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Chesapeake Output Soars; CEO Sees Gas Floor of $9-11

Chesapeake Energy Corp. kept its U.S. natural gas machine churning 24/7 in 2Q2008, and the results were enviable.

The Oklahoma City-based producer's gas output jumped 29% in the period to total 195 Bcf, well above the 156.1 Bcf reported in the year-ago quarter, and up sequentially from the 187.8 Bcf reported in the first three months of this year. Total production averaged 2.328 Bcfe/d, an increase of 84 MMcfe, or 4% over the 2.244 Bcfe/d produced in 2Q2007. The production tally was about 2% above Chesapeake's guidance.

CEO Aubrey McClendon credited Chesapeake's unconventional shale acreage in some of the largest producing basins for the upsurge. And he's confident that even if gas prices were to fall a bit more, the shale plays would keep on producing.

"My thought is the shale, tight sands will be profitable at an $8/MMBtu Nymex [New York Mercantile Exchange] price," McClendon said when asked about his outlook for U.S. gas prices. "What we see in many [conventional] gas plays across the country, those plays are at an increasingly large cost disadvantage to shale plays. If you think about our plays in the Barnett, Haynesville, etc., we've been able to drive costs down over time and over dozens, hundreds, thousands of wells. For a company trying to find five-10 well fields, you are always reinventing yourself at smaller targets.

"If gas prices stay below $9/MMBtu at the Henry Hub for some period of time, the shale plays will continue to move forward, but a lot of rigs may drop out of what you call conventional drilling. If you fixated on Henry Hub prices and the basis differential in the Midcontinent...$8 gas these days means $6 at the wellhead. There's been a quiet, silent creep into the basis differential over the last 12 months, and investors don't fully appreciate what a company gets at the wellhead, and it's less and less than what is read in the headlines..."

McClendon's call for long-term gas prices?

"I think we'll stay in the $9-11/MMBtu range," he said. "There will be times in July when it will be below that, and weather will matter a lot as well. If it's much below $9, there will be a drop-off in drilling..." He disagreed with some energy analysts' calls for gas to drop to as low as $6.25/MMBtu. "That kind of analysis only comes at the dangerous intersection of Excel and Powerpoint," he said, referring to Microsoft accounting and presentation software programs. "It can't happen in reality."

The North American gas market may get into an oversupply situation, said McClendon. "It's happened every year for the last five years. Gas prices collapsed in the last three years, and each year it occurred one month earlier than the year before. Two years ago it was in October, last year it was in September and this year it was the August contracts.

"If we were to get a further decline from here, you would see the rig count start to go down, and that's the experience in 2007 and 2006. It shows you that the industry isn't stable or break even very long...People get very, very negative on gas prices in a hurry. This is an industry that always spends its cash flow, and then you see 40% first-year declines kick in and the markets correct..."

McClendon noted that the "real feature of the market is that every time there's a draw down in gas prices, the floor is higher than it was before, as it should be, because of higher coal, higher operating costs, higher oil prices...People looking for $6-7 gas prices out of this draw-down will be disappointed."

The Barnett Shale in Texas is Chesapeake's bread-and-butter, but the emerging Haynesville Shale is coming on strong, said the CEO.

Chesapeake, the second-largest producer in the Barnett play, had average net production of 466 MMcfe/d in the quarter, which was 125% above 2Q2007 and 13% higher than in the first three months of 2008. Chesapeake currently is producing around 500 MMcfe/d from the play and expects to hit the 675 MMcfe/d mark -- or more -- by the end of the year.

A few days ago EOG Resources Inc. CEO Mark Papa said his company, which is focused on developing Johnson County, TX, acreage, is forecasting Barnett output to peak in 2009 at around 5 Bcf/d and plateau the following two years (see related story). McClendon, whose company targets Tarrant County, TX, including the city of Forth Worth, said he did not agree -- he puts the peak at around 6 Bcf/d by 2012.

"When Chesapeake arrived in the Barnett, we did not arrive thinking it would be a 10-county play," McClendon said. "We thought the horizontal core would include only about 1.2 million acres. Other companies might have thought there was a greater aerial extent, but the heart of it is only about 1.2 million we know now.

"What has changed is our estimated ultimate reserves have increased from 2.45 Bcfe for every 100 acres to 2.56 Bcfe for every 55 acres, and we've seen a steady increase," he said. The Barnett Shale "will steadily increase over time...Urban issues are likely to keep it in increments."

But putting the Barnett's remarkable growth aside, McClendon also is pumped about the Haynesville Shale in Louisiana, which, as he has said more than once, may be the largest gas shale deposit in the United States.

"I suspect other companies did not arrive at the same conclusion, but they did not have the right geoscientists, or they did not think a shale as young as this one could produce," he said. "We were lucky to get our hands on a Haynesville core by another company, which confirmed our potential of the play."

The northwestern Louisiana play is now producing 45 MMcf/d from Chesapeake's first 11 horizontal wells.

"These are the best shale wells I've ever drilled from about 2,000 wells I've drilled," said McClendon. "There's a learning curve with every other shale play, but I know of no other shale well averaging more than 9 MMcf/d in the first several weeks. From here on, we'll drill all lateral wells...and there's a great likelihood that the wells will increase and produce 10 MMcf/d or better."

Over the next few years Haynesville should ramp up to around 1.5 Bcf/d, said McClendon. What will determine the production level will be infrastructure.

"We have competitors for pipe space out there," he said of the Haynesville. "I will say that if an operator of long-distance pipe in America wants to build, you've been to see us in the last 30 days or so...We've tied up all of the takeaway that we can, which is sufficient for the time frame. In the end, we have to have transmission out of the area."

How big the play is remains a question mark, said McClendon.

"Haynesville is fascinating because it can do whatever the market needs it to do," he said. "If we are successful in developing alternative uses for gas, for instance, compressed natural gas for cars...Haynesville will be there. If it doesn't develop, Haynesville will not develop as quickly" (see related story).

On hedging losses, Chesapeake reported a net loss during the quarter of $1.649 billion (minus $3.17/share); adjusted net income was $479 million (89 cents). The company reported an after-tax hedging loss of $2.085 billion.

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