Chesapeake Energy Rig Site

Photo credit: Chesapeake Energy

The legal problems of Chesapeake Energy (NYSE:CHK) continue to grow. Last week, Chesapeake Energy and Encana (NYSE:ECA) were charged with colluding together to keep oil and gas lease prices low in the state of Michigan. Now, the governor of the state of Pennsylvania is launching an investigation into Chesapeake's Marcellus shale royalty payment practices. This is yet another skeleton in the closet, so to speak, that adds a new layer of risk to Chesapeake Energy investors.

Another black eye
Pennsylvania state law requires oil and gas companies to pay a minimum royalty of 12.5% to owners of land that has been drilled and is producing hydrocarbons. These royalties can be much higher; it just depends on the lease. However, the issue is that companies are also allowed to charge "post-production costs" for the transportation and processing of the gas, and Chesapeake Energy appears to have taken advantage of this more than its peers.


Photo credit: Chesapeake Energy

An investigation by the Wall Street Journal, which reviewed royalty checks from Chesapeake Energy, Anadarko Petroleum (NYSE:APC) and Statoil (NYSE:STO), found that the deductions taken by Chesapeake far surpassed those taken by its peers. In one example, Chesapeake Energy deducted 37% of the royalty payment for expenses such as shipping the gas on pipelines, and for processing the gas. Anadarko, on the other hand, just deducted 18% from its share of the royalty payment from that well, while Statoil didn't deduct anything. Because of examples like this, Chesapeake Energy is alleged to be defrauding landowners.

Pennsylvania has had enough
The state of Pennsylvania is beginning to push back on this practice. The state legislature has introduced a bill that would clarify the current law, and reinstate the 12.5% minimum royalty payment. That, of course, would add to Chesapeake's costs. In addition to that, some landowners have sued Chesapeake Energy in a dispute over one kind of deduction the company is taking. Right now, the settlement from that suit is estimated at about $7.5 million; however, that amount could rise as new landowners join the class action lawsuit.

The bigger problem for Chesapeake Energy, and the industry as a whole, is that these issues are eroding the trust and goodwill of that natural gas industry according to Governor Corbett. This will make it more difficult for gas producers to operate in the state, and could cause additional restrictions or fees to be added in the future. Further, the state is less likely to enact any new policies that are viewed as favorable to the industry.

Not only that, but the image hit Chesapeake Energy continues to take will impact its ability to sign new leases in the future. Landowners might decide to sign elsewhere, or not at all, no matter how much Chesapeake Energy is paying. A prime example of this would be if the moratorium on fracking is ever lifted in New York, as Chesapeake Energy might not find a warm welcome given its poor reputation.

Investor takeaway
Chesapeake Energy has a lot of unknown risks lurking, as its questionable past dealings are starting to catch up to the company. That's adding to the company's legacy image problems, which will continue to hold back the value of its stock. While these issues don't necessarily mean the stock is a sell, Chesapeake Energy must correct any mistakes it made in the past and improve its reputation before its stock will show its true worth.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Statoil (ADR). 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. The Motley Fool has a disclosure policy.

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