The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters (32 page)

Mark Papa’s mood was anything but cheery. Every month, a different rival was announcing a new shale play or an extension of an existing big field, and touting how much gas was on the way. To most in the industry, the progress tapping shale and other tough rock was heartening. To Papa, the news couldn’t have been more troubling.

Papa kept especially close tabs on what his biggest competitor, Aubrey McClendon, was up to. Papa kept reading about how Chesapeake was finding more gas in shale deposits in the Barnett, the Haynesville, the Marcellus, and elsewhere, and how the company was paying higher prices for additional acreage. Papa went on Chesapeake’s Web site to listen to Chesapeake’s quarterly conference calls, trying to learn more about the company’s strategy.

Even if they’re exaggerating, that’s a ton of gas,
he thought.

One day it hit Papa hard—a glut of natural gas was imminent, no matter what the peak-oil believers thought. Shale drilling was for real. He was gripped by fear—he ran a gas company and prices were sure to tumble. He had to find a solution. As the EOG managers settled into their seats in the resort’s meeting room, Papa got right to the point.

“Guys, we need to talk,” he began. “We’re all euphoric right now and everything looks rosy, but we need to make some radical changes.”

Papa saw confused looks on the faces of his staff, but he kept going. “I’m here to tell you, natural gas prices are going to be weak for twenty or thirty years,” he told the group. “We’re gonna have to convert this company to an oil company or we’re dead ducks. Tell your people to stop looking for gas, right away.”

Complete silence.

No one in the room really knew how to react. Gas wasn’t a cinch to extract from shale and other dense rock. But they all knew oil was much, much harder. Everyone else was buying shale gas acreage and their boss was saying they needed to look for oil? It was as if legendary New England Patriots coach Bill Belichick, in the locker room after winning the Super Bowl, told his team they were going to ditch football and learn to play another sport.

“People thought I had lost my mind,” Papa says. “Their whole lives it was about finding more gas, gas is good, the nation needs more of it.”

Papa said EOG would begin searching for oil in earnest, both in the Bakken and elsewhere in the country. His right-hand man, Bill Thomas, had been pushing them to focus on oil. Now Papa was on board.

He just hoped he wasn’t too late.

A
ubrey McClendon welcomed his guests with a warm smile.

It was a brisk March evening in 2008 and some of the most powerful men in the world were walking down the staircase at the ‘21’ Club, one of New York’s oldest and classiest restaurants, to join McClendon for dinner.

Legendary investors George Soros and Stanley Druckenmiller were there. So was Sadad Husseini, a former senior executive of Saudi Aramco, the largest oil company in the world, and the evening’s invited speaker. Matthew Simmons, an influential banker, author, and adviser to President George W. Bush, also made his way downstairs, rounding out a who’s who of energy and finance.

McClendon and his cohost that evening, stock research specialist Kiril Sokoloff, greeted their guests in a private dining room surrounded by racks of top-notch wine and near a private cellar that once held the private collections of John F. Kennedy, Ivan Boesky, and Frank Sinatra. McClendon exchanged a few words with each man, rattling off a personal detail that made each feel he was the most important guest that evening. Everyone took an appointed seat, with McClendon at the head of a long rectangular table, his confidence and swagger unmistakable.

The stock market had turned a bit rocky, housing was weakening, and some wondered if the economy could hold up. A month earlier, the market for risky “subprime” mortgages had collapsed. But investors, convinced that energy supplies were running dry, had sent natural gas prices over ten dollars per thousand cubic feet and crude above $100 a barrel, putting the energy men in the room in good spirits, especially McClendon.

Once, McClendon had been the industry’s bad boy, a self-promoting salesman who seemed to spend and borrow too much to grow Chesapeake. He had nearly imploded his company not once but twice. Now he was virtually a spokesman for the oil and gas business, promoting the wonders of homegrown natural gas and leading a group of upstart companies with dominant positions in shale formations that experts finally were beginning to appreciate.

Chesapeake shares were up 50 percent since Tom Ward quit Chesapeake a year or so earlier, making McClendon a billionaire, just like some of his dinner mates. More accurately, McClendon was a multibillionaire, including shares of his company and his other investments. George Soros wanted to have dinner with him. It didn’t get much better than that.

As waiters converged on the table, McClendon chose an assortment of top-of-the-line wines to accompany a specially ordered three-course meal featuring sautéed lobster tail and risotto with asparagus.

“This is the best wine you’ll ever drink,” Simmons whispered to an investor seated next to him.

Husseini rose to address the group, quickly painting a picture of gloom. Saudi Arabia’s oil production was slumping and the country had invited ExxonMobil, Total SA, Royal Dutch Shell, and others to search for new pockets of natural gas. Their efforts weren’t worth the cost, however, another sign of how much harder it had become to discover energy.

Oil and gas demand from China, Brazil, and other emerging-market nations was growing, Husseini noted, even as global supply came under pressure, sending prices higher. The Western world would just have to adjust to a lower standard of living, he argued.

From all the head-nodding around the table it didn’t seem as though anyone disagreed. Two years earlier, Simmons had made a similar argument in his best-selling book
Twilight in the Desert
. Oil and gas production in Mexico, the North Sea, and elsewhere was in decline, and U.S. oil fields had been written off as a hopeless cause. Shale gas seemed promising for only a few companies, like Chesapeake; shale oil from places like the Bakken wasn’t on anyone’s radar.

As Husseini finished, one of the dinner guests, Jason Selch, raised a hand to make a comment. Selch, a veteran investor who worked for real estate mogul Sam Zell, was known for being a bit cheeky. Two years earlier, he had been fired by a previous employer after dropping his pants and mooning an executive who had fired one of Selch’s colleagues.

Selch knew McClendon’s company was making rapid progress extracting gas from U.S. shale formations. It gave him an idea. “You should ask Aubrey to help,” he told Husseini. “He’s been finding lots of gas in places no one thought” it could be found.

All eyes turned to McClendon. He gave a shake of the head and a modest smile. “Thanks, but we’re too busy in the U.S.,” he told the group.

McClendon and his guests thought they had it all figured out: The world was running out of oil and gas. A few players able to find some would survive. Even fewer managing to tap exciting shale formations, like Chesapeake, would get super-rich.

Just a few weeks earlier, McClendon had told Chesapeake shareholders that his company was in such a good position that he was done buying acreage. They controlled more than thirteen million net acres and had plans to drill thirty-six thousand wells over the next few years.

The “modern-day equivalent of the great Oklahoma land runs of the 1800s” was “largely over for Chesapeake,” McClendon wrote in the company’s annual report. “We believe we have emerged with a superior position.”

McClendon’s shares were growing more valuable with each trading day. He also was profiting from natural gas futures positions in his brokerage account, according to his friends. It seemed that he and Chesapeake couldn’t be stopped.

•   •   •

O
n a Sunday morning in May 2008, McClendon drove to an Oklahoma City restaurant to meet Art Swanson, the small-time energy operator who was a high school acquaintance of McClendon’s and was working on their ambitious racetrack/golf course development. By then, the price tag for the project had topped $200 million, a sum that seemed outrageous, even for McClendon. Over pancakes and omelets, he and Swanson decided to scrap the idea.

They began to discuss business. Two months earlier, venerable investment bank Bear Stearns had collapsed, amid growing jitters about a potential bursting of the nation’s housing bubble and its impact on the financial system. The mortgage mess didn’t seem to matter to the energy world, though, as crude prices approached $120 a barrel and natural gas was close to twelve dollars per thousand cubic feet.

McClendon didn’t seem quite as upbeat and cocksure as usual, though. He leaned over to Swanson, as if to share a secret. “You know what my big fear is?” he asked.

Swanson couldn’t venture a guess. McClendon never seemed to fear much of anything.

“We could break the gas market,” McClendon said.

He confided that Chesapeake was discovering so much natural gas that their new supply, along with the gas others were extracting from shale, might overwhelm demand, sending prices tumbling and jeopardizing McClendon’s empire.

Swanson had an instant solution. “Aub, why not just pay off everything and go to cash?” he asked. “Why not hedge things?”

If McClendon sold some of his shares and gas futures positions, he could pay off his debt and walk away a rich man, like a gambler cashing in a portion of a huge stack of chips, Swanson was saying. Chesapeake also could slow or hedge some of its gas production. The company also might look for some oil, if only to spread its bets out.

Do something to reduce your risk, Swanson urged his friend.

McClendon gave Swanson a dismissive look, as if the small-fry, local producer didn’t understand the predicament he was in. “He looked at me like I was a dumbass,” Swanson recalls. “Like I just don’t get it.”

Swanson didn’t realize it, but McClendon was boxed in. He had spent years as Chesapeake’s biggest booster, and as the most vocal advocate of drilling for natural gas in the United States. Bailing out now, with Chesapeake shares soaring, risked sending a message to the market that extraordinary amounts of gas couldn’t be extracted in the country after all. After selling investors a story about Chesapeake’s growth, even someone as smooth as McClendon might have found it challenging explaining why he was taking money off the table.

McClendon also was in a bind because Chesapeake had negative cash flow—it spent more than it took in—and owed $11 billion. To make ends meet, the company regularly sold shares and debt to Wall Street investors. The only way McClendon could continue to do that was by assuring the investors that the future was bright and Chesapeake’s growth would allow it to pay off all that debt. If he turned the spigot off and ordered Chesapeake to slow its production, the company’s stock and bonds likely would crumble and McClendon wouldn’t be able to raise new cash to keep the company going. It was a game of musical chairs. If McClendon turned off the music, he’d suffer a painful fall.

Even if McClendon had wanted to pare some of his holdings, it wasn’t clear he could. Like other companies, when Chesapeake sold stock it came with conditions barring senior executives from selling shares, at least for a limited time. Besides, McClendon still believed in his company and in his country. More than 75 percent of his $18.7 million in compensation the year earlier had been in stock awards.

When he spoke with colleagues and friends, McClendon was as confident as ever in the shale revolution and in his own ability to navigate any challenges. He was the nation’s gas king, after all. “I thought that our employees and most importantly, our investors, needed to see me as a strong leader believing one hundred percent in what our company stood for,” he said.
¹

Indeed, the caution he expressed to Swanson proved fleeting. Both McClendon and Tom Ward were so bullish that by June each controlled nearly identical wagers on natural gas derivatives worth around $2.3 billion, according to trading data later disclosed by U.S. senator Bernie Sanders of Vermont and later reported by Reuters. Among three hundred banks, hedge funds, energy companies, and other traders identified by the Commodity Futures Trading Commission, only four held bigger gas bets than McClendon and Ward. McClendon held additional contracts on oil worth another $240 million, according to the data.
²

McClendon had vowed to rein in the company’s spending, but a buzz was growing about two new plays. One was the Marcellus Shale, a broad region stretching through Pennsylvania and up into Ohio and New York. A few years earlier, a geologist named Bill Zagorski at a rival company, Range Resources, had convinced his employer to take a shot at leasing and drilling this formation. After a fitful start, they were beginning to make progress.

Earlier in 2008, Terry Engelder, a noted geologist at Penn State University, shocked the industry by determining that the Marcellus held fifty trillion cubic feet of natural gas, an estimate that suggested it was one of the world’s largest fields.

Range was leasing wide swaths of Pennsylvania, but Chesapeake had caught up and passed competitors in earlier shale plays. McClendon was determined to do it again in the Marcellus. The company quickly leased Marcellus acreage, but drilling and extracting gas required additional cash Chesapeake just didn’t have, causing McClendon new headaches.

The Haynesville Shale, straddling northern Louisiana and East Texas, seemed at least as huge as the Marcellus. Chesapeake believed it was the largest natural gas field in the Unites States. Lease rates jumped as drillers such as Floyd Wilson’s Petrohawk, funded by eager Wall Street investors, descended on the area. Each well cost as much as $10 million, but some spewed enough gas in a single day to power eighty-four thousand U.S. homes. “We had never seen something like that,” Wilson says.
³

Chesapeake didn’t have enough money to get gas from both the Marcellus and Haynesville, but McClendon couldn’t resist competing for the new areas. “In these plays, if you snooze, you lose,” he told investors. “And with over four thousand landmen in the field every day buying new leases, I can assure you that Chesapeake is not snoozing.”
⁴

Chesapeake managed to get its hands on promising acreage in the Marcellus by focusing on parts of the state Range hadn’t yet locked up. It also was leasing land in the Haynesville. Coming up with money to drill new gas wells in the area before the leases expired and reverted to landowners was an entirely different story, however.

McClendon sat down with his old friend Ralph Eads, the senior investment banker at Jefferies & Co., to figure out how to find a cash infusion. They took out a giant piece of paper and began to list all the known and emerging shale plays and how much money it would take to become a dominant player in each. There was the Marcellus, and the Haynesville. The Bakken looked interesting, as did the Fayetteville and a few others.

Eyeing the list, Eads estimated that it would take more than $500 billion for companies like Chesapeake to become major players in the various regions. There was just no way McClendon’s company, or anyone else, could raise that kind of cash from investors, however. Selling stocks and bonds no longer would cut it.

“You’ve got to come up with another plan,” Eads leveled with McClendon, who agreed. They quickly developed the idea of selling portions of Chesapeake’s existing acreage to companies that had missed out on becoming players in the shale revolution but were eager to get involved.

Eads reached out to Jim Flores, the chief executive officer of Plains Exploration & Production, to discuss the Fayetteville Shale. “Aubrey and I have calculated it, and it might be the largest gas field in the world,” Eads told Flores, citing early results from a test well that showed unprecedented gas flows.
⁵

On July 1, 2008, Chesapeake and Plains announced a joint venture called a “cash and carry” deal. Plains agreed to buy a 20 percent stake in the 550,000 net acres Chesapeake had accumulated in the Haynesville Shale for $1.65 billion in cash. Plains also agreed to spend another $1.65 billion over seven years to cover half of Chesapeake’s drilling costs in the area, in exchange for just 20 percent of the future profits.

The deal was a coup for Chesapeake because it instantly raised billions in cash to pay for new wells. Just as important, the transaction proved what McClendon had been telling investors—shale acreage was really valuable. Chesapeake had spent an average of $7,100 an acre on its drilling sites in the Haynesville, but Plains paid Chesapeake the equivalent of $30,000 an acre. McClendon had instantly locked up nearly $23,000 of paper profit for each of its 550,000 acres, or almost $13 billion.