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View From Inside Chesapeake's Board of Directors

Posted: 04/30/2012 3:17 pm

Chesapeake Energy -- a major driver behind the so-called "shale gale" of shale gas production -- has been all over the news lately, with intense scrutiny of CEO Aubrey McClendon's attempt to take out more than $1 billion in loans for a complex deal to give himself a share of proceeds from the wells they're drilling. The company's board of directors blocked McClendon's new move, but he's already in hock for $846 million, the New York Times reports.

(For more on Chesapeake, check out Jeff Goodell's excellent feature in Rolling Stone, "The Big Fracking Bubble," that delves into the company's land deals, and Christopher Helman's earlier profile of McClendon in Forbes that tries to make sense of the company's beguilingly complex financial arrangements.)

In light of all this, I thought people would be interested in this view from within Chesapeake's board, from a book that is probably little-read, called Peak Oil Personalities, in a chapter by Charles T. Maxwell, an oil industry analyst and investor who has been on Chesapeake's board since 2002 -- before the shale boom really took off.

In 2002, I was invited to join the board of Chesapeake Energy Corporation... I came to the job full of traditional conventions about analytically correct balance sheet ratios, and so on. But in the first several years I was confronted by a riveting problem.

The problem, as Maxwell explains, was that fracking had opened up new areas to production, and it was all sufficiently new that it was hard to know what to expect -- so his "traditional conventions" didn't fly. But also, McClendon didn't want to stick with traditional ways of financing the operation, as Maxwell explains.

Now a page was being turned, and a new chapter was beginning. How large could this play become? How long would typical shale production keep going at economic rates of output? What would be the additional stimulation costs of this technology? Would the costs attendant on a shale-based drilling programme doom shale gas production to the bottom rung of returns on capital? Could the company afford the land position and drilling obligations required to dominate this play in acreage close to the sweet spots?

All these questions, it seems, were difficult to grapple with, because there was so little experience with fracking shale to unlock shale gas.

McClendon brought in the evidence from the field, and we debated it with him on many separate levels and with different top personnel. In the end, he wanted to seize the once-in-a-generation opportunity to pioneer a vast new play in land and reserves. That would involve tolerance of increased leverage on the balance sheet. What was the trade-off here? Such an assemblage of superior oil shale lands, the board well understood, would not likely be presented again. But, it would be an expensive endeavor. There was only a narrow window of time to make many concerted decisions.

The board backed the management's plan, and Chesapeake eventually took a dominant position in virtually all of the US natural gas and oil shale plays that have been found so far.

This felt like the beginning of a whole new industry.

As others began to agree, they wanted a piece of the action as well. This allowed Chesapeake to continue acquiring more leases, to drill not only in the "superior" shale lands, but also elsewhere.

... the board members continued to give the go-ahead to McClendon and the management team, and the company went on to obtain solid land positions in other less familiar shale plays. Then, under McClendon's strategy, Chesapeake laid off a good portion of the eventual costs of these deals via minority joint-venture ownerships and earned drilling arrangements with those late-to-the-party guests that still needed positions in active plays. Financial and operational risks were thus substantially reduced by these moves, and solid values in acreage and expected reserves were obtained at relatively low-cost.

Only time will tell how these shale plays turn out in terms of total volumes and in terms of financial returns.

None of this information is totally new, but it's fascinating to see it laid out clearly by someone who saw it develop from the inside -- and helped approve the strategy. Now, though, the board is pulling back the reins on McClendon.

In just the past couple of days, Fitch and Standard & Poor's have cut their ratings of Chesapeake's stock. S&P explained it was because of the revelations about McClendon's attempted billion dollar borrowing to get a share of profit from wells. "Turmoil resulting from these developments -- and from potential revelations resulting from the board investigation -- could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and aggressive capital spending." An analysis by Reuters chimes in: "investors should also be wary of the company's monstrous complexity. It has convoluted off-balance sheet liabilities thanks to convoluted partnerships; hedging gains have dwarfed profit since 2006; and cash flow is consistently negative." It doesn't sound good for them.

By the way, Maxwell is an industry veteran who is deeply worried about peak oil -- hence his showing up as one of a few dozen experts in Peak Oil Personalities. In the book, in addition to talking about Chesapeake (and much more), he gives his own oil forecast. I wish he'd gone into his reasons for this outlook as much as he went into the details on Chesapeake, but in any case, here's what he says:

... oil (sometimes called hydrocarbon liquids) may reach a peak of production in the period 2015-2020. I'm betting this will look more like a rough plateau. Then, after 2020, I would expect oil output to begin to gently sink... there will be public pain attached to any combination of solutions.

We're running out of time to achieve any kind of easy transition, Maxwell argues, so prices will likely soar, pushing people to find solutions of one kind or another. "This is an outcome many will protest. But this late in the game, I see no other way out."

 

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