Chesapeake (CHK): Is this really a long?

Chesapeake is an oil & gas stock that has been owned by many notable value investors (Mason Hawkins, Lou Simpson) and has often been written up as a long on VIC more than once.  In my cynical opinion, Chesapeake is an example of a stock where supposedly sophisticated investors have been continually fooled by management.  Since its IPO in 1983, Chesapeake has done a very poor job at value creation and generating GAAP earnings.  However, book value per share has gone up dramatically since Chesapeake has been continually selling shares at higher and higher prices.

Perhaps shareholders will realize that they aren’t going to make money and should stop buying stock through secondary offerings (and convertible debt).  However, I don’t think that Chesapeake is a compelling short as the company is not the worst company in the E&P space.

Accounting at Chesapeake

Accounting basics

The assets underlying the business are (potential and actual) oil & gas wells.  These wells typically require a large capital payment upfront for the land rights, test wells to figure out the best way to extract oil/gas, and wells on the rest of the land that is economic.  After a commercial well is built, there will be very strong production in the first year followed by declines in production.  Shale wells tend to decline at a much higher rate than other wells.  To some degree, the actual decline curves aren’t that certain due to differences in geology, advancements in technology (which leads to different extraction techniques being used), and the lack of experience with shale technology.  The oldest shale wells are only several years old.  Some companies believe that they will continue to produce for decades (e.g. four to six decades).

I believe that valuing these assets is extremely difficult.  The right way to value these assets is to build a discounted cash flow model (this is the method used by reserve engineers).  However, oil and gas companies almost never provide the data necessary to build these models.  For example, companies could publish decline rates and decline curves on a field by field basis.

What makes these assets even more difficult to evaluate are the continued improvements in technology and understanding of shale basins.  The industry has been shifting towards more fracturing stages, longer laterals, and more wells per drill pad.  This has generally improved well economics.  It is hard to predict what impact technology will have on future undrilled wells.  I don’t think that I’m any good at valuing these assets and will need a very large margin of safety to be comfortable with oil and gas stocks.

Oil and gas accounting doesn’t make a lot of sense

Oil and gas companies can use the “full cost” accounting method or the overly conservative “successful efforts” method.  The full cost method could come close to ensuring that the book value of an oil and gas asset reasonably matches the economic value of that asset.  Unfortunately, there are many ways to abuse full cost accounting and to therefore inflate profits.  The SEC has tried to curb abuse by introducing something called the “ceiling test”.  Unfortunately, the ceiling test makes things more complicated and in my opinion isn’t particularly helpful to investors.

You’re better off ignoring the book value of oil and gas assets and doing your own valuation work by estimating their market value.

Full cost accounting

Chesapeake uses “full cost” accounting, where all of the costs associated with developing wells are capitalized.  This method is more aggressive than the “successful efforts” method, where all costs are expensed until a particular reservoir is proven to be economic.

Capitalized interest (overly aggressive)

Chesapeake capitalizes almost all of its interest costs.  Most of these costs are capitalized into undeveloped properties.  This is a serious accounting distortion as capitalized interest does not make money.  The private market value of capitalized interest is zero.  As of YE2012, Chesapeake has $1,922M in capitalized interest.  This amount should be deducted from Chesapeake’s book value and retained earnings.

Over the years, Chesapeake’s accounting has been getting more aggressive as it has been capitalizing a greater portion of its interest costs.  They seem to have dropped slightly with the new CEO.

Capitalized internal costs (likely aggressive)

From the YE2012 10-K:

Chesapeake follows the full cost method of accounting under which all costs associated with natural gas and oil property acquisition, divestiture, drilling and completion activities are capitalized. We capitalize internal costs that can be directly identified with our acquisition, divestiture, drilling and completion activities and do not include any costs related to production, general corporate overhead or similar activities. In addition, we capitalize internal costs that can be identified with the construction of certain of our property, plant and equipment. We capitalized $434 million, $432 million and $378 million of internal costs in 2012, 2011 and 2010, respectively, directly related to our natural gas and oil property acquisition, divestiture, drilling and completion efforts and the construction of our property, plant and equipment.

There are corporate G&A costs that are needed to find land for oil and gas production.  Oil and gas companies need a head office with engineers, accountants, and lawyers.  When an oil/gas well is not yet producing, it would be reasonable to capitalize the G&A costs spent to develop that well.  When the oil/gas well is producing, it would be reasonable to expense the G&A costs needed to keep the well running.  GAAP profits can be improperly inflated by capitalizing costs that should really be expensed.  I can’t be sure about what’s happening at Chesapeake and don’t know if that is the case.  However, their G&A costs are pretty high and the overall amount seems excessive relative to the amount of G&A costs that one would need to bring the properties to production.

Ceiling test (ridiculously complicated)

If the full cost method is used, oil and gas companies have to jump through a ridiculous accounting exercise called the ceiling test.  The book value of its oil and gas assets can’t exceed the discounted future cash flow of the assets.  When natural gas prices drop, the discounted cash flow (DCF) of the assets will go down.  As natural gas prices have fallen in the past few years, many companies have had to write down the book value of their oil and gas assets.

One of the inherent problems is that DCF depends on a large number of factors that are easy to manipulate (e.g. reserve estimates, tax estimates, etc.).  If Chesapeake is being aggressive in its DCF assumptions, then it may be taking less impairments than required.  This could cause book value to be much higher than market values.

There is also a disconnect between book value and market prices due to the discount rate used.  For ceiling tests, often a discount rate of 10% is used.  Private buyers of oil and gas assets have almost always used discount rates less than 10%.  This could cause book value to be much lower than market values.

In practice, you should probably just ignore the book value of oil and gas assets and do your own valuation work.

Proved Developed Non-Producing Reserves (aggressive)

PDNPs refer to reserves that require a workover of the well or some kind of stimulation technique to recover.  For shale gas wells, one of the recovery techniques that is promising is to refracture the well.  Doing so will likely increase the ultimate recovery of oil and gas.  That extra amount of oil and gas are considered PDNPs.  Companies may also have PDNPs if a well has been drilled but not yet connected to a pipeline, or if the well has been shut down temporarily.  Chesapeake’s PDNPs are primarily from producing wells (sometimes referred to as “behind pipe”).

I believe that refracturing is currently poorly understood because it only makes economic sense to apply it to old wells.  Because shale technology is so new, there simply aren’t a lot of old wells around.  In the newest fields, there aren’t any old wells around.  I think that it is very aggressive to assume that refracturing (or other stimulation techniques) will turn out to be economic.  However, I am not a recovery engineer.

Chesapeake actually started booking PDNPs as far back as the YE2005 10-K:

Of our proved developed reserves, 555 bcfe are non-producing, which are primarily “behind pipe” zones in producing wells.  [11.3% of proved developed reserves by bcfe.]

Ever since, they have been booking PDNPs.  From the YE2012 10-K.

Of our 8.9 tcfe of proved developed reserves as of December 31, 2012, 1.2 tcfe were non-producing.  [13.4% of proved developed reserves by bcfe.]

Other similar E&P companies with lots of shale exposure book far fewer PDNPs than Chesapeake does:

Southwestern (technical report summary):  1.73% of proved developed reserves (by revenue) are PDNPs
Ultra Petroleum (technical report summary):  6.66% of proved developed reserves (by revenue) are PDNPs

This suggests to me that Chesapeake’s reserve estimation has been very aggressive.

Decline rate assumptions

Chesapeake’s decline rate assumptions have been changing over the years.  From the YE2005 10-K:

Our annual decline rate on producing properties is projected to be 24% from 2006 to 2007, 16% from 2007 to 2008, 13% from 2008 to 2009, 11% from 2009 to 2010 and 10% from 2010 to 2011.

From the YE2012 10-K:

Our annual net decline rate on producing properties is projected to be 33% from 2013 to 2014, 22% from 2014 to 2015, 17% from 2015 to 2016, 14% from 2016 to 2017 and 12% from 2017 to 2018.

I see two possible explanations:

1. The nature of Chesapeake’s wells have been changing due to the increase of shale wells (and to a lesser degree due to changes in technology).
2. If the underlying wells’ characteristics have been exactly the same over the years, then the decline rate assumptions have been getting more conservative.  This is because higher decline rates will reduce well economics.

Because I am not a reserve engineer, I don’t know if Chesapeake’s reserve assumptions have been getting more or less aggressive.

Hidden liabilities

Founder Well Participation Program (FWPP)

Chesapeake has a rather egregious insider perk called the FWPP.  Chesapeake’s founders (Aubrey McClendon and Tom Ward) are allowed to participate “alongside” Chesapeake by investing in every well that Chesapeake drills in that particular year.  Transparency regarding this program has been rather low.  The profitability of the FWPP depends on certain accounting assumptions.  How much corporate G&A is applied to each well in the FWPP?  I couldn’t find this information in the 10-K and DEF 14A.

Given that McClendon has spent over a billion dollars on the FWPP (he spent $1,531M from 2008 to 2012), it is surprising that the FWPP barely shows up on the 10-K.  The DEF 14A is extremely light on details regarding the accounting behind the FWPP.

Some have argued that the FWPP has been an incredibly good deal for McClendon since he has been able to obtain non-recourse loans for his full investment in the FWPP.  The argument is that McClendon has been secretly getting a free ride from Chesapeake shareholders.  One lawsuit points out:

Unbeknownst to Class members, starting in 2009, McClendon leveraged all of his FWPP interests in order to pay for their costs. He not only secured non-recourse loans on his ownership interests in the wells, but also secured personal loans in excess of $500 million from EIG Global Energy Partners, a hedge fund that engaged in financing transactions with Chesapeake.

In any case, Chesapeake’s SEC filings are sorely lacking in detail.

Lawsuits

Chesapeake faces various lawsuits for underpaying royalties.  For example, the municipality of Fort Worth is suing the company over underpaid royalties.  The 10-K suggests that Chesapeake may have been in the wrong in some of these cases as it has been paying settlements regarding these lawsuits.

With regard to contract actions, various mineral or leasehold owners have filed lawsuits against us seeking specific performance to require us to acquire their natural gas and oil interests and pay acreage bonus payments, damages based on breach of contract and/or, in certain cases, punitive damages based on alleged fraud. The Company has successfully defended a number of these cases in various courts, has settled others and believes that it has substantial defenses to the claims made in those pending at the trial court and on appeal.

And of course, Chesapeake has been sued by its shareholders many times.

Midstream deals with NYSE:ACMP

Chesapeake recorded a large gain from the IPO of its midstream assets.  ACMP stock continues to go up.  I haven’t looked into this very closely but Chesapeake may be contractually locked into paying inflated rates to ACMP.  This would amount to a hidden liability that isn’t found on Chesapeake’s balance sheet.  Mistream agreements extend to 2099.

*This one I’m not sure about especially because I don’t understand the industry that well and haven’t done the work.

What are Chesapeake’s assets worth?

I don’t know.  This task probably falls into the “too hard” pile.

However, if Chesapeake had valuable assets, it would likely have very strong cash flow.  Its cash from operations should exceed its cash from investing activities.  For most of the past decade, the opposite has been true.  Instead of acting like a See’s Candies that is throwing off huge gobs of cash, Chesapeake has been gobbling up cash year after year after year.  Part of this is because Chesapeake has been rapidly growing production.  But I also think that production has been growing simply due to advances in technology.  It seems that Chesapeake’s assets do not have very strong cash flow.  This suggests to me that the assets aren’t as wonderful as other people claim them to be.

Has Chesapeake made money?

At YE2012, Chesapeake had roughly $15,362M in paid-in capital and $437M in retained earnings.  Since inception it has returned over $2B in dividends in share repurchases.  If you feel like Chesapeake’s GAAP earnings are distorted, you could make adjustments for capitalized interest, capitalized internal costs, the market value of its oil and gas assets, and hidden liabilities.  Regardless, roughly $3B in GAAP profits from a capital base of around $15B is not that impressive.  I believe that Chesapeake has not made or lost much money for shareholders since its IPO in 1983.  The picture is somewhat complicated since Chesapeake raised most of its shareholder capital in the later years until natural gas dropped significantly in 2008.  But even if you take that into account, the return on shareholder capital has been mediocre at best.

Integrity of insiders and the cult of Aubrey McClendon

Oh boy.

McClendon has lived a high-flying lifestyle funded partly by Chesapeake.  The directors of the company also seem to have participated in this lifestyle.  The CEO and directors of the company fly around on private planes operated by Netjets.  Business use of this plane does not show up under insider compensation.  Personal use of company aircraft does show up as other compensation in the DEF 14A filing.  McClendon was not obligated to compensate the company for personal use of company aircraft (though he has “voluntarily” done so).

While McClendon has supposedly left Chesapeake, the company will still pay for his use of company aircraft until December 2016.

Pursuant to the Separation Agreement, no later than April 19, 2013, the Company will also transfer (in a manner that affords the full right to use, but not the ownership of) a 28.125% interest in a Citation X aircraft to an entity controlled by Mr. McClendon until December 31, 2016, and during this period will pay all costs, fees and expenses associated with such interest (other than special catering and ground transportation), in fulfillment of the Company’s obligations under Mr. McClendon’s employment agreement requiring him to use Company aircraft through the expiration of the employment agreement. In addition, he will continue to receive certain designated benefits from the Company through June 30, 2014 and will then receive a lump sum payment of $26,320 in exchange for termination of any remaining benefit continuation.

I’m not sure what “special catering” in the paragraph above means.  I presume that it refers to catering that is far more expensive than that offered by Netjets.  In the past, the company has paid hundreds of thousands of dollars to a restaurant owned by McClendon for catering services (this Reuters article has a long laundry list of McClendon’s excesses, which includes sponsoring Olympic hopefuls).

Insider compensation via free private plane use has been understated

The company does not consider the fixed costs of the Netjets planes to be part of insider compensation, even if the planes were used for personal purposes.

Antique maps

When McClendon ran into financial difficulty, the board of directors decided that it was ok for the company to purchase $12M in antique maps from McClendon to display in corporate headquarters.  Later on, shareholders sued the company.  As part of the settlement, it was agreed that the sale should be reversed.  (However, some shareholders have appealed the settlement so this matter is still tied up in courts.)

The board of directors clearly have not lived up to their fiduciary duty to shareholders.  In the same year, McClendon also received a very large bonus from the company despite the company’s terrible performance that year.

McClendon’s sports team

Chesapeake pays millions of dollars to McClendon’s sport team (the Oklahoma City Thunder).  I have no idea what the business rationale for this expense is because watching and sponsoring sports has little to do with extracting hydrocarbons economically.  The hydrocarbons in the ground don’t give a damn about Chesapeake’s brand.

From the YE2012 10-K:

In 2011, Chesapeake entered into a license and naming rights agreement with The Professional Basketball Club, LLC (PBC) for the arena in downtown Oklahoma City. PBC is the owner of the Oklahoma City Thunder basketball team, a National Basketball Association franchise and the arena’s primary tenant. Mr. McClendon has a 19.2% equity interest in PBC. Under the terms of the agreement, Chesapeake has committed to pay fees ranging from $3 million to $4 million per year through 2023 for the arena naming rights and other associated benefits. In addition, since 2008, Chesapeake has been a founding sponsor of the Oklahoma City Thunder, initially under successive one-year contracts. In 2011, it entered into a 12-year sponsorship agreement, committing to pay an average annual fee of $3 million for advertising, use of an arena suite and other benefits. Chesapeake also has committed to purchase tickets to all 2012-2013 home games. In 2012 and 2011, the Company paid PBC approximately $7 million and $6 million, respectively, for naming rights fees, sponsorship fees and game tickets, and for 2013, the amount payable for such 2012-2013 season fees and tickets is approximately $3 million, not including any amounts for playoff tickets.

Founder Well Participation Program (FWPP)

As discussed previously in this post, the business rationale for the FWPP doesn’t make a lot of sense.  I find it interesting that McClendon is still entitled to participate in the FWPP even after he has left the company.  While the FWPP will terminate 18 months early, it is still around even after McClendon has left.  This goes against the stated intent of the FWPP, which is to align management’s incentives with shareholders.  Why is this plan available to McClendon even though he is no longer managing Chesapeake???

Transparency has been extremely low and the various excuses in support of the plan seem rather flimsy.

Lou Simpson

Lou Simpson used to be one of Warren Buffett’s lieutenants and formerly managed GEICO’s investment portfolio.  He joined Chesapeake’s board of directors and personally purchased a few million dollars worth of shares.  Later on, he left Chesapeake’s board.

I’m not familiar with his actions as a director but it seems like he participated in all of the waste going on at Chesapeake.  While at Chesapeake, he flew on Chesapeake’s aircraft for personal purposes (as mentioned in the DEF 14A filing).

Southeastern Asset Management / Mason Hawkins

Mason Hawkins must have believed in Aubrey McClendon because SAM has been a major owner of Chesapeake shares since the first quarter of 2006.

In general, I am skeptical about well-regarded value investors.  It’s hard to tell how much of their performance has been from luck and how much from skill.

Does Chesapeake make good business decisions?

The lavish spending certainly doesn’t make sense.  Apparently Chesapeake had its own meteorologist, caterers, gym, and other perks at its corporate headquarters.  The compensation of key executives has been extremely high (typically several million dollars).  G&A as a percentage of revenue is very high especially if you include capitalized G&A.

In general, the related party transactions haven’t made sense.

Chesapeake’s hedging program was pretty stupid as the company bought knockout swaps under McClendon.  I don’t believe that the risks of knockout swaps were properly disclosed until the company was burned by them.

The various lawsuits against Chesapeake are probably the result of bad business decisions (though I suppose you can make an argument in favour of ruthlessness).

Matching employee’s 401k contributions with Chesapeake shares (bought on the open market) seems like a completely reckless and irresponsible investment strategy for retirement.  There is currently a lawsuit over this.  This seems like Chesapeake is trying to inflate its stock so that it can continue to sell stock at high prices, to the detriment of its employees.

The new CEO (Doug Lawler, who used to work for Anadarko) has come into the company and seems to have slashed many of McClendon’s excesses.  Many employees have been fired (the chaplains, beekeepers, the meteorologist, etc.), G&A costs have gone down, and the company is currently in the process of selling real estate.  The company owns random real estate as McClendon had real estate development ambitions and wanted to make Oklahoma classier.

Good things I can say about Chesapeake

So far this post has been pretty one-sided.  It’s mainly because I haven’t found much about the company that I like.  But I will say this about Chesapeake.  It is still a lot better than many of the other oil and gas companies out there.

Currently, some short sellers have piled into Chesapeake as 12% of the float is sold short.  The put options are also kind of cheap right now.  However, I don’t think that Chesapeake is that compelling of a short given that there are much worse E&Ps around.  See my previous posts on companies like MILL and ATPG.

*Disclosure:  No position.
EDIT:  As of Nov. 5, I owned put options.  See my newer posts on CHK.