Increased gathering fees cause royalty checks to dwindle

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


At 54, Joe Drake guns his six-wheeler up a steep rock-rutted trail on the backwoods of his 494-acre tract and points to his property line, marked by a large maple in a sea of indistinguishable trees. He knows where it lies, because as a kid his father made him walk that line to string barbed wire. The wire is long gone, but a rusted snag remains entombed in the bark. Back then, the Drakes ran a dairy farm in these pastures.


“It’s just something you’ve got in your blood that you do,” Drake said. “But dairy farmers are a dying breed … It was a good way of life.”


Today, the milking stalls have been ripped out of a long barn that still carries the stench of their manure, but stores 20-foot stacks of bailed hay instead. Drake sold all 187 head of cattle two years ago, pinched by regulated milk prices and the rising costs of independent farming. He took out a second mortgage to keep the farm afloat.


Across the road, past his house and just beyond a stand of oak and ash, the hillside’s natural shape transitions to a steep slope of pushed dirt, capped by a 7-acre flat the size of a large gravel parking lot. In the middle stands a 6-foot stack of steel pipes and valves – a gas well.


When Chesapeake arrived at Drake’s door, he was optimistic. Drake plastered a “Drill, baby, drill” bumper sticker in the window of his Ford F-250 pickup. He welcomed the chance to draw an easy income from his land, and was unswayed when his neighbors raised questions about the environmental risks of drilling. Chesapeake promised Drake one-eighth the value of whatever it made from his It seemed like a fair deal.


If any driller was going to make money for Drake, he thought, it would be Chesapeake. The company had built an empire off finding and drilling natural gas discoveries as the fracking boom rolled across the country. With uncanny foresight, its founder, Aubrey McClendon, locked up exclusive access to immense tracts of land across the country by promising property owners that their lives would be transformed by the wealth the gas under it would bring.


Then the company drilled furiously – in Oklahoma, then Texas, Louisiana and later in Pennsylvania’s Marcellus Shale – catapulting itself to the rank of second-largest producer of natural gas in the United States. It made McClendon– who snatched up a stake in the Oklahoma City Thunder basketball team and moved into a stone mansion in the posh Oklahoma City suburb of Nichols Hills – one of the richest men in the world.


McClendon – named by Forbes in 2011 as “America’s Most Reckless Billionaire” – would find his way into plenty of personal trouble. He took a personal stake in Chesapeake’s wells, and then liquidated his stock in the company in order to cover his own losses, rattling investors and ringing corporate governance alarm bells. He drew scrutiny for selling his $12 million antique map collection to the company and ire for taking a $75 million bonus as Chesapeake struggled.


In 2012, he borrowed as much as a billion dollars from the company’s private equity partners to fund his private interests. Separately, an investigation by Reuters alleged Chesapeake had rigged land leasing prices in Michigan, under McClendon’s direction, sparking a federal criminal probe.


But McClendon’s overarching design for the business nonetheless made it a formidable player. Chesapeake aggressively pursued business opportunities beyond its drilling. It created interlocking businesses and took advantage of tax breaks that deliver out-sized benefits to energy companies.


By structuring itself this way, Chesapeake earned a slice of profit from each step. Chesapeake’s subsidiaries trucked the drilling materials, drilled the wells, fracked the gas, gathered and piped it away to a hub, and then marketed the end product – what economists call vertical integration. In fact, he built Chesapeake into a powerhouse, an echo of the old Standard Oil empire, positioned to control almost every variable and armed with the leverage to get its way.


Neither McClendon nor his staff responded to requests for comment for this article.


From early on, the company viewed the local pipelines as a profit source. Chesapeake formed subsidiaries to build and run the lines, then spun them off into a separate, publicly traded company. That company would eventually evolve into Access Midstream, when Chesapeake sold its shares – one of the three deals – for $2 billion in 2012.


The strategy paid dividends. At Chesapeake’s headquarters, a group of new, distinctively-designed office buildings went up, with views south over the state capital and the city’s small skyline. The company lavished its employees with perks, too. “They’ve got a 72,000-square-foot gym, free trainers… free Thunder tickets,” said Andrea Watiker, who scheduled pipeline capacity for gas traders in one of the company’s new towers.


Confident he was in good hands, Drake endured the trucks, dirt and noise that accompanied gas drilling and signed agreements that allowed Chesapeake to run pipelines across his fields. To transport the gas from Drake’s well, Chesapeake built a pipeline that stretched south from within spitting distance of the New York border, cutting a wide swath through the forest. Then it went down beyond the white-spired church in Litchfield, and ran some 35 miles further to its handoff at the Tennessee interstate pipeline near the Susquehanna River.


What Drake didn’t know at the time was that the pipeline was more than a way to move his gas to market. It would become part of a strategy to make more money off of Drake himself.


When the first gas flowed from the well on Drake’s land in July 2012, it was abundant, and the royalty checks were fat. “We was hoping to get these loans paid off … with the big money,” said Drake, who earned more than $59,400 from the first few months of production, referring to the mortgages on his farm.


That year, many Pennsylvania landowners began receiving similarly sized payments as thousands of new wells – many of them drilled by Chesapeake – finally began producing gas. Pennsylvania fast approached Texas as the largest source of natural gas in the country, and with it, the prosperity long promised to this rural part of the United States seemed about to arrive.


But then, in January 2013, without warning or explanation, the expenses withheld from Chesapeake’s royalty checks for use of the gathering pipelines tripled. Drake’s income dwindled. His contract with Chesapeake – and Pennsylvania law that sets a minimum royalty share in the state – promised him at least 12.5 percent of the value of the gas. Drake says the company led him to believe any expenses would be negligible. “Well, they lied.”


A few miles away, the same month, his brother-in-law had 94 percent of his gas income withheld to pay for what Chesapeake called “gathering fees.” Others across the northern part of the state also saw their income slashed. “I’ve got a stack,” said Taunya Rosenbloom, a lawyer representing Pennsylvania landowners with natural gas leases. She pulled the statements of all of her Chesapeake clients into an eight-inch pile on her desk. “Everyone is having this issue.”


Drake found the statements Chesapeake mailed him each month mystifying. He pored over the papers, hired a lawyer, compared notes with his neighbors, but couldn’t make sense of the charges.


Other Pennsylvanians were similarly baffled. Sometimes, Chesapeake charged different fees to neighbors whose wells fed into the same gathering line. Other times, companies that had partnered with Chesapeake on the same well charged vastly less for expenses. No one at the Chesapeake could seem to explain how the charges were set.


“There is no rhyme or reason why one client would have such an exorbitant amount taken out when another no more than 3 miles away has only 20 percent of their royalty taken,” said Harold Moyer, an accountant in Bradford County, who represents more than 150 landowners with royalty rights. Moyer said he saw a dramatic difference between what Chesapeake usually charged compared to other energy companies in the area.


Different contracts may entitle Chesapeake to charge varying amounts. Some of the leases examined by ProPublica limit a landowner’s share of expenses to 12.5 percent – or the same as their share of the proceeds. Other contracts prohibit Chesapeake from withholding any expenses at all. Drake’s contract appears to allow Chesapeake to recoup as much money as it wants; it stipulates that he can be charged for the expense of gathering and transporting his gas without specifying his share of such expenses. Gas drillers differ significantly in how much they charge landowners for expenses. The Norwegian energy company Statoil owns a portion of the gas extracted from Drake’s well, as well as a portion of the gathering line that moves the gas to an interstate pipeline. Yet Statoil rakes off virtually nothing for its expenses, according to its statements. Statoil told ProPublica that it sells its gas independently and makes decisions about billing separately from Chesapeake.


”When it comes to deciding which, if any, deductions are appropriate, we make that assessment according to the terms of each lease and the applicable laws,” wrote Ola Morten Aanestad, in an e-mailed response to questions.


Drake peers out the window, over the hills that descend from his porch into a valley brightening with the changing colors of fall, and scowls. He can’t stand being indoors. He’s worried that he’ll spend most of next hunting season here at this table, trying to decipher Chesapeake’s statements. His monthly gas statements pile up, unorganized, on the kitchen table, below a rack of deer antlers and beside two empty cans of Coors Light and a camouflage baseball cap.


Drake’s gathering pipeline only extends a few dozen miles, far less distance than the interstate pipeline it feeds into that carries his gas through New Jersey towards White Plains, NY. Yet public documents filed with the Federal Energy Regulatory Commission show it only cost about 38 cents – on average – to move a unit of gas on the interstate system – a fraction of the $2.94 Chesapeake charged Drake to move a unit of gas a vastly shorter distance that February.


“Nobody can tell you why or how come,” Drake said. “They pass the buck, they tell you to call this person, and you are lucky if you can even get an answering machine.”


Chesapeake declined to explain its charges to Drake or to ProPublica. When a ProPublica reporter visited Chesapeake’s headquarters in Oklahoma City, the company’s director of external communications sent a message that he was “booked solid” and couldn’t talk.


There has long been dispute over how drilling companies calculate royalty payments due landowners. A 2007 report commissioned from a forensic oil and gas accountant by the National Association of Royalty Owners – an organization representing landowners in their dealings with the oil and gas industry – found that almost every company it examined had “used affiliates and subsidiaries to reduce income to royalty owners and taxing authorities.”


Nine out of 10 of the top producers in Colorado, Texas, Arkansas and Oklahoma – including ConocoPhillips, Chevron, BP and Chesapeake – had used subsidiaries to sell their gas for significantly more than the amount they reported to landowners, according to the report. They inflated their expenses, too – at least according to the six companies that provided that level of detail for the report – charging landowners, on average, 43 percent more than what they actually paid to handle the gas. (Neither Chevron nor Chesapeake provided information about their expense deductions.)


ConocoPhillips and BP declined to comment for this article. Chevron did not respond to a request for comment.


Other companies have been ensnared in similar controversies. The giant pipeline company, Kinder Morgan, which also declined to speak to ProPublica, has been accused by Montezuma County, Colo., of overstating its transportation and other expenses, and underpaying $2 million in taxes as a result. (Kinder Morgan has paid that bill, but is appealing the decision.) Chevron has faced multiple lawsuits for underpaying royalties and overstating expense deductions because of alleged self-dealing through its affiliate relationships, including a 2009 case the company settled with the U.S. Department of Justice for $45 million.


”Every company has been involved,” said Jeffrey Matthews, a vice president and forensic accounting expert at Charles River Associates, a consulting firm, in a lecture to landowners and oil and gas industry accountants in Houston. “If you’re dealing with related parties,’’ the technical term for the sort of inter-locking subsidiaries created by Chesapeake, “the costs can be double, or triple. You don’t know if you are paying for something two to three times over.”


Even so, Chesapeake stands out among its peers and is widely known to interpret contracts to match its strategies, executives in the oil and gas industry say.


The company has faced numerous lawsuits – filed by the billionaire Ed Bass, and the city of Fort Worth, among others – claiming it misrepresented its expenses. Chesapeake has paid hundreds of millions of dollars in settlements and judgments in such cases, including a $7.5 million settlement with Pennsylvania landowners last fall.


One Oklahoma lawsuit, brought by other oil companies that had partnered with Chesapeake, alleged that Chesapeake cheated them out of the final sales price of their gas and artificially inflated its operating expenses, in part by folding in the salaries of high-level management, the cost of seminars they attended, and rent and office expenses for field offices. The suit was settled in late 2004 for $6.5 million. Chesapeake denied any wrongdoing, and the settlement explicitly states that Chesapeake did not agree to “change the practices complained of” in the lawsuit.


”They were making excessive, unwarranted, and unauthorized charges,” said Charles Watson, an Oklahoma attorney involved in the case. “I don’t think it’s mistaken interpretation, I think it’s an intentional accounting maneuver to reduce the amount of money going to the royalty owners and increase the amount of money going to the operator.”


Chesapeake declined to comment about the case.


Tomorrow: Recouping costs or making profits?


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