Energy's Most Controversial Player Still Faces Huge Challenges

Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Aubrey McClendon, the founder of Chesapeake (NYSE: CHK) and it's only CEO since the company's  inception, has been accused of treating the company as his personal bank despite owning just a fraction of 1% of the outstanding shares. There have been serious issues regarding corporate governance because he has exercised a disproportionate influence on the running of the company. Below, I will examine the impact of his departure on the company's future and its impact on the company as an investment.

The Departure 

Chesapeake's controversial CEO announced his departure recently, and the stock immediately gained more than 6% in response. He has been under pressure since allegations surfaced that he used his position in the company to further his personal interests, and he is currently being investigated by the board as well as regulators.

The ostensible reason for the departure was attributed to “philosophical” differences with the board.  Oil industry experts hold McClendon in high regard for his expertise in acquiring one of the great portfolios of natural gas assets in the world, making Chesapeake second only to ExxonMobil. However, under his reign Chesapeake has had negative cash flow for every single year. The implication is that even though the company may be showing positive earnings, capital expenditures for lease acquisitions and drilling exceed the net income and, as a result, the company has found itself neck deep in debt.

In the most recent quarter the company had $16 billion in debt, which is a heavy burden for a company with a market capitalization of less than $14 billion. In 2012, to finance the funding gap, Chesapeake was compelled to sell $11 billion in assets during the year. With the continuing depressed state of natural gas prices, the company has been tardy in moving its focus away from natural gas to much higher priced and more lucrative liquids. At current prices, it does not make commercial sense to drill for gas in a substantial part of the company's acreage.

McClendon was removed as chairman last June and the board was reconstituted to accommodate representatives of the largest shareholders. In 2008 he was forced to sell almost all of his significant position of 33 million shares to meet a margin call, and his ownership, which was briefly worth $2.2 billion, is now worth about $35 million.

The large stakeholders are Southeastern Asset Management and Carl Icahn, who together control nearly 25% of the company's outstanding shares. They are looking to enhance shareholder value rather than profit for themselves.  Speculation has surfaced that the last nail in the coffin was differences over reduction in corporate overhead and capital expenditure on drilling to conserve cash resources.

Chesapeake's Future

There is no doubt that McClendon guided the company to become the second largest natural gas producer in the U.S. with the use of state-of-the-art fracking technology, which was successfully used in tapping the large natural gas reserves trapped in shale rocks. However, his injudicious spending and appetite for risk did not sit well with shareholders.

During his reign, the firm built up some of the largest natural gas assets in North America, as well as the infrastructure required to exploit them. The price the company paid was capital expenditures in excess of cash, and as of Sept. 30, 2012 the firm’s long term debt was around $16 billion, while cash and cash equivalents were less than $300 million.

I think that McClendon’s departure will help remove some of the market's suspicion about corporate governance practices and bring much greater transparency to the company's business practices. Fortunately, it appears that U.S. gas prices have bottomed out and demand is growing as power plants switch to gas from coal. However, a proper recovery will depend on successful asset sales and debt reduction, as well as an improvement in the cash position.  The new management will have to focus on the improvement of operation efficiency, the control of capital expenditures, and acceleration of the asset monetization process.

Peers

Another company that has major corporate governance issues is SandRidge Energy (NYSE: SD). The comopany's problems have been compounded because it is giving its chief executive Tom Ward a long rope to benefit from personal oil-and-gas deals, which could result in potential conflicts of interest with the company.  SandRidge has removed most restrictions on Ward’s ability to sell mineral rights or drill wells through amendments to his employment agreement. Before founding SandRidge in 2006, not surprisingly, he co-founded Chesapeake with Aubrey McClendon. At both companies, the CEOs have mingled personal finances with the finances of the publicly traded corporations that they run. It is extremely unusual for a company to allow an executive to act for personal gain because of the risk of conflict of interest. 

Like Chesapeake, SandRidge has been standing on shaky ground lately. The company recently responded to allegations of running a false and misleading investor campaign. SandRidge responded to several negative highlights from TPG-Axon regarding its financial performance. One red flag that was raised by TPG-Axon was that SandRidge's stock price has fallen 80% since the company's IPO. SandRidge returned fire, saying it has "exceeded analyst estimates for earnings before interest, taxes, depreciation and amortization for each of the past five quarters." Investors should use caution when considering an investment in SandRidge. 

Unlike Chesapeake, and long before the competition woke up, EOG Resources (NYSE: EOG) felt that unconventional, horizontal drilling could be successfully used in the oil production and proceeded to realign its acreage. With the decline in natural gas prices, the company's willingness to go against the trend is paying off handsomely. While its peers were trying to establish footholds in the competitive North American gas market, EOG concentrated on oil shale and built acreage in the Bakken and Eagle Ford, which are now among the largest in the industry.

EOG Resouces has been seeing al ot of positive coverage from the media lately. EOG Resources was recently ranked as one of the top five workplaces nationally by WorkPlaceDynamics. But awards aside, EOG and other drillers saw production in Texas’s Eagle Ford shale formation jumped 68 percent year-over-year in December 2012. EOG currently holds 644,000 net acres in Eagle Ford, and remains the largest leaseholder there. Chesapeake is the second largest leaseholder, with 490,000 acres. EOG is currently one of the best plays in oil and gas. 

Investment Opportunity

Chesapeake may look cheap because of the considerable discount to the underlying asset value in the current market price. Some of the increase in the stock price since news of McClendon’s departure became public can be traced to investor relief, but almost certainly part of it is because of speculation that Chesapeake is now in play and the entire company is on the auction block.  However, for investors the celebration will be short-lived.

Chesapeake still has to sell billions of dollars worth of assets in 2013, and it remains to be seen whether or not it can achieve satisfactory values for them.  Moreover, it's exposure to natural gas prices is largely unhedged, so any future decline could negatively affect cash flows, revenues, and profits. Unfortunately, McClendon’s departure doesn’t change the fundamental problems with which Chesapeake must now deal. Chesapeake is a high risk investment at the moment.

Conclusion

I don't recommend buying Chesapeake until there is further evidence that the company is dealing with its problems. However, given the considerable underlying asset value, current shareholders should continue to hold.


jordobivona has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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