Chesapeake’s Tempest in a Teapot

There are plenty of real economic issues that should be of concern to global markets including softening US economic data, a recession in the euro zone and the United Kingdom and a still-unfolding EU sovereign debt crisis. With all those genuine problems, there’s certainly no need to manufacture crises out of thin air.

Unfortunately, in the relentless pursuit of an attention-grabbing story, some pundits appear bound and determined to create scandals and conspiracy theories. The good news: investors who can read through the hyperbole can profit from the resulting panic.  

Over the past two weeks, a Reuters story concerning Aubrey McClendon, CEO of Chesapeake Energy (NYSE: CHK), has generated considerable controversy surrounding the stock. That single story prompted armchair prognosticators to pile on against Chesapeake’s CEO, sending the shares down more than 10 percent intraday.

I don’t recommend Chesapeake Energy’s common stock in The Energy Strategist or any other publication I write for one simple reason: the company is heavily leveraged to natural gas production and I remain bearish on gas prices over the next 2 to 3 years. However, that doesn’t change the fact that Chesapeake is a quality company with some of the best oil and gas-producing assets in the US.

Aubrey McClendon is no stranger to controversy and he’s a CEO many pundits and media commentators seem to love to hate. In 2008, he was forced to sell most of his holdings in Chesapeake because the stock collapsed amid the financial crisis and he received what amounts to a margin call from his brokers.

The resulting selling pressure, coupled with weakness in the broader market, pushed the shares down to a low of $9.38 towards the end of the year. I remember reading countless stories about how the sell-off in Chesapeake and the CEO’s forced sales were a warning sign of impending bankruptcy.

In The Energy Strategist, I recommended taking advantage of the 2008 controversy to pick up Chesapeake’s convertible preferred D shares (CHK-D), then trading around $60. This convertible preferred pays a $4.50 annual dividend in four installments on March 15, June 15, Sept. 15 and Dec. 15.

Holders of the convertibles can exchange their preferred shares for 2.265 shares of Chesapeake common stock at any time; the preferreds offer high current income as long as Chesapeake remains solvent and long-term upside when Chesapeake’s common stock recovers. Between late 2008 and late 2010 Chesapeake’s preferred shares rallied back close to their par value of $100.

The current wildly overdone controversy surrounding Chesapeake’s CEO has offered yet another golden buying opportunity in Chesapeake preferred shares and the company’s related master limited partnership (MLP) and high-yield royalty trust.

Part of Mr. McClendon’s compensation package is what’s called the Founder’s Well Participation Program (FWPP), a system that allows McClendon to purchase a 2.5 percent stake in every well Chesapeake drills. The FWPP has been in place since 1993 and can’t be terminated by the company until at least 2015 without Mr. McClendon’s assent. It was approved by shareholders in 2005 and has been disclosed in the company’s prior filings and reports with the SEC – the existence of the FWPP is nothing at all unknown or new, regardless of what some commentators might suggest.

Once the CEO pays for these wells and funds his share of drilling costs, these stakes represent his property. It’s hardly a revelation that McClendon might use this property as collateral to borrow money – he has borrowed up to $1.1 billion in this way at times. This isn’t illegal nor do these loans represent a cost or claim against Chesapeake itself because they’re collateralized by the CEO’s own personal property. More importantly, these loans are not a debt owed by Chesapeake itself but a personal obligation of Mr. McClendon.

One could argue that the fact McClendon directly participates in all of the wells drilled by Chesapeake means that his interests are even more closely aligned than most CEOs with the economics of drilling particular wells. It’s also not particularly surprising that McClendon has borrowed money from some of the same people that lend money to Chesapeake at the corporate level, because there are only so many lenders active in the energy industry.

More recently, controversy seems to have refocused on the fact that Aubrey McClendon sold his stakes in some of these Chesapeake wells at the same time the company sold its majority stake in the same wells, receiving significant proceeds. Some have raised questions over whether the CEO might time these sales to benefit his personal wealth more than Chesapeake shareholders. In my view, McClendon’s actions and record speak louder than words or conjecture.

Admittedly, Mr. McClendon is an aggressive CEO and his loans and personal business dealings, while not illegal, fit with his “cowboy” status. But that doesn’t change the fact that this visionary has made investors a ton of money over the years. Consider that McClendon was a founder of Chesapeake and since the close on the company’s first day of trading in February 1993, the stock has returned 2,190 percent, six times more than the S&P 500 over the same time period and 2.5 times more than the S&P 500 Energy Index. That hardly seems like value destruction to me.

Moreover, McClendon has successfully steered Chesapeake through a period of major change in the energy business – when the company was founded in the late 1980s unconventional “shale” fields were considered a boondoggle. But Chesapeake was an early mover in the shale and has amassed arguably the finest acreage of oil, natural gas liquids (NGLs) and gas-producing plays in the US.

Only a handful of risk-takers had the foresight and vision to recognize that changes in oil and natural gas drilling and well completion technologies would allow the US to become the world’s largest producer of natural gas. Few also recognized that the same technologies would boost US domestic oil production for the first time in decades.

Don’t forget that just ten years ago, the Energy Information Administration (EIA), part of the US Department of Energy, was forecasting that the US would become one of the world’s largest importers of liquefied natural gas (LNG) by the middle of this decade as North American production declined. Nowadays, conventional wisdom suggests the US is more likely to be a significant exporter of LNG, because domestic prices are close to 80 percent lower than in most international markets. McClendon was one of the early leaders of the industry.

In addition, many forget that the modus operandi for exploration and production (E&P) companies used to be to buy up a bit of acreage in a particular region, prove its productivity and then lease additional land. The problem with that strategy is that once a company proves that a particular field is productive, the cost of leasing additional acreage skyrockets.

Chesapeake was one of the first companies to identify an attractive play and then take on considerable debt to buy a big acreage position before other producers had a chance to move in on their new territory and bid up valuations. While undoubtedly an aggressive strategy, Chesapeake was able to buy up its acreage in some of America’s most productive shale fields at rock-bottom prices.

McClendon and Chesapeake are taking steps to address shareholders’ concerns about the FWPP, announcing the early termination of the program. It’s also quite possible that McClendon will ultimately step down as CEO of Chesapeake due to all the criticism of his stewardship and an SEC informal investigation of the FWPP issue. 

However, I care more about the business itself than its CEO and Chesapeake has been executing well.

Ultra-low natural gas prices make it tough for companies to make money drilling gas wells and with depressed gas prices likely to persist for some time, most E&P companies are focused on oilfields and gas reservoirs rich in natural gas liquids (NGLs) content. Chesapeake is in the midst of a strategic shift, reducing its drilling activity in dry gas fields and ramping up spending on its considerable acreage in oil and NGL plays.  The strategy is logical but expensive: Chesapeake this year plans to spend nearly $12 billion, an amount equal to its entire market capitalization, to fund this shift.

Clearly, the company doesn’t generate enough cash flow to make that sort of investment; Chesapeake will have to finance its funding gap through a combination of asset sales, spin-offs and borrowing. Investors and analysts have known about Chesapeake’s spending plans and funding gap for months but the good news is that the company appears well on its way to raising the necessary cash.

Even with gas prices at current levels, Chesapeake is still on course to generate close to $4 billion in operating cash flow this year. In early April, Chesapeake announced it would sell 58,400 acres in the Woodford Shale of Oklahoma to Exxon Mobil for $590 million. And back in January, the company sold a 25 percent stake in its liquid-rich Utica Shale property to France’s Total (NYSE: TOT), raising an additional $700 million.

Total also has agreed to pay up to an additional $1.63 billion over the next seven years to fund drilling costs in the Utica Shale region. Chesapeake has generated additional cash by selling midstream assets—pipelines and storage facilities—to its 30 percent owned MLP Chesapeake Midstream Partners (NYSE: CHKM). Based on its history of successfully selling non-core assets or stakes in its fields to raise capital, Chesapeake looks likely to successfully make the shift from a gas-focused producer to a more balanced oil and gas E&P company over the next few years.

And the company can still access the capital markets. The firm’s 6 1/8 bonds of February 2021 currently yield just under 6.9 percent, up from an average of about 6 percent in the first quarter of 2012. Some of the increase in borrowing costs is due to the fact that Standard & Poor’s downgraded its credit rating on Chesapeake to BB from BB+. That downgrade was likely even without the recent CEO controversy solely due to the fact that gas makes up more than 80 percent of Chesapeake’s production and gas prices remain depressed.

Nonetheless, with its 10-year bonds still yielding less than 7 percent, Chesapeake is not locked out of capital markets. In a worst-case scenario, the company could easily pare its 2012 capital spending plans to conserve capital.

Let me reiterate that I do NOT recommend buying Chesapeake’s common shares at the current time. In fact, I recommend shorting an exchange-traded fund (ETF) in The Energy Strategist that has a stake in Chesapeake and several other natural gas producers. But that position is based on my bearish outlook for gas, not some contorted rationale about conflicts of interest with the CEO. Chesapeake’s shift to a liquids-focused producer will take time and the market will continue to regard the common stock as a proxy for natural gas in the near-term.

However, the recent CEO controversy is raising unfounded concerns about the company’s long-term stability and strategy. Chesapeake is not in financial distress and will have no trouble paying its debts or meeting obligations related to its preferred shares, royalty trusts and MLPs. There’s opportunity amid this controversy.