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Chesapeake to Spin Off Granite Wash Royalty Trust

Chesapeake Energy Corp. has found another way to fund development for some of its abundant unconventional reserves, this time by launching an initial public offering (IPO) of a royalty trust for properties in the Anadarko Basin.

The Chesapeake Granite Wash Trust plans to offer up to $583.6 million in common units, according to a preliminary S-3 filing with the Securities and Exchange Commission. After issuing more than 25 million common units through the IPO, the trust would have close to 51 million total units outstanding, including 38 million common units and almost 13 million subordinated units.

The offering, to be launched on the New York Stock Exchange under "CHKR," would be centered around Chesapeake's Colony Granite Wash acreage in Oklahoma's Washita County, which is in the Anadarko Basin. Chesapeake would convey a 90% royalty interest in the producing wells and a half stake in the development wells with the IPO's closing. In exchange for the royalty interests, Chesapeake would receive all of the IPO's proceeds, which would be used to repay debt and fund capital spending projects.

Chesapeake's use of a royalty trust isn't a first. SandRidge Energy Inc., like Chesapeake headquartered in Oklahoma City, earlier this year filed for an IPO for its stakes in SandRidge Mississippian Trust I to trade under the stock ticker "SDT." The filing indicated that it would sell up to $250 million in common units, or up to 12.5 million, which implied a unit price of up to $20/unit. (SandRidge is headed by Tom Ward, who incidentally helped to create Chesapeake with Aubrey McClendon.)

The SandRidge trust owns perpetual royalty interests in oil and natural gas properties leased by the producer in the Mississippian formation in Alfalfa, Garfield, Grant, Major and Woods counties in Oklahoma, which allow the trust to receive 90% of the sales proceeds from 37 horizontal producing wells and half of the sales proceeds from 123 horizontal development wells to be drilled on 63,500 gross acres (42,600 net) held by SandRidge.

Chesapeake's trust also will be centered in the state around the Colony Granite Wash play in Oklahoma's Washita County, a subset of the Anadarko Basin. And the terms are similar: Chesapeake would convey a 90% royalty interest in the producing wells and a 50% royalty interest in its development wells. In exchange for the royalty interests, Chesapeake Energy will receive all proceeds from the offering, which it plans to use to repay debt and help fund capital expenditures for land and drilling, among other corporate purposes.

"Cash in the door to develop [proven undeveloped reserves] is good for Chesapeake" because it's not seen as a debt by the credit ratings agencies and it's an alternative to funding development through voluntary production payments, said analysts with Tudor, Pickering, Holt & Co.

The area of mutual interest targeted by the trust has about 60 producing wells and 122 development wells on 28,700 net acres, the TPH analysts said. They estimated the "royalty resource" was 43.2 million boe, which is about 38% proved developed, which would put the "selling resource at $23.50/boe," using $583 million in proceeds for 57.5% working interest and 43 million boe net to royalty.

However, the analysts questioned the "public filing headaches," which "makes us wonder...is $600 million worth it" for a company with an estimated total value of $38 billion?

According to the American Association of Petroleum Geologists, the tight sands play is about 160 miles long and 30 miles wide, covering parts of Western Oklahoma and the Texas Panhandle. Even though there are more than 2,600 wells operating now in the Granite Wash, the advent of horizontal drilling combined with hydraulic fracturing has given the decades-old play new life. Most producers' earlier wells were vertical, drilled through the Granite Wash to targets in the Atoka or Morrow formations of the Anadarko Basin.

Decline rates using horizontal techniques also are much better than some of the other unconventionals, offering a higher internal rate of return. Producers have reported that decline rates of wells in the Granite Wash are expected to be in the range of 50% to 60% for the first year, compared with 80% for some shales and tight sands.

Chesapeake estimated that its average gas production rates in 2010 from Granite Wash wells in the Texas Panhandle had increased to almost 7.7 MMcf/d from 1.77 MMcf/d in 2007. In March its West T No. 2H well there initially produced 20.5 MMcf/d of gas and 4,496 b/d of liquids.

Apache Corp., which has more than 200,000 net acres in the play, said its first horizontal well in 2009, the Hostetter No. 1-23H had an initial production rate of 17 MMcf/d and 600 b/d of oil. Last year Linn Energy LLC reported one of the highest initial production rates in the play. In July 2010 a Linn operated well in the Stiles Ranch area of Wheeler County, TX, tested at a 24-hour production rate of 27 MMcf of gas and 3,190 bbl of condensate and yielded 3,530 bbl of natural gas liquids after processing.

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