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.
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.
For its part, Enron started out largely as a gas company, too. Over time, it sold tangible assets like pipelines to focus on racier energy and telecommunications trading. In the years before it went bankrupt in late 2001, the bulk of its revenue came from trading.
Negative cash flow
Chesapeake’s cash flow from operations has not been sufficient to cover acquisitions, exploration and development costs, and building and equipment investments in any of the last 10 calendar years. Add back the proceeds of disposals, and cash flow has been positive in just one of those periods. The company’s recent cash burn is partly the result of punishingly low gas prices and its investments to boost more lucrative oil production. Be that as it may, Chesapeake has been steadily selling assets and future production to bring cash in. It aims to offset a projected $10 billion cash shortfall this year, by Fitch Ratings’ estimate, with more of the same. Meanwhile, the company has added to its debt, most recently borrowing $4 billion from Goldman Sachs and Jefferies.
Aside from net debt of more than $12 billion at the end of March, Chesapeake’s filings with regulators reveal other commitments relating to leases, partnerships and other activities. Analysts at Barclays have listed additional balance-sheet liabilities of more than $7 billion with another $2 billion-plus of obligations off-balance sheet. By comparison, the value of the company’s equity was less than $10 billion on May 21.
Enron had a similar cash flow problem. It reported positive free cash flow – cash from operations plus the proceeds of asset sales, less capital expenditures and acquisition costs – for only one year in the last seven of its existence. Revenue kept going up, with Enron reporting sales of over $100 billion in 2000, but the cash flow drain wasn’t sustainable.
Naturally, company bosses should believe in what they are doing. But promises need to be realistic. Chesapeake boss Aubrey McClendon recently claimed that the firm’s assets were worth at least $50 billion to $60 billion. That’s more than twice the company’s current enterprise value, suggesting investors are far from convinced. For the past seven years he has been saying the firm is on track for an investment-grade credit rating even though it has recently been marked deeper into junk-rated territory, with downgrades from Standard & Poor’s and Fitch coming just last week. McClendon has also called Ohio’s Utica shale one of the biggest discoveries in U.S. history, despite having drilled too few wells for Bernstein Research, for one, to attribute full value to the claim.
In its 2000 annual report, Enron said: “At a minimum, we see our market opportunities company-wide tripling over the next five years.” Enron promised to expand its business, reduce debt and improve its credit rating. McClendon has similar intentions with a two-year plan, initiated early in 2011, to increase production by 25 percent and decrease long-term debt by 25 percent “to achieve balance sheet metrics worthy of an investment grade rating.” As the cash flow, debt and rating picture shows, that’s not easy to achieve.
Chesapeake’s corporate campus boasts a 72,000 square-foot fitness center, Olympic-sized swimming pool, several restaurants and other facilities, the company’s website says. For its part, Enron paid college tuition for the children of employees, offered a corporate gym and an in-house clinic, and treated staff to first class travel, according to contemporary news reports. Both firms have featured in Fortune’s list of the 100 best companies to work for – Chesapeake in the past five annual lists, and Enron in 1999 and 2000.
Of course many companies treat employees well and there’s nothing wrong with that on its face. The top two on Fortune’s list this year are Google and Boston Consulting Group. One risk, though, is that staff become too reliant on their employer.
That can extend to retirement savings, too. The majority of Enron employees’ retirement funds were invested in the company’s stock and therefore effectively evaporated when it went bust, along with their jobs. That prompted a significant rethink of corporate retirement planning in the United States.
Yet Chesapeake hasn’t got the whole message. Employees have a range of investment options for their contributions to the company retirement plan, but their employer matches these with company stock. That’s not unique in the corporate world, but the result is that about 38 percent of Chesapeake’s main pension plan was invested in its own shares as of earlier this month. That’s about four times the 10 percent or so that is prudent, according to Plan Sponsor Advisors, a retirement plan consultancy.
Enron’s complacent directors missed, or blessed, activity by executives that ultimately brought the company down. There’s no suggestion that’s where Chesapeake is headed. But the Enron debacle contributed to the passing of the Sarbanes-Oxley Act of 2002 and provoked more general soul-searching on corporate governance practices.
Yet Chesapeake’s directors seem to have been living in the past. Over the years they have let McClendon run a personal hedge fund from the firm’s offices and take out private loans from one of Chesapeake’s business partners – just two examples of lax governance at the company. The directors in some cases have taken steps to end problematic arrangements, like the CEO’s personal participation in company projects and his sale to Chesapeake of a collection of maps, only after they came under outside scrutiny.
The company has also effectively conceded that it paid its board too much, announcing on May 18 that it would cut directors’ compensation by 20 percent. At around $530,000 last year, the average all-in compensation for Chesapeake’s directors, including tax-free use of corporate aircraft, was more than twice what the average Fortune 500 company director made in 2011, according to preliminary estimates from Towers Watson. The implication is that directors may have been too beholden to Chesapeake to ask hard questions.
It’s no surprise that as of May 21 investors had knocked the company’s shares down more than 35 percent since the end of March. Structural simplification and tighter governance – along with a more realistic plan to turn cash flow positive – could start changing their minds.