This story was co-published with The Daily Beast. by:
Abrahm Lustgarten
At the end of 2011, Chesapeake Energy, one of the nation’s biggest
oil and gas companies, was teetering on the brink of failure.
Its legendary chief executive officer, Aubrey McClendon, was being pilloried for questionable deals, its stock price was getting hammered and the company needed to raise billions of dollars quickly.
The money could be borrowed, but only on onerous terms. Chesapeake, which had burned money on a lavish steel-and-glass office complex in Oklahoma City even while the selling price for its gas plummeted, already had too much debt.
In the months that followed, Chesapeake executed an adroit escape, raising nearly $5 billion with a previously undisclosed twist: By gouging many rural landowners out of royalty payments they were supposed to receive in exchange for allowing the company to drill for natural gas on their property.
In lawsuits in state after state, private landowners have won cases accusing the companies like Chesapeake of stiffing them on royalties they were due. Federal investigators have repeatedly identified underpayments of royalties for drilling on federal lands, including a case in which Chesapeake was fined $765,000 for “knowing or willful submission of inaccurate information” last year.
Last month, Pennsylvania governor Tom Corbett, who is seeking reelection, sent a letter to Chesapeake’s CEO saying the company’s expense billing “defies logic” and called for the state Attorney General to open an investigation.
McClendon, a swashbuckling executive and fracking pioneer, was ultimately pushed out of his job. But the impact of the Financial Maneuvers that he made to save the company will reverberate for years. The winners, aside from Chesapeake, were a competing oil company and a New York private equity firm that fronted much of the money in exchange for promises of double-digit returns for the next two decades.
The losers were landowners in Pennsylvania and elsewhere who leased their land to Chesapeake and saw their hopes of cashing in on the gas-drilling boom vanish without explanation.
People like Joe Drake.
“I got the check out of the mail… I saw what the gross was,” said Drake, a third-generation Pennsylvania farmer whose monthly royalty payments for the same amount of gas plummeted from $5,300 in July 2012 to $541 last February. This sort of precipitous drop can reflect gyrations in the price of gas. But in this case, Drake’s shrinking check resulted from a corporate decision by Chesapeake to radically reinterpret the terms of the deal it had struck to drill on his land. “If you or I did that we’d be in jail,” Drake said.
Chesapeake’s conduct is part of a larger national pattern in which many giant energy companies have maneuvered to pay as little as possible to the owners of the land they drill. Last year, a ProPublica investigation found thatPennsylvania landowners were paying ever-higher fees to companies for transporting their gas to market, and that Chesapeake was charging more than other companies in the region. The question was “why”?
ProPublica pieced together the story of how Chesapeake shifted borrowing costs to landowners from documents filed with the U.S. Securities and Exchange Commission, interviews with landowners, people who worked for the company and employees at other oil and gas concerns.
The deals took advantage of a simple economic principle: Monopoly power.
Boiled down to basics, they worked like this: When energy companies lease land above the shale rock that contains natural gas, they typically agree to pay the owner the market price for any gas they find, minus certain expenses.
Federal rules limit the tolls that can be charged on inter-state pipelines to prevent gouging. But drilling companies like Chesapeake can levy any fees they want for moving gas through local pipelines, known in the industry as gathering lines, that link backwoods wells to the nation’s interstate pipelines. Property owners have no alternative but to pay up. There’s no other practical way to transport natural gas to market.
Chesapeake took full advantage of this. In a series of deals, it sold off the network of local pipelines it had built in Pennsylvania, Ohio, Louisiana, Texas and the Midwest to a newly formed company that had evolved out of Chesapeake itself, raising $4.76 billion in cash.
In exchange, Chesapeake promised the new company, Access Midstream, that it would send much of the gas it discovered for at least the next decade through those pipes. Chesapeake pledged to pay Access enough in fees to repay the $5 billion plus a 15 percent return on its pipelines.
That much profit was possible only if Access charged Chesapeake significantly more for its services. And that’s exactly what appears to have happened: While the precise details of Access’ pricing remains private, immediately after the transactions Access reported to the SEC that it collected more money to move each unit of gas, while Chesapeake reports that it also paid more to have that gas moved. Access said that gathering fees are its predominant source of income, and that Chesapeake accounts for 84 percent of the company’s business.
What’s more, SEC documents show, Chesapeake retained a stake in the gathering process. While Chesapeake collected fees from landowners like Drake to cover the costs of what it paid Access to move the gas, Access in turn paid Chesapeake for equipment it used to complete that process, circulating at least a portion of the money back to Chesapeake.
ProPublica repeatedly sought comment and explanations from both Chesapeake and Access Midstream over the course of several months. Both companies declined to make executives available to discuss the deals or to respond to written questions submitted by ProPublica.
Days after the last of the deals closed, Drake and other landowners learned the expense of sending their gas through Access’s pipelines would eat up nearly all of the money they had been previously earning from their wells. Some saw their monthly checks fall by as much as 94 percent.
An executive at a rival company who reviewed the deal at ProPublica’s request said it looked like Chesapeake had found a way to make the landowners pay the principal and interest on what amounts to a multi-billion loan to the company from Access Midstream.
“They were trying to figure out any way to raise money and keep their company alive,’’ said the executive, who declined to be named because it would jeopardize his dealings with Chesapeake. “I think they looked at it as an opportunity to effectively get disguised financing…that is going to be repaid at a premium.’’
***
At 54, Joe Drake guns his six-wheeler up a steep rock-rutted trail on the backwoods of his 494-acre tract and points to his property line, marked by a large maple in a sea of indistinguishable trees. He knows where it lies, because as a kid his father made him walk that line to string barbed wire. The wire is long gone, but a rusted snag remains entombed in the bark. Back then, the Drakes ran a dairy farm in these pastures.
“It’s just something you’ve got in your blood that you do,” Drake said. “But dairy farmers are a dying breed… It was a good way of life.”
Today, the milking stalls have been ripped out of a long barn that still carries the stench of their manure, but stores 20-foot stacks of bailed hay instead. Drake sold all 187 head of cattle two years ago, pinched by regulated milk prices and the rising costs of independent farming. He took out a second mortgage to keep the farm afloat.
Across the road, past his house and just beyond a stand of Oak and Ash, the hillside’s natural shape transitions to a steep slope of pushed dirt, capped by a 7-acre flat the size of a large gravel parking lot. In the middle stands a 6-foot stack of steel pipes and valves – a gas well.
When Chesapeake arrived at Drake’s door, he was optimistic. Drake plastered a “Drill, baby, drill” bumper sticker in the window of his Ford F-250 pickup. He welcomed the chance to draw an easy income from his land, and was unswayed when his neighbors raised questions about the environmental risks of drilling. Chesapeake promised Drake one-eighth the value of whatever it made from his well. It seemed like a fair deal.
If any driller was going to make money for Drake, he thought, it would be Chesapeake. The company had built an empire off finding and drilling natural gas discoveries as the fracking boom rolled across the country. With uncanny foresight, its founder, McClendon, locked up exclusive access to immense tracts of land across the country by promising property owners that their lives would be transformed by the wealth the gas under it would bring.
Then the company drilled furiously -- in Oklahoma, then Texas, Louisiana and later in Pennsylvania’s Marcellus Shale – catapulting itself to the rank of second-largest producer of natural gas in the United States. It made McClendon – who snatched up a stake in the Oklahoma City Thunder basketball team and moved into a stone mansion in the posh Oklahoma City suburb of Nichols Hills -- one of the richest men in the world.
McClendon – named by Forbes in 2011 as “America’s Most Reckless Billionaire” -- would find his way into plenty of personal trouble. He took a personal stake in Chesapeake’s wells, and then liquidated his stock in the company in order to cover his own losses, rattling investors and ringing corporate governance alarm bells. He drew scrutiny for selling his $12 million antique map collection to the company and ire for taking a $75 million bonus as Chesapeake struggled.
In 2012, he borrowed as much as a billion dollars from the company’s private equity partners to fund his private interests. Separately, an investigation by Reuters alleged Chesapeake had rigged land leasing prices in Michigan, under McClendon’s direction, sparking a federal criminal probe.
But McClendon’s overarching design for the business nonetheless made it a formidable player. Chesapeake aggressively pursued business opportunities beyond its drilling. It created interlocking businesses and took advantage of tax breaks that deliver out-sized benefits to energy companies.
By structuring itself this way, Chesapeake earned a slice of profit from each step. Chesapeake’s subsidiaries trucked the drilling materials, drilled the wells, fracked the gas, gathered and piped it away to a hub, and then marketed the end product – what economists call vertical integration. In fact, he built Chesapeake into a powerhouse, an echo of the old Standard Oil empire, positioned to control almost every variable and armed with the leverage to get its way.
Neither McClendon nor his staff responded to requests for comment for this article.
From early on, the company viewed the local pipelines as a profit source. Chesapeake formed subsidiaries to build and run the lines, then spun them off into a separate, publicly traded company. That company would eventually evolve into Access Midstream, when Chesapeake sold its shares – one of the three deals – for $2 billion in 2012.
The strategy paid dividends. At Chesapeake’s headquarters, a group of new, distinctively-designed office buildings went up, with views south over the state capital and the city’s small skyline. The company lavished its employees with perks, too. “They’ve got a 72,000-square-foot gym, free trainers… free Thunder tickets,” said Andrea Watiker, who scheduled pipeline capacity for gas traders in one of the company’s new towers.
Confident he was in good hands, Drake endured the trucks, dirt and noise that accompanied gas drilling and signed agreements that allowed Chesapeake to run pipelines across his fields. To transport the gas from Drake’s well, Chesapeake built a pipeline that stretched south from within spitting distance of the New York border, cutting a wide swath through the forest. Then it went down beyond the white-spired church in Litchfield, and ran some 35 miles further to its handoff at the Tennessee interstate pipeline near the Susquehanna River.
What Drake didn’t know at the time was that the pipeline was more than a way to move his gas to market. It would become part of a strategy to make more money off of Drake himself.
***
When the first gas flowed from the well on Drake’s land in July 2012, it was abundant, and the royalty checks were fat. “We was hoping to get these loans paid off…with the big money,” said Drake, who earned more than $59,400 from the first few months of production, referring to the mortgages on his farm.
That year, many Pennsylvania landowners began receiving similarly sized payments as thousands of new wells – many of them drilled by Chesapeake -- finally began producing gas. Pennsylvania fast approached Texas as the largest source of natural gas in the country, and with it, the prosperity long promised to this rural part of the United States seemed about to arrive.
But then, in January 2013, without warning or explanation, the expenses withheld from Chesapeake’s royalty checks for use of the gathering pipelines tripled. Drake’s income dwindled. His contract with Chesapeake – and Pennsylvania law that sets a minimum royalty share in the state – promised him at least 12.5 percent of the value of the gas. Drake says the company led him to believe any expenses would be negligible. “Well, they lied.”
A few miles away, the same month, his brother-in-law had 94 percent of his gas income withheld to pay for what Chesapeake called “gathering fees.” Others across the northern part of the state also saw their income slashed. “I’ve got a stack,” said Taunya Rosenbloom, a lawyer representing Pennsylvania landowners with natural gas leases. She pulled the statements of all of her Chesapeake clients into an eight-inch pile on her desk. “Everyone is having this issue.”
Drake found the statements Chesapeake mailed him each month mystifying. He pored over the papers, hire
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