Oklahoma City-based Chesapeake Energy Corp. has looked at the markets for gas, producing properties and gas infrastructure and determined it's a good time to unload some assets and scale back drilling and production plans, particularly in light of abundant supply and low prices.

Last week the company said it is planning transactions to take advantage of market interest in low decline-rate producing natural gas assets and for midstream gas assets. The announcement came along with the company's 2008-2009 financial plan and initial production and budget forecasts for 2009, which include curtailment of some production due to low prices.

"To protect the company's long-term shareholder value, we believe Chesapeake needs to respond to the current oversupply of natural gas and defer natural gas production and drilling activity until natural gas supply and demand come into better balance," said CEO Aubrey McClendon. "We will continue monitoring the natural gas markets and adjust our production volumes and drilling activity as market conditions dictate."

Chesapeake said during the next four months it anticipates completing the first transaction, the sale of a nonoperated minority interest in certain company-operated producing assets in Kentucky and West Virginia, representing approximately 145 Bcfe of proved reserves and 30 MMcfe/d (net) of production, or approximately 1.5% of the company's current proved reserves and net production. The company said it believes these assets will be attractive to both the master limited partnership (MLP) and financial markets due to the low-risk, long reserve-life and low decline-rate profiles of the properties.

The company said it intends to retain drilling rights on the properties below currently producing intervals and outside of existing producing wellbores. Chesapeake expects to raise approximately $550 million from the Appalachian asset sale, which is anticipated to close by the end of 2007. Additionally, Chesapeake said it plans to pursue the sale of four similar packages of mature properties approximately every six months in 2008 and 2009 for further proceeds of approximately $2 billion.

For the second transaction, Chesapeake intends to form a private MLP or an alternative financial structure to own a nonoperating majority interest in its midstream gas assets, which consist primarily of gathering systems and processing assets. These assets, which are expected to grow substantially in future years, currently generate annualized cash flow of about $100 million. The company said it believes this transaction will be valued in excess of $1 billion.

"Our announcement addresses two important topics in our industry today: low natural gas prices and attractive asset values for sellers of natural gas assets into the MLP and financial markets," said McClendon. "[W]e believe that current low natural gas prices are temporary and result from a modest oversupply of natural gas in the U.S. This oversupply has largely been caused by two consecutive mild winters in the U.S., increases in imports of liquefied natural gas [LNG] resulting from an exceptionally warm European winter last season and increased production from domestic producers through higher drilling activity levels."

During the next nine quarters, Chesapeake said it believes the MLP and financial markets will allow it to monetize approximately $3.5 billion of assets that, in management's opinion, are not adequately reflected in Chesapeake's current market valuation.

In response to currently low gas prices, Chesapeake has elected to temporarily reduce its gross daily gas production by approximately 200 MMcf through a combination of production curtailments and deferred pipeline hook-ups. The reduction will amount to roughly 125 MMcf/d net to Chesapeake, or about 6% of the company's current net production, and will be focused in the Fort Worth Barnett Shale, South Texas, Deep Haley and Anadarko Basin areas where many of the company's most prolific wells are located.

Chesapeake has also elected to reduce its operated drilling rig count from current levels of 155-160 rigs to 140-145 rigs by the end of 2007. This reduction will lower the company's previously budgeted capital expenditures by approximately 10% in both 2008 and 2009, a combined $1 billion.

"Over the past year, the U.S. rig count has increased by approximately 70 rigs to around 1,800 rigs while Chesapeake's operated rig count has increased by approximately 50 rigs, representing about 70% of the nation's overall increase in drilling activity," McClendon said. "As a consequence of Chesapeake's drilling success, the company's gross natural gas production has grown by approximately 550 MMcf/d during the past year, accounting for approximately 50% of the total increase in U.S. natural gas production while using only about 9% of the nation's rigs."

Because Chesapeake's production growth during most of 2007 has exceeded internal projections, the company said it expects to meet its previously released production guidance of Aug. 2, which projected an 18-22% increase for 2007 and a 14-18% production increase for 2008, despite the asset sales, production curtailments and reduced drilling activity. Further, the company's initial projection for 2009 production growth is 12-16%.

McClendon said Chesapeake has realized about $630 million in gains from its gas hedges so far this year.

"[A]s of the middle of last week [Aug. 27-31], the mark-to-market gain on our remaining 2007 through 2009 natural gas hedges was approximately $1.5 billion," he said. "We have hedged approximately 60% of our 2007 second half natural gas production through swaps at a weighted average price of $8.47/Mcf, approximately 70% of our 2008 natural gas production at an average price of $9.18/Mcf and approximately 27% of our 2009 natural gas production at an average price of $8.98/Mcf. Additionally, we have hedged approximately 12% of our 2007 second half natural gas production through collars at a weighted average floor of $6.94/Mcf, approximately 4% of our 2008 natural gas production at a weighted average floor of $7.41/Mcf and approximately 2% of our 2009 natural gas production at a weighted average floor of $7.50/Mcf. The swap amounts include certain knockout swaps that may or may not be effective hedges at contract settlement dates depending on future natural gas prices."

In a recent client note, Sun Trust Robinson Humphrey/the Gerdes Group noted that "market concerns have surfaced regarding losses associated with knockout provisions of Chesapeake's September natural gas hedges.

"Our analysis suggests losses related to those provisions equate to no more than $25 million, or a negligible 5 cents/share in value degradation. Relative to the E&P sector, CHK [Chesapeake] trades at roughly a 15% premium, has 10% better capital productivity, approximately 15% stronger growth, significantly higher margins (due to opportunistic hedging) and 58% upside to our target price." The firm reiterated its "buy" rating on Chesapeake.

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