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In a mad dash for damage control, I imagine the board was meeting ‘round the clock, consuming endless pots of tea and writing 8-Ks and proxies furiously in an effort to put a lid on the latest misadventures in financing by CEO Aubrey McClendon and distance themselves from his actions.

The Board

It’s been quite a week for the Board of directors cleaning up after Aubrey McClendon’s recent financing shenanigans involving his personal stake in Chesapeake Energy wells.

On April 20 the board issued a statement that the Founders Well Participation Program (FWPP) runs with complete shareholder approval and the Board of Directors is fully aware of McClendon’s financing activities

By April 26 McClendon’s FWPP agreement was amended and will end in 2015. The board also stressed that McClendon would issue a separate accounting of his financing activities and they retracted the previous statement that the board was fully aware of his financial activities and corrected it to the board is generally aware of the use of FWPP interests to obtain loans.

The DEFA14A reiterated the closure of the FWPP, the separate filing by McClendon and the clarification from fully aware to generally aware.

Can’t say these things too many times.

Chesapeake is now in the news and no doubt wishes it wasn’t. The media is concerned about an almost two decades old agreement granting the CEO and founder participation rights in Chesapeake’s wells. McClendon is granted up to a 2.5% interest that belongs solely to him and his debt is non-recourse to Chesapeake. It has been benignly neglected by both the board and investors over the years and in fact was resoundingly approved for continuance by shareholders in 2005. What makes it a hot topic today is the quiet accumulation of a substantial amount of debt by McClendon using these wells as collateral. One might argue since they are his property, he has the right to use them in whatever way he sees fit. Unfortunately, that has not always worked out for shareholders as McClendon’s tendencies to love leverage in his personal finances has come back to bite shareholders in the past-- non-recourse or not.

The FWPP allows McClendon to buy up to 2.5% of all the wells that will be spudded by CHK in the upcoming year. He buys all of them or none of them. This has been interpreted by the board as an alignment of his interests with shareholders. Contrary to outside perception, these wells are not a big source of cash. The well interest is, in fact, not profitable at all. Looking at three years worth of costs and expenses, you might ask why he wants to be involved in this expensive form of shareholder alignment.

Accounting of founder well participation plan

in millions
Q1 2011 2010 2009 2008
Natural gas and oil revenues $40.2 $127.1 $87.9 $171.5
Lease operating expenditures (8.9) (26.1) (19.5) (22.6)
Net cash flow 31.2 100.9 68.4 148.9
Capital expenditures (89.3) (242.8) (184.5) (212.6)
Net after capex ($58.1) ($141.9)($116.1) ($63.7)

These assets, while not generating any free cash, are worth $410 million (valued by the PV 10 required by the SEC) or $852 million valued by a looser interpretation of PV 9 estimates. It creates an asset McClendon can use as collateral for loans. By living on leverage he has easily paid the lease and capex expenditures and had a bit of mad money left over.

Loans and FWPP expense from the 2010 proxy

Loan amounts
2008-2010 $666.0

FWWP expense
2008-2010 $321.7
2008-2010 and Q1 2011 $379.8
Net including Q1 2011 $286.2

The loans against the well interests generated some cash for McClendon even after paying expenses. The wells never have.

It was the size of the loans and the potential conflicts of interest between the lender, McClendon and Chesapeake that brought the FWPP arrangement to the attention of the media, unhappy shareholders, and finally the SEC. McClendon's biggest personal lender is EIG Global Energy Partners who is also a financier to Chesapeake. That raises the inevitable question of conflict of interest. Were McClendon’s loans part of a quid pro quo for favorable terms for EIG that were not in the best interest of CHK shareholders? Some analysts believe EIG and their investors were in a position insisting on sweeter terms dealing with Chesapeake as part of a package that included loans to the CEO.

From EIG’s website:

EIG Global Energy Partners has a singular focus on being the preeminent provider of institutional capital to the energy sector globally.

We see ourselves as the consummate niche investor. We only invest in energy projects, companies, and related infrastructure. Within these sectors there is very little we haven't seen or done. Since 1982, with $11 billion deployed in over 260 energy projects and companies around the globe, EIG has demonstrated its commitment to the energy industry throughout the peaks and troughs of business and commodity cycles.

As recently as November 2011, EIG and its limited partners were buying $1.25 billion in preferred shares from Chesapeake to monetize Utica shale projects. The yield was a generous 7% and had a repurchase value of 10% IRR or a return of 1.4X on the initial investment. The last preferreds I bought yielded 4% and promised me the capital back—maybe.

This is not a particularly favorable arrangement for CHK shareholders.

Reuter’s reported that McClendon received a total of over $1 billion loan from an affiliate of EIG Global Energy Partners. Reuters reported that Energy Fund XV (an EIG fund) loaned McClendon $500 million and Energy Fund XIV loaned him $375 million. The investments in McClendon were pitched to EIG fund holders as a way to profit from the wells.

As we can see, there are no profits from the wells—at least on paper. It might not be the great investment shareholders in the funds were led to believe. If McClendon’s stake is running in the red, there is a good chance the other 97.5% is not profitable either.

Answering the call for more transparency, there was a supplemental disclosure from McClendon outlining the founder affiliates he uses to manage his FWPP holdings, the value of those holdings, and the loan amounts.

His filing admits to a total loan value of $846 million and not the $1 billion that has been quoted in the press. It would be fortunate if the loan amount is not in the billions of dollars since the assets backing these loans are only valued at $852 million and to get a value that high, the non-standard PV 9 calculation was used. The PV 9 used by McClendon includes proved developed/undeveloped, probable and leasehold that the PV 10 SEC approved measure does not.

If the standard PV 10 is used the value drops to $410 million. Does this make EIG a bit nervous about the expected profits on those wells?

Founder Loan Principal Proved Average Daily PV9 SEC PV10
date reserves production
Arcadia Aug. 1993 $181mm 239 bcfe 35 mmcfe $23mm $117mm
Larchmont Dec. 2008 $375mm 433 bcfe 87 mmcfe $422mm $217mm
Jamestown June 2010 $291mm 138 bcfe 25 mmcfe $196mm $76mm
Totals $846 mm 810 bcfe 147 mmcfe $852mm $410mm

What may be keeping investors up at night with this short fall in collateral is a nasty flashback to 2008 when the board hastily renegotiated McClendon’s contract in order to bail him out of a margin call. That involved a $75 million signing “bonus” to be used to pay the partner well expenses. Otherwise he would not have made it. The board also bought $12 million worth of antique maps one could argue the company might do without all in order to get McClendon out of his highly leveraged tight spot. If it happens again, it could cost considerably more and his assets won’t cover it.
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the PV 9 does not include leaseholds and probable. It does include proved UD
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I would never invest in CHK with the current BOD and mgt. The contrast between CHK and Apache (a true class act) just becomes more and more glaring over time.

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Wonderful post! The true value of these assets are obscured by Aubrey's misadventure. It is time they let this CEO go and bring someone who can run the ship without all this "rocking".

What is the true value of CHK's assets? That's for much smarter brains than me. But it would be a good to take a stab at it, as I suspect we may be presented some interesting buying opportunities in the coming weeks.
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Good post, KitKat.

I agree entirely.

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What is the true value of CHK's assets? That's for much smarter brains than me. But it would be a good to take a stab at it,

Easier said than done IMO. Having followed CHK for several years I think is is fair to say that it is nearly universally accepted that CHK's assets are worth more than the share price would indicate.

The how much arguments that I have seen pretty much fall into 3 distinct groups and none to date answer a question that I think may be the most important of all at this point.

The first is what I call the Aubrey says so argument where all you do is go download the most recent investor presentation and place your trust in Aubrey. (Good luck with that)

The 2nd attempt that I have observed is to calculate what CHK's individual plays might be worth based on past monetizations by CHK or by similar properties in the area where CHK has assets. Although this looks to be a little more grown up approach, I have yet to see anyone adjust for the fact that in many cases CHK's previous partners paid prices, that based on what we know now, were simply too high i.e. there is a snow balls chance in hell that something like CHK's Barnette assets would fetch anywhere near what CHK was able to get for them in the past.

The final group comes from the bear camp which from what I can tell is willing to concede the assets have plenty of value but due to the well deserved distrust of Aubrey (Never does anything he says he will do) & the balance sheet problem believe the value will never be unlocked.

Even if you assume the latest brouhaha might change Aubrey's behavior there remains a very large unknown when it comes to placing a value on CHK. What is he going to sell and for how much? If you are willing to trust Aubrey than according to him the plan is to sell assets to cover funding shortfalls while the company makes the transition to being a more balanced producer. (Get oilier) Both certainly make a lot of sense until you realize that the most frequently discussed asset sale are either the Permian and or Mississippian assets which are the very type of proven assets CHK needs to keep if they want to get oily quickly. This IMO is all of the evidence you need to realize that the biggest problem that CHK would experience by selling the gas assets is that CHK would be forced to admit how little value the gas assets currently have.

For me this leaves CHK and any potential CHK investors in a bit of a Catch 22 situation where to sell ng assets would help the balance sheet issue and allow them to get oilier quicker but the downside would be any reassessment investors would make on the remaining ng assets current value. Selling oil assets on the other hand will raise more money in the short term but will limit their ability to cope with low ng prices if they persist.

I've been a Aubrey critic for so long that perhaps I've lost all perspective, but IMO if in fact he ends up raising funds by disposing of his arguably most valuable assets (In part because the value is well understood) while hanging on to established ng plays and the Utica then IMO what you are seeing is Aubrey once again making a leverage bet based on his hunches of how things will work out.

In other words same ol', same ol'.

Just my 2 cents and for CHK investors sake I'd love for Aubrey to prove me wrong.

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Man the Aubrey's been dethroned party didn't last long. A crappy quarter with a crappier outlook.

It ought to be one of the better CCs you will likely get to listen to this year. :<)

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