The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters (29 page)

“We were viewed as damaged goods,” Papa recalls. “Something must be wrong with us, most people thought.”

After Enron’s collapse in 2001, investors warmed to EOG, but the company was no energy power. For that matter, Papa, a Pittsburgh native, was no natural-born wildcatter. In school, he only began to focus on petroleum engineering because he wanted to flee his cold city.

“It seemed most energy companies were located in warm-weather places, so that sounded good to me,” he says.

Papa had a curious mind, though. By 2003, he was among those following George Mitchell’s lead and getting natural gas from the Barnett Shale. He also grew excited about other spots that seemed full of gas. “You know, half of this country has shale under it,” he told a conference in Boston in early 2004.

Papa began to wonder if this rock might yield oil as well. “Industry dogma was that pore spaces of shale rock were so small and oil molecules so much bigger than gas molecules” that it didn’t seem possible that oil could flock from shale rock, he says. “We decided the prize of finding billions of barrels of oil” was worth examining whether that hypothesis was valid.

That year, while poring over pictures of a forty-foot-long shale-core sample that had been run through a CT scanner, Papa and his geologists detected a network of passageways. They determined that the pore spaces in shale were large enough to let oil flow, even though this rock looked as impermeable and thick as a slab of marble. Soon, EOG established a presence in the Elm Coulee field in Montana.

By 2005, EOG also had become a significant leaseholder in western North Dakota. After hearing Johnson and his partners pitch their 40,000-acre block, EOG agreed to buy it and take a chance on the area.

EOG drilled its first well in Parshall in April 2006. At that point, Papa and his company were much more focused on searching for natural gas around the country than on finding oil. They were simply taking a flyer on Johnson’s acreage.

The first well in the Parshall field was a huge disappointment, producing less than one hundred barrels of oil a day. The crew kept at it, though, and spectacular results burst forth almost immediately after the first clunker. Some of EOG’s Parshall wells were true gushers, producing more than five thousand barrels a day, at least initially. Rising oil prices meant some of the best wells paid back their costs in less than a year, a remarkable turnaround. It turned out that crude trapped in the rock in the area was under especially high pressure, making it perfect for oil production.

Many of Johnson’s leases were due to expire in less than four years, so the pace of EOG’s drilling picked up. EOG was a public company, unlike Continental, so it had good access to money from equity and debt investors, aiding the effort. The company was especially tight-lipped about its results, partly because it was gun-shy after the embarrassing implosion of its former parent, Enron.

Still, some of EOG’s results from the Parshall field leaked out, and a few industry members began to wonder if getting oil from the Bakken and other challenging shale formations in the country was within the realm of possibility.

Harold Hamm and Continental had struck out on their wells in North Dakota, just as the experts and rivals had predicted. Now they also had a serious competitor on their doorstep.

•   •   •

B
y 2003, Charif Souki was hustling to raise financing to build his LNG import facility in Sabine Pass, Louisiana, just over the Texas border. Cheniere shares traded a bit higher, moving up to three dollars a share. No one really thought Souki would be able to build such a huge and costly terminal, though.

Souki was about to get some good news from an unexpected source.

During the first half of 2003, members of Congress had become worried that rising natural gas prices would weigh on voters. The previous winter had been especially cold, and concern grew that another cold season would send energy prices higher. The politicians turned to Federal Reserve Board chairman Alan Greenspan, who had earned the nickname of “the Maestro” for conducting U.S. monetary policy, for advice.

Testifying on June 10, 2003, before the House Committee on Energy and Commerce, Greenspan said the country’s situation was dire. The Fed chairman lamented the “seeming inability of increased gas well drilling to significantly augment net marketed production,” and he bemoaned the spike in natural gas prices, which by then were at $5.28 per thousand cubic feet, up from $3.65 a year earlier and just $2.55 in July 2000.

“In the United States, rising demand for natural gas, especially as a clean-burning source of electric power, is pressing against a supply essentially restricted to North American production. . . . We are not apt to return to earlier periods of relative abundance and low prices anytime soon.”

Greenspan’s comments struck an immediate chord. His argument that it was getting harder to tap cheap gas supplies echoed growing concern that the United States, and the world itself, was running out of energy. Back in 1956, an irascible but brilliant Texas-born geologist working for Shell named Marion King Hubbert had created a model that seemed to prove the world was running out of oil and natural gas. Hubbert, who earlier in his career was active in a movement that pushed for democracy to be disbanded, allowing scientists and engineers to take the reins of government, had predicted that oil production would peak in the United States by the early 1970s and global oil production would level out around 2006.

“It’s quite a simple theory and one that any beer drinker understands,” explained prominent British petroleum engineer Colin Campbell, a Berlin native and a fan of Hubbert’s theory. “The glass starts full and ends empty and the faster you drink it the quicker it’s gone.”
¹⁶

For years, Hubbert’s argument, a Malthusian notion that became known as the peak oil theory, was dismissed by the energy establishment. But when U.S. oil production
did
peak in 1970 and an energy crisis ensued, some began to suspect that Hubbert might have been on to something. By the time Greenspan issued his own warning, a consensus was emerging that the heyday of oil and gas production was over.

Greenspan had a solution, though. The United States needed to become a major importer of liquefied natural gas, he told Congress. The country then could get its hands on cheaper natural gas being produced around the world.

Then Greenspan uttered words that could have come out of Charif Souki’s own mouth: “Access to world natural gas supplies will require a major expansion of LNG terminal import capacity,” he said.

Alan Greenspan’s speech changed everything for Souki. It was a seal of approval, out of the blue, as if Martin Scorsese had pointed to a struggling actor, ready to give up on Hollywood, as the next Marlon Brando. Within weeks, investors and potential customers gained confidence in Souki’s strategy, helping Cheniere’s stock jump to six dollars a share. If Greenspan backed the idea, then the regulatory process was unlikely to be very arduous, investors figured. And if Greenspan agreed the country was running out of natural gas and would have to import LNG, it had to be true.

“All of a sudden I didn’t have to go through the first part of my spiel that gas prices were going past three or four dollars,” Souki recalls. “I could skip the first forty-five minutes” of the pitch.

“People stopped thinking we were completely crazy,” he says.

When Souki and his team approached the Federal Energy Regulatory Commission to seek permission to build their Louisiana plant, the agency said it hadn’t seen such an application in years and needed time to study the issue. Souki was encouraged nonetheless. A few companies even expressed interest in acquiring Cheniere. Souki turned them down, more confident than ever that he could build his facility, maybe even a few of them.

In December 2003, when Michael Smith and his new company signed contracts with Dow Chemical and ConocoPhillips to turn their LNG into natural gas at Souki’s original terminal, Cheniere stock climbed anew because it still owned 30 percent of Smith’s facility.

Less than a year later, in the summer of 2004, Cheniere reached deals of its own with France’s Total and the United States’ Chevron to import one billion cubic feet of gas a day each for twenty years at Cheniere’s Sabine Pass facility. According to the terms of the agreement, the two giant global energy companies agreed to ship liquefied natural gas to Cheniere’s terminal. There it would be deposited into one of Cheniere’s massive 170-foot-tall, or seventeen-story-high, storage tanks, each the size of a football field and almost big enough to contain Madison Square Garden.

Cheniere would return the supercold liquid to its gaseous form, or “regasify” it, using sixteen vaporizer modules that act like giant Jacuzzis to warm the gas. Then the natural gas would be injected into a pipeline connecting the terminal to nearby pipelines, allowing Total and Chevron to sell their gas throughout the United States. Cheniere agreed to charge each company $125 million a year to convert the one billion cubic feet of gas, the approximate amount needed to meet the heating and cooking needs of a city the size of Chicago for four days and about 3 percent of the nation’s daily gas needs.

It was similar to lugging a pocketful of change to a Coinstar machine at a supermarket and paying a fee to have it converted to more useful dollar bills. The only difference was that the terms of the deals Souki had crafted were for the energy giants to pay Cheniere to provide the gas conversion service, even if it was never used. That was the only way Cheniere could afford to build the project.

Within months, Souki had gone from an obscure dreamer with an oddball idea to the head of a company that might save the country. By then, there were plans for forty new or expanded LNG terminals under consideration in North America. Cheniere set the price terms that others copied, though, and Souki was at the vanguard of an emerging LNG revolution.

Investors who once shunned Souki’s company now threw money at it. By the end of 2004, Cheniere’s stock had soared to more than sixty dollars a share. The company quickly sold $300 million of new shares and borrowed $800 million through the sale of debt, putting it on its way to raising the financing necessary to build its LNG receiving terminal. In March 2005, the company broke ground on its facility and split its stock in half, a sign of the continued exuberance of investors. Finally, Souki was on his way.

When two huge hurricanes, Katrina and Rita, hit the Gulf Coast in the summer of 2005, Cheniere’s construction efforts were set back, as the design was altered to prepare for future big storms. But the hurricanes also sent U.S. natural gas prices soaring, encouraging additional energy producers to examine ways of shipping gas from foreign locales to the United States. Soon, Souki was meeting senior executives at Exxon, Conoco, Shell, and other major companies about using Cheniere’s prospective site to regasify LNG the giants wanted to shift to sell in the United States.

Souki excited Wall Street investors and analysts by saying his company would build a string of LNG terminals around the country. The United States was producing nearly fifty billion cubic feet a day of natural gas, and expectations were that the level would drop to nearly forty billion in just five years. Cheniere’s imported gas would be crucial to keeping the nation’s lights on and its cities warm.

By the end of 2005, it didn’t seem as if anything could stop Charif Souki. As the company’s largest shareholder, he now owned shares worth over $100 million. He bought a 4,000-square-foot home in Houston’s tony Memorial Park neighborhood, some real estate in Colorado, and his own eleven-seat Bombardier Challenger jet.

“It all felt great,” Souki says.

A
ubrey McClendon never wanted Tom Ward to quit Chesapeake Energy. McClendon always figured their disagreements could be overcome. He never had a true understanding of the stress Ward was feeling and was astounded when he turned in the company keys.

Now that Ward was gone, however, McClendon had a new freedom to run the company exactly as he wished. Ward had dragged his feet on many of McClendon’s expensive moves. Now McClendon had the green light to buy even more acreage in shale formations.

It still wasn’t clear whether drilling in this rock would pan out. Major oil and gas companies still ignored most shale formations, and for good reason. Some, such as the Barnett, were producing impressive amounts of natural gas, but these fields weren’t exactly changing the world or even the country. Less than 5 percent of the nation’s gas production came from shale fields in 2005.

That didn’t stop McClendon from upping his bet. In 2006, Chesapeake spent nearly $4.3 billion on acquisitions, most of it on acreage that had no proven production, the kinds of deals Ward was most uncomfortable with.

Chesapeake drilled over a thousand wells that year, while adding nearly $2 billion more debt to push its debt load up to $7.4 billion. Not only that, but much of the acreage Chesapeake purchased was not yet “held by production.” In other words, the company had to drill productive wells or the leases would revert to landowners. That put pressure on Chesapeake to speed up its drilling.

By early 2007, some Chesapeake investors had become uncomfortable with McClendon’s land rush. He agreed to slow things down. But McClendon couldn’t resist when he met a local petroleum engineer named Ronnie Irani at an IHOP restaurant in January 2007.

Irani placed a group of maps on the table in front of McClendon and explained why he was so excited about an area in Wyoming called the Powder River Basin, a field he was convinced could produce more than five billion barrels of oil from the Niobrara Shale formation.

It was a “Bakken look-alike,” McClendon says.

McClendon was smitten. At that point, less than 10 percent of Chesapeake’s production came from oil. Irani was presenting McClendon with a chance to become a true energy king by adding oil to his huge position in natural gas. He called his assistant to cancel his next meeting so he could keep talking to Irani.

Chesapeake and Irani reached a secret deal to buy one million acres in the formation, relying on third-party brokers to try to hide their interest. Word of Chesapeake’s buying leaked out nonetheless, and prices soared. Land that sold for as little as eleven dollars an acre in early 2007 now rocketed past $900.

McClendon was swinging for the fences, like a true wildcatter.

“When you look at the sweep of history in this industry,” McClendon later explained, “those who move first to lock in big new acreage positions when technology changes emerge as the winners.”
¹

Nevertheless, members of Chesapeake’s board of directors began to raise questions about the headlong push into shale formations. Conventional wisdom held that it was becoming harder, not easier, to produce oil and gas in the country and the world. While shale wells seemed to show impressive early results, the production seemed to decline quickly. Betting on America and this challenging rock appeared risky, and the debt was piling up on Chesapeake’s balance sheet.

Charles Maxwell was among those with concerns. The seventy-year-old energy industry analyst, who had joined Chesapeake’s board of directors in 2002, was a firm believer in the peak oil concept. Maxwell wasn’t convinced Chesapeake’s costly acquisition spree would produce a surge in gas.

“I spent eleven years at Mobil Oil and my big-oil crowd was unconvinced” about whether meaningful amounts of gas could come from shale at reasonable cost, Maxwell recalls.

McClendon brought in evidence from the field to try to show that new techniques were allowing Chesapeake’s exploration and production team to extract natural gas like never before. McClendon agreed that others were finding it harder to produce energy. But he argued to Maxwell and others that Chesapeake was capable of extracting significant new supplies of gas.

“We can do it and it will be worth it for us,” McClendon insisted to the board.

With prices sure to rise further, McClendon said the company had to seize a “once-in-a-lifetime” opportunity by making more deals. Not only that, but natural gas produced almost half the carbon dioxide tonnage of comparable amounts of coal and two-thirds as much carbon dioxide as oil, making it cleaner.

Maxwell and other board members eventually came around. “This felt like the beginning of a whole new industry,” he later wrote.
²

There was only one problem: McClendon was spending more money than Chesapeake had, and more than his chief financial officer, Marc Rowland, had allocated to new purchases.

Rowland delivered the bad news to McClendon in the spring of 2007. “Aub, we’re about to run out of money,” he told McClendon.

“Okay, go do a billion-dollar issuance,” McClendon said.

With that, Rowland got in touch with global banking giants Credit Suisse and UBS. They quickly reached out to a group of mutual funds and other large investors. Almost immediately, the investors committed to forking over $1 billion to buy Chesapeake’s senior debt. They had such faith in McClendon and the Chesapeake team that they didn’t ask to meet the Chesapeake executives or even require them to hold a conference call to explain why Chesapeake was a safe credit.

Marc Rowland knew investors were running for their checkbooks. But the Chesapeake CFO also knew the company was taking in less than it was spending to lease land and drill on it. And he was well aware that McClendon wanted to spend more to expand in shale and other acreage. Chesapeake would have to find new ways to raise cash from investors, he concluded.

Rowland and McClendon arranged a phone call with McClendon’s fraternity brother at Duke, Ralph Eads, who was a senior investment banker at Jefferies & Co., to try to come up with an answer to their problem.

“I can get the assets,” McClendon said. “You have to get the money.”

Working with a group of Wall Street bankers, they turned to a sophisticated financing scheme called a volumetric production payment, or VPP. In this kind of deal, Chesapeake would receive up-front cash in exchange for oil and gas production to be delivered over a number of years to a vehicle set up by Wall Street investment banks. The banks would sell interests in the vehicle to hedge funds and other banks.

Chesapeake’s banks reached out to investors to test their interest in stakes in future production from some gas wells in Kentucky and West Virginia. McClendon and Rowland hoped to pull $550 million from the deal. There was so much demand, though, that Chesapeake pocketed a cool $1.1 billion.
³

Chesapeake began turning to VPPs on a regular basis, raising over $6 billion from nearly a dozen of these kinds of deals. More than ever, McClendon and Chesapeake had become reliant on Wall Street bankers and investors since the company wasn’t taking in enough cash to meet its spending needs.

McClendon assumed an even more public position, emerging as a spokesman and cheerleader for natural gas, fracking, and shale drilling, a shift that helped the company attract even more investors. While many energy executives try to keep a low profile, worried about being tarred as greedy polluters, McClendon embraced the spotlight, extolling the wonders of “clean-burning, domestically produced onshore natural gas.”

Chesapeake adopted a new tagline, “America’s Champion of Natural Gas,” and erected billboards in the Fort Worth area featuring actor Tommy Lee Jones. The company even made plans for an online television station to promote their gas drilling efforts, called Shale.TV. The more McClendon could help grow demand for natural gas, the more it would help Chesapeake’s bottom line while also sparking enthusiasm for the company on Wall Street.

McClendon saw himself as a booster of America and its natural resources. He confessed to never having visited Asia, Africa, or Australia. “I’m as parochial of a guy as you’ll find. . . . There’s a lot to see in the U.S. and I’ve been satisfied with that,” he said.
⁴

McClendon also seemed to enjoy poking fun at giant oil companies, who still scoffed at shale formations in the United States, even as they cut deals with foreign governments to explore abroad. “When we go to bed every night, our assets aren’t subject to a coup or a new tax regime or something like that,” he told a reporter.
⁵

McClendon was an all-American energy star, representing a new wave of wildcatters absolutely sure they would shake up the country, and the world.

•   •   •

A
s McClendon’s confidence and ambition grew, so did his appetite for extravagance. Growing Chesapeake was his focus, but building Oklahoma City into a world-class city became a new passion. In the summer of 2006, McClendon and Ward joined forces again, this time to back a local friend and power broker, Clayton Bennett, in a $350 million deal to buy the Seattle SuperSonics pro basketball team.

At the time, Bennett claimed to have no interest in moving the team to Oklahoma City, assuaging residents of Seattle scared of losing the franchise. But McClendon, a 20 percent owner of the team, couldn’t help himself when the
Oklahoma Journal Record
asked him about the purchase. “We didn’t buy the team to keep it in Seattle; we hoped to come here,” he said. “We know it’s a little more difficult financially here in Oklahoma City, but we think it’s great for the community and if we could break even we’d be thrilled.”
⁶

For speaking his mind and acknowledging that the owners held out hope of moving the team after all, National Basketball Association commissioner David Stern slapped McClendon with a record $250,000 fine. Two years later, the team did move to Oklahoma City.

McClendon wanted his company to be first-class and he wanted to help Oklahoma City gain its own recognition. The city had gone through its share of difficult times. In 1995, Timothy McVeigh, a man brimming with anger at the U.S. government, set off a bomb so powerful that it destroyed Oklahoma City’s Alfred P. Murrah Federal Building, as well as destroying or damaging over three hundred buildings nearby, taking 168 lives, including nineteen children under the age of six.

McClendon cared about Oklahoma City and was determined to help it reinvent itself as a cultured and world-class city. And he also knew that as Oklahoma City’s reputation improved, Chesapeake would be able to recruit better talent. It also didn’t hurt that McClendon received kudos and thanks for his focus on the city.

“You can’t attract first-rate employees, especially young ones,” McClendon says, “if your city is a dud.”

McClendon turned Chesapeake’s campus into one that a Silicon Valley mogul might envy. There was a 72,000-square-foot fitness center, an Olympic-size swimming pool, and an elaborate health center. Young, clean-cut security men patrolled the grounds, questioning visitors and lending the campus a Big Brother air.

The company bought local stores and built an upscale shopping venue called Classen Curve, featuring a gastro sports pub and a gourmet restaurant serving raw vegan fare. McClendon even persuaded organic food chain Whole Foods to build a store in the area. Chesapeake would spend over $240 million to buy at least 109 local properties, according to data compiled by Reuters.

Local politicians couldn’t have been more appreciative. “We don’t have the money to do it and he does,” said Sody Clements, the mayor of Nichols Hills, the suburb of Oklahoma City that was Chesapeake’s home.
⁷
The
Daily Oklahoman
called McClendon a “one-man economic boom.”

One day in 2007, Art Swanson, an acquaintance from high school, approached McClendon with a grand idea. “Every billionaire owns a golf course,” Swanson told McClendon. “What you need is a private racetrack.”

McClendon loved the idea and was agog when Swanson introduced him to Fritz Regier, a driver from Porsche’s factory in Germany, who came to Oklahoma to discuss the project.

Soon McClendon was buying up tracts of land in Arcadia, Oklahoma, half an hour from Oklahoma City, to serve as his very own racetrack. He still wanted that golf course, though, so he hired famed golf-course architect Tom Fazio to design a course for the racetrack’s infield. They began work on creating an American version of the Nürburgring, the motorsports complex around the German village of Nürburg.

•   •   •

N
atural gas prices drifted a bit lower in the summer of 2007 amid signs of growing supplies. Chesapeake trimmed its gas production by 6 percent in September, joining some other gas producers in easing production. McClendon told investors that he would slow the company’s spending once again, promising to reduce capital spending by 10 percent in 2008 and 2009.

“It’s now prudent to pull in the reins and let the market rebalance,” McClendon told analysts in a conference call.
⁸

At the time, most experts were sure falling prices and rising supplies had resulted from the relatively mild weather that summer and the previous winter, which reduced demand for gas for air-conditioning and heating. Some thought the price weakness might also be attributable to consumers and businesses that were easing their reliance on gas after several years of high prices.

In September, the government reported that domestic gas inventories hit nearly three trillion cubic feet, a record high for that time of year. Few thought anything remarkable was going on, though. Supplies seemed high because demand was weak, not because anything special was happening in the nation’s shale gas production. The previous year had also seen a temporary glut of gas, and natural gas prices soon rebounded. It seemed far-fetched to think any kind of revolution might be brewing that the experts were missing.

Sure enough, natural gas prices rebounded by late 2007 while oil prices surged, amid fears that demand was outstripping supply.