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.