by Russell Gold
Duke kept the game close and trailed by only two points with two seconds left. After a time out, senior forward Gene “Tinkerbell” Banks caught the inbound pass at the top of the key, turned, and shot the ball over his defenders’ outstretched hands as time expired. The ball went straight through the rim, tying the game and sending it into overtime. Banks was electric in the extra period, notching several rebounds and baskets. In the final seconds, when a teammate missed a shot, Banks grabbed the rebound and laid it in for the victory. Thousands of Duke students rushed onto the court in euphoric celebration. These days Duke is a basketball dynasty. That day, a David had defeated a Goliath. Eads recalls being among the throng that celebrated on the hardwood. McClendon has a different memory. He says both of them were in a rush to drive an hour west to Greensboro, where they had tickets to a Bruce Springsteen concert.
By an odd coincidence, I was among the ten thousand people at Cameron for the game. My family had moved to nearby Chapel Hill for a year, and my father took me to the game that day. We sat about as far from courtside as possible, just a couple rows from the rafters. When the game was over, we got in our car and drove ten miles back home. On Monday I went back to fourth grade and told my friends about having been at the game. A few months later, at the end of the school year, my family moved back to Philadelphia.
McClendon moved home to Oklahoma City a few weeks later after the basketball game, finishing his time at Duke with a 3.7 grade-point average and a fiancée. Later that summer, he married Kathleen Upton Byrns, a granddaughter of the founder of Whirlpool Corporation. Eads, who was a member of the wedding party, went to New York and began training as an investment banker at Merrill Lynch, where he learned how money moved through the modern financial world. Years later, Eads and McClendon would work together again, the financier finding money for McClendon to keep up a torrid pace of leasing and drilling. I was again orbiting around the action as a Wall Street Journal reporter keeping tabs on Chesapeake. I first interviewed McClendon in August 2006 in Oklahoma City. On my flight home, I wrote in my notebook: “Is he a huckster, a dynamic salesman, a visionary, a fool? I can’t tell.”
A couple months before McClendon returned home from Duke, oil prices hit $39 a barrel. Revolutions and war between Iran and Iraq drove up crude oil to this never-before-seen level. Adjusting for inflation, this 1981 price was the equivalent of $100 oil. A generation would pass before crude regained this plateau. As McClendon settled in Oklahoma City, crude prices were falling due to a global recession and increased output from the Middle East. Drilling rigs idled. And aggressive loans to oil companies began to cause trouble at the Penn Square Bank, a major financial institution in Oklahoma City where McClendon, as a kid, had deposited money from mowing lawns and selling holiday cards door to door. The bank had been cofounded by McClendon’s great-uncle Robert S. Kerr. Bank auditors found Penn Square had too many loans that weren’t being repaid, there was not enough cash, and inexperienced loan officers had too much autonomy. The bank was awash in loans to oil companies. When oil prices dropped, these loans began to go unpaid. Penn Square had farmed out its loans to other banks across the country. When Penn Square went under, its loans sunk the Continental Illinois National Bank in Chicago, then the seventh largest in the country. The slow-motion collapse of Penn Square turned Oklahoma City from a boomtown into a ghost town. The regional economy of the US oil patch sunk into the doldrums.
In the midst of this crisis, young Aubrey McClendon needed a job. The small company where he landed, Jaytex Oil & Gas, was owned by his uncle, Aubrey Kerr Jr. His uncle offered him a position as a staff accountant. It was steady work but, like his father’s job servicing gas stations, it was not glamorous. After nine months at Jaytex, McClendon took on a new assignment in the land department, where he was responsible for figuring out who owned the mineral rights to any particular parcel and getting them to sign a lease. Mineral rights are often split, and landmen often must hunt down a long-forgotten family member who owns one thirty-second of the oil and gas. The work involves a lot of digging through county courthouse land records. This work appealed to McClendon. “In land, I found my true love in the oil/gas business,” he wrote in an email to me in 2006. “Learning to become an oil/gas landman combined my love of history with my appreciation for the precision of numbers learned through accounting.”
In 1982 McClendon realized that Jaytex wouldn’t survive the downturn. He left the company and struck out on his own. He bought a typewriter, some oil-and-gas maps, and rented a one-man office. He spent the next few months acquiring leases and trading them. He soon began to bump into another independent landman named Tom Ward. If McClendon had been born into a privileged life, Ward was the opposite. He came from Seiling, a tiny town in northwestern Oklahoma, into what he called “a fairly dysfunctional family.” Ward can be gruff, while McClendon is all polish and charm. Ward went to the University of Oklahoma, a far cry from elite Duke. After graduating, he struck out on his own as a landman. His early success in the business came not from geological acumen but from recognizing and exploiting Oklahoma’s oil and gas laws.
In southern Oklahoma, there is a large gas field called the Golden Trend. A company that wanted to drill a well might acquire the mineral rights to the vast majority of a 640-acre block of property but run into problems locking up all the rights. In this situation, the company could apply to the state for a forced pooling order. If granted, all of the mineral owners in the block who had not signed a lease would be forced to participate, or pooled. The farmers (or whoever owned the mineral rights) who hadn’t signed would be entitled to the highest amount paid to the farmers who had signed. Ward figured that if a big energy company wanted to go through the bother of obtaining a forced pooling order, it must be excited about the geology and prospects. He spent his days driving around and locating the holdouts, explaining that they were going to be pooled and then offering them a bit more than the state would pay. In this way, he would get a small slice of another company’s well—without the cost of hiring geologists and engineers to do any actual exploration work. He was, in essence, piggybacking off the work of other companies. This strategy proved successful, except that he kept finding himself in competition with McClendon, who had figured out the same trick. They bid against each other, driving up prices and eroding each other’s profits. In the summer of 1983, McClendon and Ward agreed to collaborate instead of compete. This partnership was the beginning of Chesapeake Energy.
From that point on, the two men often pursued separate deals but worked under a fifty-fifty agreement that intertwined their interests and split the risks. Any deal that Ward worked out, McClendon would take a 50 percent share—and vice versa. Despite joining forces, the partners maintained separate offices in different buildings. Indeed, in the twenty-three years they worked together, they never had offices in the same building.
Neither man any had training to read a well log or study subsurface geology, the typical background for oil company executives. What they knew was land and money. Recognizing their limits, they weren’t attracted to the high-risk world of drilling wildcat wells. “We clearly could not outthink a geologist or an engineer,” McClendon said a few years ago. So the partners pursued oil fields “where once the geology was recognized and the engineering solution had been crafted, that it was the land guys that then made the difference.” Success for the young Oklahomans didn’t require any particular technology or engineering skill. It required hustle and money, and an ability to lease land before anyone else.
By the end of the decade, the partnership had outgrown its model of buying small slices of other people’s wells. Ward and McClendon migrated to acquiring large tracts of land, drilling and operating their own wells. Ward gravitated toward operations. McClendon took over finance and land operations. In May 1989 the partners incorporated Chesapeake Operating. Even after the early-eighties oil bust, Oklahoma remained filled with hundreds of small-time operators, raising money and drilling a handful of wells. Even
today, there is one oil operator for every 1,200 Oklahomans, nearly twice the rate of Texas. Getting into the business wasn’t hard. It took the gift of gab and the ability to raise money from friends, family, and business associates. “Oil is the Oklahoma business, and it’s a family business,” said Dewey Barlett Jr., part of a family involved in both energy and Tulsa politics. It was a point of pride for many Oklahomans to be invested in a well or two. These deals were free-wheeling, often sealed with a firm handshake, a confident smile, and the promise that everyone was putting his own money into the venture. This arrangement worked just fine, except when the foundation of trust crumbled. Then acrimony and lawsuits took over.
That’s what happened in an energy deal that turned into a lawsuit which has been largely forgotten, and misunderstood by those who remember it. The case involved allegations of fraudulent land deals, double-crossing petroleum engineers, and what turned out to be a dry hole in rural Beckham County. Tom Ward had put together what he called the East Virgil prospect: land in westernmost Oklahoma, near the Texas panhandle and less than a mile from a successful well. He hired a geologist to prepare a subsurface map of his acreage that suggested there might be oil and gas there.
Ward had leased the land and put together the package but was looking for someone else to take over and drill the prospect. (As usual, McClendon and Ward split the prospect evenly.) Ward offered the deal to Ralph E. Plotner Oil & Gas, a company owned solely by Ralph Plotner, an Oklahoma City salesman for a local radio station who had decided to get into the oil business a year earlier. On his first venture into his new trade, the neophyte had trudged through snow to a farmhouse, got the farmer to sign a lease, and drilled a successful well with the help of a friend. Plotner Oil agreed to buy a stake in the East Virgil prospect and took over as the operator. Then Ward rounded up another investor, Continental Trend Resources, run by Harold Hamm. (The company is now known as Continental Resources and is a major oil producer; Hamm is regularly listed as one of the country’s wealthiest billionaires.) Eventually Plotner Oil bought a 40 percent interest, Continental took 20 percent, and another small company held 25 percent. The remaining 15 percent was held equally by TLW Investments, a company wholly owned by Ward, and Chesapeake Investments, a company owned by McClendon and his wife.
After the well was drilled and didn’t turn up any oil or gas, the partnership soured. It all ended up in a lawsuit in which Plotner Oil claimed that Ward had lied to him while promoting the East Virgil prospect. He said he was impressed when told that Ward and McClendon had had personally invested more than $2 million in the prospect, paying $500 an acre to accumulate between 4,500 and 5,000 acres. But during the trial, it came to light that they hadn’t spent $500 an acre. They had spent only $300 an acre, according to testimony that the jury relied on.
Megan Hann, a petroleum geologist who worked for McClendon and Ward, was subpoenaed to appear at the trial. Her testimony damaged her employers. She said that Ward regularly overstated reserves, or recoverable oil and gas, to potential investors. At first, she said, the embellishments were small, but by 1990 “the exaggerations got pretty large.” Hann said she sat in on meetings where she heard Ward make these outlandish claims, but remained silent. She attended these meetings to present the geology, not the economics. “I didn’t believe it was my place” to contradict Ward when talking to potential investors, she said. But when her friends and family asked for tips, she testified that she advised them not to put in any money. She also said that she heard Ward tell Plotner he had spent $500 an acre, and repeat the same to Harold Hamm.
One day, driving back from Hamm’s office in Enid, she asked Ward why he had spent so much on what was basically an unproved prospect. “I was surprised that they had bought the acreage for five hundred dollars an acre,” she testified under oath, “and he said that they really had not bought it for five hundred an acre. It was—they had three hundred dollars—around three hundred an acre into the prospect.” Harold Hamm also testified that Ward had told him he bought the acreage for $500 an acre, and that he later learned that Ward had actually paid less. This testimony would prove crucial. The jury believed that Ward and McClendon had misled Plotner and other investors in the East Virgil prospect. It handed up a verdict against Ward and McClendon, awarding Plotner Oil $904,000 in actual damages and $1.25 million in punitive damages. Ward and McClendon appealed, but the appellate court sided with Plotner Oil and upheld the award. The Oklahoma Supreme Court let the lower court ruling stand.
The appellate court also discussed a damning piece of evidence about the founding of Chesapeake Energy. Plotner had testified during the trial that he had relied on a consulting petroleum engineer named Kenny Davidson, whom he had hired to evaluate the prospect. The justices wrote that “sufficient evidence on the record existed to support a conclusion by the jury that Davidson was secretly working for Ward and McClendon to defraud Plotner Oil even before he was officially hired as the first employee of Chesapeake Operating.” Davidson remained at Chesapeake until he retired in 2005.
A couple days before the Oklahoma jury began deliberating the case, Chesapeake Energy filed paperwork for an initial public offering (IPO). Chesapeake Operating had grown quickly as it got into the business of drilling its own wells. In 1992 the company sold oil and gas worth $10.5 million, up from less than $400,000 two years earlier. The number of wells it owned went from two to twenty-nine. Chesapeake Energy had been formed only a couple years earlier, pulling together assets held by Chesapeake Operating and other entities owned by Ward, as well as by McClendon and his wife.
The new company struggled to find money to keep its doors open. The young executives tried to get traditional bank loans but were turned away. When they did find lenders, the deals were on onerous terms. McClendon secured a line of credit from the Trust Company of the West (TCW), a large Los Angeles investment group, and drew it down quickly. Then Chesapeake secured another loan from Belco Oil & Gas, an energy business owned by the wealthy Belfer family in New York City. An earlier family-backed company, Belfer Petroleum, had merged with Houston Natural Gas, a company that formed the basis of Enron. A member of the family had remained on the Enron board until the end and lost billions of dollars on paper when the stock became worthless. To get both loans, which carried a stiff 9 percent interest rate, both Ward and McClendon had to guarantee the loans with their own personal holdings.
Chesapeake’s financial position was precarious. A few months before filing for an IPO, the giant firm Arthur Andersen resigned as Chesapeake’s independent accountant. One of the most important duties of a public company accountant is to tell investors whether it believes the company is at threat of financial liquidation over coming months. Arthur Andersen wasn’t confident that Chesapeake met that “going concern” definition. It wouldn’t give its imprimatur. Chesapeake disagreed and found another accountant. A few years later, Arthur Andersen, one of the “Big Five” accounting firms, surrendered its license in the wake of the Enron implosion. It had been Enron’s auditor, and hadn’t raised flags about it as a going concern.
McClendon was the chairman and chief executive of the new company, Ward the chief financial officer. Both men were paid $175,000 in salary, but were given an unusual perk. Each could purchase a small 2.5 percent stake in every well that Chesapeake drilled. To prevent cherry picking, they had to choose each year whether to invest in all the wells the company drilled or decline to participate altogether. Ward and McClendon would pay their share of the well costs and receive proceeds from any oil or gas produced. Over the next year, Chesapeake spent nearly $40 million drilling wells. McClendon and Ward’s share of the costs was $1 million each—several times their annual salary. It was an unusual setup that required the executives to borrow large sums. Years later it would cripple McClendon’s career and become a major reason why shareholders rejected its two board of directors candidates in 2012.
Overseeing the perk was a board of directors that wasn’t exactly a paragon of independence. In
addition to McClendon and Ward, there was a childhood friend of McClendon’s who did legal work for the company. McClendon and Ward were in hock to the other four directors. In May 1992 these four lent $1.65 million to the company’s founders, in an unusual financial arrangement to help McClendon and Ward pay off money they owed the company. In the post-Enron financial reforms instituted a decade later, this kind of loan was prohibited due to the conflicts created. The directors owed their paid positions to McClendon and Ward. The executives’ pay and perks were approved by the directors. If the directors felt it was necessary to fire one of the founders, wouldn’t it be human nature to hesitate, as McClendon and Ward might not be able to repay their personal debts to the directors? It was a knot of conflicts that left shareholders on the outside.
Chesapeake was the worst performing IPO of the year, McClendon said in a webcast with investors about a decade later. A share of the company ended 1993 worth less than half what it sold for on the first day of trading on Nasdaq. But the money raised selling shares to the public allowed the company to pay down some of its debt to TCW, and it soon secured a more conventional bank loan. Even after raising about $25 million in the IPO, McClendon prowled for more money. He was willing to pursue unconventional sources of funds, inventing them if necessary. In October of that year, he struck a deal with another energy company to help cover the costs of developing a gas field in Texas. Chesapeake boasted that it “believes a financing arrangement of this type is unprecedented in the industry.” This creativity helped keep Chesapeake with enough money to keep drilling. Soon Wall Street began to notice this small company and its gutsy chief executive. From the beginning of 1994, the stock soared for two years, rising nearly 2,000 percent. McClendon drove Chesapeake like a fancy race car, speeding through the curves.
In the first few years, Ward and McClendon worked around the clock. Ward generally arrived at the office between five and six in the morning, put in twelve hours, ate dinner at home, and then worked more. McClendon came in to work later but would often stay at work until two o’clock or later. “There were days when I would be coming in, and he would be going home,” said Ward. “We believed we could overcome any deficiencies with hard work.” Ward’s job was to find places to drill and let Aubrey figure out how to get the money together to finance the growth.