How Chesapeake Energy went from darling to dud by Cyrus Sanati @FortuneMagazine April 25, 2012, 3:45 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — Chesapeake Energy is almost out of rope. Investors have punished the company in recent days, sending its shares down as much as 25%, following reports that Aubrey McClendon, Chesapeake’s co-founder and chief executive, engaged in some questionable transactions with the company. But while accusations of sweetheart deals are troublesome, they are really the least of Chesapeake’s worries. The company is drowning in debt and can no longer rely on hedging to shield itself from low natural gas prices. Chesapeake and its embattled chief executive are now in a race against time to diversify the company’s production away from natural gas to oil, so they can prove to investors that they can make money the old fashioned way – by actually earning it through the drillbit. McClendon grew Chesapeake from a small energy company into the second-largest producer of natural gas in the U.S. in just a few short years, second only to ExxonMobil XOM . He did it by aggressively reinvesting the company profits to acquire large tracts of drillable land. Whenever the company’s cash on hand wasn’t enough to meet McClendon’s ambitious growth target for the year (a normal occurrence), the company would issue debt, sell an asset, or sell forward the future production of a well in order to raise cash. McClendon also used his own money to buy minority stakes in several wells controlled by Chesapeake. While such transactions are permitted, the revelation this month that the company was fronting the money McClendon needed to service his share in the wells has become a center of conflict between the company and investors. Several shareholders lawsuits have since been filed claiming that McClendon and the board breached their fiduciary duty to shareholders by not disclosing the transaction. MORE: Exxon’s big bet on shale gas In the past, investors had given McClendon the benefit of the doubt when it came to growing Chesapeake, looking beyond its negative free cash flow and increasingly troublesome debt load. But while Chesapeake CHK sold itself as a premier energy exploration and production firm, it seemed to function more like a Wall Street hedge fund. That’s because the company’s consistently profitable bets hedging gas on the futures markets managed to outstrip the company’s so-so performance at the drill bit year after year. Plunging prices Natural gas prices strengthened for most of the last decade but have gone nowhere but down in recent years. The weakness in prices initially impacted those producers that got into the game late as they paid more for their acreage positions. Eventually, though, even first movers started to feel the sting as prices crashed through floor after floor. Chesapeake weathered the storm by successfully hedging the vast majority of its short-term production at above market prices. It was cheap and easy to find investors willing to take the other side of the bet as very few believed that prices would eventually fall as low as they did. McClendon and his lieutenants were seen as financial masterminds as the company was able to make money during one of the most trying times for the natural gas industry. The firm claims it had hedging gains 22 out of the past 24 quarters, netting the firm $8.4 billion since 2006, a feat that the firm boasted in a recent presentation to investors makes Chesapeake the best hedger in the industry “by far.” In 2011, the firm made $2.4 billion in hedging gains on a total net income of only $1.7 billion. Along with hedging, the company was able to stay in the black and grow its operations by engaging in long-term supply agreements called volumetric production payments (VPPs). This enabled the company to collect cash up front for the delivery of gas to customers in the future. From 2007 to 2011, the company engaged in nine such deals, which are all off balance sheet, with time horizons as short as five years to as long as 15 years. The deals brought in $5.6 billion in the last five years, which contrasts with the $187 million total net loss the company booked during that time. Accounting rules say that the company does not have to book that $5.6 billion as debt, even though the VPP forces the company to sell gas at a predetermined rate for years in the future. Hedging and VPPs have helped Chesapeake fund its growth and keep it afloat for years, but all good things come to an end, and for Chesapeake, the end is now. Natural gas prices have become so low that Chesapeake can no longer profitably hedge its production. The company says it currently has no hedges on for 2012, leaving it fully exposed to the market. Meanwhile, Chesapeake is still trying to issue VPPs, but many of the properties ripe for such an arrangement – mature fields that require little overhead – have already been spoken for. Additionally, with gas prices so low it might be forced into selling gas forward at an unattractive price. Looking to oil as a savior Chesapeake believes that the solution for its cash flow woes is to pump more oil than gas. Oil has a much higher profit margin, so it is on the right track, but Chesapeake may have waited too long to make the transition. The company started drilling for black gold in earnest last year and has shown some initial success, but its production mix remains gas heavy at 80% gas and 20% oil. It needs billions of dollars to tap the potential in its fields, money the company does not have. It has enlisted the help of private equity to fund some wells through the issuance of perpetual preferred shares in wells that have been hived off into a separate subsidiary. Private equity heavyweights like KKR and EIG Global Energy Partners have signed on, but the investments they have made have not been large enough to move the needle. MORE: America’s energy job machine is heating up As a last resort, the company announced earlier this month a plan to sell $8 billion to $10 billion worth of assets. Trouble is, the assets Chesapeake owns that are in demand have a greater mix of oil as opposed to gas, the same type of assets the company needs to keep. Chesapeake is therefore faced with having to sell its natural gas-heavy properties at a large discount or selling its oilier properties and jeopardizing its future growth. After taking into account all the sales and deals done so far this year, Citigroup estimates the company’s funding gap for 2012 remains a sizable $5.8 billion and projects a further funding gap of $4.4 billion to $5.7 billion next year. The projection is based on the assumption that natural gas prices will average around $2.50 per mmbtu, which is plausible given the record-level of gas currently in storage following this year’s warm winter. But it is unclear how long investors will continue to support a company that is so deep in the hole. Chesapeake has tried to lay low but the uncovering of McClendon’s questionable transactions has put it under a microscope. Funding gaps are one thing but corporate malfeasance is something else entirely. If Chesapeake fails to fully address this situation and make amends, it could act as the match that bring McClendon’s carefully crafted house of cards tumbling down.