Wednesday, April 18, 2012

Chesapeake Energy Needs To Be Sold

Aubrey McClendon Should Find His Own SandRidge To Play In

Chesapeake Energy (CHK) dropped as much as 10% today after a number of weeks of downward movement.  The drop today was occasioned by the revelation by Reuters that Mr. McClendon has borrowed as much as $1.1 billion (with a B) against his minority interest in CHK's wells.  CHK has always had a poor governance record and a "colorful" CEO in Mr. McClendon, but for some reason investors tolerated these shortcomings.  Mr. McClendon did after all start the company from nothing and build it to one of the largest natural gas producers in the world.  However, it is increasingly clear that CHK is still being run like a small wildcat driller rather than a large public company.  It is time for CHK to clean up its act, put Mr. McClendon out to pasture, and stop treating public shareholders like chumps.  In the process, there is money to be made.

CHK has had a variety of public ethical and governance failings and this is not the first time Mr. McClendon's personal affairs have impacted the company.  In 2008 he was forced to liquidate his holdings in CHK equity because the stock price plunged in the financial crisis and Mr. McClendon had been using margin debt to accumulate shares.  In 2009, he sold his antique map collection to CHK for several million dollars (and realized a gain).  For many years he has been allowed to buy a 2.5% stake in every well CHK drills, unique among public oil and gas companies.  The list goes on and on.  Despite repeated shareholder calls for better governance and a more activist board of directors, very little has been done to clean the place up.  After shareholder lawsuits settled in 2011, the board agreed to appoint a lead independent director, hire a compensation consultant, and make some other minor changes.  Clearly this has not solved the problem.  Consequently, the market appears to be assigning a significant governance or "McClendon" discount compared with peers.

What is especially frustrating to a value investor like me about the heavy discount this company carries is that CHK is actually a collection of jewel assets that would be worth much more under another management team.  CHK is currently the number two producer of natural gas in the US and is rapidly climbing the ranks of the nation's top oil producers.  Even better, CHK has so many unexploited drilling opportunities just waiting to be tapped that the company is literally struggling to fund all of the extremely attractive wells it could have running.  Oil majors (Exxon, Total, Statoil, etc.) simply do not have the ability to organically increase reserves and production the way CHK can.  The majors struggle to replace the reserves that they use up by producing oil and gas every year, which is why you periodically see them go out and buy a medium sized exploration and production company with lots of untapped reserves.  This is also the reason Exxon acquired XTO Energy in 2010 (XTO at the time was a large oil and gas producer with ample untapped reserves).  The assets CHK is sitting on would be a treasure trove to an oil major which has more cash than good drilling opportunities.  Yet with Mr. McClendon and his muzzled board of directors in place, CHK continues to plod along, creating long term value but universally hated by investors.

The latest scandal and the resulting plunge in CHK's stock price is yet another ndicator that the company needs to be cleaned up.  If it cannot or will not do so, this collection of jewel assets should be managed by someone else, most likely via a sale of the company.  We saw a brief glimpse of a possible clean-up or sale in late 2010 when Carl Icahn began acquiring a material stake in the company.  Mr. Icahn is well known as an activist investor and the shares began rising as investors anticipated some action.  For reasons which are not clear, Mr. Icahn sold his interest in the company in the first half of 2011, which took a lot of pressure for change off CHK's management and board.

It high time that CHK be cleaned up.  The institutional investors who own large stakes need to make it clear that this sort of behavior is unacceptable.  If Mr. McClendon and his pet board of directors cannot or will not change, they need to be ousted and the company sold to the highest bidder.  Mr. McClendon has been an innovator in this industry, but he obviously does not understand how to run a major US public company.  I would recommend that he follow his former partner's lead.  Mr. Ward left CHK a few years ago and started SandRidge (SD), a growth oriented exploration and production company on a far smaller scale than CHK.  Mr. McClendon should find his own SandRidge to play in and stop milking public shareholders at CHK.

Do I hear an opening bid?

As always, do your own due diligence, consult your advisors, do not construe anything here as investment advice, and BE CAREFUL.  There are an inifinite number of ways to lose money.

Disclosure: I am long CHK equity and options.


  1. Obviously disappointing, and a big one day drop.
    But over the last month UPL and KWK have had the same poor performance. I'm long UPL.
    Natural gas is getting ever cheaper, and whereas production is cut back as a result, natural gas is still produced as a by product of oil drilling.
    I'm worried it might take a long time before it gets better - may be better to look for companies that use natural gas, but that's less of a pure play on this trend.

    1. I rather doubt it will take more than another year for the gas market to rationalize. However I have a "Texas hedge" in the form of completementary long positions in chemical companies that benefit from cheap natural gas.