When oil prices wave goodbye to the natural gas market and head for the moon, even the staunchest gas-focused producer can turn wistful thinking of the liquid hydrocarbon and what might have been.

"I would love to change all of our almost 2 billion barrels of oil-equivalent reserves into oil, but it's not possible," Chesapeake Energy CEO Aubrey McClendon told analysts during an earnings briefing last week. "We definitely have an all-hands alert around here looking for oil, and we do have a lot of plays that are prospective for oil, just nothing on the scale that could move the needle the way that the Barnett [Shale] moves the needle and the Fayetteville [Shale] moves the needle..."

Still, when it comes to building an enterprise "on a sustainable asset foundation for decades to come," gas is the way to go, McClendon said, particularly since today's near-$100/bbl oil prices reflect the fact that the commodity is growing ever scarcer "and the visibility of forward production is increasingly opaque."

In the race for their shares of the world energy market, natural gas is looking more like the tortoise to oil's hare. In other words, he who peaks first finishes last.

"We believe in some part of the world the transportation system is going to have to move to natural gas, whether it's natural gas directly into vehicles or a derivative of natural gas supplied by electricity for some kind of plug-in capability for cars," McClendon said. "To us, the world oil market is doing what it should be doing; it's looking for a price that is capable of restraining demand."

With that in mind, don't look for a return to the 6:1 price relationship between oil and gas to return to markets anytime soon, McClendon said. And he's taking some of the credit for that, suggesting that Chesapeake and other gas producers right now are providing consumers with "a real windfall...We think consumers ought to love the situation that they're in." In fact, if the CEO of the Oklahoma City-based producer had his druthers, clean-burning gas would be free, at least for now.

"We are essentially 100% hedged through the winter, and so we'd just assume gas prices go to zero and we give all the gas consumers a big break and get them fully back in the game and geared up to consume a lot of gas in 2008 and beyond."

Longer term, McClendon said gas will be closing the gap with oil as it gets priced more for its "availability and affordability and cleanliness as well." While the tortoise has yet to pass the hare, Chesapeake already has a clear view of the finish line and the bountiful domestic gas resources that lie beyond, according to McClendon.

"If you want to drill big gas wells onshore in America today, wells that can make more than 30 million [cubic feet per day], we believe there are only three places to go: the deep Anadarko Basin in Western Oklahoma, the Deep Haley area in West Texas and the Deep Bossier trend in East Texas. Chesapeake has a premier leasehold position in all three areas, and so we believe our big gas well exposure is unique in the industry," McClendon said.

The 2007 third quarter was Chesapeake's 25th consecutive quarter of sequential U.S. production growth, the company said. Over the last 25 quarters, Chesapeake's U.S. production has increased 417%, for an average compound quarterly growth rate of 7% and an average compound annual growth rate of 30%.

Daily production for the 2007 third quarter averaged 2.026 Bcfe, an increase of 158 MMcfe, or 8%, over the 1.868 Bcfe of daily production in the 2007 second quarter and an increase of 429 MMcfe, or 27%, over the 1.597 Bcfe/d produced in the 2006 third quarter. Virtually all of the company's production growth on both a sequential and year-over-year basis was through the drillbit, Chesapeake said. Average daily production for the quarter consisted of 1.851 Bcf of natural gas and 29,130 bbl of oil.

Chesapeake has raised its previous forecasts for total production growth for 2007 to 21-23% from 18-22% and for 2008 to 18-22% from 14-18%, while reaffirming its 12-16% production growth forecast for 2009.

For the third quarter, Chesapeake generated net income of $346 million (72 cents/share), operating cash flow of $1.085 billion and earnings before interest, taxes, depreciation and amortization (EBITDA) of $1.24 billion on revenue of $2.027 billion and production of 186.4 Bcfe. Results include an unrealized after-tax mark-to-market gain of $16 million resulting from commodity and interest rate hedging programs. Excluding this item, Chesapeake generated adjusted net income in the 2007 third quarter of $330 million (69 cents/share) and adjusted EBITDA of $1.195 billion.

Average prices realized during the 2007 third quarter (including realized gains or losses from oil and natural gas derivatives, but excluding unrealized gains or losses on such derivatives) were $7.41/Mcf of gas and $69.25/bbl of oil, for a realized natural gas equivalent price of $7.76/Mcfe. Realized gains from oil and gas hedging during the 2007 third quarter generated a gain of $1.70/Mcf and a loss of $1.51/bbl for a 2007 third quarter realized hedging gain of $286 million, or $1.53/Mcfe. Excluding hedging activity, Chesapeake's average realized pricing differentials to Nymex during the 2007 third quarter were a negative 45 cents/Mcf and a negative $4.62/bbl.

By comparison, average prices realized during the 2006 third quarter (including realized gains or losses from oil and natural gas derivatives, but excluding unrealized gains or losses on such derivatives) were $8.39/Mcf of gas and $60.62/bbl of oil, for a realized natural gas equivalent price of $8.54/Mcfe. Realized gains from oil and natural gas hedging activities during the 2006 third quarter generated a gain of $2.33/Mcf and a loss of $4.43/bbl for a 2006 third quarter realized hedging gain of $301 million, or $2.05/Mcfe. Excluding hedging activity, Chesapeake's average realized pricing differentials to Nymex during the 2006 third quarter were a negative 52 cents/Mcf and a negative $5.43/bbl.

Chesapeake is in the process of monetizing company-operated assets in Kentucky and West Virginia with a transaction expected by the end of the year that will generate proceeds exceeding $1 billion. In addition, the company also plans to pursue four more monetizations of similarly mature properties in 2008 and 2009 for further proceeds of approximately $2 billion. Chesapeake also is in the process of selling noncore assets in the Rocky Mountains and in the southeastern Oklahoma Woodford Shale play for expected proceeds of more than $300 million. These sales are anticipated to close by the first quarter of 2008. In total, Chesapeake is anticipating receiving monetization and sale proceeds of approximately $3.3 billion by year-end 2009.

The company is forming a private master limited partnership (MLP) to own a nonoperating interest in its midstream gas assets outside Appalachia, which consist primarily of gas gathering systems and processing assets. These assets, which are expected to grow substantially in future years, currently generate annualized cash flow from operating activities in excess of $100 million. The company believes its MLP transaction will be valued at more than $1 billion and is anticipated to close in the first quarter of 2008.

No MLP is planned for any producing assets as Chesapeake favors an outright asset sale to a producer MLP, McClendon said.

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