Recouping costs or making profits?

Chesapeake Energy’s $5 billion shuffle

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This is the third of three parts. This story was co-published with The Daily Beast.



For Joe Drake to know how Chesapeake calculated his gathering costs, he has to pay lawyers and accountants to audit the company, or take his grievance to arbitration, a process that would cost him tens of thousands of dollars. In either case, he would need to see the purchase agreements that describe the company’s gas sales in detail. They list far more precisely than Drake’s own statements exactly what costs were incurred, how much gas might have been lost along the way or used by the company for its own purposes, what marketing fees Chesapeake’s subsidiary charged, and the final, real price of the gas.


But Chesapeake isn’t required to share these agreements. They are proprietary.


“When it comes to production expense,” said Charles River’s Matthews, “you’re at their mercy.”


The deals that led to much higher expense charges for Drake and his neighbors involve some sophisticated financial engineering.


Over 12 months, Chesapeake sold off a significant portion of its nationwide system of gathering pipelines in three separate transactions. By December 2012, almost all of the pipes were controlled by a single company – Chesapeake’s former affiliate, Access Midstream. Taken together, the sales brought $4.76 billion in cash into Chesapeake’s coffers.


The reason behind the moves was simple: All that profligate spending – the Oklahoma City offices, corporate jets and huge executive salaries – had come at roughly the same time that the price of gas tumbled to historic lows, analysts at several Wall Street investment firms told ProPublica. Chesapeake “desperately needed cash,” observed Tony Say, who once headed Chesapeake’s marketing division – the same part of the company that now handles transportation for the gas.


In its securities filings, Chesapeake said that the deals brought the company $1.76 billion more than it had invested to build and maintain its pipelines and the companies that ran them, leaving the impression that the sales were an unqualified boon for Chesapeake.


But a look at an SEC filing by Access Midstream tells a different story: Chesapeake was going to have to give much of that money back.


On the same day as the last of the major sales, Chesapeake signed long-term contracts pledging to pay Access a minimum fee for transporting its gas. In some cases, the fee held no matter what happened to the price of gas, or even how little of it flowed out of Chesapeake’s wells.


Chesapeake also promised to connect every new well it drilled to Access’s lines for the next 15 years in Ohio’s Utica Shale, a potentially lucrative emerging drilling field, and made similar agreements elsewhere.


According to ProPublica projections based on figures disclosed by the companies in late 2013, Chesapeake’s commitments would have it paying Access a whopping $800 million each year. Over 10 years, the contracts would generate nearly twice as much money as Access had paid Chesapeake for its businesses in the first place.


In plain words, Chesapeake and a company made up of its old subsidiaries were passing money back and forth between each other, in a deal that added little productive capacity but allowed both sides of the transaction to rake in billions of dollars.


Access’ chief executive, J. Mike Stice, told a group of investment banking analysts last September that the deals amounted to a “low-risk business model” that “most people haven’t understood.”


”Nobody really has the access to contractual growth that (Access Midstream) has,” Stice said.”It doesn’t get any better than this.”


The SEC filings provide other detail about the ways that the two companies devised to remain inextricably linked, even though Chesapeake has sold the stake it once had in Access.


At the same time it signed its contracts, Access pledged to subcontract a slice of its business back – again – to companies still owned by Chesapeake. It also agreed to buy industrial equipment used to compress the gas for the pipelines from a company owned by Chesapeake. In essence, Chesapeake would get a rebate on the fees it had guaranteed to Access. Chesapeake never answered questions about whether that rebate was figured in to the price it charged Joe Drake and his neighbors.


In its royalty statements to Joe Drake, Chesapeake says the expenses it had deducted reflect what it costs the company to move his gas. The company has said in public statements about the royalty disagreements in Pennsylvania that it is merely recouping its costs. But ProPublica’s projections drawn from figures previously reported by both companies show that Chesapeake could earn back billions of dollars of the transportation fees it is paying Access over the next 10 years.


There are other ties between the two companies. Access’s chief executive, Stice, once worked for Chesapeake CEO Aubrey McClendon as the chief operating officer of one of the companies that used to run the pipelines. Chesapeake’s chief financial officer, Dominic del Osso, sits on the board of Access Midstream Partners, and as of 2011, according to SEC records, owned thousands of shares of Access stock.


The relationships raise questions about Chesapeake’s assertions that its contracts are arm’s-length agreements, and that its expenses reflect its true cost of operating.


”They had a lot of disguised debt,” said Philip Weiss, a chief investment analyst with Baltimore Washington Financial Advisors, who has covered Chesapeake over the years, and was often concerned that the company has understated its financial obligations. In this case, he said, Chesapeake’s expensive contracts with Access might not just be the cost of operating, but another unusual long-term financial obligation that would weigh down the company, but which wouldn’t be reflected in the normal measures of debt. “The use of off-balance-sheet debt is often a way to try to avoid getting as much investor scrutiny.”


For six months Chesapeake declined to answer questions about these discrepancies posed by ProPublica. But in its latest annual financial filings made public just two weeks ago, Chesapeake noted for the first time that it had $36 billion worth of what it called “off-balance-sheet arrangements,” including $17 billion of long-term commitments to buy gathering services. This appears to be the first time the company has acknowledged that it owes more money than what has been identified as debts in previous SEC filings.


In the filings, Chesapeake said that the $17 billion figure didn’t include reimbursement from royalty owners, and that landowners and corporate partners alike “where appropriate, will be responsible for their proportionate share of these costs.”


In an earlier, September 2013 quarterly filing, there were hints of the same activity, but with no disclosure of the salient details to shareholders that might help them understand what was really going on. Chesapeake reported that its expenses related to its pipeline and marketing business roughly doubled in the months after it sold its pipelines, compared to the same period a year earlier, and that its revenues for that part of its business also increased accordingly, covering the new costs. Chesapeake told investors it had cost the company more than $8 to transport a cubic foot of gas or its oil equivalent – an astronomical amount unheard of in the energy industry.


“Something is wrong with this calculation,” said Fadel Gheit, a seasoned industry analyst for the investment firm Oppenheimer, who estimated the figure was off by a decimal point before later confirming that it matched the numbers Chesapeake had reported to the SEC. “It can’t be.”


In fact, none of the financial analysts who cover Chesapeake that ProPublica spoke with could explain the explosion in Chesapeake’s marketing and transportation revenues and expenses using oil sales alone.


“The change in marketing, gathering, compression revenue and expense is staggering,” wrote Kevin Kaiser, a financial analyst with Hedgeye, a private equity group in New York, in an email to ProPublica.


Neither Chesapeake’s investor relations group, nor its media staff would comment on whether the deals amounted to disguised debt that landowners would repay. In interviews, one former Chesapeake employee with knowledge of the company’s operations dismissed the notion that Chesapeake was essentially paying back an off-balance-sheet loan by paying unusually high fees for use of the pipelines.


“The timing supports that – that Chesapeake got paid a lot of money and the gathering fees get paid back over time, and it looks like a loan arrangement,” said the former employee. “But to jump to the conclusion that the whole thing is a sham and a means by which they are going to defraud royalty owners is not true.”


Only in its latest filing at the end of February, after months of queries from ProPublica, did Chesapeake add a note – two sentences in 299 pages – stating that its contracts with Access and other companies played into the rising figures. But the company did not specify how much.


And to the extent that the real costs of gathering and transporting gas can be gleaned from securities reports and Joe Drake’s own statements, there’s still a big gap between what Chesapeake reports it paid out, and what Access reports it received for gathering services.


In the meantime, one thing is for sure: all the escalating costs, side deals, and unexplained debt aside, Access is making more money than ever, while Chesapeake – so recently fighting to stay alive – has emerged from its troubles and is turning a profit.


Joe Drake, on the other hand, is almost back to where he began.


He recently cancelled a fishing trip to Canada and doubled back on the question of how to make a living from the farm. With his livestock gone he will now focus on growing and bundling hay, which he will sell to other farms so they can feed their animals. The natural gas boom has become little more than a sideshow.


“We are surviving,” he said. “But we learned that a good old handshake don’t cut it anymore.”


For more from ProPublica on fracking, read about the latest health studies and our investigation on Native Americans being cheated out of $1 billion by schemes to buy drilling rights on their oil-rich reservation.


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