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Reuters -- Special Report: Chesapeake's deepest well: Wall Street

BY CARRICK MOLLENKAMP Reuters Modified: May 9, 2012 at 10:02 pm •  Published: May 9, 2012
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Far from the drilling rigs of Oklahoma, America's second-largest natural gas producer is having to dig ever deeper into the well that really fueled its growth: Wall Street.

In a Times Square office building, a team tapped by Chesapeake Energy Corp deployed more than 40 bankers, lawyers and other experts to plot another chapter in that strategy.

Dubbed Glenn Pool, it was more financial engineering than petroleum engineering. In essence, Chesapeake sold future rights to the gas in its wells. The deal took in approximately $850 million last year.

Glenn Pool proved so innovative that a trade magazine honored it this March. In an especially creative twist, the borrowings were chopped into two slices and sold to investors — akin to the way subprime housing loans were turned into securities and sold last decade.

Deals like Glenn Pool are known as volumetric production payments, or VPPs. These and other sophisticated financings are central to the business model of a company that in some ways resembles a hedge fund, using borrowed money to make big financial bets.

The financial-engineering strategy began as a way for CEO Aubrey McClendon to expand the company. Now, Chesapeake has become so reliant on deals like Glenn Pool that more such transactions may be necessary just to tread water.

Today, the Oklahoma City company is taking in more money from bankers, other investors and its own financial bets than it is from its oil and gas. Most big energy companies, such as Exxon Mobil Corp, typically earn more selling oil and gas than they spend on investments, financing and other costs, making them cash rich. Chesapeake is expanding so fast that it takes in much less revenue from its oil and gas than it spends, leaving it stretched.

Hence its business depends on deal-making: raise money from investors to acquire land and drill wells; sell the rights to the gas and oil in those wells; plow that money into new land and wells; repeat the cycle all over again.

FUNDING SHORTFALLS

Now, some analysts question whether Chesapeake can keep striking enough deals to sate its cash needs, which are growing acute as natural gas prices languish. The gap between cash coming in and cash going out shows “massive internal funding shortfalls,” according to an April report by Standard & Poor's.

On Wednesday, Moody's Investors Service changed its outlook for Chesapeake's debt to negative from stable, citing “an even-larger capital spending funding gap for 2012,” due both to lower energy prices and higher spending.

Between now and the end of 2013, Chesapeake expects as much as $23.1 billion in costs for outlays such as wells and property, according to the company and analysts. Yet funds from operations over the same period are expected to total as much as $8.3 billion. To cover the gap, Chesapeake plans to raise as much as $20.5 billion from new ventures, including selling future production rights.

“There seems to be little acknowledgement by management or the board that the company faces a major financial crisis,” analysts at International Strategy & Investment Group in New York said in a report May 1.

Chesapeake says it has no trouble keeping itself well-financed.

“Chesapeake has superb assets and a track record of successfully completing large transactions to monetize assets in varying market conditions,” said spokesman Michael Kehs. “We'll let our record speak for itself.”

A Reuters examination of Chesapeake's books, VPP deals by the company and its CEO, and other novel transactions shows the financing is growing increasingly complex and costly — and in some cases is intertwined with the personal finances of the chief executive.

Last week, Reuters reported that McClendon had co-owned and actively traded in a $200 million hedge fund that bought and sold the same commodities produced by Chesapeake.

On Tuesday, Reuters reported that one of Chesapeake's chief financiers, EIG Global Energy Partners, arranged $450 million in personal financing for McClendon in March. That brought to $1.55 billion the total amount of financing McClendon has taken out against his stakes in wells drilled by Chesapeake. Of that amount, $1.33 billion came from EIG — which has also helped line up $2.5 billion for Chesapeake itself since November.

GOVERNANCE CRISIS

The disclosures have embroiled the company in a corporate-governance crisis, prompting the board to strip McClendon of his chairmanship and U.S. regulators to open informal inquiries.

EIG is drawing attention for its central role in financing McClendon's personal borrowings, which he took on to fund a lucrative perk giving him the right to receive stakes in company wells so long as he shoulders his share of the costs.

The coterie of financial engineers is much wider. It includes executives at Jefferies & Co, chiefly Ralph Eads III, a Houston oil banker and McClendon's fraternity brother at Duke University.

The deals are so big that they require major trading partners and financiers, like Barclays PLC, which handled Glenn Pool. Wall Street's biggest banks, including Deutsche Bank AG, Morgan Stanley, and Wells Fargo & Co, stepped in as both trading partners and lenders, according to court documents and company statements.

All told, the financiers have helped Chesapeake raise approximately $40 billion in financing since 2000. They've used their trading desks to hedge bets on gas prices and interest rates, and advised on a host of deals, records show.

Some of the same financiers that have bankrolled Chesapeake's deals also have made personal loans to McClendon, including Goldman Sachs Group Inc. and Wells Fargo, according to filings in Oklahoma. For collateral with Goldman, McClendon put up part of his wine collection. Wells Fargo and Goldman declined to comment.

Chesapeake has strengths that could enable it to ride out the storm. Low interest rates have made its junk bonds popular with investors. What's more, Chesapeake is “asset rich,” S&P said, noting how the company “has been adept at structuring varied and innovative transactions to generate funds.”

With its aggressive financial management, some analysts say, Chesapeake could be making a correct bet that it can reinvest the cash it's raising in higher-yielding assets, such as new wells.

“They know what they are doing,” said John Rittenhouse, chief executive of EDF Trading, a London firm that is one of Chesapeake's largest trading partners. “It is a question of redeploying capital.”

15 MILLION ACRES

Chesapeake's remarkable rise dates to 1989, when McClendon co-founded the company. He dispatched “land men” across America to scout out energy plays, eventually building an empire on 15 million acres of land in 16 states. It's one of the biggest property-buying sprees ever by a public company in the United States, a combined area nearly the size of West Virginia.

As Chesapeake sped its expansion, it needed to raise ever-larger sums to lease land and drill on it. An important tool is the volumetric production payment, or VPP, which it first used in 2007.

The deals allow Chesapeake to sell to trading partners future natural gas and oil production in exchange for upfront cash. Rivals have used VPPs, but Chesapeake has tapped them much more.

Reuters tallied 10 VPP deals by Chesapeake and two by McClendon. Chesapeake's use of VPPs has grown as rivals have moved away from them. The problem, analysts say, is that a company gives up future cash from a well. They also are a relatively expensive source of capital.

“It is rare for (exploration and production companies) to use VPPs as financing vehicles, especially in recent years,” said Joseph Allman, a J.P. Morgan Chase & Co analyst who follows Chesapeake.

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