COLUMN-Chesapeake woes may be lifeline for U.S. natgas-Campbell

Thu May 3, 2012 10:35am EDT

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By Robert Campbell

NEW YORK May 3 (Reuters) - Consider the following, as yet hypothetical, situation. The United States' No. 2 natural gas producer is forced into a radical shift in corporate strategy, leading to a sharp reduction in the wells it drills.

Imagine the impact this shift might have on the natural gas market. The cause of today's decade-low gas prices is over-enthusiastic drilling by many gas producers.

Take out one of the top drillers and perhaps a bit more economic rationality prevails. At the very least the rate of growth in gas production slows, giving demand time to catch up with supply.

This isn't a mere thought experiment. It is what could happen very soon at Chesapeake Energy, which produces about 9 percent of the natural gas in the United States.

Until recently, it was difficult to see Chesapeake being forced into a major transformation.

But Reuters' revelations about its chief executive's personal financial dealings and yet another disappointing quarterly financial report may well force radical change upon the company that bills itself as "America's Natural Gas Champion."

Already big shareholders are starting to put their weight behind calls for an overhaul.

It's early yet, but the potential impact on natural gas prices of a big shift in strategy cannot be ignored.

So let's look at how one might restructure Chesapeake.

The company's current strategy relies on locking up leases on attractive shale deposits of oil and gas then --at least this is the plan-- selling them on to other companies.

Buy low and sell high. A classic route to profit.

But there's a critical weakness in this strategy. Holding onto the lease usually requires capital expenditure.

Often, unless a certain number of wells have been drilled on a lease within a certain number of years, the lease reverts to the landowner within a set period of time.

If that happens there's usually no compensation to the leaseholder. Repayment of signing bonuses? Forget it!

That is the root of Chesapeake's financial problems. Its extensive landholdings require heavy spending to maintain ownership, but the company only generates a small proportion of the cash needed to pay for this needed investment.

For instance, in the first quarter of 2012, Chesapeake's operations --mainly producing and selling oil and natural gas-- generated only $251 million in cash.

But over the same period the company invested nearly $3.62 billion in new wells, leases and equipment. The gap was made up with funds generated by asset sales and "financing activities."

Even though the company has promised to scale back leasing efforts, its financial plan targets asset sales of at least $14 billion by the end of 2013 to fund drilling and other activities.

CASH CRUNCH

The cash need is staggering. And the current turmoil hardly puts Chesapeake in a good bargaining position.

Already potential bidders must be wondering if they can squeeze out a better deal for Chesapeake's assets given its financial travails.

Indeed, the company's recent efforts to clean up its tarnished reputation after Reuters reported CEO Aubrey McClendon had borrowed up to $1.1 billion against the personal stake he acquired in wells drilled by the company may be making things that much more difficult.

The controversial Founder Well Participation Program (FWPP), which entitled McClendon to take a 2.5 percent stake in each well drilled on a Chesapeake lease, had effectively become an off-balance-sheet financing vehicle for Chesapeake.

Even though the debt was not guaranteed by Chesapeake, the FWPP increased the amount of borrowed money that could be employed when drilling without swelling Chesapeake's balance sheet with yet more debt.

With the FWPP now slated to be terminated by the end of June, Chesapeake is faced with the prospect of having to fund that 2.5 percent stake in every future well through its own balance sheet.

Here's where the gas market may benefit.

Rather than continue the high wire balancing act of trying to raise billions of dollars each quarter to fund operations, Chesapeake abandons its pretensions to empire and focuses ruthlessly on returns.

In other words, it bites the bullet, slashes drilling to preserve cash and relinquishes many leases. Vanity projects go out the window.

Jettisoning leases secured with handsome signing bonuses would not be painless. Such a step would likely force Chesapeake into a huge write-off on its asset base.

Shareholders, and possibly debtholders, would have to suffer. A host of trial lawyers in Oklahoma City would probably find long-term employment.

But for the rest of the gas market, the effect of such a reversal of strategy at Chesapeake could well be golden.

A big aggressive driller suddenly withdraws from the market. Marginal leases that would have been produced at today's prices for the sake of keeping title revert to the landholder.

And probably no one touches them for a while given today's dismal natural gas prices.

If so, the shakeout in the sector will have begun. If the second-biggest producer abandons the "drill to keep drilling" strategy that has run the industry into the ground, there may well be hope for the survivors.

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