The Boom (25 page)

One day, driving back from Hamm’s office in Enid, she asked Ward why he had spent so much on what was basically an unproved prospect. “I was surprised that they had bought the acreage for five hundred dollars an acre,” she testified under oath, “and he said that they really had not bought it for five hundred an acre. It was—they had three hundred dollars—around three hundred an acre into the prospect.” Harold Hamm also testified that Ward had told him he bought the acreage for $500 an acre, and that he later learned that Ward had actually paid less. This testimony would prove crucial. The jury believed that Ward and McClendon had misled Plotner and other investors in the East Virgil prospect. It handed up a verdict against Ward and McClendon, awarding Plotner Oil $904,000 in actual damages and $1.25 million in punitive damages. Ward and McClendon appealed, but the appellate court sided with Plotner Oil and upheld the award. The Oklahoma Supreme Court let the lower court ruling stand.

The appellate court also discussed a damning piece of evidence about the founding of Chesapeake Energy. Plotner had testified during the trial that he had relied on a consulting petroleum engineer named Kenny Davidson, whom he had hired to evaluate the prospect. The justices wrote that “sufficient evidence on the record existed to support a conclusion by the jury that Davidson was secretly working for Ward and McClendon to defraud Plotner Oil even before he was officially hired as the first employee of Chesapeake Operating.” Davidson remained at Chesapeake until he retired in 2005.

A couple days before the Oklahoma jury began deliberating the case, Chesapeake Energy filed paperwork for an initial public offering (IPO). Chesapeake Operating had grown quickly as it got into the business of drilling its own wells. In 1992 the company sold oil and gas worth $10.5 million, up from less than $400,000 two years earlier. The number of wells it owned went from two to twenty-nine. Chesapeake Energy had been formed only a couple years earlier, pulling together assets held by Chesapeake Operating and other entities owned by Ward, as well as by McClendon and his wife.

The new company struggled to find money to keep its doors open. The young executives tried to get traditional bank loans but were turned away. When they did find lenders, the deals were on onerous terms. McClendon secured a line of credit from the Trust Company of the West (TCW), a large Los Angeles investment group, and drew it down quickly. Then Chesapeake secured another loan from Belco Oil & Gas, an energy business owned by the wealthy Belfer family in New York City. An earlier family-backed company, Belfer Petroleum, had merged with Houston Natural Gas, a company that formed the basis of Enron. A member of the family had remained on the Enron board until the end and lost billions of dollars on paper when the stock became worthless. To get both loans, which carried a stiff 9 percent interest rate, both Ward and McClendon had to guarantee the loans with their own personal holdings.

Chesapeake’s financial position was precarious. A few months before filing for an IPO, the giant firm Arthur Andersen resigned as Chesapeake’s independent accountant. One of the most important duties of a public company accountant is to tell investors whether it believes the company is at threat of financial liquidation over coming months. Arthur Andersen wasn’t confident that Chesapeake met that “going concern” definition. It wouldn’t give its imprimatur. Chesapeake disagreed and found another accountant. A few years later, Arthur Andersen, one of the “Big Five” accounting firms, surrendered its license in the wake of the Enron implosion. It had been Enron’s auditor, and hadn’t raised flags about it as a going concern.

McClendon was the chairman and chief executive of the new company, Ward the chief financial officer. Both men were paid $175,000 in salary, but were given an unusual perk. Each could purchase a small 2.5 percent stake in every well that Chesapeake drilled. To prevent cherry picking, they had to choose each year whether to invest in all the wells the company drilled or decline to participate altogether. Ward and McClendon would pay their share of the well costs and receive proceeds from any oil or gas produced. Over the next year, Chesapeake spent nearly $40 million drilling wells. McClendon and Ward’s share of the costs was $1 million each—several times their annual salary. It was an unusual setup that required the executives to borrow large sums. Years later it would cripple McClendon’s career and become a major reason why shareholders rejected its two board of directors candidates in 2012.

Overseeing the perk was a board of directors that wasn’t exactly a paragon of independence. In addition to McClendon and Ward, there was a childhood friend of McClendon’s who did legal work for the company. McClendon and Ward were in hock to the other four directors. In May 1992 these four lent $1.65 million to the company’s founders, in an unusual financial arrangement to help McClendon and Ward pay off money they owed the company. In the post-Enron financial reforms instituted a decade later, this kind of loan was prohibited due to the conflicts created. The directors owed their paid positions to McClendon and Ward. The executives’ pay and perks were approved by the directors. If the directors felt it was necessary to fire one of the founders, wouldn’t it be human nature to hesitate, as McClendon and Ward might not be able to repay their personal debts to the directors? It was a knot of conflicts that left shareholders on the outside.

Chesapeake was the worst performing IPO of the year, McClendon said in a webcast with investors about a decade later. A share of the company ended 1993 worth less than half what it sold for on the first day of trading on Nasdaq. But the money raised selling shares to the public allowed the company to pay down some of its debt to TCW, and it soon secured a more conventional bank loan. Even after raising about $25 million in the IPO, McClendon prowled for more money. He was willing to pursue unconventional sources of funds, inventing them if necessary. In October of that year, he struck a deal with another energy company to help cover the costs of developing a gas field in Texas. Chesapeake boasted that it “believes a financing arrangement of this type is unprecedented in the industry.” This creativity helped keep Chesapeake with enough money to keep drilling. Soon Wall Street began to notice this small company and its gutsy chief executive. From the beginning of 1994, the stock soared for two years, rising nearly 2,000 percent. McClendon drove Chesapeake like a fancy race car, speeding through the curves.

In the first few years, Ward and McClendon worked around the clock. Ward generally arrived at the office between five and six in the morning, put in twelve hours, ate dinner at home, and then worked more. McClendon came in to work later but would often stay at work until two o’clock or later. “There were days when I would be coming in, and he would be going home,” said Ward. “We believed we could overcome any deficiencies with hard work.” Ward’s job was to find places to drill and let Aubrey figure out how to get the money together to finance the growth.

McClendon’s goal was to become a big company. But even as Chesapeake grew, Ward insisted on knowing about every well and often visited the field to talk to the drillers and crews. When he left the company, in 2006, it was because Chesapeake had grown so large that he couldn’t be hands on anymore. “It was causing me a lot of stress,” he said. “I couldn’t keep up.” I asked him if he ever considered asking McClendon to slow down, during the early years or later on. He chuckled at the suggestion. “Oh, no. That wasn’t our model. We were only going to get bigger. That was our lifestyle. That was Chesapeake.” I asked how he would describe the company he had helped create. “More. More,” he answered.

Within a couple years, a flaw emerged in Chesapeake’s business model. To continue growing its production and profit, as Wall Street wanted, it drilled a lot of wells. Soon the company’s cupboard of drilling opportunities ran low. It needed to restock to continue its torrid pace. An opportunity presented itself in late 1994, when Occidental Petroleum drilled a successful deep well into a Cretaceous-era rock formation called the Austin Chalk in central Louisiana. The Los Angeles company was so excited about the well that it put it on the cover of its annual report. Chesapeake was making good wells in the Austin Chalk a couple hundred miles to the west in Texas, using similar techniques. McClendon decided to follow Occidental’s lead, despite signs that Louisiana wouldn’t prove as easy as Texas. Wells on the eastern side of the Sabine River were deeper and under more pressure, which meant that they were more expensive. And the Louisiana wells produced more water along with oil, raising costs further. What’s more, Chesapeake wasn’t entitled to the kind tax exemptions in Louisiana that it received in Texas. Facing this challenged drilling environment, Occidental leased one hundred thousand acres over a couple years. Chesapeake wasn’t willing to take it slowly. It spent $179 million vacuuming up more than one million acres, an area only slightly smaller than Delaware.

Chesapeake said this new Louisiana acreage would be the “focus of the Company’s exploration and development activities in the foreseeable future.” It budgeted $125 million for drilling in 1997 and borrowed $200 million to fund its efforts. By early 1997, Chesapeake told investors it had hundreds of well locations waiting to be drilled, more than twice as many as its nearest competitor. There was just one problem. The wells produced oil and gas, but not enough to justify the cost of drilling them. Chesapeake had gambled that the geology it was accustomed to in Texas would be uniform across a wide area. That wasn’t the case. In early 1997 it spent $40 million to drill ten wells. The company generated barely $1 million in oil and gas for its effort. A couple of Wall Street analysts began raising questions, including one who noted that Chesapeake’s estimates for how much oil and gas could be found in Louisiana “seem quite aggressive.” In June, after months of positive reports about the Louisiana Austin Chalk, Chesapeake precipitously changed its message, stunning investors. Most of the acreage it had leased wouldn’t support profitable wells. It would write down the value of its investment in Louisiana, and it wouldn’t grow as quickly as it had previously promised. The market clobbered its stock on the day of this announcement, and the share value continued to plunge in the following months. By July 1998, seeing few viable possibilities, the board of directors put the company up for sale. The stock was worth one-third of its value the day before announcing the abysmal well results in Louisiana. There were no serious offers for Chesapeake.

McClendon has always been a voracious consumer of information. Ralph Eads recalled how he was impressed that in college, McClendon’s dorm room was full of magazines and books that weren’t on the curriculum. He was just reading them. Years later, when Chesapeake built a corporate gym, a plastic file holder was attached to the wall next to McClendon’s preferred workout machine. On the holder was written, “Aubrey’s Reading File—Please Do Not Disturb.” His staff made sure it was full by the time he arrived in the morning for his exercise. McClendon’s urge to gather more information than anyone else led him to seek a meeting in early 2000 with Peter Cartwright, founder and chief executive of Calpine, a California company that owned power plants that used natural gas to generate electricity. McClendon and his chief financial officer, Marcus Rowland, hopped on the company’s corporate jet, a seven-seat Cessna Citation II, and flew out to San Jose for a lunch meeting at a restaurant near Calpine’s headquarters. Calpine was an aggressive company in the recently deregulated power market. It owned power plants with a capacity to generate 4,273 megawatts, and was either building, or planned to build, enough new plants to quadruple its power capacity.

McClendon crunched the numbers and realized that if Calpine did build all those new power plants, it would burn through five billion cubic feet of natural gas a day, or about a 10 percent increase in US gas consumption. Calpine’s view was that gas was inexpensive, and companies such as Chesapeake could find more. But over the previous few months, McClendon had grown convinced that the American energy industry was going to struggle to keep gas production steady, much less increase it. If demand was headed up—and supply wasn’t—the gas market was about to change. After lunch, the Chesapeake executives headed back to the airport. As they boarded their jet to return to Oklahoma City, McClendon turned to Rowland and said, “We got a chance.”