The Big Fracking Bubble: The Scam Behind Aubrey McClendon's Gas Boom

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After graduation, McClendon married his college sweetheart and went to work for a small Oklahoma City oil company owned by his uncle. He worked in accounting for a few months, but quickly became what is known in the industry as a "landman" – the person who finds and negotiates the leases that allow drillers to extract oil and gas. "Landmen were always the stepchild of the industry," he says. "Geologists and engineers were the important guys – but it dawned on me pretty early that all their fancy ideas aren't worth very much if we don't have a lease. If you've got the lease and I don't, you win."

In 1982, McClendon struck out on his own as a landman. He was 23, living in a modest house, making $24,000 a year. "I bought a typewriter, rented an office, bought some maps and basically just started to follow around other companies, trying to see what crumbs they would leave," he says. He called his tiny outfit Chesapeake Investments – for no reason except that "I always loved that region of the country." He soon forged a partnership with another landman, Tom Ward. "We worked together for six years," Ward recalls, "doing deals for scraps of land in Oklahoma, faxing each other in the middle of the night. Eventually, we got the hang of it."

When the fracking revolution began, McClendon says, he and Ward quickly realized that the new technique offered them an opening. In the natural gas industry, the advantage had long gone to operators with the geological and engineering expertise to pinpoint gas reservoirs. Now it didn't matter where you drilled – the gas was pretty much evenly distributed throughout the earth's deep shale layers. The edge suddenly belonged to operators who could lock up as much land as quickly and as cheaply as possible – precisely the skill that Ward and McClendon had developed scraping around Oklahoma land deeds. In 1989, the two men chipped in $50,000 to form a new company, Chesapeake Energy, to focus primarily on shale gas. It grew like a Silicon Valley startup: By 1993, when Chesapeake went public, the firm was valued at $25 million.

From the outset, financial risk-taking was as much a part of the firm's success as technological innovation. Chesapeake was the first gas-exploration company to issue high-yield junk bonds, which gave it a steady cash flow to pay for leasing and drilling. "To be able to borrow money for 10 years and ride out boom-and-bust cycles was almost as important an insight as horizontal drilling," McClendon says. "For the first time, we were able to build a company where, if something didn't work for a little bit of time, we could regroup and find something that did work."

By 2003, Chesapeake had expanded deeper into Oklahoma and Texas, as well as Louisiana and Arkansas. "They became a land-acquisition machine," says Phil Weiss, an analyst at Argus Research who has followed the firm for more than a decade. The key to success was discovering new gas plays before other companies, then leasing vast tracts of land as quickly and quietly as possible.

Chesapeake's land operation became almost as technologically sophisticated as its drilling operation, with a huge databank of property records and mineral-ownership rights across the country. "The goal is not just to pump gas," explains Pickens. "It's also to lock up future reserves." The company's financial statements estimate that it currently holds drilling rights to as much as 100 trillion cubic feet of gas – enough to supply the entire country for five years.

At Chesapeake, McClendon operated more like a land speculator than an oilman. "Our approach is to go in early, quietly and big," says Henry Hood, who directs Chesapeake's land purchases. "We like to get our deals signed before anybody knows what we're up to and tries to run up prices." But buying up such huge swaths of land requires huge chunks of cash – and the money often comes not from gas production, but from selling off land or going into debt. After Chesapeake drills a few wells in a region and "proves up" the reserves, it hawks the leases to big oil and gas companies looking to get into the shale-gas game. In 2010, it pocketed $2.2 billion by selling land it bought in Texas for $2,000 an acre to one of China's largest oil companies for $11,000 an acre. "That's a five-to-one return on investment," says Jeff Mobley, Chesapeake's senior vice president for investor relations.

In recent years, the company has also sold off the future proceeds it expects to receive from thousands of wells – a complex financing deal that enables it to borrow cash now without counting the debt it will owe when it has to drill the wells later. The very first deal, made with Deutsche Bank and a Swiss investment firm, brought Chesapeake more than $1 billion in return for 15 years of future production from 4,000 wells. "It's not illegal, but most gas and oil companies don't do it," says Bob Brackett, an analyst with Sanford C. Bernstein & Co. "Chesapeake's poor credit rating pushes them to turn to unconventional financing."

To make its operations even riskier, leaseholders like Chesapeake are required by law to drill on the land within three to five years after acquiring the rights or wind up forfeiting the lease. "The more land they acquire, the more capital they have to spend upfront," says Deborah Rogers, a former investment banker who learned just how precarious Chesapeake's business model was when she looked into the firm's financial statements after the company sunk wells near her property in Texas. "Then they have to drill it or lose it, which further adds to capital costs. And the more they drill, the more gas they produce, which lowers the price of gas and further reduces their revenues. In the end, this drilling treadmill is difficult to sustain for long – especially if the wells under­perform, or the resource turns out to not be as valuable as they thought."

This sort of gambling suits McClendon, who is known for placing big bets – and sometimes losing big. During the financial meltdown in 2008, McClendon was forced to sell off 94 percent of his stock in Chesapeake – some 33 million shares – for $550 million to meet a margin call on his personal investments. (Only a few months earlier, the stock had been worth $2 billion.) Despite the dramatic setback, Chesapeake's board boosted McClendon's annual salary to $112 million, making him the highest paid CEO at any S&P 500 company at the time. The pay hike, which sparked a shareholder lawsuit, was scorned by Wall Street analysts. "McClendon clearly thinks of Chesapeake as his own personal piggy bank," says one. In the end, that piggy bank may prove to be empty: In February, Chesapeake announced that, because of low gas prices, its revenues will fall $3.5 billion short of its expenses this year.

Until a few years ago, Bradford County was a forgotten landscape of struggling dairy farms and strip-mall nail salons dotting the Susquehanna River in northeastern Pennsylvania. Then, in 2007, gas speculators looking for the next big play zeroed in on the geologic formation called the Marcellus Shale, a 300-foot-thick layer of gas-soaked rock that underlies much of Pennsylvania, as well as parts of Ohio and New York. Chesapeake was one of the first operators to rush into the region, buying up nearly two million acres of land in just a few months. Since then, the company has drilled more than 600 wells here, and it hopes to drill thousands more, virtually covering the region with rigs. "In 10 years," McClendon says, "the Marcellus is likely to become the most productive natural gas field in the world." The county, population 62,000, has already been transformed from sleepy farmland to industrial boomtown: the roads crowded with trucks hauling water, the rail lines rumbling with trains hauling sand, the roadside bars overflowing with drill hands from Oklahoma and Texas, the hotels and motels booked for months in advance.

Chesapeake's operations in the region are run out of an old department store in the county seat of Towanda, located on the banks of the Susquehanna some 20 miles south of the New York state border. It feels more like a military outpost than a corporate office, with dozens of white SUVs emblazoned with the Chesapeake logo parked in rows out front. Inside, offices are separated by thin walls thrown up in a hurry, many of them decorated with arty shots of drilling rigs in pristine landscapes. In these parts, the company's PR efforts are squarely aimed at quelling any environmental fears. To underscore how safe fracking is, Brian Grove, Chesapeake's director of corporate development in the Marcellus region, explains that the layer of shale being drilled is 7,000 feet beneath the surface, whereas drinking water rarely runs deeper than 1,000 feet. "That leaves 6,000 feet of rock in ­between," he says. "There is no way that any fluids are going to migrate from the shale rock up to the drinking-water aquifers."

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