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from Breakingviews:

Did Chesapeake miss Enron lessons?

By Christopher Swann and Robert Cyran The authors are Reuters Breakingviews columnists. The opinions expressed are their own. Chesapeake Energy, the embattled U.S. natural gas producer, seems to have missed some of the lessons of Enron’s demise. There have been no allegations of fraud. But the U.S. gas firm’s vast trading operation, fondness for complicated holdings and relationships, and corporate generosity are among the traits that, in hindsight, should have invited greater scrutiny of Enron’s edifice.

Chesapeake is a force in the U.S. gas market. It owns real assets, and it is the second-largest producer in the United States, accounting for about 9 percent of gross domestic gas supply according to a recent company presentation. It is the most active driller of new U.S. wells, and has substantial proven and unproven reserves. Meanwhile, joint-venture partners including Total of France and Norway’s Statoil attest to the substance of the projects they are involved in.

By contrast, while Enron’s byzantine structure and other questionable features may have developed to support aggressive expansion, they ultimately helped conceal essentially fake trading activities and fraudulent accounting. There is no suggestion that is the case, or might ever be the case, at Chesapeake. And other companies are complex or, for instance, offer generous perks without running into trouble. Yet it’s notable that Chesapeake, a self-described “bold” competitor in a sector close to Enron’s, has seemingly failed to avoid some of the defunct energy giant’s well documented flaws.

Corporate complexity Some Wall Street analysts admitted that they didn’t really know how Enron made money. The company had evolved into a labyrinthine organization that combined real energy assets, a black box trading operation and a web of off-balance sheet structures.

For its part, in conjunction with its energy properties and trading business, Chesapeake had seven joint ventures as of March 31, according to its first-quarter filing with financial regulators. U.S. gas sector rivals typically have only one or two such partnerships - Devon Energy, whose market value is more than twice that of Chesapeake, has only one. Chesapeake also had 10 so-called volumetric production payment agreements (deals to sell future production of gas or oil in return for up-front payments) and four separate holdings classified for reporting purposes as variable interest entities, including a controlling stake in a separately listed master limited partnership.

“The company is impossible to fully understand,” says Phil Weiss, an analyst who covers Chesapeake at Argus Research. “It’s what I can’t see that worries me.”

Oversized trading businesses Chesapeake has reported realized cash gains on hedging of $8.5 billion for the period from January 2006 to March 2012. That’s more than four times its cumulative $1.8 billion of net income over the same period. That makes the company look more like a hedge fund than a gas producer, even though it still holds plenty of gas assets.

from Breakingviews:

Hot infrastructure auctions drive down returns

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The market for infrastructure assets is heating up. Yield-hungry investors are keen on large, predictable businesses in the less rickety bits of Europe. So auctions like E.ON’s sale of its German gas pipes run pretty hot. Even if the bets are less extravagant than during the credit boom, returns will suffer.

The 3.2 billion euro price tag for E.ON’s “Open Grid Europe” doesn’t look hair-raising: it’s in line with book value, and about 10 times EBITDA. Low-cost debt helps: Macquarie’s infrastructure fund, which teamed up with a Canadian money manager, Abu Dhabi’s sovereign fund, and a German insurer, got banks to stump up 2.2 billion euros or so of cheap loans, ahead of a likely bond sale.

Nonetheless, robust auctions tend to mean higher prices. To win, Macquarie had to fight off three other serious consortia. Rivals and sector-watchers reckon the Macquarie group paid at least 200 million euros more than the next bidder, and question how it will achieve its target 10-percent plus internal rate of return from the investment.

Of course, business plans differ, although regulators probably limit a buyer’s wiggle room. Macquarie may also be more optimistic about an eventual exit price. And today’s low-yield world is undoubtedly compressing return expectations for all investors, not just in infrastructure.

Still, lower anticipated returns also reduce the margin for error. Like Vattenfall’s sale of its Finnish assets late last year, the E.ON disposal is a reminder of how much cash is chasing assets. That appetite comes both from infrastructure funds and from other enthusiasts for long-term investments, such as stewards of pensions and petrodollars.

from Global Investing:

Three snapshots for Tuesday

The euro zone just avoided recession in the first quarter of 2012 but the region's debt crisis sapped the life out of the French and Italian economies and widened a split with paymaster Germany.

Click here for an interactive map showing which European Union countries are in recession.

The technology sector has been leading the way in the S&P 500 in performance terms so far this year with energy stocks at the bottom of the list. Since the start of this quarter financials have seen the largest reverse in performance.

from Breakingviews:

Iran’s yuan oil payments won’t catch on, yet

By Una Galani

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Iran’s yuan-for-oil payments won’t catch on, yet. Tough sanctions from the United States have pushed the Islamic Republic to accept the Chinese currency as part-payment for crude exports to the People’s Republic. But while the yuan should play a bigger role in the world’s energy settlements by the end of the decade, Iran’s shift won’t be the catalyst.

It makes sense for China to use its own currency to pay for oil imports. The move transfers foreign exchange risk away from the world’s second largest oil consumer and supports the government’s long-term drive to establish the yuan as an alternative global reserve currency to the dollar.

For Iran, the yuan trade is more a matter of necessity than desire. Sanctions have made it hard to deal in freely convertible dollars or euros - the currency of Chinese oil payment to Iran since 2006 - so it has been forced to let its largest customer pay in its own non-convertible currency, just as it let India pay in non-convertible rupees.

The Chinese might like the Iranian deal to start a trend in the Middle East, but less politically squeezed producers will be reluctant to follow Tehran’s example. While China might be more willing to buy oil denominated in yuan, Gulf producers have other considerations.

They peg their currencies closely or entirely against the dollar and hold most of their foreign reserves in dollar assets. Although the tie to U.S. monetary policy is not ideal, the choice is rational for economies dominated by a single commodity mostly priced and traded in dollars - and for governments which still rely on U.S. military support.

from Global Investing:

Oil falls. So does the Russian stock market

Russian equities have had their worst week since early-December, with losses of over 6 percent. But don't look too far for the reason -- world crude futures have fallen to three-month lows around $114 a barrel on worries that U.S. and world economic growth may not be picking up after all.  They too have fallen 6 percent so far this week. Check out the following graphics showing how Russian stocks and its currency move in lock-step with oil prices:

If anything, the falls on Russian assets are outpacing the weakness on global crude oil markets in recent months, possibly because the jitters that caused last December's massive falls have not been entirely overcome. Anti-government demonstrators are no longer hitting the streets but  with President-elect Vladimir Putin to be sworn in next week, fears are the  Kremlin may prefer squeezing more cash from energy companies to implementing the reforms the economy desperately needs.  Latest plans flagged on Thursday  to raise oil and gas extraction taxes would seem to confirm these worries and are hitting energy sector shares -- half the Moscow index.

All this has widened Russian stock valuations to almost record levels against the broader emerging equity set.  But that is unlikely to entice buyers if the oil price stays where it is -- after all half of Russia's revenues come from oil and it needs an oil price of around $120 a barrel  to balance its budget. Chris Weafer, chief strategist at Troika Dialog puts it succinctly:

Russia does not have a strong enough domestic story to compensate for the commodities export risk

from Global Investing:

In India, no longer just who you know

It's not what you know but who you know. There are few places where this tenet applies more than in India but of late being close to the powers in New Delhi does not seem to be paying off for many company bosses.

Look at this chart from specialist India-focused investor Ocean Dial. It shows that since mid-2011 companies perceived as politically well-connected have significantly underperformed the broader Mumbai index. The underperformance has intensified this year.

According to David Cornell, portfolio manager at the fund, this is down to several factors such as The Right to Information Act which has helped curb unfettered corruption as well as shifting political power away from the centre towards provincial governments.  He says:

Political connections at a corporate level are no longer a pre-requisite for stocks to perform. Stay away from areas of the economy that rely on government patronage such as real estate, mining and power.

On Friday, media reported that Reliance, a giant company once seen by many as exemplifying India's politics-business nexus, would not be allowed to recover $1.2 billion costs before starting to share gas production profits with the government.  Reliance shares slumped 1.7 percent after the report. This year they have risen just 4 percent, less than half the gains of the Mumbai index.

from MacroScope:

Dr. Doom goes to Beverly Hills

When it comes to predicting a dark future, Nouriel Roubini – the NYU economist who earned the moniker Dr. Doom after he correctly predicted the financial crisis – is not about to let anyone get in his way.

Even if it’s his host. And even, or maybe especially, when there are 500 witnesses.

That’s precisely what happened Wednesday morning, when Michael Milken – the former junk-bond king – shared the stage with Roubini at Milken’s Global Conference. What was billed as an interview in one of the Beverly Hilton’s grand ballrooms had the feel of a pitched battle.

Roubini warned of a massive oil shock following a potential clash between Iran and Israel – or possibly the United States, sometime after the November presidential elections.  He talked about geopolitical instability in the Middle East. “It’s a mess,” he said.

Milken countered with a graph showing the U.S. has bigger fossil fuel reserves than any other country in the world, and suggested that natural gas, extracted from shale reserves that are largely outside the Middle East, will eventually make Arab clashes irrelevant to energy.

Roubini: “I think people are a bit too optimistic about how fast the shale revolution is going to occur…. I think people believe that in five years from now we are going to be energy independent – I think they are deluding themselves…  I think it’s more like a 10-20 year process.”

Milken: “I think I want to answer that with leadership.”

from Breakingviews:

Oil majors can only admire Colombia’s titan

By Raul Gallegos

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Global oil majors can only sit back and admire Colombia’s titan. State-controlled Ecopetrol just reported a 37 percent jump in first-quarter earnings and a 50 percent EBITDA margin that exists in the dreams of the likes of ExxonMobil. Replacing reserves will be tricky for Ecopetrol going forward, but the company, now worth a whopping $135 billion, still looks like the best oil play in Latin America.

The numbers tell an engaging story. Ecopetrol oil extraction costs are at least 40 percent cheaper than the industry norm. It managed to increase production by 11 percent in the latest quarter, while Exxon’s volume dropped. Ecopetrol’s replacement rate, at 1.6 barrels for every barrel produced, and 38 percent return on equity also far exceeded those of its larger U.S. rival.

It won’t be news to Ecopetrol’s existing shareholder base, which enjoys the 70 percent payout ratio and a 5.5 percent dividend yield. Its U.S.-listed certificates are up by over 50 percent this year. Healthy growth is also priced in, as Ecopetrol trades at nearly eight times trailing EBITDA, miles ahead of its larger cousins. Even Brazil’s Petrobras, widely considered the region’s benchmark oil producer, only fetches a multiple of a little over six.

The company’s secret sauce is its rock-bottom on-shore extraction costs. It’s a luxury not afforded to most listed companies that spend large amounts of cash seeking new reserves around the world, including expensive ones located deep beneath the ocean. Ecopetrol has been replacing reserves on the cheap, but their lifespan, at six to seven years, is the company’s one noticeable lag among peers. Ongoing guerrilla attacks on its infrastructure are another significant risk.

Ecopetrol says it hopes to triple reserves by 2020. With so much unexplored territory in Colombia, it just might get there. The company now commands the same market value as BP. If Colombia’s government can keep Marxist rebels at bay, Ecopetrol could also give other industry giants a run for their money.

from Breakingviews:

Chesapeake board does too little, too late

By Christopher Swann and Robert Cyran The authors are Reuters Breakingviews columnists. The opinions expressed are their own. Chesapeake Energy’s decision to do the right thing shouldn’t impress investors. Its directors are only doing so under duress. Stripping Chief Executive Aubrey McClendon of the chairmanship and ending his personal investments in the firm’s wells are obvious and very belated moves. But McClendon’s deal-making and borrowing have accompanied lagging returns. Shareholders deserve more radical changes in the boardroom.

Many of Chesapeake’s woes may have been exacerbated by allowing McClendon to take a slice of each of the company’s wells. Sure, he shared the costs of drilling but the way he borrowed reduced his personal risk, giving him an incentive to push Chesapeake into a perpetual spending spree. Furthermore, as a risk-taker by nature, McClendon pushed the firm to take on far too much debt - close to half of which resides off the balance sheet. The firm’s monstrous complexity, thanks to dozens of side deals, also looks to have been driven partly by a desire to fund this empire-building.

Unfortunately, the board’s moves don’t amount to enough. Chesapeake’s long underperformance meant the board had plenty of time to consider the impact of the well program’s perverse incentives. Even accounting for dividends, Chesapeake investors have lost about 40 percent over the past five years, against positive returns of more than 50 percent for rival EOG Resources and 85 percent for Range Resources.

Yet directors didn’t act until a media firestorm consumed the company. What little steps they have taken so far reinforce their unwillingness or inability to rein in McClendon’s risk-taking unless they have a gun to their heads. They virtually admit as much by allowing him to stay on as chairman until they identify his replacement, rather than having one of them take on the role, if only temporarily. In any event, one outsider is going to find it tough indeed to stand up to the firm’s founder and chief executive backed by a supine board.

At the very least, additional board members are needed, in addition to the two seeking reelection who shareholders can vote against in the upcoming annual meeting. McClendon has at least amassed an impressive energy portfolio. But he increasingly looks to be the wrong man to harvest these resources. His financial legerdemain has left the firm highly vulnerable and means investors may never get to reap the full benefits from Chesapeake’s most promising businesses.

from Breakingviews:

Chesapeake tangle goes far beyond CEO

By Christopher Swann and Robert Cyran The authors are Reuters Breakingviews columnists. The opinions expressed are their own.Questions about Chesapeake Energy go beyond its chief executive’s dubious dealings. Aubrey McClendon’s personal stakes in oil and gas projects and the extent of related disclosure have put the $12 billion U.S. energy giant on the back foot and tied its board in knots. But investors should also be wary of the company’s monstrous complexity. It has convoluted off-balance sheet liabilities thanks to convoluted partnerships; hedging gains have dwarfed profit since 2006; and cash flow is consistently negative.

Chesapeake, the nation’s second-largest gas producer, has become its own worst enemy. Revelations that McClendon, the company’s flamboyant co-founder, failed to disclose $1.1 billion of personal borrowing to co-invest in wells with the company have raised the specter of serious conflicts of interest and shaken investors. The company originally said its board was “fully” aware of the CEO’s financing transactions, but on Thursday said the directors were only “generally” aware and moved to end the co-investment program - which U.S. regulators are now scrutinizing.

All the while, though, Chesapeake itself is becoming harder and harder to understand. The firm has been scrambling to raise about $10 billion in cash this year to help cope with a hefty debt load and sliding U.S. natural gas prices. Three transactions earlier this month raised $2.6 billion, but added to off-balance sheet debt and made the firm’s structure even more tangled.

Chesapeake has negotiated seven joint ventures which give rival firms part-ownership of oil or gas fields in return for stumping up cash and a portion of drilling costs. No peer has a network of deals on anything close to this scale. Rival Devon Energy, which has a market value more than twice that of Chesapeake, has just one joint venture. And Chesapeake has concluded 10 volumetric production payment deals, under which it will hand over future output in return for cash paid upfront. The company has sold at least $4 billion-worth of its future gas production in this way, according to Argus Research.

Investors wanting to wrap their heads around the firm must also contend with the fact it placed the cash flow from certain wells into a royalty trust - a type of vehicle in which the bulk of profit has to be distributed to its owners - and sold about half its interest for $440 million. The firm is also trying to sell a 20 percent stake through a public offering in its oilfield services firm, Chesapeake Oilfield Services, for $862.5 million.

Visibility is further impeded by the firm’s over-active hedging business. Chesapeake reported realized gains on energy trading of $8.4 billion between 2006 and 2011. That’s more than four times its cumulative $1.8 billion of net income over the same period. “We don’t hedge just to say we’re hedged, we hedge to make money,” Chesapeake declared in a recent investor presentation. No gas rival trades energy on anything close to this scale, and it makes McClendon’s firm look at least as much like a hedge fund as a gas producer.

Yet despite Chesapeake’s opacity and a 20 percent-plus fall in its market value since the end of March alone, investors still seem largely to give the company the benefit of the doubt. Its market capitalization is about $12 billion. That values the company at about 11 times estimated earnings for 2012 - in line with Devon Energy, but below the equivalent ratios for EOG Resources and Encana.