Sometimes you have to go with your gut, and when your gut ends up being right, you get this warm and fuzzy feeling that you may actually know a thing or two.

Frequent readers of The Corner Office Blog know that I’ve been bearish of Chesapeake Energy (CHK: chart, web, Y!) due to their huge amount of debt (and the pilfering of shareholders to pay off that debt by diluting the stock) when commodity prices were at record highs.

I’ve owned CHK before and have made money off the stock, but when credit started tightening over the last year to 18 months, I knew CHK would end up with a target on its back just due to the debt alone.

Well, it seems the debt has come back to haunt Chesapeake, along with an in-house trading philosophy that ended up costing the company $1.6 billion on paper, and forced CEO Aubrey McClendon to sell all of his own companies shares involuntarily.

Here’s how it all went down.

Chesapeake was making money hand over fist when commodity prices were high, just like any other player in the field.  Then, their trading operations made the gamble that the run on oil and gas wouldn’t continue.  So the company bought options and other financial vehicles to lock in the current rates (around $120/bbl for oil at the time) to protect from what they saw as an expensive downside risk (also known as hedging).

So what happened?  Oil continued to rise to a high of just over $145/bbl in July of this year.  That’s actually a good thing for Chesapeake, right?  Not necessarily.  Since Chesapeake hedged their oil at $120, they were only getting paid $120 for every barrel they pumped, not $145 that was the current market price.  Again, they’re still making boo-coo bucks at $120 oil, but they could have been making more.

The fact that they could have been making more shows up as a loss on the balance sheet.  All in all, Chesapeake could have made as much as $1.6 billion more if they had not hedged their oil and gas at lower prices.  So this goes as a loss on the books for the second quarter.

What effect does the debt have?

Creditors typically want to see that their their loans are safe, and as such they write in certain conditions that if met, they reserve the right to call the note.  Sort of like having a margin call if you can’t maintain the margin requirements.

So I suspect that the $1.6 billion loss on Q2 earnings triggered such an event.  Since banks would like nothing else than to have cash right now, they probably capitalized on the opportunity to call Chesapeake on a loan, and I suspect it was a big one.  So now Chesapeake has to scramble to come up with a boat load of money to pay off the note.

As a result, there is a fire sale going on right now in the oil patch in Oklahoma and Texas.  I suspect Chesapeake is selling everything they can, from surplus oilfield equipment to leases, just to raise money.

But what about the CEO’s shares?

Chesapeake CEO Aubrey McClendon was so sure of the prosperity of his own company that he bought shares… on margin.

When the second quarter results showed a multi-billion dollar loss, the shares couldn’t have headed for the deep end fast enough.  Due to insider trading rules, McClendon couldn’t unload shares prior to the news, so he had to ride it out.  By the time the smoke cleared, the brokerage called him on failure to maintain margin requirements and sold his shares for him.  All of them.

So what does all this mean?

It means that there are a ton of CHK stock holders out there that are stark raging mad.  And rightfully so, but it appears for now that they really don’t have a stick to shake.  Chesapeake gambled and hedged oil and gas and got burned.  End of story.

It also means there are going to be opportunities to capitalize on Chesapeake’s misfortune.  There will be some leases available at rock bottom prices since the price of oil is falling, and some weak hands are being flushed out of the patch.

Corner Office Comments

Debt isn’t always a bad thing, and can be used as leverage in some cases.  However, when you hold a lot of debt in an industry that’s making record profits, you’d be wise to get rid of the debt as soon as possible.  If and when the credit industry tightens, those with the most debt will be the first to be denied.

Energy, Investing, Oil & Gas CHK, hedging, margin, oil and gas