Since it was founded in 1989, Chesapeake has drilled 562 wells in places like Oklahoma, Texas and Louisiana. At the end of June the company had estimated proved reserves of 12.3 million barrels of oil and 351 billion cubic feet of gas. Revenues in 1996 hit $149 million, up from $67 million in 1995. The company earned 79 cents per share this year, up from 63 cents in 1995.

A nice record, but nothing compared with how Chesapeake has done on Wall Street. At a recent 67 1/4, Chesapeake trades at 85 times earnings, 4.2 times net asset value and 22 times cash flow, defined as net income plus depreciation, exploration expenses and deferred taxes. Its market capitalization is $2.3 billion.

Most of that huge market gain has come in under two years. The stock, issued in February 1993, was a split-adjusted 4 1/2 in early 1995.
 

  Compare this with Union Pacific Resources Group, an oil and gas exploration company spun off in 1995 from the railroad giant. With reserves of more than 184 million barrels of oil and almost 2.2 trillion cubic feet of gas, giant Union Pacific Resources trades at 25 times earnings, 1.5 times its net asset value and 8 times cash flow.

Investors are valuing the oil Chesapeake has in the ground at the equivalent of $32 a barrel. They are valuing Union Pacific's at just $11. Among 35 smallish exploration companies the average stock market price for each equivalent barrel of oil still underground is $7.

Is Chesapeake's oil worth almost five times the average? Doubtful. Oil is oil.

But, then, maybe Wall Street thinks Chesapeake's boss is a miracle man. Who is he? A native Oklahoman with a B.A. from Duke University, McClendon got the oil bug when he saw the riches that the 1981 energy boom brought to his state. "The other alternative was to become a CPA," he says.

McClendon met cofounder Tom Ward in the 1980s. Both were independent oil producers; they teamed up in 1983.

McClendon is still drilling on Wall Street. He took to the road in mid-November peddling a secondary offering of 4 million Chesapeake shares that raised $257 million. It's the company's second visit to the equity markets this year. With the prices his stock fetches you can hardly blame him.

If McClendon isn't a miracle man and if his oil isn't better than other folks' oil, how come his stock is so dear? It's beloved of momentum investors. This is unusual; bandwagon investors usually prefer companies with promising new technologies that are difficult to value. This allows the promoters to claim that the sky's the limit. But oil is oil.

Or at least oil is oil where common sense is involved. But there is a lot of nonsense around the stock market these days. Joining in with calls to buy Chesapeake stock are its investment bankers J.P. Morgan and Donaldson, Lufkin & Jenrette.
 

Chesapeake has one of the highest percentages of undeveloped reserves I've ever seen at an oil company.

 
    You guessed it. Chesapeake is an oil company with a "story." Chesapeake's specialty is horizontal drilling, an oil exploration method. McClendon says technological advancements like this are the fuel behind Chesapeake's fire. "Three-dimensional seismic and horizontal drilling allows us to find and extract oil and gas that would not have been economical to extract three or four years ago," he says.

This seems such a compelling "story" that it makes supposedly smart investors overlook something funny about Chesapeake. Its PUDs—proven undeveloped reserves—account for 61% of the company's reserves, a staggeringly high proportion. Michael Spohn, director of research at Petroleum Research Group in Rye, N.Y., says: "Chesapeake has one of the highest percentages of undeveloped reserves I've ever seen at an oil company."

Others in the industry are much more conservative than Chesapeake about what they consider proved but undeveloped reserves. On average, undeveloped reserves among both large and small oil drillers followed by Spohn's outfit come in at 23% of total reserves. At Union Pacific Resources, which is drilling for oil in some of the same areas as Chesapeake, only 10% of its reserves are undeveloped.

The problem with PUDs? It's almost impossible for investors to know how much of the undeveloped reserves will actually prove developable. Says one industry veteran: "PUDs are pie-in-the-sky."

Consider, for instance, the undeveloped 53 billion cubic feet of gas equivalent Chesapeake says it has as of June in an area of southern Louisiana called the Austin Chalk Trend. These "reserves" may never amount to anything, but Chesapeake identifies them as reserves nonetheless.
 

Chesapeake is aggressive on other fronts as well. In each of the past five years the company has had to cut the reserve estimates it had made at the start of the prior fiscal year. Over the period Chesapeake has reduced estimated reserves by some 57 billion cubic feet of gas. Although this isn't a huge number—the downward adjustments amounted to between 2% and 8% of the total each year—it raises a flag. McClendon says: "Reserve estimates are always tweaked year to year. The important thing is the reserves went up in total." But industry experts counter that repeatedly having to reduce reserves is a tactic used by a company with something to prove.

Oil companies have, on occasion, traded at huge premiums to their reserves and their peers'. One example was Standard Oil of Ohio in the early 1970s, which traded at multiples significantly higher than others in its industry. Sohio made a major oil find in Alaska's Prudhoe Bay. Its stock traded up because of great expectations, later realized, for the find.

Chesapeake has no Prudhoe. What it does have: leases on 1 million acres in Louisiana's Austin Chalk, costing $125 million. This is where Chesapeake will focus its energies, drilling up to 500 wells. It has a working interest in four completed wells now; one is dry and three are operating.
 

Will the Louisiana Austin Chalk pan out for Chesapeake? The economics in the area are tough.

 
    Will the Louisiana Chalk pan out for Chesapeake? The economics of horizontal drilling in the area are tough. The company's financials state that it sinks roughly $5 million into each well. Add estimated land, interest on debt and geological costs, and you get estimated total expenses of $22.8 million, $5.7 million per well.

Chesapeake expects its Louisiana Chalk wells to produce an average 7 billion cubic feet of gas equivalent. Maybe, but the best well drilled in the area, owned by Occidental Petroleum, should produce 5.5 billion cubic feet of gas equivalent. According to a local geologist, Chesapeake's best well pales next to Occidental's. This is because when each well declined to 2,400 pounds of pressure, a measure of how much oil and gas remain, Chesapeake's only produced 40% of what Occidental's had done.

Give Chesapeake the benefit of the doubt and assume its three working wells produce 21 billion cubic feet of gas. After paying 20% royalty to the landholders, Chesapeake has the equivalent of 16.8 billion cubic feet of gas left. To locate this gas, industry experts estimate it has spent the equivalent of $1.36 per thousand cubic feet.

Chesapeake must pay such costs as removing water from the well—a huge problem in the Austin Chalk—and transporting gas. Those costs—between 40 cents and 55 cents per thousand cubic feet—bring the total up to around $1.90. The market for natural gas over the past year has been around $2.45 per thousand cubic feet. Not much profit.

A report by oil industry analyst John S. Herold found that for the five years ending in 1994, Chesapeake's costs were $2.51 per equivalent barrel of oil. In 1995 it rose 42%, to $3.56 per barrel. For 1996 the cost is either $4.11 or $5.63, depending on whether lease costs are included. Herold's report asks: "Is real economic value being created?"

Well, yes. McClendon's and Ward's shares are each valued at about $340 million. Momentum investors playing the stock have done very well.

McClendon and Ward have not been selling their holdings, but by selling fresh equity at inflated prices they have raised cheap money and enhanced the value behind their shares at public expense.

Momentum or no, some insiders are bailing out. Filings show Chesapeake director Frederick Whittemore selling 58% of his 420,750-share stake, venture capitalist and director Edgar Heizer selling 67% of his stake and John Mack, president of Morgan Stanley, selling his 172,250 shares. Belco Oil & Gas, one of Chesapeake's partners in Texas and a player in the Louisiana Chalk, is dumping its 48,600 shares.