The Boom (28 page)

Pinkerton grew concerned about this haste in 2008 after meeting with Pennsylvanians who thought the gas industry was the second coming of coal mining that left the state scarred, with streams poisoned by acid that leached from opened mines. He wanted to be more transparent and hired a team to talk to the public and government officials. He also tried to enlist other CEOs in this effort. He said he couldn’t get through to McClendon. “Aubrey was just too schizophrenic. He was everywhere. I couldn’t get him on the phone. He totally agreed with me. But he was going so fast, running so many rigs,” said Pinkerton. “He was spending all this money and had twenty-five-year old engineers from Oklahoma drilling wells by telephone.”

Still, Chesapeake’s strategy was copied and envied. Investment professionals wanted to hear how McClendon had pulled the company from the brink of collapse and transformed it into a Wall Street darling. The company’s conference calls, where McClendon would talk at length about his view of the energy landscape, were crowded with people dialing in to listen to the Oracle of Oklahoma City.

To finance its rapid expansion, Chesapeake began spending more money than it took in. In its financial results for April through July 2004, the company reported generating $328.8 million from energy operations. It spent $337.9 million on drilling, leasing, and other expenditures. It was, in Wall Street jargon, cash-flow negative. There’s nothing wrong with being cash-flow negative—and there are many reasons a company would want to be cash-flow negative. Think of a real estate developer building a skyscraper. It may well run cash-flow negative for a couple years, drawing down a construction loan, line of credit, or cash it has built up. When construction is complete and the building is leased, the developer would become cash-flow positive as rents come in. But the spring of 2004 was only the beginning for Chesapeake. Through the end of 2012, it reported positive cash flow—it made more than it spent—in only three of the subsequent thirty-four quarters. In the first three months of 2012, it reported a $4.1 billion negative cash flow. Over an eight-year span, it spent more than $30 billion on leasing and drilling than it made selling the oil and gas it pumped from its wells.

Building up an inventory of wells to drill turned out to be easy for Chesapeake. Finding capital to finance this operation was tougher. McClendon was endlessly creative in this search. He borrowed money from Wall Street and issued shares; he supersized an existing financial product called the volumetric production payment (VPP), which allowed it to get cash up front in exchange for future gas production. He sold minority stakes in gas fields to foreign companies and he placed complex financial hedges—bets, really—with Wall Street traders on the future movement of natural gas prices.

Facing this seemingly endless demand for capital, McClendon found an ally in his old Duke friend Ralph Eads. A year after leaving El Paso in 2003, Eads bought a stake in a small Houston firm called Randall & Dewey that specialized on advising companies buying and selling assets in the Gulf of Mexico. But Eads soon steered the company into the more lucrative shale business. McClendon and Eads had remained friends in the two decades since they had graduated from college but had done little business together. That began to change in 2004, when Eads advised Chesapeake on a $425 million acquisition of a small company. Over the next couple years, McClendon talked to Eads regularly about how much capital Chesapeake needed to develop these shales. Intrigued, Eads sat down and scratched out some rough numbers. He figured out how large the Barnett, Marcellus, and a couple other shales were and how many wells would be required. Then he multiplied this figure by how much the wells cost and added in costs to build pipelines. His rough estimate was that Chesapeake and other companies needed $35 billion a year of
external
capital to drill these wells. In other words, $35 billion above and beyond what they generated from selling energy.

“Wow,” he recalled thinking. “That’s a lot of money.” Then another thought occurred to him. There is no way Wall Street will supply even close to that much capital through debt and buying new shares in these companies. Seeing a business opportunity for his firm, which he had sold to New York investment bank Jefferies Group in February 2005, Eads set out to create a new financial ecosystem to find money to drill shale. He helped companies raise capital by selling off older, conventional assets and took a commission on these sales. He found foreign energy companies that wanted to participate in the US shale boom and brought them together with companies such as Chesapeake that were willing to sell minority stakes in exchange for money. Another commission. And Eads went on a global road show, proselytizing to big institutional investors in China, Korea, India, and Norway on the returns they could achieve from shale. More commissions. Under Eads, Jefferies climbed the league tables—an annual ranking of Wall Street mergers business—like a soccer club with a rich new owner moving up into the Premier League.

Jefferies’s pitch material grew into a two-volume, spiral-bound book. It exuded confidence, brimming with upbeat assessments: shale offers “large resources with little geologic risk” and “superior returns.” The book’s core message was that there were companies with more shale acreage than money to drill. These companies needed partners with deep pockets to help them drill. He aimed the pitch squarely at the heart of the global financial system. Investors around the world have enormous sums of money and seek places to invest that provide high returns. Eads and McClendon were selling an investment opportunity that hit all the right notes. It was a large investment opportunity—$35 billion a year and growing—and it offered strong returns. And the investment was in the United States, which didn’t run the risk of governments nationalizing assets or armed bands attacking expatriate engineers.

In a four-year span, from 2008 until 2012, money flowed into North America from Japan, China, Korea, Norway, Australia, India, South Africa, Malaysia, France, and the United Kingdom. Jefferies counted thirty-seven deals that raised a total of $163 billion. By any measure, it’s an astounding amount of money, equal to the value of companies such as Coca-Cola or Google. Not all buyers came from overseas. One of the largest deals was when Exxon Mobil bought XTO Energy for $31 billion. Chesapeake alone raised $33.7 billion in a series of deals, for almost all of which Eads served as financial adviser.

People in the oil and gas industry use a metaphor to describe what happened in the mid-2000s. The treadmill, they say, was turned up. What had been a casual pace on the machine—raising money, drilling wells, selling energy—became faster and faster until it was a sprint. While there were many companies and CEOs who sped up the tempo, they were all trying to keep up with McClendon. His desire for “more,” as his longtime business partner Tom Ward stated, was the driving force in the rapid development of US shale resources.

Chesapeake discovered a lot of natural gas and leased it up. Its competitors, caught in the company’s slipstream, followed its lead. The result was a lot of natural gas—more than anyone had previously thought possible. And when there is too much of a commodity, prices begin to drop. This is especially true when the US economy takes a sharp turn downward. McClendon missed this turn. On August 1, 2008, he said that gas prices would stay in the $9 to $11 range. A year later, they were at $4. “The only thing that went wrong with our strategy was the financial collapse of 2008,” McClendon said later. With its heavy debt and drilling commitments, this price decline was a recipe for trouble. It was a major oversight.

“It all goes back to the Austin Chalk,” said Dan Pickering, a Houston investment banker whose firm Tudor, Pickering, Holt was involved in the shale boom and its deals. “These guys have historically run until they fall off the edge of the cliff. In the Austin Chalk, the geology wasn’t there. This time around, it was financial leverage. You want to push and push right up to the very edge and not go over. Figuring out where the edge is, that’s hard.”

Chesapeake had another large source of revenue that helped the company grow. McClendon placed aggressive bets on future movements of natural gas prices. He was a good trader, generating large profits. Between 2001 and 2011, Chesapeake reported $36.7 billion in revenue from selling the oil and gas it produced. Over the same period, McClendon generated $8 billion in trading profits. For every dollar that Chesapeake took in over that period, eighteen cents came from Wall Street trading, not wells. Over this span, McClendon had seven years of gains from trading and only four down years. And his good years were very good, while his down years didn’t generate particularly large losses. Only once, in 2004, did he generate a loss of more than $100 million. Five times, his trading resulted in billion-dollar gains. This extra cash was critical to Chesapeake’s rapid growth. Chesapeake used it for aggressive leasing, speeding up the pace of shale development and forcing other companies to ramp up their spending if they didn’t want to be left empty-handed.

McClendon also traded on his personal account and for a hedge fund he set up with Tom Ward in about 2004. I stopped by the offices of the hedge fund, called Heritage Management Company, one day in 2007. It was in a 1930s skyscraper on Fifth Avenue in Manhattan. There was no receptionist, so I walked through the foyer into a small room where I startled four traders seated around a large table, staring intently at their twin computer monitors. They didn’t want to talk about the company and ushered me out of the office. When I later asked McClendon about his outside investments, he replied, “I just play the stock market, I play the commodity markets. Sometimes I win, sometimes I lose.” He said later that the fund helped give him insights into the market, which helped him manage Chesapeake better.

Still, the arrangement was unusual. McClendon was the CEO of an expanding natural gas company that grew to control a substantial portion of the domestic gas market and was active in futures trading. McClendon was also actively trading the same energy contracts for his personal account. Were Heritage traders allowed to place bets on future movements of commodity prices
before
Chesapeake secured its price hedges or publicly announced increases or decreases in drilling? The potential existed for “front running,” when a trader buys or sells commodities before executing his company’s trades. This could allow McClendon to profit from advanced knowledge of price movements. There is no evidence that anyone oversaw the operation, at least anyone besides McClendon.

By 2008, McClendon and Chesapeake were whales in the futures market, a massive electronic exchange where contracts for billions of barrels of oil and trillions of cubic feet of gas are traded. How big is difficult to say with precision. Trading positions on the New York Mercantile Exchange are zealously kept out of sight by a club of investment bankers, hedge fund manager, physical traders, and speculators. Those in the club, where membership requires access to billions of dollars of collateral, share snippets of gossip about who is betting prices will rise or fall. But for those outside, information can be tough to come by. This veil of secrecy has fallen only one time, and the snapshot of the investors and traders setting energy prices in the summer of 2008 showed that McClendon and several close associates were among the largest participants.

US Senator Bernie Sanders, an independent from Vermont, pulled the curtain back when he released a confidential list of futures market speculators compiled by the US Commodity Futures Trading Commission, a disclosure that sent futures traders into conniptions. The list of who held the natural gas contracts was a who’s who of global capitalism and energy. In descending order, they were BP, Barclays, Morgan Stanley, JPMorgan, and Shell. The sixth largest was the reclusive Tulsa billionaire George Kaiser, who owns a private gas exploration company, and who lent money to McClendon and often talked to him about market fundamentals. The eighth largest was John Arnold’s Centaurus Advisors, a major Houston hedge fund in which McClendon had invested.

Chesapeake Energy held gas contracts to make it the seventeenth-largest participant in the futures markets, by far the largest position for an energy company of its size. Only a few individuals made the list. After George Kaiser, there was T. Boone Pickens (number 12). The next individual on the list was Aubrey McClendon, followed by his longtime business partner Tom Ward (numbers 52 and 53). Taken together, this cluster of Texans and Oklahomans all connected through McClendon and including Ward, Chesapeake Energy, Centaurus, and Kaiser held about 10 percent of the total natural gas futures contracts, a large accumulation on an exchange that helped set the continental price of gas. The largest single trader—BP—held only 7 percent.