Visualizing Aubrey McClendon "Rehypothecation" Scheme... And The China Trail

Aubrey McClendon is no amateur when it comes to shady personal transactions involving his company, nat gas giant Chesapeake: Back in October 2008, just after the financial crisis erupted, he was forced to sell more than 31 million Chesapeake shares for $569 million to cover margin calls generated from buying CHK stock just prior on margin. The company’s stock fell nearly 40 percent the week of McClendon’s share sales. McClendon issued an apology but the company’s credibility with many shareholders suffered significantly. It looks lie the story is repeating itself, only this time the margined security is not company stock, but company loans. As Reuters reports in a must read special report "Since he co-founded Chesapeake in 1989, McClendon has frequently borrowed money on a smaller scale by pledging his share of company wells as collateral. Records filed in Oklahoma in 1992 show a $2.9 million loan taken out by Chesapeake Investments, a company that McClendon runs. And in a statement, Chesapeake said McClendon’s securing of  such loans has been “commonplace” during the past 20 years. But in the last three years, the terms and size of the loans have changed  substantially. During that period, he has borrowed as much as $1.1 billion – an amount that coincidentally matches Forbes magazine’s estimate of McClendon’s net worth." Ah yes, net worth calculations, which always focus on the assets, but endlessly ignore the liabilities (as Donald Trump will be first to admit). But ignore that: what is more notable here is the circuitous way that McClendon basically lifted himself by his, or rather CHK's bootstraps: all the loans are collateralized by his 2.5% working interest in new CHK wells drilled every year. In essence a roundabout way of generating "cash" by hypothecation, and levering into an "upside" corporate case. Should CHK however incur asset impairments, and/or if the current price of gas stays at or $2.00, then not only will CHK be gutted but so will the asset quality securing the private loans to the CEO, which on top of everything have no covenants ("There are no covenants or obligations in my loan documents or mortgages that bind Chesapeake in any way," McClendon wrote in an email to Reuters.) and thus no stakeholder protections. Is it any wonder then that CHK is getting creamed as of right now as investors are once again reminded that CHK may not quite play by the rules?

All this can be visualized as follows:

What specifically are the loans:

  • In June 2009, McClendon agreed to borrow up to $225 million from Union Bank, a California lender, pledging his share of wells as collateral.
  • In December 2010, he borrowed $375 million from TCW Asset Management, a private equity firm.
  • And in January 2012, McClendon borrowed $500 million from a unit of EIG Global Energy Partners, a private equity firm formed by former TCW  executives. It is unclear how much, if any, of those loans have been repaid.

Someone over at TCW really likes Aubrey. Someone with Chinese backing. Reuters digs in:

The lender behind $500 million worth of Aubrey McClendon’s personal loans is a private equity firm with headquarters across the street from the White House and the Chinese government as a minority owner. The firm, EIG Global Energy Partners, is run by R. Blair Thomas, an attorney and veteran energy investor. Formerly the Energy & Infrastructure Group of Trust Company of the West, EIG spun out of TCW in January 2011. It had $9.5 billion under management at the end of last year.


Those deep pockets – along with special ties to McClendon - have enabled it to bankroll his share of Chesapeake wells, according to minutes of a February 2011 meeting between EIG and the New Mexico State Investment Council, the state’s public investment fund.


At the meeting, EIG chief operating officer Randall Wade sought a $50 million investment from New Mexico. Asked about a prior EIG investment in McClendon’s well interests, Wade boasted EIG had known Chesapeake for more than 25 years and “provided pre-IPO financing for them in the late 1980s.”


Those tight bonds, Wade said, have created other unique opportunities for EIG. “In fall 2008, Mr. McClendon didn’t have liquidity to participate in the (well) program in 2009, at which point EIG entered into discussions with him and ultimately” formed a special purpose vehicle called Larchmont Resources, Wade said. Through Larchmont, EIG acquired the rights to all of McClendon’s well stakes for 2009 and 2010. EIG then set up a new  special purpose vehicle – Jamestown Resources – to control McClendon’s well shares in 2011, with rights to 2012, Wade said.


EIG’s investments have been extremely profitable. “EIG sweeps 100 percent of the cash flow generated by those projects until EIG has gotten all of  its money back plus a 13 percent realized return,” Wade told New Mexico investors. EIG also gets a 42 percent cut of McClendon’s share of the well  profits “in perpetuity,” he said.


EIG declined comment.


In February, EIG announced that China Investment Corp.(CIC), China’s sovereign wealth fund, had acquired a minority stake for an undisclosed amount. CIC declined comment.

Hmm, the last time we saw special purpose vehicles was around the time of Enron and Lehman. They rarely end well. And something tells us that CIC knows this too well. What we would like to know is what happens when the inevitable capital shortfall occurs, because China has deep pockets, and can afford to wait until natgas hits $0.00, or goes negative (yes, it is technically possible), and CIC is forced to "take out" the stake of other EIG partners. Because last we checked, China was doing all it can to rapidly mobilize recently nationalized YPF's assets. Has Aubrey merely become the patsy to allow China a foothold in US nat gas interests?

Finally, to all those scrambling to short the company: beware. CHK has a history of being able to fund itself with HY bonds and other unsecured debt come hell or high water. If and when the stock tanks, the short interest will surge on expectations of a funding shortfall. Alas, courtesy of the Fed's malevolent capital misallocation enabling, we are more than confident that the firm will be able to issue as much HY debt (unsustainably at 10%+, but that is irrelevant for the short-term) as it needs, crushing all short theses. What this means, simply, is that anyone who believes traditional fundamental analysis will and should work in the CHK case is likely to get burned, especially if China is involved which will have its own tactics vis-a-vis the future of McClendon and/or CHK. And all, of course, courtesy of the Chairman of course.

Full Reuters special report here.