You Couldn't Pay Me to Invest in Chesapeake Energy

There are some investments you should stay away from no matter how attractive they look. Chesapeake Energy (NYS: CHK) is one for me. I wouldn't touch this natural gas driller with a 30-foot pole and I don't think you should, either.

Reason No. 1: CEO Aubrey McClendon
Probably the most important job a CEO has is capital allocation. How should the company use its profits? In the case of Chesapeake, answers probably include signing leases for drilling rights, buying rigs and drilling wells, returning money to shareholders, and, apparently, persuading the board to make sweet deals with the CEO (see below).

So how would you judge CEO Aubrey McClendon as a capital allocator? Well, one way is to look at return on assets (ROA) over time and compare it to several competitors. If the purchase of assets (such as drilling rights and rigs) generates a high return (net income), then that was a good use of the company's resources. Here's how Chesapeake and several competitors stack up:

Company

ROA in 2008

2009

2010

2011

Chesapeake Energy 7.7% 4.1% 5.0% 4.0%
Apache (NYS: APA) 13.8% 7.4% 9.9% 11.0%
Devon Energy (NYS: DVN) 10.2% 4.6% 8.0% 7.8%
Newfield Exploration (NYS: NFX) 12.0% 4.9% 8.6% 7.1%
Southwestern Energy (NYS: SWN) 13.2% 11.4% 11.8% 9.7%

Source: S&P Capital IQ.

While nearly all these companies have seen lower ROA recently, thanks to lower natural gas prices (and thus lower profits), Chesapeake's ROA is consistently at the bottom.

But investors interested in Chesapeake have an extra source for judging: McClendon himself. And he doesn't come up smelling like roses.

A few years ago, he borrowed money using his Chesapeake shares as collateral. When the stock market fell in the fall of 2008, McClendon got the dreaded margin call. He had to sell 94% of his Chesapeake shares -- about $552 million worth -- to cover his obligation.

It gets better (or worse). Last week, Reuters reported that McClendon has borrowed more than $1 billion. The collateral is the 2.5% ownership stake that McClendon has in wells the company drills. The money is letting him invest in even more wells.

Gee, this sounds familiar. At some point, he'll have to pay that billion dollars back. Maybe he'll end up selling his stake in the wells, just like he had to sell his shares previously to cover an earlier ill-conceived loan. Worse, what if one of the lenders decides to call the loan? What kind of pressure could they exert on Chesapeake?

If McClendon's so willing to take big risks with his own money, what's he doing with shareholder money at Chesapeake?

Reason No. 2: The board of directors
Turning to the board of directors, this group is supposed to be the shareholders' direct representative with the company, making sure management is working in the best interests of the company and shareholders. Here's part of how the board's been accomplishing that:

  1. Paying $12.1 million to buy a collection of historical maps from McClendon in December 2008, which appeared to be part of a bailout for his margin call. The maps had been hanging on the walls around corporate headquarters for years and all it was costing was some insurance coverage. Why did the company all of a sudden have to buy the maps that month?
  2. Approving an extra bonus of $75 million to him. It was called a "well cost incentive award" in 2008, but it appeared to be part of a bailout for his margin call. "You got into financing trouble? Here's an extra $75 million for showing up each morning."
  3. Reducing McClendon's share ownership requirement in his contract at the end of 2008 after he had to sell 94% of his shares to cover that margin call. "Oh, you violated the terms of your employment contract? Let's change the terms!"
  4. Letting McClendon buy a 2.5% ownership stake in every well the company drills. This is a rare perquisite, according to The Wall Street Journal.
  5. Letting a company that's been a "big financier to Chesapeake" be the biggest lender to McClendon on this newly revealed loan.

Are these the actions of a board looking out for shareholders?

Those are my two major reasons: I trust neither McClendon nor the board to run the company for shareholders' benefit. However, I could also mention:

  • The really low price of natural gas hurting revenue and profit.
  • The fact that the company is spending more obtaining and extracting natural gas than it receives for selling it ("a practice it says is necessary to take advantage of newly discovered shale formations," writes the Journal, which leads me to ask if the company plans to make up for it on volume).
  • The off-balance sheet arrangements that, according to Moody's, come close to doubling the company's reported debt level.

All of these are yellow, if not red, flags for me.

Now tell us what you really think
I don't care how much money you think you can make in this company when natural gas prices go back up -- which won't happen as long as supply outstrips demand. In my opinion, there's too much risk from letting McClendon manage your ownership stake when he can't seem to manage his own private investments, too much risk from the board apparently treating the CEO better than the shareholders it nominally works for, and too much risk from the way Chesapeake is running its business.

I'm staying away from buying Chesapeake Energy shares and I suggest you do the same.

So what energy company should you invest in? In this special free report, we reveal the name of a well-positioned energy stock that should do well for your portfolio. Click here to read further.

At the time this article was published Fool analyst Jim Mueller doesn't own shares of any company mentioned. He's an analyst for the Motley Fool Stock Advisor newsletter service. The Motley Fool owns shares of Devon Energy. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy, Moody's, and Devon 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's disclosure policy is never messed-up.

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Jack Robbins

RESPONSE TO ''You Couldn't Pay Me to Invest in Chesapeake Energy"

I certenitly would not want the Oil Industry causing any more Gulf of Mexico catastrophe's !!!!
NATURAL GAS IS THE ANSWER TO THIS PROBLEM
as well as cheeper gas for our automobiles....and etc.........

April 25 2012 at 11:45 AM Report abuse rate up rate down Reply
kcwranglrz

Even Madoff made his book look better than they do at Chesapeake. Now what about the 5 million dollars approved to a buddies land company on Oct 14, 2010. It was paid to Romac Energy LLC of Longview Texas. What did Chk get in return nothing rather they tossed Romac another 7.8 million dollars of investors funds through 2011. Once again Chk got nothing for those funds and Wayne Hartt pocketed some cash. The proof of the payments can be found in Eastern federal court in Marshall Texas. Of course Romac sues Chk for breech and after about a year Romac dismissed the case, yet Chk still recieved nothing for 12.8 million investor dollars spent. How many more deals are floating out there like this one?

April 25 2012 at 8:40 AM Report abuse rate up rate down Reply