Chesapeake, Horizon, Earnings

Jim Brown
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Chesapeake CEO Aubrey McClendon probably wishes he could visit the bottom of one of his wells after the firestorm over his loans last week. Anywhere the press could not find him would have been preferable. The headlines said McClendon borrowed $1.1 billion from the company against a personal ownership in the wells Chesapeake drilled. On the surface that sounded pretty bad. Why would McClendon have an personal ownership in company wells and why would CHK loan him money against that ownership especially in the current natural gas pricing environment. The reality of the situation is not that bad.

McClendon founded Chesapeake. It was his company before it went public. As part of the conversion to a public company McClendon got a "Founder's Participation Agreement." The board allowed him to keep a 2.5% stake in every well Chesapeake drilled. The program was approved by shareholders in 2005. On the surface that sounds like a huge benefit but it did not work out that way. You see he also had to pay out of his own pocket 2.5% of the cost to drill each well. Over the past three years McClendon has had to pay $661 million in drilling costs while gas prices fell to decade lows. CHK has been drilling wells at a very rapid pace over the last three years.

McClendon earns $17.9 million as CEO of Chesapeake so coming up with $661 million over the last three years put him in a world of hurt. He had to come up with $68 million in 2008 but that rose to $315 million in 2011 because of the faster pace of drilling and higher costs to drill. McClendon was forced to sell some of his stake in 2011 but the price has not yet been disclosed. At the end of 2011 his pretax income from all the wells to date was $409 million.

McClendon was forced to sell a majority of his shares in CHK in 2009 when he received some massive margin calls when the price of gas and the price of CHK shares plunged. He lost $1.9 billion when CHK shares fell from $74 to $16.52 where he was forced to sell to cover the margin call. He had leveraged himself multiple times over because he could not believe the drop in his stock price. He kept doubling down until he had nothing left and lost it all. After his stake in CHK was wiped out the board awarded him shares in succeeding years to help rebuild his stake. As of last week he had 1.78 million shares worth $31 million.

McClendon has built a monster company that he clearly believed in dearly. That belief cost him his fortune and there is a good possibility his current $1.1 billion in loans will be called and he will lose the 2.5% founders stake as well. This is a great lesson in how not to leverage yourself to the hilt. Multiple shareholders have now sued for the full details in the loans and compensation arrangements. McClendon may have done nothing wrong but he has made a lot of bad decisions. He might be better off to just cut his losses and drop all his revenue share agreements and just live on the $17.9 million salary. I suspect everyone reading this newsletter could be very happy on that kind of money and not have to suffer through the heartache McClendon has undergone over the last five years.

Deepwater Horizon Anniversary

Friday was the two year anniversary of the Deepwater Horizon disaster in the Gulf of Mexico. Tens of billions of dollars were spent cleaning it up and additional tens of billions are still at risk for BP and its partners in the government liability trial ahead. The civil class action case has been settled for $7.8 billion but there are thousands of plaintiffs that will probably opt out and go after BP on their own.

The government trial could cost BP $20 billion or more in court costs, legal fees, fines and penalties. The judge has set May 3rd as a date for all parties to show up and lay out their plans for trying the case. After May 3rd the judge will probably set a new court date for the trial to start. BP would like to settle rather than risk a gross negligence finding and see the fines escalate from $1100 per barrel of oil spilled to $4400 per barrel. With 4.5 million barrels spilled that is a huge difference in dollars. The government feels they have a pretty good case after a dozen commissions and agencies conducted independent investigations and all found BP more or less at fault with lesser liability to the actions of others with the possible exception of Halliburton.

Stories in the press last week told of new surveys of fish in the gulf with dramatic problems from the pollution. Pictures of deformed fish, fish with various diseases including petroleum rot where chunks of skin decay and fall off from exposure to oil. Fish without any outward signs showed high levels of toxicity from ingesting other fish, algae and plankton that had been exposed. It will take years before the current fish population dies off and takes their toxicity to the bottom and away from the surface food chain.

In the aftermath of the disaster the government forced stringent new rules on the deepwater drillers that required certification of existing systems and replacement of many to bring them up to a higher level of safety. Stronger blow out preventers with multistage shears capable of slicing through the strongest drill pipe was one major change. Many deepwater rigs are still restricted from unlimited use because the equipment needed to upgrade them is on backorder. Transocean said in their fleet status report last week that only 30 of its 63 active floaters and 18 of its 27 ultra-deepwater rigs had obtained the required third party certification according to the new rules. Six Transocean rigs were headed for the shipyards in Q2 for equipment upgrades so they would be eligible for new contracts.

The disaster spawned a new business of well intervention. New well applications must show access to equipment to be used in the case of a blowout to reduce the amount of oil in the water and to quickly shutoff any runaway well. Helix (HLX) has one system in use and Exxon, Shell and the other majors are putting the finishing touches on a billion dollar system to accomplish the same task. Future blowouts should be resolved much quicker with a lot less oil in the water.

Energy Earnings Surprises

Halliburton and Schlumberger surprised analysts when they beat the street on earnings and raised guidance for the future.

Apparently the decline in the gas patch has not been nearly as disruptive to the service companies as many analysts expected. Halliburton started the ball rolling on Monday with record sales in North America despite the declines in the number or natural gas rigs. The company said the rapid increase in rigs drilling for oil helped offset the decline in gas activity. Halliburton is the leader in the pressure pumping used in fracturing oil and gas wells. HAL cited the number of new fields where drilling is just starting to accelerate as a reason why business would be even better in the future.

The CEO said the current price squeeze in pressure pumping was temporary as it requires less horsepower (number of pumps) to frac an oil well than a gas well. However, the rapid increase in oil well drilling will absorb the available pumps soon.

Halliburton said it was moving five more fracking fleets in Q2 in addition to the eight fleets moved last quarter. The company is also deferring delivery of new equipment until the nationwide activity adjustments are complete and they can gauge future demand.

UBS said the compressed margins, 20% instead of 25%, will likely be an overhang to HAL earnings for the next couple of quarters but the stock is already trading at a 45% discount to historical valuations on advance worries that did not come to pass. Halliburton earned 75% of its income in North America.

Halliburton, along with the other fracking companies, suffered from escalating component prices. Guar, a key ingredient in fracking solutions, comes from a crop grown mostly in India. The price of Guar rose +1,000% over the last year. Guar now represents more than 30% of the total frack price to Halliburton customers.

The image below shows how many Halliburton vehicles are required for a frac job on a gas well.

Haliburton Frac Job Picture

Schlumberger rallied after reporting earnings that beat the street and upgraded guidance. Earnings of 98 cents (+37%) beat the street by a penny on revenue that rose +21.7% to $10.61 billion. The rotation out of the gas patch and into liquids production was causing some stress but it was expected to be temporary since the rigs were reappearing in liquids rich areas. The company was upbeat about the accelerating pace of exploration worldwide saying active rigs outside North America could grow by 10% in 2012.

SLB said what little spare capacity in the offshore seismic sector was filling up fast and backlogs were in the 30% range, up from 16% in Q4. Pricing was also accelerating. Drilling in the Gulf of Mexico and other offshore basins was also rapidly increasing. The CEO said prices for large international contracts was rising and capacity was tightening further. Schlumberger has a much stronger international business than Halliburton and is less impacted by the gas rotation in the USA.

Number three in the pressure pumping business in the U.S. is Baker Hughes (BHI). The company warned back in mid March that the shift away from gas drilling would impact its Q1 earnings. They said the rotation of rigs from gas fields to oil fields was causing "underutilization" of its pressure pumping fleet along with higher than expected personnel and logistics costs. They said shortages of critical raw materials such as the guar gel were also a problem. BHI said there was ample demand in the liquids rich basins but getting equipment and people to those areas in a timely manner was a challenge. A pump technician in the Marcellus Shale area of Pennsylvania may not want to move to South Dakota where temperatures hit 30 below in the winter. An analyst at Simmons and Co. said the problems BHI laid out in their earnings warning were mostly specific to Baker Hughes because of their heavy focus on the gas fields. Baker reports earnings on Tuesday.