In mid-April, The Shareholders Foundation, a private, non-traded firm that acts as a securities class action manager for investors, announced a lawsuit on behalf of a Chesapeake Energy (CHK) shareholder, alleging breach of fiduciary duty, material disclosure violations, and other wrongdoing by Chesapeake. This appears related to news earlier this week that Chesapeake CEO Aubrey McClendon received loans of over $1 billion dollars against his stakeholder interest in certain of the company's wells. The loans were intended to fund his responsibility for drilling costs.
While granting CEOs interest in producing wells is not infrequent among energy stocks, the extent to which McClendon borrowed under what Chesapeake calls "The Founders Well Participation Program", coupled with the Chesapeake board's apparent failure to fully disclose these loans, signals trouble for the company. Investors with a long memory will recall that similar loans caused trouble for McClendon and Chesapeake back in 2008, when Chesapeake allegedly used corporate funds to help McClendon out of financial woes brought on by personal over-leveraging related to the same well ownership scheme. The 2008 CEO bail out also included a provision for Chesapeake to purchase McClendon's personal antique map collection. The stockholder lawsuit filed over that action was just settled in January.
Looking to Increase Liquid Assets and Cash Flow
Earlier this month, Chesapeake, which produces 9% of US gross natural gas supply, announced several deals meant to counter a funding shortfall, including a forward commodity sale through a volumetric production payment with Morgan Stanley (MS) worth $745 million, a $1.25 billion preferred sale of stock from its subsidiary CHK Cleveland Tonkawa LLC (private, not traded), and a sale of Oklahoma land to competitor Exxon Mobil (XOM).
In what appears to be another move to raise much-needed capital, Chesapeake also announced a plan to spin off its oilfield services business as a closely related separate company, Chesapeake Oilfield Services. In its registration statement to the SEC Chesapeake valued the IPO at up to $862.5 million. If the S-1 is approved by the SEC without substantial changes Chesapeake will retain a controlling interest in Chesapeake Oilfield Services through voting stock and administrative, facilities, and master services agreements.
According to Chesapeake, it is trying to counter record-low gas and liquid natural gas prices by stimulating demand, in part through making compressed natural gas (CNG) and liquid natural gas (LNG) more widely available gas alternatives, including through partnerships with 3M (MMM) and General Electric (GE).
According to its April 2012 Investor Presentation, Chesapeake increased production in fiscal year 2011 by 15% overall to 3.27 bcfe a day, and increased proved reserves by 10% to 18.8 tcfe, an increase of 1.7 tcfe from 2010, net of sale of 2.8 tcfe production capacity during 2011. In response to record low dry natural gas prices, Chesapeake is pulling back from dry gas rigs and refocusing on liquid natural gas and other liquids production, as it plans to focus 85% of its drilling capabilities on mainly liquid plays.
Its April 2012 Investor Presentation also reiterated Chesapeake's position as the 11th largest US liquids producer, with 18% of total production and 47% of natural gas and liquids revenue deriving from liquids. Chesapeake expects to raise proved reserves from 18.8 tcfe currently to 34 tcfe in 2015. Given the company's current debt position, I think that this is over-optimistic as these gains would rely largely on acquisition rather than exploitation of existing plays. Additionally, I believe that Chesapeake's diversion of resources from dry gas to LNG indicates that its drilling capacity is already stretched.
Chesapeake believes that gasoline and diesel prices above $4 a gallon will force the market to CNG, LNG, and DNG (diesel/natural gas blend, which does not currently have CARB certification) vehicles, first in the US and then overseas, leading to export demand. As few vehicles outside of Chesapeake s fleet are equipped to run on these mixtures, I believe it will take more influence than Chesapeake has to drive this change.
Chesapeake's strategy of only exploiting US onshore plays may be working against it. While many of its competitors, including Marathon Oil (MRO), Apache (APA), and Devon Energy (DVN) have recognized and moved to exploit LNG plays, all have done so on a global basis. Dry natural gas is typically not suitable for cross-continental export, particularly at current low prices. LNG, while a candidate for export, has very little overseas demand for product from the US since most continents are adequately supplied by local, and therefore cheaper, LNG plays. This is a major example of what Chesapeake's competitors are doing differently, and part of the reason why Marathon and Apache are showing year-over-year growth while Chesapeake struggles.
Devon is submitting negative revenue growth, of -6.2% on a three year average, compared to Chesapeake which is standing still with three year revenue growth of 0.0%. Worrisome for Chesapeake, Devon is re-focusing its efforts on the North American continent and is in a much better position financially to exploit the plays where Chesapeake is currently operating; already 68% of Devon's production is from LNG. Devon's margin is also extremely healthy, standing at 41.1%. This shows that despite Chesapeake's contention that the market for LNG needs to be built, there is already strong demand in the US for this product. The demand is not on Chesapeake.
Chesapeake's $10.3 billion debt load brings it down to the lowest price to earnings ratio reported by any US energy producer. Chesapeake's P/E is at 6.0, Exxon is at 9.5, Marathon is at 6.6, Devon is at 9.1, and Apache is at 6.4. A price to book comparison gives us an even better snapshot of these companies. Trading around $18.00, Chesapeake has a P/B of 0.9, Exxon around $86 has a P/B of 2.6, Marathon around $29 has a P/B of 1.2, Devon around $66 has a P/B of 1.2, and Apache around $91 has a P/B of 1.3.
The questions over corporate governance offset the fact that Chesapeake is trading cheap. In my opinion, it is unlikely that Chesapeake would bail out its CEO in 2012 as it did in 2008. With this in mind, investor calls for a leadership change may be successful. However, I don't believe that a leadership change would correct the debt troubles and lack of diversification Chesapeake is facing quickly enough to make needed material improvements in its balance sheets. I believe that Chesapeake faces a substantial decline in stock price over the coming months. Because of this, I expect the current mean analyst recommendation of Hold to change to Underperform or Sell as fallout from the latest CEO misdeeds accumulates.