by Russell Gold
People in the oil and gas industry use a metaphor to describe what happened in the mid-2000s. The treadmill, they say, was turned up. What had been a casual pace on the machine—raising money, drilling wells, selling energy—became faster and faster until it was a sprint. While there were many companies and CEOs who sped up the tempo, they were all trying to keep up with McClendon. His desire for “more,” as his longtime business partner Tom Ward stated, was the driving force in the rapid development of US shale resources.
Chesapeake discovered a lot of natural gas and leased it up. Its competitors, caught in the company’s slipstream, followed its lead. The result was a lot of natural gas—more than anyone had previously thought possible. And when there is too much of a commodity, prices begin to drop. This is especially true when the US economy takes a sharp turn downward. McClendon missed this turn. On August 1, 2008, he said that gas prices would stay in the $9 to $11 range. A year later, they were at $4. “The only thing that went wrong with our strategy was the financial collapse of 2008,” McClendon said later. With its heavy debt and drilling commitments, this price decline was a recipe for trouble. It was a major oversight.
“It all goes back to the Austin Chalk,” said Dan Pickering, a Houston investment banker whose firm Tudor, Pickering, Holt was involved in the shale boom and its deals. “These guys have historically run until they fall off the edge of the cliff. In the Austin Chalk, the geology wasn’t there. This time around, it was financial leverage. You want to push and push right up to the very edge and not go over. Figuring out where the edge is, that’s hard.”
Chesapeake had another large source of revenue that helped the company grow. McClendon placed aggressive bets on future movements of natural gas prices. He was a good trader, generating large profits. Between 2001 and 2011, Chesapeake reported $36.7 billion in revenue from selling the oil and gas it produced. Over the same period, McClendon generated $8 billion in trading profits. For every dollar that Chesapeake took in over that period, eighteen cents came from Wall Street trading, not wells. Over this span, McClendon had seven years of gains from trading and only four down years. And his good years were very good, while his down years didn’t generate particularly large losses. Only once, in 2004, did he generate a loss of more than $100 million. Five times, his trading resulted in billion-dollar gains. This extra cash was critical to Chesapeake’s rapid growth. Chesapeake used it for aggressive leasing, speeding up the pace of shale development and forcing other companies to ramp up their spending if they didn’t want to be left empty-handed.
McClendon also traded on his personal account and for a hedge fund he set up with Tom Ward in about 2004. I stopped by the offices of the hedge fund, called Heritage Management Company, one day in 2007. It was in a 1930s skyscraper on Fifth Avenue in Manhattan. There was no receptionist, so I walked through the foyer into a small room where I startled four traders seated around a large table, staring intently at their twin computer monitors. They didn’t want to talk about the company and ushered me out of the office. When I later asked McClendon about his outside investments, he replied, “I just play the stock market, I play the commodity markets. Sometimes I win, sometimes I lose.” He said later that the fund helped give him insights into the market, which helped him manage Chesapeake better.
Still, the arrangement was unusual. McClendon was the CEO of an expanding natural gas company that grew to control a substantial portion of the domestic gas market and was active in futures trading. McClendon was also actively trading the same energy contracts for his personal account. Were Heritage traders allowed to place bets on future movements of commodity prices before Chesapeake secured its price hedges or publicly announced increases or decreases in drilling? The potential existed for “front running,” when a trader buys or sells commodities before executing his company’s trades. This could allow McClendon to profit from advanced knowledge of price movements. There is no evidence that anyone oversaw the operation, at least anyone besides McClendon.
By 2008, McClendon and Chesapeake were whales in the futures market, a massive electronic exchange where contracts for billions of barrels of oil and trillions of cubic feet of gas are traded. How big is difficult to say with precision. Trading positions on the New York Mercantile Exchange are zealously kept out of sight by a club of investment bankers, hedge fund manager, physical traders, and speculators. Those in the club, where membership requires access to billions of dollars of collateral, share snippets of gossip about who is betting prices will rise or fall. But for those outside, information can be tough to come by. This veil of secrecy has fallen only one time, and the snapshot of the investors and traders setting energy prices in the summer of 2008 showed that McClendon and several close associates were among the largest participants.
US Senator Bernie Sanders, an independent from Vermont, pulled the curtain back when he released a confidential list of futures market speculators compiled by the US Commodity Futures Trading Commission, a disclosure that sent futures traders into conniptions. The list of who held the natural gas contracts was a who’s who of global capitalism and energy. In descending order, they were BP, Barclays, Morgan Stanley, JPMorgan, and Shell. The sixth largest was the reclusive Tulsa billionaire George Kaiser, who owns a private gas exploration company, and who lent money to McClendon and often talked to him about market fundamentals. The eighth largest was John Arnold’s Centaurus Advisors, a major Houston hedge fund in which McClendon had invested.
Chesapeake Energy held gas contracts to make it the seventeenth-largest participant in the futures markets, by far the largest position for an energy company of its size. Only a few individuals made the list. After George Kaiser, there was T. Boone Pickens (number 12). The next individual on the list was Aubrey McClendon, followed by his longtime business partner Tom Ward (numbers 52 and 53). Taken together, this cluster of Texans and Oklahomans all connected through McClendon and including Ward, Chesapeake Energy, Centaurus, and Kaiser held about 10 percent of the total natural gas futures contracts, a large accumulation on an exchange that helped set the continental price of gas. The largest single trader—BP—held only 7 percent.
The second week of October 2008 was abysmal for anyone invested in the global stock market. The Dow Jones Industrial Average fell 18 percent, it worst five-day span since the depths of the Great Depression. On Friday, the tenth of October, the Dow—a group of the market’s largest, most important companies—traveled a vertiginous path in its most volatile day ever. Even in this market, Aubrey McClendon had a particularly bad week.
Shortly before noon on that Friday, Chesapeake disclosed that McClendon had been forced to sell off virtually all of his shares in the company. He had borrowed substantial amounts of money from brokerage firms, using the value of his 33.5 million shares in the company as collateral. When the value of these shares fell, triggers embedded in these loans were crossed, forcing McClendon to pay back his lenders. McClendon had maintained a margin account for years, using his Chesapeake shares as collateral to trade stocks, bonds, and commodities. He had entered the week with a 5 percent stake in the company worth $2.32 billion a couple of months earlier. His stake in Chesapeake had always been a point of pride. He linked his personal wealth to shareholders because he was a shareholder. After the sales, he owned $32 million in Chesapeake shares. “I got caught up in a wildfire that was bigger than I was,” McClendon said over that weekend.
His financial house in tatters, McClendon borrowed $30 million a week later from Centaurus Capital, the Houston hedge fund that traded in natural gas and other commodities. Centaurus was run by John Arnold, a thirty-six-year-old former Enron whiz kid trader and billionaire hedge fund manager. As collateral for the loan, McClendon put up his stake in a Centaurus fund. The filing, in the Oklahoma County Courthouse, went unnoticed for years. In retrospect, it is a stunning document. Aubrey McClendon, the CEO of one of the largest natural gas producers in the United States, was investing in a hedge fund that amassed enormous profits trading natur
al gas. The fund owned considerable gas assets.
This debt was the first, but not the last, that McClendon accumulated beginning in late 2008. He borrowed from individuals and firms with large energy-trading operations. He pledged his ownership stake in the Oklahoma City Thunder to Bank of America. To George Kaiser, he pledged his venture capital company, then a half interest in some of his privately held oil and gas wells, and later his collection of petroleum memorabilia. To Goldman Sachs, he pledged a large portion of his wine collection, which ran seventy-eight pages and included two six-liter bottles from the famed La Tâche vineyard in Burgundy and more than two hundred bottles of cabernet sauvignon bottled in 1983 by Château Margaux.
That “more” was McClendon’s governing philosophy is clear from even a cursory look at both his and the company’s assets. Chesapeake had acquired leases to drill on more of the United States than any other company had ever amassed—15.3 million acres—and bought a large three-story office building in Oklahoma City just to house all of the land records. Along the way, Chesapeake started buying up property in northern Oklahoma City for a corporate headquarters. Starting with a single building, Chesapeake snapped up 111 acres and built a dozen three-story redbrick buildings, with gray roofs and white dormer windows. The campus fitness center was state of the art, with squash courts and a basketball court good enough for the New Orleans Hornets of the NBA to use when they evacuated following Hurricane Katrina in 2005. Chesapeake also built a shopping center across the street, attracting the first Whole Foods Market in the state.
McClendon had also personally gone on a buying and building spree—much of which became collateral for his debts. He acquired an ownership stake in a television station and several restaurants in Oklahoma City. He created a large tree farm and opened a roadside restaurant on Route 66 with a sixty-six-foot-tall soda bottle that lights up at night called Pops that sells five hundred different varieties of soda. Near where his wife grew up in Michigan, he planned a massive lakeside development and ended up in a lengthy battle with the local township over zoning. Near Gull Lake, Minnesota, he housed his collection of eighteen antique wooden-hull motor boats, including a 1936 Ditchburn yacht valued at $1.5 million. He acquired a vacation home in Bermuda and planned another in Hawaii.
His largest personal collection, however, was the stake in wells he built through the Founders Well Participation Program, the perk that allowed him to purchase a 2.5 percent stake in nearly every well that Chesapeake drilled. In 2008 it drilled 1,733 wells. McClendon elected to participate—and the bill for his participation kept growing. He was likely already the largest single owner of oil and gas properties in the United States. Four years later, Chesapeake disclosed that his small slices of thousands of wells produced the equivalent of the 147 million cubic feet of natural gas a day, enough to supply all residential customers in Connecticut or Kentucky.
For many executives, the fall of 2008 was a humbling time, a time to reassess business strategies and survive the financial storm. Chesapeake charged forward, but investors were increasingly unhappy. In late November, just a few hours before the market’s Thanksgiving holiday, Chesapeake filed forms with the federal security regulators to allow it to issue $1 billion in new shares. Shares prices plunged when trading reopened. Within a few days, Chesapeake reversed itself and said it would slash spending. “These filings were a mistake,” McClendon said in a conference call with investors. “I apologize for that and ask your forgiveness for it.”
Chesapeake’s shares dropped fell by 59 percent in 2008, and McClendon exited the year with a dented ability to convince investors that he could guide the company in the right direction. But the Chesapeake board members decided to reward McClendon. In early 2009 they gave him a new five-year contract and a onetime $75 million “retention” bonus. The money would help him pay his obligations to the Founders Well Participation Program. The company also agreed to buy McClendon’s collection of antique maps for $12.1 million. The board’s generosity made McClendon the highest-paid CEO in the United States in 2008.
The maps, the special retention bonus, and other problems came to a head in June, when the pro- and anti-McClendon camps gathered for Chesapeake’s annual shareholders’ meeting. These events are usually highly scripted affairs, a cavalcade of praise for the executives. That year’s meeting was tempestuous. One longtime investor assailed McClendon for confusing rising gas prices with his own success. “Your greed and your ego took over, and you bet the farm that your success would continue,” said Jan Fersing, a Fort Worth businessman. “So, your two-billion-dollar fortune was not enough; you wanted more. But this time your hand got stuck in the cookie jar, and you couldn’t let go until your own cookies were taken in the process. And after your embarrassing losses, but with a carefully picked and extremely well-compensated board of directors, Chesapeake shareholder funds were partially used to cover your losses.”
McClendon remained calm.
“I’ve worked one hundred hours a week, at least, since 1989 building this company. I’ve sacrificed a lot to do that. I sacrificed five hundred million dollars that I lost last fall as a result, not because of bad decisions but because of things beyond my control in this country’s economy and with regards specifically to natural gas prices. So, I’m sorry that you find me as egocentric and greedy. But, I’ll tell you there’s not a harder-working guy out there who thinks every day about how to create shareholder value,” he replied.
After a couple more shareholders praised Chesapeake, the final member of the audience spoke. “Hi. My name is Ralph Eads. I’m a longtime shareholder of the company. Virtually everybody in my family owns the stock. It’s been, for like some of the other folks here, transformative for me. I am a longtime professional in the oil and gas business; I know a lot about the industry, and I know a lot about this company. And I’ll just say it is the finest company, and Aubrey is the finest CEO. And I’m here today—I made the trip from Houston—to thank the board for the compensation arrangement they did with Aubrey. It kept him—it will keep him in the saddle for the next five years, and that will make everybody in the room and all the shareholders a lot of money. So, I know it was a difficult decision for you guys, and controversial, but I want to tell you I appreciate it a lot. Thank you.”
McClendon thanked him for his comments, without noting his longtime friendship or business relationship, and moved on.
Chesapeake continued its strategy of spending more than it brought in—and closing its funding gap by selling off assets. Over the next couple years, it sold six volumetric production payment deals for $3.6 billion. These agreements with large Wall Street banks provided Chesapeake immediate cash in exchange for future gas production from its wells. Chesapeake used the cash it received to fund a still-ambitious growth campaign. As Chesapeake did more VPPs, the amount of gas it promised to deliver grew—as did its obligation to pay to pump this gas and deliver it without getting any money. Few paid attention to these deals. One exception was Pawel Rajszel, a young security analyst in Toronto, who issued a scathing report to his clients in April 2010, arguing that these deals put the company in significantly more debt than it cared to acknowledge. Pointing out that Enron had pioneered the VPPs a decade earlier, he wrote, “Due to what we consider an accounting loophole, Chesapeake is effectively able to hide its VPP liabilities from its balance sheet—something even Enron Oil and Gas Company did not do.” While investment professionals didn’t pay much attention to Rajszel’s prescient warning, Chesapeake’s debt-rating agencies agreed these deals should be accounted for as debt. McClendon spent considerable time trying to change their minds. When he didn’t, he told investors these debt watchdogs were wrong. “They see VPPs largely as debt, which is kind of nutty,” he said in 2010.
Chesapeake also sold off assets and, with the help of Ralph Eads, lured foreign investors as partners in Colorado, Pennsylvania, Louisiana, Arkansas, and Texas. Beginning with a deal to sell 20 percent of its acreage in the Haynesville Shale, in northern Lo
uisiana, to Plains Exploration & Production Company for $3.16 billion, McClendon attracted buyers for the land he had built up. By the beginning of 2012, he had struck deals to sell off minority positions in Chesapeake assets worth more than $20 billion. Other companies copied this strategy of bringing in joint-venture partners, but Chesapeake pioneered the practice and was the most active. Chesapeake was good at using its landmen to snap up acreage in newly discovered shale fields before anyone else and then selling off a chunk to companies from China, France, or Norway to recoup its investment—sometimes even before it drilled more than a handful of wells. By 2011, the shale revolution had succeeded at finding too much natural gas. Prices were falling. After promising investors it would live within its means, McClendon said that Chesapeake needed to capture new opportunities. And it kept spending more than it made, leasing and borrowing and selling what it could.
In August 2011 Aubrey McClendon appeared on Mad Money, a cable financial news show on CNBC. He was there to boast about a newly discovered shale—the Utica—in Ohio. It was a typical performance. The Utica is “one of our biggest discoveries in US history.” Maybe twenty-five billion barrels of oil and petroleum liquids. Really big. Chesapeake had drilled in total only fifteen wells in the Utica—and only six modern horizontal wells. From this small sample, it extrapolated that the discovery could be worth between $15 billion and $20 billion. It was a bold statement, considering the entire company was worth about $22.6 billion at the time.
Not long after, Chesapeake began to turn the acreage it had leased into money. Before the end of the year, two deals came together. One was a joint venture with French oil major Total to sell a quarter of its Utica acreage in ten counties in eastern Ohio. Chesapeake had also created a new subsidiary, placed most of its Utica acreage into it, and then sold $500 million in shares of this subsidiary to EIG Global Energy Partners. EIG, which ultimately spent another $750 million on CHK Utica shares, received a nice 7 percent annual dividend on its investment, plus the first 3 percent of revenue from the first 1,500 wells drilled in the Utica. Eads represented Chesapeake, as financial adviser on the joint venture and as adviser helping to connect Chesapeake with EIG. It was the twentieth and twenty-first transactions that Eads had undertaken for Chesapeake, cumulatively generating $28 billion for the company, since the beginning of 2007.
