Should You Fear the Skeleton Lurking in Chesapeake Energy’s Closet?

Photo credit: Copyright © Encana Corporation. All rights reserved.  

On Wednesday, the state of Michigan charged Chesapeake Energy (NYSE: CHK  ) and Encana (NYSE: ECA  ) with colluding to keep oil and gas lease prices artificially low in the state. These charges which have penalties that could include prison terms for individuals and up to a million dollar fine for the companies adds a new layer of risk to an investment thesis in Chesapeake Energy. The question is if this unknown and another still to be uncovered is something to be feared by investors.

History lesson
The case against Chesapeake and Encana dates back to 2010 when the oil and gas leasing boom hit Michigan. Both companies were interested in securing drilling rights to the Collingwood Shale region and according to the state colluded to avoid paying risings prices for leases with landowners. The land rush in the state had pushed lease prices to as high as $3,000 per acre by the middle of 2010, however, soon thereafter lease prices began to plunge.

While both companies deny collusion, the two did hold talks about forming a joint venture in the state that year. While no joint venture agreement was reached, emails surfaced from high-ranking executives at both companies that discussed ways to avoid "bidding each other up" according to an investigation by Reuters. If its true that these two companies did engage in anti-competitive practices it opens up a whole other layer of legal issues.

Photo credit: Copyright © Encana Corporation. All rights reserved.  

The skeleton
In addition to the charges brought forth by the state of Michigan, Chesapeake Energy and Encana both could face federal charges under the Sherman Antitrust Act. Penalties for violating it are severe. Criminal penalties of up to $100 million can be levied on a corporation found in violation of this law. However, under federal law the maximum fine can be increased to twice the amount the conspirators' gain from illegal acts or twice the money lost by victims of the crime if either of those amounts are over $100 million. Because of this there is a risk that these companies could be forced to pay out stiff penalties in the future if found guilty. Needless to say, that unknown is a big risk facing investors.

While both companies are hoping for a civil resolution to the matter, it might not be that easy. The other issue is the fact that the U.S. Department of Justice is looking at more than just the leases in Michigan. Chesapeake Energy was engaged in an aggressive land grab that saw it spend billions of dollars to lock up millions of acres across the U.S. As a leader in the land grab the company will be at the forefront of any future action taken by the government on leasing issues. One of the problems is the perception out there that the company as well as its competitors didn't use the most ethical approach when securing its leases.

Photo credit: Chesapeake Energy 

The movie Promised Land, for example, tells the fictional story of a drilling company's pursuit of drilling leases in a small town. While that company doesn't collude with a competitor, it does use less than ethical means to sway public opinion so that it's easier for the company to secure the drilling rights. This perception of loose ethics within the oil and gas industry is really what's at the core of the collusion charges against Chesapeake Energy and Encana. The wildcat mentality of landsmen and drilling executives could come back to haunt the industry if its found that these companies went too far when locking up leasing rights. 

Investor takeaway
The charges levied against Chesapeake Energy and Encana are pretty serious and could have a financial impact before all is said and done. In addition to the potential financial consequences there is always the possibility of additional penalties such as being barred from signing new leases for a period of time, for example, could be levied. That said, given that the land rush in America is largely over it's unlikely that any negative outcome such as that will have a significant long-term impact on either company's ability to grow. So, while this legal matter is something investors need to keep an eye on as it adds a big new risk it's not yet a reason to sell.

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