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Chesapeake CEO Sees 'Pain Across Whole Industry' in Near Term

By next spring U.S. natural gas prices will be $6-7/Mcf and around 900 gas rigs will be operating onshore, Chesapeake Energy Corp. CEO Aubrey McClendon said last week. However, gas producers will be in a world of hurt for the next few months because of a lack of storage capacity, he said.

McClendon offered his take on the domestic gas market, and he and his management team detailed the company's 2Q2009 performance during a conference call with energy analysts and investors.

Because of continued low wellhead prices, Chesapeake voluntarily curtailed around 400 MMcf/d of its gross output in 2Q2009, which represented around 13% of its total operated production capacity (see NGI, April 20). Although gas prices have barely rebounded, McClendon explained why the company has ramped up the curtailed volumes.

"By holding some production off we certainly did benefit," he said. The "basis...actually improved pretty dramatically and wellhead prices did improve...The basis story is a really important one."

The energy industry, said McClendon, "has been long gas and short pipe...We're getting ready to move into a world where we will be long pipe and short gas, and we have already seen basis differentials...come together...Given where storage is, it was our analysis that we're going to be full up on storage by the end of the year.

"As we get closer to that, pipeline pressures are going to increase, and that is going to cause involuntary curtailments. Our view was that there was no reason for us to voluntarily curtail gas when pretty soon everybody is going to start involuntarily curtailing gas...We didn't see any reason to take it on the chin for the team more than we did. Instead, we'll just let the system work, to spread the pain across the whole industry here over the next couple of months."

EOG Resources Inc. CEO Mark Papa said Friday increased pipeline pressures because of high gas storage could force curtailments "across the board" within the next two months (see related story).

If the industry shuts in gas wells as expected, by early next year gas prices may be double current prices and the gas rig count, now around 675, will be at around 900 rigs, said McClendon.

"We're probably at a bottom" on the gas rig count, he said. "We don't expect the rig counts to pop up too many going forward. I would be surprised to see it above 1,000 or 1,100 over the next 12 months or so...I think we're in a time when service companies are realizing the same things a lot of E&P [exploration and production] companies are realizing: that everything is different as a result of these shale plays. We're not going back to a service industry supporting 1,700 or 1,800 rigs in the U.S. There will have to be a rationalization of capacity in the industry.

"In the meantime I think most of that capital will stay around and keep prices reasonably low for us."

The Oklahoma City-based producer is readying for the long term in any case. It is in "continuing discussions" with several companies about a possible joint venture (JV_ on "some or all"of its Barnett Shale properties, a deal that should be completed by year's end. The deal would be one of several already completed or contemplated; an estimated $2.35-3.05 billion of assets may be sold this year and another $1.25-1.8 billion of assets are targeted for sale in 2010.

The asset sales, combined with strong operating cash flow, said McClendon, "will enable the company to continue funding its highly economic investment program solely from internal resources while at the same time reducing the company's debt levels both absolutely and on a per proved Mcfe basis."

Chesapeake has sold or agreed to sell around $900 million worth of properties since the end of March. Among other things, a fifth volumetric production payment (VPP) worth $371 million was completed for some producing properties in South Texas. The properties, with estimated proved reserves of 68 Bcfe, currently produce 55 MMcfe/d. The transaction is valued at $5.46/Mcfe.

Another sale worth an estimated $208 million involved some producing and gathering assets in Louisiana. A set of onshore domestic midstream and surface assets was sold for $172 million, and some producing assets in Central Texas were sold for $75 million. Still pending is completion of a $70 million sale to multiple buyers for some midstream assets.

Several transactions also are under way to creatively finance drilling activities in the company's Haynesville and Barnett plays. Some Haynesville Shale assets worth an estimated $225-250 million are to be sold through another VPP that is scheduled to be completed within the next three months. An undisclosed private equity firm also wants a half stake in some of its Barnett Shale and Midcontinent midstream assets that are worth more than $550 million.

Last week Chesapeake's liquidity got a boost from Plains Exploration & Production Co. (PXP) after it agreed to make an early $1.1 billion payment for its share of drilling costs in the companies' Haynesville Shale JV in exchange for a 12% discount. Last year PXP paid Chesapeake $1.65 billion cash to become a 20% JV partner in Chesapeake's Haynesville Shale leasehold (see NGI, July 7, 2008). In another transaction PXP agreed to fund -- over several years -- half of Chesapeake's drilling and completion costs for future JV wells until PXP had paid Chesapeake an additional $1.65 billion.

PXP has 110,000 net acres in the shale play under the agreements, and it has the right to a 20% stake in additional acreage purchased by Chesapeake in the play. Under the amended agreement, Chesapeake is to receive $1.1 billion in cash by the end of September instead of an estimated $1.25 billion that would have been paid by PXP over the next three years. The revised terms would reduce by about 12% PXP's total drilling carry obligations, Chesapeake said.

Chesapeake in late July the company issued its 2Q2009 operating information (see NGI, Aug. 3). Last Monday Chesapeake issued the quarterly earnings report.

The company's net income totaled $237 million (39 cents/share) in 2Q2009, compared with a loss of $1.64 billion (minus $3.16) in 2Q2008. Operating cash flow was $1 billion, versus $1.47 billion a year earlier. Excluding all one-time items, net income was $377 million (62 cents/share). Quarterly results included a one-time realized hedging gain of $597 million.

Chesapeake, which is 92% weighted to natural gas, produced 223 Bcfe in 2Q2009. Average daily production rose 4% sequentially from 1Q2009 to 2.45 Bcfe/d from 2.37 Bcfe/d, and production was up 5% from 2Q2008's production of 2.33 Bcfe/d. Average quarterly output consisted of 204 Bcf of natural gas and 3.15 million boe of oil and natural gas liquids. Natural gas production rose to 2.04 Bcf/d in the period versus 1.95 Bcf/d in the year-ago period.

Average realized gas prices fell to $5.56/Mcf in 2Q2009 from $8.18 a year earlier. Chesapeake said its gas and oil hedging positions with 14 different counterparties had a positive mark-to-market value of $900 million as of July 31.

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