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Reuters Special Report: Inside Chesapeake, CEO ran $200 million hedge fund

Chesapeake CEO Aubrey McClendon for at least four years ran a hedge fund that traded in the same commodities his company produces.
BY JOSHUA SCHNEYER, JEANINE PREZIOSO AND DAVID SHEPPARD Modified: May 2, 2012 at 8:20 pm •  Published: May 2, 2012
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That committee has helped Chesapeake “lock in” high prices for the gas it sells. This year, the company has not hedged. It told investors in a presentation that it doesn't expect natural gas prices — near 10-year lows — to continue falling.

The company's own trading has been a big success. “The bottom line is that Chesapeake has delivered $8.4 billion in realized hedging gains to shareholders since 2006,” said Kehs, the company spokesman. “That's extraordinary shareholder value added through innovation and by far the best record in the oil and gas industry.”

After Reuters disclosed McClendon's $1.1 billion in loans, Standard & Poor's cut Chesapeake's debt rating, citing “shortcomings” in corporate governance. The SEC and the Internal Revenue Service have begun probes in the wake of the loans report.

Chesapeake shares rose more than 7 percent on Tuesday on the news that McClendon is being replaced as chairman. After the stock market closed, the company reported a first-quarter net loss of $71 million. Its shares fell 5 percent in after-hours trading and are down almost 20 percent this year.


A search of Chesapeake's public filings turned up no disclosure of McClendon's hedge fund, Heritage.

Reuters traced its roots to Delaware, where it was registered in 2004 by Corporation Trust Company, a firm that helps companies incorporate. Another filing in New York, where Heritage employees executed many of the fund's trades, lists its mailing address as Chesapeake headquarters in Oklahoma.

A Heritage telephone number listed in several business directories was answered “Chesapeake Energy” by a person who said she hadn't heard of the fund. The fund is also listed in a database compiled by the National Futures Association, which doesn't disclose its owners.

Heritage also shared at least one employee with Chesapeake: John D. Garrison. Garrison, an accountant listed as executive business manager for Chesapeake Energy in federal election campaign donation filings and as a Chesapeake employee since 2004, handled the hedge fund's bookkeeping, Cirino said. The arrangement is not illegal.

Business directories including Dun & Bradstreet also list Garrison as Heritage's chief financial officer. Garrison declined to comment when a reporter visited his home near Oklahoma City.

Heritage was born when commodity trader Cirino and four other traders went searching for capital to start a hedge fund, Cirino said. Through industry contacts, they landed a coveted audience with McClendon and Ward, already famed Oklahoma drillers before becoming pioneers of the shale-gas boom.

The Chesapeake founders, Cirino recalled, agreed to seed the fund with a total of $40 million of their own cash. But McClendon and Ward insisted on full ownership and involvement in the fund's trading strategy, Cirino said.

“They took a leap of faith to invest money in us, so we knew we were on the line,” said Cirino, Heritage's former head trader and risk officer. “That they were in charge was made very clear.”

The fund's trading wasn't limited to energy markets. It bet on a variety of goods, from natural gas to cocoa and coffee. It even had a cattle trader in Oklahoma.

As Heritage racked up stellar returns of between 15 to 25 percent a year, McClendon and Ward decided to open the hedge fund to outside investors, including friends and associates, Cirino said. When Ward left Chesapeake in 2006, he retained his stake in the fund.

By 2007, Heritage was managing around $200 million, Cirino said. That enabled Ward and McClendon to profit in another way: by charging outside investors a management fee equal to 2 percent of assets and pocketing 20 percent of the fund's profits. It's a typical structure in the hedge fund industry, known as “2 and 20.”

Cirino and Ward's recollections differ on at least one point. Ward said he didn't interact with the fund's outside investors. Cirino recalled that “every investor I was involved with either met with McClendon and Ward or at least spoke with them by phone before investing.” The hedge fund's healthy gains were a lure, but “the cachet of those two individuals certainly also helped,” Cirino said.

In addition to weekly Monday conference calls and regular emails, the two owners met frequently with traders in New York and occasionally in Oklahoma, Cirino said.

In 2007, as the price of natural resources surged on booming demand from China and other fast-developing countries, commodity traders with a successful track record were popular on Wall Street. After three years of double-digit returns, the fund's traders told McClendon and Ward they wanted an equity stake, Cirino said.

But the executives weren't ready to cede control, Cirino said, and the traders left to open their own shop, Perennial Capital LLC, a $200 million fund that has no financial ties to McClendon or Ward. Cirino said the departure was amicable.

At Heritage, all of the money from external investors was returned by 2008, Cirino said. McClendon and Ward continued to operate the fund during that year, Ward said, but by 2009, Heritage traded no more.

What happened next to McClendon's commodity-trading ventures is unclear.

By June 2008 — as natural gas and oil prices were peaking, and just before the financial crisis — McClendon and Ward both held huge positions in natural-gas derivatives, according to confidential trading data disclosed last year by U.S. Senator Bernie Sanders, an independent from Vermont.

The trading information was assembled as part of a CFTC inquiry into derivatives markets and their impact on real-world energy prices. McClendon and Ward were among only a handful of individual investors identified by the CFTC. Most of the other players were big corporations.

The data indicated McClendon and Ward were betting that the rally of 2008 would continue. By purchasing derivatives, they controlled nearly identical positions in natural gas worth around $2.3 billion apiece, according to Reuters calculations based on closing futures prices as of June 30, 2008. McClendon held oil contracts worth another $240 million, the CFTC data showed.

Of 300 banks, hedge funds, energy companies and other traders identified in the CFTC survey, only four held larger bullish bets in natural gas.

Oil fell by more than 75 percent between July and December. Natural gas futures dropped almost 60 percent.

It isn't clear how McClendon and Ward's investments fared. McClendon would not discuss his trading. Ward said he could not recall the outcome of his own trades in 2008.

McClendon suffered a well-documented personal cash crunch later that year, however.

In early 2008 McClendon held a big position in Chesapeake stock purchased with borrowed money. Later that year, margin calls from his brokers forced McClendon to unload more than 90 percent of his Chesapeake shares and suffer a $2 billion paper loss. His selling contributed to an 88 percent fall in Chesapeake's share price from its all-time high of $74 that year. Chesapeake has since restricted “leveraged” trading in the company's shares by its executives.

Months later, McClendon became one of the highest paid CEOs in America for the year, receiving a total compensation package worth $112 million. The payout included a one-time cash bonus of $75 million to help him meet requirements for paying the costs of his personal stakes in Chesapeake-owned wells.

(Additional reporting by Sarah N. Lynch, Brian Grow, Anna Driver and Roberta Rampton. Editing by Blake Morrison and Jonathan Leff.)


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