Years ago (2011), I became fascinated with an article in Forbes; ‘In His Own Words: Chesapeake’s Aubrey McClendon Answers Our 25 Questions’. It evangelized not only the company that McClendon built but also the goodwill the industry was doing for the American people. The man knew how to talk a book! I encourage you to read it. Let’s look at a few particularly captivating quotes from McClendon (underlines are mine):
On land acquisition:
“I learned along the way that most of my fellow E&P CEOs were not landman, they were geologists and engineers. And when the game changed in the past five to seven years, and land acquisition became the key to capturing the greatest values from the unconventional plays, I felt like I had a natural advantage over most of them because I understood how to put together a very formidable Chesapeake land machine to “capture the flag” in big plays.”
On the option value of land:
“When we put our land position together in that play, we spent roughly $1.2 billion to buy about 600,000 acres of land, giving us an average cost basis of about $2,000 per acre, or roughly $0.40 per barrel of oil equivalent. I ask you, could you go to Wall Street and buy an option to develop 3 billion barrels of oil equivalent at a cost of $10-$15 per barrel for a call option cost of only $0.40 a barrel?”
“… we intend to drill all of the high-graded acreage that we own and will also always be on the lookout for new plays…. we’re also quite adept at selling down our new big leasehold blocks to bring in partners and we’re quite successful at selling mature plays as well…. In addition, please remember that we just sold in a very low gas price environment, our interest in the Fayetteville Shale for an approximate $3.5 billion profit. I think that is a testament to our land acquisition skills, as well as our resource development skills, and obviously a very strong comment about our ability to create billions of dollars in shareholder value every year in addition to the everyday job of drilling wells.”
“With regard to our debt levels, our debt continues to decline every day on a relative basis as our asset base increases and our debt will remain flat in the years ahead. In addition, you may be familiar with our 25/25 Plan where we told our investors in January 2011 that by the end of 2012 our debt would be 25% less than it was at year-end 2010, or basically at $10 billion in total. We will certainly achieve that goal, and I also believe that by year-end 2015 our debt levels will remain below $10 billion and the value of our company should be north of $75 billion and people will have stopped long ago about asking about our balance sheet – it will be rock solid.”
A couple things… these quotes did not age well. I am not a Chesapeake hater. I am certainly not an Aubrey hater. They just happen to be poster-children and the best examples of the system.
An aside: A group of us were at an FBO at Hobby Airport in Houston waiting for our pilot to signal we were ready to board. As we were waiting, a tiny plane limped up and parked in front of us. It was the plane version of ‘The Little Engine That Could.’ Out pops McClendon with a jovial smile on his face. This was two weeks after he was kicked out as the CHK CEO. He walks up to our group, points at his plane, and says, ‘I’m not sure that thing was designed to leave Oklahoma, but the first thing they offered me was a chauffeured Camry!’ Pleasantries were exchanged, and then he taps the youngest person in our group’s shoulder and tells him, ‘At this rate, I may need you to pick up breakfast,’ then waved us goodbye and off he went. I was in my mid-twenties, trying to figure everything out, and the industry’s freshly fallen king took a few minutes to poke fun of himself and give us some cheap laughs. It was a great moment and said a lot about the guy. Now let’s get back to it.
There is no doubt that McClendon believed the quotes above and thought it would turn out well for all involved. However, the assumptions underlying those quotes turned out to be wrong. I would argue predictably wrong. Even worse, company structure didn’t allow CHK to recover from those false assumptions to fight another day. They certainly tried.
We all remember the cornerstone assumptions of the shale value proposition from prior posts:
These concepts are simple (remember, we like simple after that whole Enron debacle). The entire concept can be drawn quickly on a nearby cocktail napkin:
With these principles agreed upon, the first stage of the modern shale boom was off. Public independents, like CHK, and private equity firms set out to get their hands on all the acreage they could because it was a cheap option to extract future profits through the drill bit. You can’t print more land, so each group assembled their army of geologists and landmen as quickly as possible and sent them into the homes and offices of small landowners living in double-wides to ranch owners with tens of thousands of acres and houses all over the world. The goal was to create a company whose asset value looked like the chart below, a real call option in the form of drillable acreage:
Many proved to be good options traders and sold their positions to others. Other companies kept going with the expectation that they would eventually exercise their basket of options and convert them to cash flow. The company’s asset base would then go from a portfolio of options to option + cash flow. The balance sheet’s asset side is graphed something like this:
Drawn another way, the business is beginning to look like the aggregation business that Enron put together in years past. Shale company takes a principal position in acreage positions with the expectation of extracting hydrocarbons and selling them into a market later. The mechanism is different, but the process is the same: aggregate hydrocarbons, warehouse them on your balance sheet, sell at a profit. The main difference is that the shale company began to bundle business lines and services while Enron unbundled the business lines and services of the pipeline companies.
Many companies took the concept of bundling even further, building pipelines and even their own service companies (a la Chesapeake). There’s nothing inherently wrong with this. It’s just another form of leverage on a bet you’re already long. If that bet works out, you can fund the high cost of capital businesses with cheap money supported by your businesses with a lower cost of capital. In this case, Chesapeake and others were raising cheap debt and equity on the promise of producing a large, cash flowing PDP wedge and using that cheap capital to fund the high cost of capital businesses like land acquisition and service companies. The graph would look something like this over the life of the company. There is plenty of cash flow to pay back both debt and equity providers assuming the shale value proposition above holds.
All is well when the chips fall your way. Think of it as cashing out equity in your home to pay for a stock option or investing in your buddy’s friend’s cousin’s start-up. High fives all around if it works. Bummer if it doesn’t. Devastating if it doesn’t AND you lose your job and the ability to pay for the mortgage. The mechanism is slightly more complicated when a company has significant cash flows and scores of people willing to make a deal, but the fundamentals are the same.
Next, we’ll look into exactly what made this situation fragile, the reactions of companies when the first signs of problems popped up, why those (for the most part) didn’t work, the pros and cons of some of the balance sheet fixes and who wins and loses from those fixes.
 Before it starts… I know options typically have value below their strike price. I’m trying to keep it conceptual. Also, that assumes some level of liquidity. That assumption applied to acreage in the past. Today, however, the above chart is an accurate view of how the market values most acreage positions. $0.0/acre.
 It’s interesting to note the x-axis on both of these graphs. This asset base is short time on its cash flow, implying that high current prices would be favorable. Simultaneously, it’s long time in its options portfolio if you assume that a reasonable person would only get long a call option if they thought the underlying would go up over time. We’ll explore this later.