This week, it was announced Chesapeake Energy (CHK) was fined $428,400 for “knowing and willful submission” of inaccurate royalty reports as levied by the US Interior Department's Office of Natural Resources Revenue (ONRR). “It is imperative that companies file accurate and timely reports required by existing law so ONRR can ensure American Indian and taxpayer assets are protected,” said ONRR director Greg Gould. He further stated, “It is simply unacceptable that a company continues to file inaccurate reports after an audit order instructed the company to make the necessary corrections.” This latest federal government fine on Chesapeake Energy adds to a growing list of royalty dispute legal cases between the company and landowners in Pennsylvania, Ohio, and New York State, Texas and in its home state of Oklahoma.
Last week the Pennsylvania Attorney General’s office opened a formal investigation into yet another round of Pennsylvania landowner’s complaints about how the company is calculating its royalty payments. The latest round of complaints comes from a group of Pennsylvania Marcellus shale landowners in Bradford County and right on the heels of a September 2013 Pennsylvania landowner’s royalty payment class action lawsuit. In that case, Chesapeake agreed to pay $7.5 million to settle the claims however this settlement awaits approval by a federal judge.
Complaints against the company appear to have accelerated since 2012. According to the financial reporting services firm, YCharts.com, the company’s total debt load was $25.2 billion in 2011, $26.04 billion in 2012 and $25.8 billion in 2013. The value of its stock declined from year 2007 high of $60.00 a share to yesterday’s close of $25.01. In Texas Chesapeake has faced royalty lawsuits from the city of Fort Worth, Arlington Independent School District and energy investor Ed Bass. The Dallas/Fort Worth International Airport, netted $5.3 million in additional royalties after settling with Chesapeake last year said Shayne Moses, a Fort Worth lawyer who represented DFW Airport. Moses stated, “You can tie everything to prices tanking, but they’ve also gotten more brazen.”
In early 2012, the company began aggressively selling off key assets as it raced to raise cash to meet upcoming debt obligations. In June of 2012, facing immediate debt obligations, Chesapeake agreed to sell its highly valued pipeline complex to Global Infrastructure Partners for more than $4 billion.
At that time Chesapeake owned pipelines in Texas, Louisiana, Pennsylvania and other gas-producing states, a total 3,953 miles of pipelines under its control. This meant the company could ship its natural gas to market on favorable terms while charging other oil and gas companies fees to ship their gas to market over its extensive pipeline system. While it gained $4 billion in cash from the sale of it's pipeline system to Global, it lost an estimated $50 million a year in cash flow from fees the company charged other companies and now having to pay fees to ship its natural gas production through the pipeline complex it no longer owns. It also may mean Chesapeake can now deduct these new costs from its landowner royalty payments.
The main issue of contention for landowners remains whether or not the calculation of the payments is on the price of the natural gas at the well head or as it moves through the system of pipelines, separators, dryers, and compressors as it works its way to market. These “marketing costs” as referred to by the oil and gas industry vary greatly among companies. In Chesapeake Energy’s case, based on their continuing need to sell off critical assets in every part of their business model, these costs may in fact be rising.
Further hampering Chesapeake Energy’s ability to gain profits and reduce debt, is its significant volumetric payment commitments whereby they have agreements to sell future natural gas production at a fixed price, not necessarily to current market prices. It’s a form of futures trading which is common in the industry. In the company's case, they began selling their future natural gas production back in 2011 and 2012 as natural gas market prices declined to an all time low of $1.72 per million BTU. As the market price of natural gas has now risen to the plus $4.00 per million BTU range. This means Chesapeake cannot immediately take full advantage of the recent upward price movements in the market.
According to Bill Powers, an independent energy analyst who has written extensively about the shale gas industry, despite having sold off more than $15 billion in assets to date, the company closed its 2013 financial operations at almost $26 billion in total debt while posting a $118 million profit loss for the year. With debt levels essentially unchanged from 2012 to 2013, its stock price is mired in the mid $20 per share range, it must continue to work through its volumetric payment commitments. It remains under intense pressure to cut costs wherever it can. Powers further stated, "They are running out of things people will buy from them."
In many of its landowner agreements they have legal rights to deduct bona fide marketing costs from their royalty payments however many question how this is being done. State officials are also looking at how the industry practice of internal sales of natural gas within a given company's entities might be depressing the price of its production resulting in lower royalty payment calculations.
Given its difficult financial position and the need to keep selling off key assets, Chesapeake Energy’s royalty payments will most likely remain an area of significant legal contention. These realities are all a far cry from the year 2008 when so many great and grand things shale gas for American landowners was proclaimed by Chesapeake Energy’s founder and now deposed former CEO Aubrey McClendon.
To learn more about the federal agency which fined Chesapeake Energy, go to: http://www.onrr.gov/
To learn more about Chesapeake Energy’s Texas lawsuits, go to: http://www.nytimes.com/2013/12/22/us/fort-worth-sues-driller-citing-millions-in-lost-royalties.html?_r=0
To learn more Chesapeake Energy’s key financial statistics, go to: https://ycharts.com/companies/CHK/key_stats
To learn more about Bill Powers, go to: http://www.powersenergyinvestor.com/
Disclosure: The writer does not hold any U.S. securities in any oil or gas industry drilling company. He is not a member of any environmental or anti-fracking group and is not being paid by or has any financial arrangements with any of the entities or people listed in this article.