CEO Aubrey Mcclendon Relied on Financial Engineering to Build His Company; Now He Needs More and More Deals Just to Tread Water

DRILLING FOR CASH

CEO Aubrey McClendon relied on financial engineering to build his company; now he needs more and more deals just to tread water. Chesapeake’s deepest well: Wall Street

By Carrick to investors – akin to the Mollenkamp way subprime housing loans NEW YORK, MAY 9, 2012 were turned into securities and sold last decade. ar from the drilling rigs Deals like Glenn Pool are of Oklahoma, America’s known as volumetric produc- Fsecond-largest natural tion payments, or VPPs. These gas producer is having to dig and other sophisticated financ- ever deeper into the well that re- ings are central to the business ally fueled its growth: Wall Street. model of a company that in some In a Times Square office build- ways resembles a hedge fund, us- ing, a team tapped by Chesapeake ing borrowed money to make big Energy Corp deployed more than 40 financial bets. bankers, lawyers and other experts to The financial-engineering strat- plot another chapter in that strategy. egy began as a way for CEO Aubrey Dubbed Glenn Pool, it was more McClendon to expand the company. financial engineering than petroleum Now, Chesapeake has become so reli- engineering. In essence, Chesapeake ant on deals like Glenn Pool that more sold future rights to the gas in its wells. such transactions may be necessary just The deal took in approximately $850 mil- to tread water. lion last year. Today, the Oklahoma City company is Glenn Pool proved so innovative that taking in more money from bankers, other a trade magazine honored it in March. investors and its own financial bets than In an especially creative twist, the borrow- it is from its oil and gas. Most big energy ings were chopped into two slices and sold companies, such as Exxon Mobil Corp, typi-

SPECIAL REPORT 1 DRILLING FOR CASH Chesapeake’s deepest well: Wall Street

cally earn more selling oil and gas than they Chesapeake has a superb total amount of financing McClendon has spend on investments, financing and other track record for completing large taken out against his stakes in wells drilled costs, making them cash rich. Chesapeake transactions. We’ll let our record by Chesapeake. Of that amount, $1.33 is expanding so fast that it takes in much speak for itself. billion came from EIG – which has also less revenue from its oil and gas than it helped line up $2.5 billion for Chesapeake spends, leaving it stretched. Michael Kehs itself since November. Hence its business depends on deal- Chesapeake spokesman The disclosures have embroiled the making: raise money from investors to company in a corporate-governance crisis, acquire land and drill wells; sell the rights prompting the board to strip McClendon to the gas and oil in those wells; plow that of his chairmanship and U.S. regulators to money into new land and wells; repeat the open informal inquiries. cycle all over again. EIG is drawing attention for its central role in financing McClendon’s personal FUNDING SHORTFALLS borrowings, which he took on to fund a Now, some analysts question whether lucrative perk giving him the right to re- Chesapeake can keep striking enough deals ceive stakes in company wells so long as he to sate its cash needs, which are growing shoulders his share of the costs. acute as natural gas prices languish. The gap The coterie of financial engineers is between cash coming in and cash going out much wider. It includes executives at Jeffer- shows “massive internal funding shortfalls,” ies & Co, chiefly Ralph Eads III, a Hous- according to an April report by Standard ton oil banker and McClendon’s fraternity & Poor’s. brother at Duke University. On Wednesday, Moody’s Investors Ser- The deals are so big that they require vice changed its outlook for Chesapeake’s UNDER FIRE: McClendon was stripped of the major trading partners and financiers, debt to negative from stable, citing “an chairmanship over his personal financial dealings like Barclays PLC, which handled Glenn even-larger capital spending funding gap but remains CEO. REUTERS/Sean Gardner Pool. Wall Street’s biggest banks, including for 2012,” due both to lower energy prices Deutsche Bank AG, Morgan Stanley, and and higher spending. Wells Fargo & Co, stepped in as both trad- Between now and the end of 2013, varying market conditions,” said spokes- ing partners and lenders, according to court Chesapeake expects as much as $23.1 bil- man Michael Kehs. “We’ll let our record documents and company statements. lion in costs for outlays such as wells and speak for itself.” All told, the financiers have helped property, according to the company and A Reuters examination of Chesapeake’s Chesapeake raise approximately $40 billion analysts. Yet funds from operations over the books, VPP deals by the company and its in financing since 2000. They’ve used their same period are expected to total as much CEO, and other novel transactions shows trading desks to hedge bets on gas prices as $8.3 billion. To cover the gap, Chesa- the financing is growing increasingly com- and interest rates, and advised on a host of peake plans to raise as much as $20.5 bil- plex and costly – and in some cases is in- deals, records show. lion from new ventures, including selling tertwined with the personal finances of the Some of the same financiers that have future production rights. chief executive. bankrolled Chesapeake’s deals also have “There seems to be little acknowledge- Last week, Reuters reported that Mc- made personal loans to McClendon, includ- ment by management or the board that the Clendon had co-owned and actively traded ing Goldman Sachs Group Inc. and Wells company faces a major financial crisis,” ana- in a $200 million hedge fund that bought Fargo, according to filings in Oklahoma. For lysts at International Strategy & Investment and sold the same commodities produced collateral with Goldman, McClendon put Group in New York said in a report May 1. by Chesapeake. up part of his wine collection. Wells Fargo Chesapeake says it has no trouble keep- On Tuesday, Reuters reported that one of and Goldman declined to comment. ing itself well-financed. Chesapeake’s chief financiers, EIG Global Chesapeake has strengths that could en- “Chesapeake has superb assets and a Energy Partners, arranged $450 million able it to ride out the storm. Low interest track record of successfully completing in personal financing for McClendon in rates have made its junk bonds popular with large transactions to monetize assets in March. That brought to $1.55 billion the investors. What’s more, Chesapeake is “asset

SPECIAL REPORT 2 DRILLING FOR CASH Chesapeake’s deepest well: Wall Street

An innovative deal The Glenn Pool transaction was a breakthrough, generating approximately $850 million for Chesapeake. Here’s how it worked:

Chesapeake had about 3,300 wells in oil and Helped by bankers at Barclays, it put those natural gas ﬁelds in northern Oklahoma. assets in two trusts.

GLENN POOL OIL AND GAS TRUST I

$397.4 million

$482.2 million

GLENN POOL OIL AND GAS TRUST II

Chesapeake Barclays received fees for Moody’s rated the trusts Investors will receive money received cash. arranging the deal, which as investment grade. generated from natural gas included “hedges” on gas prices. produced at the wells.

Source: Moody’s Investor ServiceNote: The $850 million ﬁgure is net of reserve and transaction costs rich,” S&P said, noting how the company The deals allow Chesapeake to sell to ing scandals involving Enron and others a “has been adept at structuring varied and in- trading partners future natural gas and oil decade ago. novative transactions to generate funds.” production in exchange for upfront cash. Among McClendon’s advisers on these With its aggressive financial manage- Rivals have used VPPs, but Chesapeake has deals are Jefferies & Co. and its vice chair- ment, some analysts say, Chesapeake could tapped them much more frequently. man, Ralph Eads III. Both were members be making a correct bet that it can reinvest Reuters tallied 10 VPP deals by Chesa- of the Sigma Alpha Epsilon fraternity at the cash it’s raising in higher-yielding as- peake and two by McClendon. Chesa- Duke, are big donors to the North Caro- sets,Striking such as new wells. it rich peake’s use of VPPs has grown as rivals lina university, and share a love of expensive Chesapeake has raised about $38 billion “They know what they are doing,” said have moved away from them. The problem, French wine. Jefferies’ connections extend since 2000 John Rittenhouse, chief executive of EDF analysts say, is that a company gives up fu- into Chesapeake’s corporate suite. Mc- Trading,Volumetric aproduction London firm that isHigh one yield of ture cash from a well. They also are a rela- Clendon has credited his CFO, Domenic payments* corporate debt Chesapeake’s largest trading partners. “It is tively expensive source of capital. Dell’Oso, a former Jefferies banker, for $6.40b $15.50b a question of redeploying capital.” “It is rare for (exploration and produc- forming the “industry-leading VPP pro- IPO tion companies) to use VPPs as financing gram.” 15 MILLION ACRES $0.51b $38.04b vehicles, especially in recent years,” said Jo- A Jefferies spokesman declined com- Chesapeake’s remarkable rise dates to seph Allman, a J.P. Morgan Chase & Co ment. Dell’Osso didn’t reply to a request 1989,Follow-on when McClendon co-foundedConver tiblthee analyst who follows Chesapeake. for comment. company.offerings He dispatched “land men” acrossdebt Technically, VPP deals don’t increase a Chesapeake has disclosed some but not America$7.11b to scout out energy plays, eventu$8.52b- company’s debt, because they are deemed all of the details of its VPP structures in ally*Pref buildingerred share an empireSource: on 15 Thomson million Reuters acres to be asset sales. But some analysts say company statements. In 2008, for example, of land in 16 states. It’s one of the biggest VPPs are controversial because they ef- Chesapeake told investors that it had raised property-buying sprees ever by a public fectively move future obligations to opaque $1.1 billion in a VPP deal with affiliates of company in the United States, a combined off-balance sheet structures. Once a well is Deutsche Bank and UBS. area nearly the size of West Virginia. moved off the books, it can be difficult for GOLDMAN HELPS As Chesapeake sped its expansion, it investors to track production. needed to raise ever-larger sums to lease Broadly, investors frown on off-balance- Details on some VPP deals emerged in a land and drill on it. An important tool is sheet activity because it is much more dif- lawsuit wending its way through federal the volumetric production payment, or ficult to monitor the use of money. Murky court in New York. Mary Linda McCall of VPP, which it first used in 2007. vehicles were a major factor in the account- Harris County, Texas, claims she has stakes

SPECIAL REPORT 3 An innovative deal The Glenn Pool transaction was a breakthrough, generating approximately $850 million for Chesapeake. Here’s how it worked:

Chesapeake had about 3,300 wells in oil and Helped by bankers at Barclays, it put those natural gas ﬁelds in northern Oklahoma. assets in two trusts.

GLENN POOL OIL AND GAS TRUST I

$397.4 million

$482.2 million

GLENN POOL OIL AND GAS TRUST II

Source: Moody’s Investor ServiceNote: The $850 million ﬁgure is net of reserve and transaction costs

DRILLING FOR CASH Chesapeake’s deepest well: Wall Street

in four wells that improperly were used to Striking it rich hedges against its own positions in the deal. back unspecified Chesapeake VPP deals. Chesapeake has raised about $38 billion Next, it was time for Barclays to get the The lawsuit alleges Chesapeake didn’t since 2000 blessing of a ratings agency. In May 2011, disclose that in 2008, two VPPs paid $132 Moody’s Rating Service gave it a thumbs- Volumetric production High yield million to an entity called Chesapeake In- payments* corporate debt up, granting the deal – two layers of debt, vestments. Reuters reported last month that $6.40b $15.50b one maturing in 5 years and the other in 10 McClendon used Chesapeake Investments years – investment-grade ratings of Baa2 IPO to hold personal stakes in company-drilled and Baa3. $0.51b wells, and pledged those wells as collateral $38.04b Glenn Pool was innovative because prior to his lenders. VPP deals had remained on bank balance In this case, the VPPs, called Blue Devil Follow-on Convertible sheets. “Barclays Capital has pioneered a and TW Investors, were constructed by offerings debt new approach in its recent transactions $7.11b $8.52b Wells Fargo, the lawsuit says. with Chesapeake,” Energy Risk magazine Chesapeake won a court order to dis- *Preferred share Source: Thomson Reuters wrote in bestowing an honor on the deal, miss the case last September. A federal “allowing a broad array of investors to take judge ruled that Chesapeake in fact had part in the investment while giving the gas only sold future oil and gas carved out of This time, dozens of people worked on producer a lower cost of capital.” the company’s “working interest” in the Glenn Pool, including employees from The debt then was sold in two buckets. wells. McCall’s attorneys filed an appeal at Barclays Capital’s structuring, syndication, The first – five-year debt sold to investors the U.S. Court of Appeals for the Second and ratings teams, according to the award such as hedge funds – fetched $397.4 mil- Circuit in New York. description. lion. The second – 10-year debt sold to Records unearthed by McCall’s lawyers longer-term investors such as insurance CREATIVE TOUCH also show that a bank owned by George companies – raised $482.2 million. Kaiser, a billionaire Oklahoma investor, is a In a typical VPP, an energy producer gets The return paid by Chesapeake on the lender to McClendon. In 2008, a $21 mil- cash by exchanging future production Glenn Pool deal wasn’t disclosed. Chesa- lion investment from a Kaiser foundation, rights with a trading partner, such as a peake’s borrowing costs on other recent and financing from an affiliate of Goldman bank. In the Glenn Pool deal, the trading deals have been divulged, however. Some Sachs, enabled an enterprise called Argo- partners—the two trusts—raised money analysts say those borrowings are coming at naut VPP LLC to provide Chesapeake $412 by selling debt to investors. The investors a high price as the company’s financing gap million. In exchange, Argonaut received well then would recoup their investment from widens and it makes a dash for cash. production in Oklahoma and Arkansas. the revenue raised by the sale of natural gas MORE IN THE PIPELINE A year later, McClendon turned to Kai- from wells in seven counties in northern ser for a personal loan. Documents filed in Oklahoma. In the first quarter, Chesapeake spent more Oklahoma show that McClendon pledged The sale of debt to investors meant the than $2.5 billion drilling and completing distributions from two of his personal com- buyers needed to be assured of a return. wells, resulting in a cash shortfall. To cover panies as collateral to Kaiser. The size of the That meant the deal needed a credit rating. it, Chesapeake relied on a series of conven- loans is not known. By spring 2011, the Glenn Pool deal was tional loans and creative deals to raise cash A spokesman for Kaiser declined com- almost ready to be graded by the ratings totaling $3.4 billion. ment. firms. To verify that natural gas was in the Between Dec. 31 and Feb. 9, for ex- In the past 12 months, Chesapeake’s ground, engineers from a Houston firm con- ample, Chesapeake tapped three loan com- VPPs and other deals have gotten more ducted a review, confirming there was plenty. mitments from banks to raise $2.35 billion, complex. One example is Glenn Pool Oil & There was another risk for the debt in- according to a regulatory filing and analysis Gas Trust I and II, which was executed by vestors: the fluctuation of gas prices and by J.P. Morgan Chase’s Allman. the Barclays Capital unit of Barclays PLC. cash flows. To comfort investors, Barclays Chesapeake is going beyond VPP deals This one stood out as cutting edge, earn- served as a middleman, providing hedges – to other novel structures. Consider the two- ing the British bank a “deals of the year” financial contracts that effectively provide stage deal it pulled off in November and honor from a commodities and risk trade more stable prices or cash flow. The bank December, when it traded 700,000 acres in publication called Energy Risk. then reduced its risk exposure by taking eastern Ohio for $1.25 billion.

SPECIAL REPORT 4 DRILLING FOR CASH Chesapeake’s deepest well: Wall Street

A Chesapeake subsidiary, CHK Utica LLC, owns the leaseholds on the land. It BIG BETS: Chesapeake issued $750 million in perpetual preferred has spent heavily for shares to an investment consortium led by acreage in plays such EIG, the Washington, D.C., investment- as the Eagle Ford shale management firm that also has loaned formation in Texas. heavily to McClendon. REUTERS/AnnA DRIVER The consortium also includes an affiliate of private-equity firm Blackstone Group and Magnetar Capital – an Illinois hedge fund that profited handsomely with bets on subprime housing. The consortium not only will receive a juicy dividend of 7 percent. It also will get royalty interests from gas produced from wells on the land. The deal spree continues: In April, Chesapeake raised a total of $2.6 billion. A Chesapeake unit issued preferred shares to EIG and Magnetar in return for gas production in Oklahoma, this time net- ting $1.25 billion. Chesapeake also raised $745 million in a VPP with Morgan Stanley. And the company agreed to sell a leasehold on 58,400 acres to raise $590 million in a deal with an Exxon Mobil subsidiary. This month, McClendon told investors in a conference call that more deals are afoot. “We’ll have to work a bit harder on the asset monetization front to counteract cur- rently soft U.S. natural gas prices to hit our year-end target,” McClendon said. “The good news is, the positives for our company are enduring, and the negatives we believe, are short-term.”

Additional reporting by Anna Driver in Houston

FOR MORE INFORMATION Carrick Mollenkamp [email protected] Michael Williams, Global Enterprise Editor [email protected]

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SPECIAL REPORT 5