Keep Chesapeake at Bay

 | Apr 23, 2012 | 1:30 PM EDT
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Silence says a lot. I've avoided talking about Chesapeake Energy (CHK) since 2010, even though readers of my columns are aware of how strongly I feel about long-term value in the natural gas space.

There's a reason I've avoided Chesapeake, however, even though it is by far the largest independent and dedicated natural gas company in the U.S. It's because Chesapeake CEO Aubrey McClendon treats the company as his personal fiefdom, without regard to shareholders.

The latest news details the extent to which McClendon has used company-secured loans to finance personal stakes in the wells that Chesapeake drills, painting a picture of a CEO who has only his ego and personal income in mind and sending shareholders running for the hills.

I know what you're thinking: Shareholders finally give up the ghost on a natural gas company with amazing assets that is under pressure from sub-$2 gas and a CEO with a sweet tooth for the good life; maybe this is an opportunity to buy on the cheap and ride the forthcoming resurgence of natural gas. As the saying goes, there are no bad bonds only bad bond prices, right? For once, however, I cannot suggest purchasing Chesapeake shares -- not at any price.

Consider Chesapeake's long history with McClendon at the helm:

  • It starts with the booting of partner Tom Ward, clearly one of the smartest men in the oil business.
  • It continues with a frenzied purchase of shale assets on credit in the Eagle Ford, Barnett, Haynesville and Marcellus regions.
  • The scope and nominal amounts of Chesapeake's wide-scale derivative use (in theory, to hedge future production against price variation) look more like the trading a hedge fund would employ than a natural gas producer's normal activities.
  • The purchase of more leases demands continued breakneck production, and those costs brought on a steady diet of joint ventures to sell assets and raise cash with various international heavyweights, including CNOOC (CEO) in China, Total (TOT) of France and Australia's BHP Billiton (BHP), to name just the three largest dealmakers.
  • Off-balance sheet volumetric production payments are present-day income producers that kill future profit potential. They are easy profit prey for the likes of Morgan Stanley's (MS) gas desk, yet they are needed to keep the balance sheet barely afloat.
  • A short foray by Carl Icahn popped shares just long enough for Icahn to show his smarts by exiting the name.

Of course, all this is happening as McClendon takes some heady bonuses and personal loans to cover his costs of developing every well at the company. That's right: This is a CEO entitled to own 2.5% of every well that Chesapeake drills.

The short analysis of Chesapeake is that the off-balance sheet debt, joint ventures, volumetric production payments, futures and forwards create a mélange of confusion. What the hell is this company really worth? No one can tell you.

That's why the final reason to ever own these shares -- that is, a possible takeover -- is always talked about but not in the cards. Who would have the courage to take this mess over and competently restructure it into a real gas company? ExxonMobil (XOM) might consider doubling down on its XTO purchase, trying to catch an average somehow -- buy XTO at a $7-per-thousand-cubic-feet premium, and average down with Chesapeake at $1.50 per mcf. (And even that scenario is a stretch.) Knowing McClendon, however, he'd rather let the shareholders go broke. After all, he's tried that once already in 2008.

Here's the plan: Instead of trying to catch a falling knife in Chesapeake, stick with natural gas names that won't continue to disappoint you, at least in the corporate governance realm. Names such as SandRidge Energy (SD), Ultra Petroleum (UPL) and EnCana (ECA) will also sink in a dropping gas market, but at least you won't feel like suing the CEO, which Chesapeake's shareholders are now preparing to do.


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