In March, I wrote a long article about the fracking boom for Rolling Stone, focusing on Chesapeake Energy, whose CEO, Aubrey McClendon proudly boasted to me, "We’re the biggest frackers in the world." The story raised questions about the financial underpinnings of the company and suggested that today’s natural gas boom is likely to be a short-lived euphoria driven by new drilling technology and corporate greed.
Well, this morning Reuters hit with an important story revealing that the financial shenanigans at Chesapeake are even more complicated than anyone knew. And, as always, McClendon is right in the middle of it.
Reuters reports:
McClendon has borrowed as much as $1.1 billion in the last three years by pledging his stake in the company’s oil and natural gas wells as collateral, documents reviewed by Reuters show.
The loans were made through three companies controlled by McClendon that list Chesapeake’s headquarters as their address. The money is being used to help finance what could be a lucrative perk of his job – the opportunity to buy into the very same well stakes that he is using as collateral for the borrowings.
The story caused Chesapeake’s stock to tank as much as 10 percent during the day and made it one of the most actively traded stocks on Wall Street. Let me unpack this a little and explain why this is a big deal.
The first thing you need to know is that McClendon has a long history of financial recklessness. In October of 2008, McClendon had to liquidate nearly his entire holding of Chesapeake stock – worth some $552 million -- to meet a margin call on personal investments. The move caused Chesapeake’s stock to tank, losing 39% of its value virtually overnight.
The second thing you need to know is that McClendon has long treated Chesapeake as his own personal piggy bank. One example: in 1993, the company’s board (who are all McClendon’s buddies) set up an unusual perk for the CEO, known as the Founder Well Participation Program, which essentially gives him the right to buy a 2.5% share in every well that Chesapeake drills. McClendon has to pay proportionate part of the well’s operating expenses, but when – if – the well starts producing, he gets 2.5% of the revenue. This is sweet deal, one that essentially allows him to siphon money out of the ground (McClendon claims it aligns his interests with the interests of the company) "I don’t know any other gas or oil company that gives the CEO as share of production," Phil Weiss, an oil analyst at Argus Research told me. "If it works so well for stockholders, why don’t other companies do it?"
Today, Reuters revealed that during the last three years McClendon has borrowed more than a billion dollars in order to pay the operating expenses of the wells that he participates in. For collateral, he has used his ownership in the wells – that is, the future production of the gas and oil. So he is essentially using the promise of buried gas and oil to finance the drilling of the wells, for which he will receive future royalties.
O.K., that’s unorthodox enough. But a billion dollars in loans to cover operating expenses for his tiny share of Chesapeake’s wells? If the company’s wells are performing so well, why does McClendon need to borrow a billion dollars to cover operating expenses? Maybe he’s broke. Or maybe, as some analysts have suggested, the wells aren’t performing as well as the company would like you to think they are.
But it gets worse. McClendon arranged the financing of some of these loans through EIG Global Energy Partners, a global equity firm that also finances deals for Chesapeake. The potential for conflict of interest is obvious; you can imagine a quiet quid pro quo where McClendon gets cheap terms on his personal loan and EIG gets a piece of one of Chesapeake’s billion-dollar financing deals. I’m not suggesting McClendon or EIG made such an arrangement. I’m suggesting that it’s possible to imagine it happening.
And then there is the issue of disclosure. You would think that when the CEO of a publicly-traded company takes out a billion dollars worth of loans against company assets, it would be disclosed in the company’s Securities and Exchange Commission filing. Henry Hood, the general counsel for Chesapeake (who also happens to be an old college buddy of McClendon’s) told Reuters that indeed it is, buried deep down in the fine print, and that the company’s disclosures are "fully compliant all legal and regulatory requirements." But if that’s true, it was news to the shareholders Reuters interviewed.
In the coming days, financial journalists are going to have a lot of fun following up on this story. Among the questions worth asking:
1. If Chesapeake plays this fast and loose with disclosure on McClendon’s loans, why should we not assume they are also playing fast and loose with disclosure about chemicals that are injected underground during fracking operations or the disposal of polluted flow-back water?
2. Where is the Securities and Exchange Commission on this? How is that the CEO of a publicly traded company can take a billion dollars in loans, use the wells as collateral, and not disclose it in any significant way to shareholders? Does the name Bernie Ebbers mean anything to anyone these days?
3. How long are Chesapeake’s stockholders going to tolerate a CEO whose first priority is to pocket billions for himself, rather than maximize profits for shareholders? As Frances McKenna, who writes about the accounting industry for Forbes put it, the company’s response to questions about McClendon’s secret billion dollar loans "is not only disingenuous, it’s borderline delusional." One Wall Street analyst I talked to today was even more blunt: "Long term, it is in the best interests of shareholders for someone else to be running the company."
4. How close to bankruptcy is Chesapeake? The company already projects a $10 billion revenue shortfall this year, thanks in part to rock-bottom natural gas prices (caused, in part, by over-drilling in the rush to cash in on the fracking boom). But the company’s complex accounting methods make it almost impossible for analysts and stockholders to determine what the risks really are. The fact that the CEO is taking out billion-dollar loans and not openly disclosing them only furthers the perception that everything is not as it appears at Chesapeake – that the company is Enron with drilling rigs. I mean, Enron might have been a bunch of crooks, but when they went down, at least they didn’t leave a legacy of toxic drinking water and industrial wastelands.