by Russell Gold
There is no evidence to suggest that McClendon knew what El Paso was doing in California. But El Paso’s actions throughout 2000 ended up throwing a lifeline to a struggling Chesapeake all the same. These higher gas prices ended up in hundreds of thousands of home heating bills. The average cost of keeping a home warm with natural gas rose by nearly $400 that winter. More than 1.1 million US households struggled to pay their energy bills, as the combination of rising fuel costs and a rising unemployment took their toll. The rising natural gas prices, which McClendon had predicted, helped put Chesapeake back on track. Its stock price, after bottoming in 1999, began to rise along with interest in the Oklahoma City gas producer.
9
THE FALL OF AUBREY McCLENDON
In late 2002 McClendon delivered a simple message to any audience he could find: the United States was running out of natural gas. “It will be better to be a provider of energy than a consumer of energy for the next twenty years,” he told a meeting of energy company executives in Dallas. A couple months later, he pooh-poohed the idea that natural gas production would rise. It was much more likely to fall. The United States produced about twenty-four trillion cubic feet of natural gas a year. “There is no way to get to thirty by 2010,” he said. US natural gas prices were headed higher, he told anyone who would listen. Few paid attention. Chesapeake was a small gas producer—it ended the year twenty-first on an annual list of the largest US oil and gas companies—and McClendon was just another slick Oklahoma driller talking up a position that benefited his own bottom line.
Undeterred, McClendon steered Chesapeake on a risky strategic course to take advantage of his vision for gas. He bought other gas producers and leased millions of acres, spending a lot of borrowed money. Then in 2004 he began to notice what was happening in and around Fort Worth with the Barnett Shale.
McClendon assimilated this new information with his existing theory of rising natural gas prices. The United States was short of gas, and these new newfangled shale wells produced a lot of gas. It didn’t take much for Chesapeake to begin vacuuming up shale acreage and drilling on it. In 2004 Chesapeake was the eighth largest driller of wells in America. The next year it was the fourth largest. The year after, it was the largest. It would hold on to the top spot for several years. Between 2004 and 2011, it drilled more wells than any other company in the world. Every day, its drill bits began chewing into the earth to start nearly four new wells. The second most active driller wasn’t even close.
The small company, named after the East Coast’s Chesapeake Bay, where McClendon had spent time boating, became a gas powerhouse by drilling and drilling and then drilling some more. Other companies—XTO Energy, EOG Resources, Devon, and Anadarko Petroleum—followed this path, but Chesapeake set the breakneck pace. Chesapeake’s metamorphosis into the world’s largest driller required a combination of McClendon’s single-minded focus on turning Chesapeake into a large and powerful company, as well as Eads’s ability, as the company’s go-to investment banker, to find outside financing for his friend’s aspirations.
The fly in the ointment was that fracking shale provided more natural gas (and later oil) than McClendon ever envisioned. The industry figured out how to lower costs by drilling wells faster. The wells grew longer, traveling through and opening up more shale, and fracking became more efficient and productive. The cost of producing a cubic foot of gas fell. For a time, profits grew fat and gas extraction leapt upward. This surge of new gas stood in stark contrast to what McClendon and others in the industry thought was going to happen. But McClendon kept his foot on the accelerator, pushing the gas market in the United States from shortage to glut. This change ended up collapsing gas prices. He was hoisted by his own petard.
Sitting on a stage at an industry conference in 2012 with McClendon, Edward Cohen, former chief executive of Atlas Energy, a large Marcellus Shale operator, described the situation succinctly: “We’re sort of like the farmers who always want to plant more and more. And the more they plant, the lower prices go.”
Aubrey McClendon is a handsome man. He has a prominent chin. He is fit and has an outdoorsy mien. He wears wireless glasses and wears his wavy hair long; it breaks from a side part, flowing in one direction across his forehead, where a few strands turn into large looping curls. The rest undulates back to the base of his skull, where it gathers in a swirled mass that at once looks messy and the work of an expensive stylist. He could be mistaken for retired NFL quarterback Archie Manning.
He is articulate and smart, without being condescending. He can take complex ideas and simplify them. His mind is constantly in motion, digesting information and examining who he is talking to, seeking out ways to connect. Most energy executives are engineers and speak with a tinge of the frustration that comes when the answer is clear to them but eludes others who haven’t studied the data. McClendon is a born salesman, leading others to the answer that he has already grasped. His instincts soon become your insights.
This gift of persuasion was on display in early 2012 when he spoke with two visitors to the Oklahoma City campus. Chesapeake, he explained, was a simple manufacturing operation. There were four inputs into this factory. “We have leaseholds,” he said, using a term for acreage that the company has leased for drilling. “We have capital,” he continued. By this he meant, in a word, money—or, at least, access to money. “We have science, and we have people. Human resources. Those are the only four inputs we have. And we only have one output: oil and gas.”
Energy exploration isn’t like developing a new cancer drug, where scientific breakthroughs are guarded and patented. The science of shale—and the pioneering techniques used to fracture it—are shared through formal and informal channels. Engineers write papers about characteristics of rocks and publish them for others to see. A fracking site isn’t a closed laboratory, sealed behind layers of security and confidentiality agreements. Workers from different companies all participate. The service companies brought in to do specialized work might as well be teenage gossips. The industry employs spies—which it calls scouts—to gather information on its competitors’ wells. It is a remarkably open community, a system that has developed over the decades. A wide diffusion of knowledge ultimately helps everyone drill better wells and lower costs.
Chesapeake didn’t pioneer either of the two technologies that brought about the shale revolution. Mitchell Energy—and engineers such as Nick Steinsberger—first figured out how to use chemically slickened water to fracture shales. Devon was the first to commit to drilling hundreds of horizontal wells into shales, enabling engineers to frack more of the rock and create giant gas wells. What did Chesapeake do? McClendon figured out how to finance the revolution, tapping into Wall Street’s deep reservoir of capital. He sold the revolution to the world’s bankers. Of his four inputs, McClendon’s signature contribution was attracting capital.
Drilling leases aren’t hard to obtain. They require a large checkbook. Most landowners are happy to sign for a nice payday. To get the leases requires hiring a lot of landmen, as well as paying their per diems to live out of hotels and drive up and down rural roads. At one point, Chesapeake employed about five thousand contract landmen to lease up areas where it wanted to drill. People and leaseholds are just capital by another name. It takes hard work to chase shale, but capital is the mainspring that turns the gears.
Consider Chesapeake’s activities in the Barnett Shale. Eight years after its first shale well, it had accumulated 350,000 acres in northern Texas. It bought some companies to obtain their leases. But the overwhelming majority came in small deals, where its landmen knocked on doors, sat down at kitchen tables, and got the landowner to sign a lease. Chesapeake built its Barnett acreage through small individual transactions. It was a mind-boggling amount of work. It is not unusual for a large international oil company to negotiate with a foreign government, and in one deal acquire a half million acres. That’s not how leasing works in the United States. Deals must be struck with thousands of individ
uals. To excel in the shale boom required a small army of landmen and a different kind of energy company.
“It took us two hundred sixty thousand transactions to put together our Barnett asset. How many companies in the world could do one thousand transactions, much less two hundred sixty thousand to put it together?” said McClendon. “We have a unique skill set. There is no chance in a million we could go and drill an offshore oil well or an international well as well as our partners could. There is also no chance in a million they could do what we can do onshore in the US.”
Building up its Barnett acreage required, first and foremost, people on the ground, meeting with community groups to discuss concerns about where well pads would be located and how many trucks would rumble through a neighborhood. As interest in the Barnett rose, so did prices paid per acre—from $5,000 to $25,000 and above. Even assuming that Chesapeake paid $10,000 per acre, the investment went well into the billions of dollars. And McClendon’s ambitions didn’t stop at the boundaries of the Barnett. Chesapeake plunged into other emerging shale hot spots: the Fayetteville in Arkansas, the Haynesville in Louisiana, the Marcellus in Appalachia, the Utica in Ohio, and the Eagle Ford and the Permian Basin in Texas. McClendon’s pronouncement that it took four inputs can be boiled down to one. It took money, and a lot of it.
His greatest strength ultimately became his greatest weakness. He was so good at raising capital that he created an enormous company, which turned out to be too big to change its direction quickly enough after the financial collapse in 2008. And his ability to raise billions of dollars—not for Chesapeake, but to fund his own personal wells—would eventually lead to his downfall and departure from Chesapeake.
McClendon became convinced by around 2003 that whichever company could grab the most acreage would succeed. Those who dallied would be left behind. By the middle of 2006, he was already declaring victory in the land grab. “The winners for the next ten to twenty years have already been chosen, and the losers will pay the price for years to come. History has shown that Oklahomans did very well in the land run of 1889,” he said, a reference to the giveaway to settlers of two million acres. “I believe that history will also note that Chesapeake did very well in the land run of 2000 to 2006.” Every lease signed by Chesapeake contained a countdown. Depending on the lease, the company had between three and five years to drill a well. Once the well was drilled and began producing gas or oil, Chesapeake could hold the lease forever—or as long as the well was in operation. If no well was drilled, the lease would expire, and its investment would be lost. Talking to investors in 2006, McClendon boasted that it was meeting its drilling obligations. It had 101 drilling rigs operating, the highest number of any company since 1985, and it was adding rigs.
McClendon wasn’t a mere participant in the great shale land grab. He created it. John Pinkerton was the longtime chief executive of Range Resources, the first company to drill wells targeting the Marcellus Shale. “When Aubrey joined the party, all of a sudden the land grab started,” he said. This acceleration was unhealthy for all involved. The public wasn’t prepared for the onslaught of landmen, regulators were forced to play catch-up, and the industry drilled wells so quickly that common sense was jettisoned at times.
Pinkerton grew concerned about this haste in 2008 after meeting with Pennsylvanians who thought the gas industry was the second coming of coal mining that left the state scarred, with streams poisoned by acid that leached from opened mines. He wanted to be more transparent and hired a team to talk to the public and government officials. He also tried to enlist other CEOs in this effort. He said he couldn’t get through to McClendon. “Aubrey was just too schizophrenic. He was everywhere. I couldn’t get him on the phone. He totally agreed with me. But he was going so fast, running so many rigs,” said Pinkerton. “He was spending all this money and had twenty-five-year old engineers from Oklahoma drilling wells by telephone.”
Still, Chesapeake’s strategy was copied and envied. Investment professionals wanted to hear how McClendon had pulled the company from the brink of collapse and transformed it into a Wall Street darling. The company’s conference calls, where McClendon would talk at length about his view of the energy landscape, were crowded with people dialing in to listen to the Oracle of Oklahoma City.
To finance its rapid expansion, Chesapeake began spending more money than it took in. In its financial results for April through July 2004, the company reported generating $328.8 million from energy operations. It spent $337.9 million on drilling, leasing, and other expenditures. It was, in Wall Street jargon, cash-flow negative. There’s nothing wrong with being cash-flow negative—and there are many reasons a company would want to be cash-flow negative. Think of a real estate developer building a skyscraper. It may well run cash-flow negative for a couple years, drawing down a construction loan, line of credit, or cash it has built up. When construction is complete and the building is leased, the developer would become cash-flow positive as rents come in. But the spring of 2004 was only the beginning for Chesapeake. Through the end of 2012, it reported positive cash flow—it made more than it spent—in only three of the subsequent thirty-four quarters. In the first three months of 2012, it reported a $4.1 billion negative cash flow. Over an eight-year span, it spent more than $30 billion on leasing and drilling than it made selling the oil and gas it pumped from its wells.
Building up an inventory of wells to drill turned out to be easy for Chesapeake. Finding capital to finance this operation was tougher. McClendon was endlessly creative in this search. He borrowed money from Wall Street and issued shares; he supersized an existing financial product called the volumetric production payment (VPP), which allowed it to get cash up front in exchange for future gas production. He sold minority stakes in gas fields to foreign companies and he placed complex financial hedges—bets, really—with Wall Street traders on the future movement of natural gas prices.
Facing this seemingly endless demand for capital, McClendon found an ally in his old Duke friend Ralph Eads. A year after leaving El Paso in 2003, Eads bought a stake in a small Houston firm called Randall & Dewey that specialized on advising companies buying and selling assets in the Gulf of Mexico. But Eads soon steered the company into the more lucrative shale business. McClendon and Eads had remained friends in the two decades since they had graduated from college but had done little business together. That began to change in 2004, when Eads advised Chesapeake on a $425 million acquisition of a small company. Over the next couple years, McClendon talked to Eads regularly about how much capital Chesapeake needed to develop these shales. Intrigued, Eads sat down and scratched out some rough numbers. He figured out how large the Barnett, Marcellus, and a couple other shales were and how many wells would be required. Then he multiplied this figure by how much the wells cost and added in costs to build pipelines. His rough estimate was that Chesapeake and other companies needed $35 billion a year of external capital to drill these wells. In other words, $35 billion above and beyond what they generated from selling energy.
“Wow,” he recalled thinking. “That’s a lot of money.” Then another thought occurred to him. There is no way Wall Street will supply even close to that much capital through debt and buying new shares in these companies. Seeing a business opportunity for his firm, which he had sold to New York investment bank Jefferies Group in February 2005, Eads set out to create a new financial ecosystem to find money to drill shale. He helped companies raise capital by selling off older, conventional assets and took a commission on these sales. He found foreign energy companies that wanted to participate in the US shale boom and brought them together with companies such as Chesapeake that were willing to sell minority stakes in exchange for money. Another commission. And Eads went on a global road show, proselytizing to big institutional investors in China, Korea, India, and Norway on the returns they could achieve from shale. More commissions. Under Eads, Jefferies climbed the league tables—an annual ranking of Wall Street mergers business—like a soccer club wi
th a rich new owner moving up into the Premier League.
Jefferies’s pitch material grew into a two-volume, spiral-bound book. It exuded confidence, brimming with upbeat assessments: shale offers “large resources with little geologic risk” and “superior returns.” The book’s core message was that there were companies with more shale acreage than money to drill. These companies needed partners with deep pockets to help them drill. He aimed the pitch squarely at the heart of the global financial system. Investors around the world have enormous sums of money and seek places to invest that provide high returns. Eads and McClendon were selling an investment opportunity that hit all the right notes. It was a large investment opportunity—$35 billion a year and growing—and it offered strong returns. And the investment was in the United States, which didn’t run the risk of governments nationalizing assets or armed bands attacking expatriate engineers.
In a four-year span, from 2008 until 2012, money flowed into North America from Japan, China, Korea, Norway, Australia, India, South Africa, Malaysia, France, and the United Kingdom. Jefferies counted thirty-seven deals that raised a total of $163 billion. By any measure, it’s an astounding amount of money, equal to the value of companies such as Coca-Cola or Google. Not all buyers came from overseas. One of the largest deals was when Exxon Mobil bought XTO Energy for $31 billion. Chesapeake alone raised $33.7 billion in a series of deals, for almost all of which Eads served as financial adviser.
