Mergers And Acquisitions
Would BP Please Buy Chesapeake Energy?
Christopher Helman, 04.29.09, 06:00 PM EDT
Someone's got to save shareholders from Aubrey McClendon and his monster pay package.


Amid mounting furor from investors and analysts over Chief Executive Aubrey McClendon's $110 million pay package, Chesapeake Energy's shareholders need a savior.

A BP ( BP - news - people ) takeover has been rumored since last November, when Chesapeake Energy ( CHK - news - people ) suffered a liquidity crunch that collapsed shares. The troubled deepened when McClendon was forced to sell 90% of his holdings to satisfy margin calls.

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Yahoo! BuzzThe British supermajor looked to be a natural white knight. Last September BP bought its second of two slugs of natural gas acreage from Chesapeake for $3.6 billion. BP says it's very happy with the assets, with upstream boss Andy Inglis telling analysts a month ago that initial results in the Woodford Shale area were 50% better than BP had expected. With natural gas prices low and likely heading lower, a BP acquisition of Chesapeake could undergird growth for years to come.

Unfortunately, a deal now won't stop the madness of McClendon's pay package. His $2 billion fortune erased, you can't blame McClendon for looking to claw it back. His executive bailout, approved in late December, starts with $1 million in salary, then a $20 million stock grant and a $75 million bonus.

McClendon is required to invest the bonus money in Chesapeake's drilling program--in order to earn a 2.5% royalty interest in every well the company drills. This kind of CEO perk is unique among big publicly traded energy companies--McClendon's stakes in his company's wells are thought to have generated royalties of more than $150 million in the past three years.

But there's more: McClendon's bailout also included $12 million the company paid for his collection of maps and watercolors, $600,000 for the private use of the corporate jets, nearly $600,000 for accounting services and $131,000 for personal "engineering support." Chesapeake paid $4.6 million to sponsor the NBA's Oklahoma City Thunder, of which McClendon owns one-fifth.

The directors on Chesapeake's board, such as former Oklahoma Gov. Frank Keating, owe a fiduciary duty to shareholders, but they owe McClendon their seats and an average $700,000 each in annual renumeration. Keating's son and daughter-in-law also work at Chesapeake, earning more than $130,000 a year.

Outcry is building. The Louisiana Police Employees Retirement System wants records detailing the board's deliberations. Stock analyst Ben Dell of Alliance Bernstein titled a recent report "Will Chesapeake's board please stand up?" and said McClendon's package was unparalleled in the industry.

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McClendon, who co-founded the company in 1983, does deserve a nice bonus. In addition to the deals with BP, he orchestrated asset sales to Norway's StatoilHydro and Plains Exploration, all told raising close to $10 billion in cash and guarantees for Chesapeake. One veteran equity analyst points out that McClendon's pay package is just 1% of that total--a fraction of what investment bankers would have charged in fees to broker the same deals. "No question he's pulled some incredible rabbits out of his hat," he says.

Yet shareholders need to think about the future. Better to have a chief executive who is not distracted by his basketball team, his watercolor collection or his political vendettas (McClendon was a lead sponsor of the Swift Boat Veterans attacks on John Kerry in the 2004 presidential race).

An acquisition of Chesapeake by BP would put an end to the nonsense. BP Chief Executive Tony Hayward took over in 2007 after Sir John Browne was forced out in a perjury scandal. Hayward has stridently focused on cutting waste at BP.

His reorganization of BP's corporate office culled nearly 5,000 redundant positions, including 20% of senior executive posts. This year the company expects more than $2 billion in cost reductions. Hayward's own comp package (paid in British pounds) comes to less than $5 million.

So what would BP get in a deal? Chesapeake has interests in more than 40,000 wells producing some 2.3 billion cubic feet of gas a day (the energy equivalent of about 400,000 barrels of oil a day). These generated net income of $600 million in 2008 on revenues of $11.6 billion. Chesapeake's high water mark was in 2007, when net income topped $1.9 billion on high gas prices.

Cash flow is king, but the real prize is the company's 15 million net acres, boasting 36,000 potential drilling sites--good for a decade's worth of drilling. This untapped inventory is the result of McClendon's "land grab" strategy. Prompted by Chesapeake's success in tapping gas trapped in the geologically tricky Barnett Shale of Texas, McClendon set out in 2003 to buy up promising acreage in other shale regions: the Marcellus, Fayetteville and Haynesville.

The prices of acreage in all of these plays has plummeted since last year. Some acres in the Barnett that were fetching $25,000 now go for $3,000. Natural gas prices, at $3.20 per mmbtu, have gotten so low that Chesapeake in mid-April shut in 400 million cubic feet of daily gas production, about 13% of its total output. Sounds like a good time to buy.

The price tag for Chesapeake would be in excess of $40 billion, considering its $13 billion in equity market cap, $1.6 billion in cash and approximately $20 billion in long-term debt and obligations.

BP could well manage the financial burden of a takeover. Despite announcing quarterly earnings Tuesday that at $2.4 billion were 60% below last year, BP is in fine shape. It has $8 billion in cash, a reasonable 23% debt to capital ratio, and expects to raise $3 billion from divestments this year. It has budgeted $19 billion in 2009 capital spending.

What's more, by 2011 the company intends to sell 20% of its stake in troubled Russian joint venture TNK-BP. If pressed, BP could likely sell the entire stake for some $10 billion. Clean-burning natural gas in U.S. fields or Russian crude oil. Which would you rather own?