We have been watching the demise of Chesapeake Energy (CHK) unfold. In addition to the news of $1.1 billion in unreported loans, Reuters has now exposed a $200 million hedge fund which Aubrey McClendon ran from the headquarters of Chesapeake Energy. This hedge fund invested in the same commodities that Chesapeake produces. Further, Senator Nelson has now called for an investigation by the Department of Justice to look into possible fraud and price manipulation.
The issues of corporate governance, potential fraud, the use of off balance sheet financing and the complexity of financial engineering has been nothing short of breathtaking. But I think we need to step back and examine the full import and implications of shale gas economics because Chesapeake may simply be a microcosm of a more systemic anomaly which is much broader and more problematic.
Seduction is heady business…literally. As we all know the very best part of seduction is what is in your mind, not necessarily what is reality. As so it may be with shale gas. While we were enjoying the exceptional economic party of the last twenty years, corporate America rose to new heights and an interesting dynamic quietly slipped into place. I am speaking of what I call the two economies: one real and one virtual.
The real economy is based on actual goods and services. The virtual economy is based on a perception that goods and services exist.
The financial markets are meant to provide capital to legitimate businesses for commodities or products supplied to people who need them. Public relations has an obvious role in promoting such commodities or services but somewhere along the way we began to substitute legitimate products for public relation generated perceptions or mere spin.
Industry has claimed shale gas reserve figures round the globe which are off the charts. The USGS recently slashed such estimates by 80% in the U.S. for the Marcellus Shale. Then the Polish government, working with USGS, slashed estimates there by 85% and now we learn that reserve estimates are being slashed considerably in India as well. But such original and erroneous reserve estimates by industry give the perception that shale gas is overtly abundant. It also froths the markets and makes capital more available.
Apparently, in this virtual economy, it is no longer necessary to show proof of an actual widget or a truly proved natural gas field, you merely spin a widget or reserves to receive a huge influx of cash from Wall Street. For instance, the Powers Energy Investor noted that Chesapeake and Southwestern had claimed average EUR’s in the Fayetteville of as much as 2.4-2.6 Bcf. But there has never been a single shale well in the Fayetteville play that has ever produced more than 1.7 BCF according to production data filed with the Arkansas Oil and Gas Commission. Most do well to produce even 1 Bcf and the average for Chesapeake wells is 541 mcf. Other examples abound.
So, have we created entire industries such as shale gas that spin so well that monies now chase virtual widgets on a vast scale?
I suppose it was a logical progression. We had already shifted from a manufacturing economy to a service based economy so we were used to the idea that you need not provide something physical for an exchange. Further the Internet has grown exponentially and virtual realities are commonplace, so the intellectual leap to a “virtual” economy or “virtual” reserves was simply a change…in perception.
We first bundled mortgages that would obviously never be paid and shifted them here, there and back again with the sleight of hand of a good magician. We have now bundled leases and shifted them here, there and back again in a shale gas land grab which McClendon himself bragged made him more money than actually drilling for gas. During an earnings call he stated, “I can assure you that buying leases for x and selling them for 5x or 10x is a lot more profitable than trying to produce gas at $5 or $6 per million cubic feet.”
Try producing gas at $1.85 per mcf.
In this virtual economy, some have learned to use hype and in some cases just plain lies to froth the stock market into a frenzy only to move in to shift assets, or perhaps just the perception of assets, here, there and back again for more fees and better pay. McClendon borrowed $1.1 billion without ample shareholder disclosure against assets of a publicly traded company which he ran and shifted more assets within a hedge fund that was trading in the very commodities that Chesapeake Energy was engaged in producing. Again without disclosure to shareholders.
During the past decade or so income inequality in this country has moved off the charts. The average CEO total pay package is over $400 million for the top ten CEO’s in America while the worker bees haven’t kept up with inflation. And yet it is they who actually created that $400 million in wealth. McClendon was allowed to participate in wells using someone else’s money to pay expenses while other executives at his company were forbidden to engage in such activities. He apparently made about $63 million in 2011 on such activities.
This game is elitist like LaCrosse and only played by certain players in certain elite positions. It is not baseball.
Now in this virtual economy we have numbers questioned by the SEC in public filings, non-disclosure of material information, jobs figures apparently grossly inflated, assets hidden off balance sheet, layer upon layer of opaque financial transactions, industry providing government authorities such as the SEC with reserve projections without insistence by such authorities of independent verification and the list goes on. All the while the industry PR machines spin day and night to create the illusion that something really, truly exists. But does it?
It is interesting to note that small business owners can’t typically bundle, hype and shift virtual products. They have to actually provide something real in a legitimate exchange. Billions of dollars are not available to them to swap for a possible inside trade that may be based on nothing more real than superb BS.
And yet small business owners are the ones who have been impoverished. They are the ones whose businesses have failed and faltered and struggled. They are also the largest provider of net new jobs in the U.S., in spite of all the oil and gas industry’s rhetoric, and hence a collision of the two economies, real and virtual.
In other words, the real economy has been derailed by its avatar.
Unmitigated greed at any cost is never sustainable. Considerable off balance sheet financing can hide a multitude of sins. Unfortunately, a good argument can now be made that hiding sins is precisely why it is used. Elitist, insider deals and machinations have clearly not been fixed since the last meltdown. Excruciating financial engineering should not be needed in a truly healthy economy or a truly healthy company.
All organic systems have checks and balances. Ideas acted upon can build empires, provide products, feed the masses. Perceptions, however, are hollow and will ultimately bring down empires, destroy the ability to produce products and will never ever fill a hungry belly. The capital markets should not be available for that kind of exploitation. Spin is not an acceptable alternative to real goods and services.
It is now as though we believe our own internet fiction; that virtual economies can replace the real thing and perceptions can replace real goods like the actual energy we need.
Deborah Rogers is an Earthworks board member.