It's Worse Than You Think at Chesapeake Energy

"Keep pulling the sweater ... Eventually the thing will unravel."
-- Zoolander

That odd quote from Ben Stiller's classic comedy has been stuck in my head ever since I published a story on the compensation for Chesapeake Energy's (NYSE: CHK  ) Aubrey McClendon.

I got plenty of good feedback on the story, and a number of folks who shared the view of McClendon as the consummate big-spending gambler. I also heard a couple of times that the extent to which McClendon gets rich from Chesapeake only begins with the compensation package that I focused on previously.

So I guess I'll keep pulling ...
The latter may be entirely true. As part of the company's "related party transactions" discussion in its proxy is an overview of the Founder Well Participation Program. This provides McClendon the opportunity to buy into -- by paying applicable capital expenses and operating costs -- the wells that the company drills, up to a 2.5% interest.

The amount McClendon pumps into this program is no small matter -- in 2010 the net expenses for him were well over $100 million -- but neither are the rewards. In the first quarter of this year alone, the revenue from his interests was $40 million. In 2009, the future net revenue of McClendon's interests, discounted at 10% per year, was valued at $108 million. In 2010, that value had grown to $308 million.

And don't forget the windfalls that McClendon stands to collect when Chesapeake sells assets. In February, for example, the company sold its Fayetteville shale gas assets to BHP Billiton (NYSE: BHP  ) for $4.75 billion. While I was unable to find any disclosure of exactly how much McClendon pocketed from the sale, the company's proxy does highlight that he sold his stake in conjunction with the company's sale.

When you consider these kinds of numbers, it's as if McClendon is running his own little (or not so little!) oil and gas company, except that this smaller "company" gets the benefit of the resources, size, and reach of the massive Chesapeake. The arrangement also sheds light on why the company would be providing McClendon with $250,000 worth of personal accounting services. A small-company CFO might take home a salary that looks a lot like that.

Don't worry! We'll pick up the tab
Shareholders may look at this arrangement and brush it off because it seems pretty fair. McClendon pays well costs out of pocket and he gets a share of the spoils.

But I think it's silly to assume that McClendon is simply tapping his piggy bank to pay these costs. Between 2005 and 2010, Chesapeake's total debt more than doubled, from $5.5 billion to $12.5 billion. Combine that with McClendon's stock-margin debacle, and it's clear that the man is not afraid of a little debt.

As I noted above, it's as if McClendon has his own little company here, and it's quite possible he's using a lot of borrowed money to stock that company with pieces of Chesapeake assets.

Of course it's even better than that because we've seen that Chesapeake's board of directors has no problem at all with picking up the tab for McClendon's costs when he runs into a rough patch. In 2008 -- the year of the margin debacle -- McClendon was handed the now-infamous $75 million bonus by the board. And where did that bonus go? To the FWPP as a credit against future costs owed by McClendon.

So the big 2008 bonus wasn't simply a matter of McClendon wanting to make up for his well-deserved stock losses. Instead, he may have suddenly found himself in a position that would have prevented him from continuing to snatch up his piece of Chesapeake's jewels.

That's when it really helps to have a board that makes more than $600,000 (on average) and wants to keep you happy.

What's good for the goose ...
This is all done under the party line that McClendon brings "unique skills and energy to the organization" and that the company needs to "retain and motivate" him.

Combining my prior discussion with the plum deal he gets with the FWPP, shareholders really need to ask themselves where the line is between McClendon needing to be "motivated" and him simply being a run-of-the-mill greedy CEO using a company to line his pockets.

Even over at SandRidge (NYSE: SD  ) , where Chesapeake co-founder Tom Ward has brought a lot of the ridiculous Chesapeake pay practices, the company has canceled its well-participation program. Though SandRidge didn't go into extended detail about the cancellation, it did note in its proxy that it "[believes] that termination of the WPP will permit us to retain a greater working interest in future wells, thus increasing proved undeveloped reserves." That certainly sounds like a favorable deal for shareholders.

The bottom line is that Chesapeake's board makes a joke out of the word "governance," and while Aubrey McClendon may be good at what he does, there's no justifying the way he grows his personal balance sheet at the expense of Chesapeake shareholders. Until there's some drastic change in the way Chesapeake conducts itself, there's no way that I'd touch the stock.

That said, the stock market is, as ever, a market for stocks, and there are some quality investors that can't seem to get enough of Chesapeake stock. Our own Motley Fool Alpha has recommended the shares multiple times, and well-regarded value managers Mason Hawkins and Staley Cates at Longleaf Partners own the single largest stake in Chesapeake, currently valued at nearly $2.5 billion.

But if you're looking for an energy stock whose compensation practices won't make you gag, check out the stock that my fellow Fools identified as "the only energy stock you'll ever need."

Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (10) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 08, 2011, at 2:19 PM, strelna wrote:

    It sounds as if it needs to be established if there is not a substantial conflict of interest. Can shareholders have confidence that the board is fully acting solely in their best interests and that of the company itself when the separate activities and financial well-being of the CEO plays such a large part in their deliberations?

    Surely this kind of thing should be scrutinized in a public company. Good article. And thank you. I had no idea.

  • Report this Comment On June 08, 2011, at 2:32 PM, jekoslosky wrote:

    I've never known what to make of McClendon's pay. It seems outrageous. Yet, the company has been one of the best performers in my portfolio, which you can see here: http://bit.ly/kt1ggi.

    It certainly has me rethinking my long-term view on the company.

  • Report this Comment On June 08, 2011, at 3:52 PM, KurtEng wrote:

    Thanks for the good article. I sold my stocks in CHK because of the CEO pay. I have never liked the amount of debt they had, and when there is an egomanical CEO racking up that debt, it probably means trouble. I'll find somewhere else to put that money.

  • Report this Comment On June 08, 2011, at 6:26 PM, TMFKopp wrote:

    @KurtEng

    CHK could turn out to be a good investment, but like you I just have trouble trusting what the future will bring when the CEO treats shareholders like this.

    Matt

  • Report this Comment On June 09, 2011, at 4:31 AM, KurtEng wrote:

    Matt,

    I agree that it could be a good investment and I made good returns on the stocks I bought. When I sold, I imagined myself checking the price in the future and seeing a huge missed return. However, there are other natural gas / oil producers that I would rather invest in. Devon Energy and Ultra Petroleum, for example.

  • Report this Comment On June 09, 2011, at 7:33 AM, rjf53 wrote:

    Nice article Matt

    A couple years ago when I decided to reduce my exposure to NG I gave CHK the boot in part because I decided I was sick of holding my nose over crap like this.

    Ironically, last year when I went looking for more exposure to NG I started look at SD. It took me all of 20 minutes before I noted the same things going on at SD. Fortunately, the fact that SD had eliminated the OPP caused/allowed me to keep looking and eventually I bought SD which has worked out well.

    Although your article wasn't about SD I would point out when looking at Tom's compensation that SD doesn't issue options. So IMO, while you can argue he is still grossly overpaid, at least you have a better understanding of how deeply his hand is in your pocket.

    With Aubrey I doubt anyone knows for certain.

    B

  • Report this Comment On June 09, 2011, at 5:25 PM, TMFKopp wrote:

    @rjf53

    "With Aubrey I doubt anyone knows for certain."

    I think this is an unfortunate truth, but I'm continuing to dig to see if I can't shed a little more light on the issue.

    Matt

  • Report this Comment On June 10, 2011, at 2:14 PM, oldmechanic wrote:

    sounds very much like some of the swindlers i been taken by. Keep up the good work.

  • Report this Comment On June 10, 2011, at 2:17 PM, x937 wrote:

    Natural Gas is the best thing since sliced bread. However, the companies running the show, appear to be flawed in major ways.

    I own 280 acres, and cheasapeake's gas lease expired 2 years ago. (A ten year term). They are claiming "force majure" (aka - act of god), which gives them the right to continue the lease forever, as well as by "payment". (They sent a check, I did not cash it, therefore, it's not a payment).

    Now, it gets interesting. Cheasapeake sold a share (~33%) at the rate of 4 million +. Interesting, however, the lease has expired. What is going on? They never paid me more then 800/year, lol. There is no well, no pipeline, and I'm suing them to end their "false" lease claim, etc.

    ---

    I'm also an engineer, and I strongly suspect that the resistance to natural gas, is coming from within the gas companies. Ouch...it's the tail wagging the dog. They are sabatoging natural gas to protect their oil, coal, etc. Investing in this stock might be investing in slippery characters.

  • Report this Comment On June 10, 2011, at 2:21 PM, x937 wrote:

    fyi: I didnt divulge anything private about chk. They publically, put something against my "expired" lease, and it's availiable for inspection (even online).

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