Wednesday, April 18, 2012

Chesapeake Energy (CHK) Discovers Gas-Powered Self-Licking Ice Cream Cone

CEOs have a lot of power.  They can hire and fire thousands of employees at will.  They negotiate deals worth billions of dollars.  They even have a new prerogative of which I was previously unaware:  Energy CEOs can use equity in projects they don't yet own as collateral for loans to acquire those projects from their employer.  That's the deal the CEO of Chesapeake Energy (CHK) has worked out with the company he runs.  This freebie has apparently never been disclosed to this natural gas producing company's shareholders but takes the risk on the company's balance sheet to a whole new metaphysical level.  

This particular deal by itself doesn't materially endanger the company as long as the wells in question keep producing.  Chesapeake's shareholder equity cushion of $16.6B for the quarter that ended last December is plenty big to cover the notional loan amount of $1.1B.  The bad news is that non-disclosure of this moral hazard raises questions about other potential sweetheart deals the company has not revealed.  It also raises the issue of agency costs to shareholders if executives are accustomed to using their company's balance sheet as a backstop for self-enriching deals.  This perk's sole purpose is to enable insiders to strip productive assets from a healthy company.  If those assets suddenly become nonviable (lower natural gas prices and pipeline disruptions can do that), the loan could become non-performing but the company can't recover from this credit event because it already owns the collateral for the loan.

This deal is the embodiment of the self-licking ice cream cone theory, applied to business value creation.  In the final days of the Soviet Union, Communist Party officials and intelligence operatives took control of state-owned assets to enrich themselves and become power brokers in post-Soviet Russia.  I cannot determine how this deal is any different from those events.  

Full disclosure:  No position in CHK at this time.