Chesapeake Energy has been getting a lot of attention lately, and not the good kind.
An investigation by Reuters found that its CEO, Aubrey McClendon, had been leveraging his interests in the company’s wells to secure over a billion dollars in personal loans, setting up a possible conflict of interest. After the news broke, Chesapeake’s stock dropped by a quarter, the company’s Board of Directors discontinued the program that gave McClendon a stake in the wells, and the SEC announced it would be investigating the deals.
It seemed like a good time to touch base with Arthur Berman.
Berman is the head of Labryth Consulting, a Houston-based geological consulting firm. He’s developed the reputation of a one-man cloud, raining on the parade of America’s natural gas cheerleaders.
In a nutshell, Berman thinks the industry is over-leveraged, over-hyped and bound for a market “correction.” It should be noted at the outset that many people in the industry disagree with his analysis. But With the McClendon controversy focusing attention on issues Berman has been talking about for years, StateImpact Texas gave him a call to see what he’s thinking:
Q: To begin with could we just get your general impression. What are you thinking when you read the news about Chesapeake and McClendon?
A: None of this comes as a surprise to me. But to me, the takeaway that the average person ought to get is, this is characteristic of how unstable and unsustainable these kinds of propositions are.
So what do we know? Well, what we know is that Mr. Mcclendon has been given the right to participate in Chesapeake’s wells. He doesn’t get to choose which wells – he either invests in them all or not at all.
And he has exercised that right. I don’t think there’s anything particularly wrong with that. But what it tells us is that this whole shale gas adventure is just not profitable. Here’s a guy who is invested in all of Chesapeake’s wells and he – I can’t remember the exact numbers – but he lost something like 60 or 70 million dollars in 2009 and he lost more than 100 million dollars in 2010 and he’ll probably lose even more than that in 2011. So right there, it’s just a barometer that tells you, how profitable are Chesapeake’s wells? Well, why does McClendon have to borrow to cover his losses if they’re profitable? They’re not profitable. That’s the takeaway. It’s real simple.
Q: You mention that these types of arrangements aren’t really typical. You don’t really see this in many natural gas outfits?
A: No. It’s not at all typical, at least from my experience in the business. For the CEO of a public company to have a working interest ownership in the company’s well, well it’s just not that common.
Q: If natural gas prices were so low, how is he even able to get over a billion dollars in loans? It seems to me like that would indicate that some people thought that there would be some sort of profitability here at some point.
A: I guess it depends on when he borrowed that money. If he borrowed it last week, that’s one story. I don’t know what the price of natural gas is today, but last time I checked it was about $1.9 per MMBtu (one million British thermal units), so pretty darn low. But gas prices have been higher over the term of this investment, and there are other vehicles that the companies have available to them – mainly hedging. It doesn’t surprise me that somebody will lend him, or someone like him, that money.
Now there’s another piece to this whole story that’s quite interesting. And that is that he apparently, this is according to Forbes, he had made some sort of an arrangement that’s called a variable production payment (also known as a volumetric production payment) in addition to this loan. What [that] is, is that I come to you and I say, look I got X number of wells that are already in the ground producing gas and oil or whatever, and what I’d like you to do is give me money now and I’ll pay you back that money with the future proceeds from that production.
So in addition to the money that he outright borrowed, a big number to you and me – there was some 100 or so million dollars of an additional kind of debt in this volumetric production payment. So he’s borrowed against the wells that will have future production, plus he’s also agreed to give a certain amount of that production to somebody else who gave him money up front.
Q: Last time we talked, you were discussing these same themes. Namely, companies over-leveraging and the idea that at some point the market might catch up with that. Now, this individual case falls into that general narrative. What kind of impact could this have? If we see Chesapeake in really serious trouble, can that affect the larger industry? The markets? Or specifically, would that affect what’s happening on the ground in a state like Texas?
A: I guess the point that the people in Texas should understand is that Chesapeake Energy drills more wells in the United States than anybody else except possibly Exxon Mobil.
And so I guess the question – and I don’t know the answer because it’s speculative – but if this scandal and this issue for some reason causes Chesapeake to have to cut back the number of wells it drills in Texas, that could be significant just for mineral owners who have agreements with this company and other companies.
They expect that these operators are going to perform because they get a bonus. They get a certain payment for leasing land to the companies, but the real payment comes in the form of a royalty. After the well has been drilled and it’s producing, these mineral owners get a percentage of the production at the top, and that’s where they really making their money. So I think it’s too early to say what the short-term or the long-term effects are, but it’s worth noting that Chesapeake is a huge, huge player in all of the onshore drilling that’s going on, not only in Texas but in the United States. In some ways, I guess it would be reasonable to say that if Chesapeake goes, so goes the overall business picture.