysts on Thursday. "More helpful, perhaps, is to reassess a stressed valuation case that acknowledges an inflated risk premium..."

The Bank of America team cut its 2012 earnings estimate to 75 cents from $2.01. "However, when the dust settles we fully believe successful execution of Chesapeake's transition from gas to liquids positions the shares [as] one of the most opportunistic value plays of the large cap U.S. oils in 2012."

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