Chesapeake Energy’s stock price dropped to the lowest level since March 2009 on Tuesday, after a major credit ratings agency downgraded the nation’s second-largest natural gas producer on news that the company will take a $4 billion loan — higher than the $3 billion previously announced — to pay off an existing credit line. It’s the latest worrisome development for cash-strapped Chesapeake, which has been battered in recent weeks by revelations about its opaque business methods and the controversial financial dealings of its charismatic CEO Aubrey McClendon.
Over the last year, Chesapeake shares have fallen more than 50% — and nearly 6% on Tuesday — mirroring the precipitous decline in natural gas prices, which has been driven by a glut of gas on the market. Ironically, the over-supply of natural gas has been fueled, in part, by Chesapeake’s relentless, multi-year campaign to buy up and drill vast tracts of land using a controversial practice called hydraulic fracturing, or “fracking.” Today, the company has built up a staggering land portfolio of over 15 million acres. Chesapeake, along with other energy companies that employ fracking, have been so successful at bringing new natural gas onto the market that the price of the commodity has fallen to the lowest level in a decade.
As the price of natural gas has slumped, Chesapeake has faced a growing cash crunch, estimated to be over $10 billion this year. In response, McClendon has said the company intends to move away from natural gas drilling to more lucrative oil drilling, becoming what he calls a “more balanced liquids-focused producer.” Still, it needs to raise cash. Last Friday, Chesapeake announced plans to take out a $3 billion loan from investment banks Goldman Sachs and Jeffries & Co. On Tuesday, Chesapeake upped the amount to $4 billion. The company said the purpose of the loan is to “repay borrowings under the company’s existing corporate revolving credit facility and for general corporate purposes.” In other words, Chesapeake is taking a loan — on which it must pay a steep 8.5% interest rate — to pay off another loan. The energy giant said it plans to repay the new debt by selling large chunks of its land portfolio, including one of its crown jewels, a massive, 1.5 million-acre oil-rich holding in the Permian Basin in West Texas, which could fetch $5 billion or more.
Meanwhile, in a mysterious twist, legendary corporate raider Carl Icahn has reportedly acquired a significant stake in Chesapeake stock, but the billionaire investor has yet to reveal his position. Icahn had sold his Chesapeake shares last year for $30, but recently told CNBC he thought the stock — currently below $15 — is undervalued.
On Tuesday, credit agency Standard & Poor’s dropped Chesapeake’s already-“junk”-level debt status even further. The agency attributed the downgrade to “mounting turmoil stemming from revelations that underscore shortcomings in Chesapeake’s corporate governance practices, covenant concerns, and the likelihood Chesapeake will face an even wider gap between its operating cash flow and planned capital expenditures than we had previously anticipated.” The ratings agency specifically highlighted “revelations about personal transactions undertaken by Chesapeake’s CEO, Aubrey McClendon, that pose potential conflicts of interest.”
The revelations (many first reported by Reuters, which has been conducting an in-depth investigation into Chesapeake and its CEO) include: McClendon ran a secret $200 million hedge fund that traded natural gas at the same time he was privy to potentially market-moving information in his role as CEO of the natural gas giant. McClendon also received over $1 billion in undisclosed personal loans over the last three years, secured by his stake in Chesapeake’s oil and gas wells. Some of the loans came from private equity firms that were doing business, or planned to, with the company. As the disclosures piled up, Chesapeake’s board stripped McClendon of his role as chairman. Both the Internal Revenue Service and the Securities and Exchange Commission are examining the company.
As if that wasn’t enough, CNBC has raised the possibility that Chesapeake may be involved in artificially inflating ticket prices for the Oklahoma City Thunder basketball team. McClendon owns 19.2% of the team, and the Oklahoma City-based natural gas giant spent $3 million last year to rename the Thunder’s home venue Chesapeake Energy Arena. In recent years, the company has spent millions more on tickets — “the equivalent of 500 season tickets in prime locations throughout the arena or 2.8 percent of the arena’s capacity” — and McClendon can frequently be found court-side.
In a note to clients this week, Argus Research analyst Phil Weiss, who has a “sell” rating on the stock, reiterated his view that McClendon should be replaced as Chesapeake’s CEO.
When we consider the full financial picture at Chesapeake, including its high debt levels (both on- and off-balance-sheet), its use of financial engineering, the relatively low quality of its financial data, the questionable nature of some of the CEO’s transactions with the company, and the apparent unwillingness of the board to put a stop to at least some of these practices, we continue to believe the best thing for investors would be to replace the board and/or the CEO. We have long maintained our view that the company has a strong asset base (though it could be less attractive than we have believed if natural gas prices don’t rise to more profitable levels). However, we think that investors are likely to keep the company in the penalty box without a real change in its financial practices. Such change needs to start at the top.
Weiss and other company observers have raised questions about Chesapeake’s use of complex financial arrangements with Wall Street banks and private equity firms. In fact, as Reuters reported last week, exotic financial deals such as “volumetric production payments,” (VPPs), in which Chesapeake sells future rights to its expected gas output in exchange for up-front cash, have become an increasingly important source of income for the company. One such deal, called Glenn Pool, raised $850 million for the company last year, according to Reuters. The transactions have become critical for a company that expects to spend over $20 billion on wells and production over the next two years, but anticipates generating less than $10 billion from its actual drilling operations.
McClendon has also made complex financial deals for his personal portfolio. In March, the Pittsburgh Post-Gazette reported how McClendon, using an affiliate company, is “mortgaging his stake” in several Brooke County, West Virginia oil and gas leases owned by Chesapeake. The affiliate, called Jamestown Resources, is striking deals to borrow cash up-front, for the promise of a share of the gas production profits in the future. McClendon has long argued that his large personal stake in Chesapeake wells means that he “eats his own cooking,” and thus has added incentive to perform well as CEO.
In a statement announcing the $4 billion loan from Goldman Sachs and Jeffries, Chesapeake said “strong investor demand” was the reason for raising the amount from $3 billion. “We appreciate this strong vote of confidence from investors,” said McClendon, adding that the loan will give the company “greatly enhanced financial flexibility to execute our planned asset sales from a position of strength and to complete our transformation from a natural gas-focused producer to a more balanced liquids-focused producer.”