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Hedges Trip Chesapeake in 'Record Quarter'

Notwithstanding a hedging strategy that fell victim to robust commodity prices, Chesapeake Energy Corp. executives last week touted a "record quarter" on a per-share adjusted basis with earnings of $1.09/share, the most in the company's 15-year history.

Chesapeake reported a first quarter loss of $143 million, 29 cents/share, due to an unrealized noncash after-tax mark-to-market loss of $704 million from hedges. "The tremendous upward move in natural gas and oil prices caused our mark-to-market positions to substantially move against us during the quarter...," CFO Marcus Rowland told analysts during a conference call last week.

With that unpleasantness out of the way, Rowland and CEO Aubrey McClendon went on to tout Chesapeake's first-quarter performance, which included production of 2.2 Bcfe/d, an increase of 31% over the year-ago period.

"We are especially proud of our 31% increase in average daily production in the 2008 first quarter compared to the 2007 first quarter and by our adjusted net income per share increasing by 25% to an all-time record level," McClendon said. "This is strong evidence that our rapid production growth is translating into proportional gains in per-share net income despite inflationary pressure on the industry's cost structure."

And then McClendon turned to globe-gazing and talk of more unpleasantness -- the good kind.

"What a remarkable time it is to be a natural gas producer. For example, food riots have broken out in many places around the world, with the probable result over time of a slowing of biofuel supply growth and an increased demand for fertilizer, much of which will come from natural gas," McClendon said. "I believe the biofuels slowdown should also result in a greater emphasis on natural gas-powered vehicles and plug-in hybrids in addition, which both should lead to greater direct and indirect demand for natural gas, a good thing, we believe, for food and energy consumers around the world and also for the environment around the world as well."

Power shortages in South America, southern Africa, the Mideast, China and India spell greater global demand of gas to fire power plants. "And just two days ago, as American Electric Power's CEO announced plans for a new gas-fired power plant in Oklahoma City [Chesapeake's home], he said he feared looming electricity shortages in the U.S. in the next few years," recounted McClendon.

Noting that "no one really likes to" conserve electricity, McClendon reads the writing on the wall as more purchase orders for natural gas turbines. Outside of the U.S. those turbines more often than not will be fired with regasified liquefied natural gas (LNG), said McClendon. "So anytime you read an article about electricity shortages around the world, please remember that's hugely bullish for worldwide natural gas prices directly and U.S. gas prices indirectly. Likewise, rising demand for electricity leads to greater coal consumption and, not surprisingly, we have seen a doubling of coal prices in the last year, both nationally and internationally. This puts a very strong and much higher floor price under natural gas prices in the U.S. than there has ever been in the past."

With no fears of LNG flooding the market, Chesapeake has plenty of domestic gas to meet demand, McClendon told analysts. The company announced that proved reserves reached a record 11.5 Tcfe and that Chesapeake achieved a first quarter reserve replacement rate of 395% from 601 Bcfe of net additions at a drilling and net acquisition cost of $1.95/Mcfe.

"We...believe that we are on track to reach 13 Tcfe of proved reserves by year-end 2008 and 15 Tcfe by year-end 2009," McClendon said.

Chesapeake said it agreed to sell 94 Bcfe of proved reserves for $623 million, or $6.63/Mcfe, in a volumetric production payment (VPP) transaction and said it would sell its remaining Arkoma Basin Woodford Shale properties for anticipated proceeds of more than $1.5 billion.

In the VPP deal -- the second such transaction for the company -- Chesapeake will sell assets with current net production of approximately 47 MMcfe/d. Chesapeake will retain drilling rights on the properties below currently producing intervals. The Woodford Shale sale of properties in Hughes, Pittsburg, Coal and Atoka counties in Oklahoma is a high-grading measure, the company said.

The company's average prices realized during the first quarter (including realized hedging gains/losses and excluding unrealized gains/losses) were $9.05/Mcf and $74.73/bbl, for a realized natural gas equivalent price of $9.33/Mcfe. Excluding hedging activity, Chesapeake's average realized pricing basis differentials to Nymex during the 2008 first quarter were a negative 40 cents/Mcf and a negative $3.76/bbl.

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