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Chesapeake Ready to Partner in Fayetteville, Marcellus -- Maybe More

Chesapeake Energy Corp. last week completed the sale of its Woodford Shale assets in the Arkoma Basin to BP America Inc. for $1.7 billion in cash, and now it is looking for joint venture partners to share the costs and the rewards in its Fayetteville and Marcellus shale plays.

Chesapeake agreed in July to sell BP all of its Woodford Shale interests, and that transaction was completed last week (see NGI, July 21). With cash in hand, Chesapeake plans to spend some money in its Haynesville, Barnett, Fayetteville and Marcellus shale plays, said CEO Aubrey McClendon. Selling off the Woodford assets also gives the company a tighter focus, he said.

"We now turn our focus to negotiating joint venture arrangements in the Fayetteville and Marcellus shale plays," McClendon said. Chesapeake wants to sell up to 25% of its interests in the two plays using a transaction similar to one it completed with Plains Exploration and Production Co. (PXP), he said.

PXP in July bought a 20% stake in Chesapeake's Haynesville Shale holdings for $1.65 billion in cash, and PXP agreed to fund half of the drilling and completion costs for Chesapeake's remaining 80% stake in the play until another $1.65 billion has been paid (see NGI, July 7). The deal gives PXP around 110,000 net acres in Chesapeake's Haynesville Shale holdings at an implied value of $26,500-30,000/acre.

More "PXP-style" transactions would allow Chesapeake to "receive partial consideration in cash at closing and then receive a tax-efficient carry of development costs over time as wells are drilled," said McClendon. "There is strong industry interest in both plays and also in our preferred deal structure." More transactions could be announced by the end of September, he added.

McClendon explained Chesapeake's evolving business strategy during a conference call with analysts a few days ago.

"During the past year you've begun to see a powerful new aspect of our business strategy develop," the CEO told energy analysts. "We have now become a seller of assets occasionally rather than just a developer of assets. Why the change, you might ask. Well, in our view if gas prices are likely to remain relatively flat for a while in the $9-11 range, then it makes sense to bring some of our more distant present value forward and monetize it at today's attractive prices."

Chesapeake, he said, has two ways to advance its present value forward.

"The first is through volumetric production payments or VPPs," McClendon said. "They give us the ability to monetize some of the low declined mature gas assets that are valued in the stock market of Chesapeake at less than $3/Mcfe and monetize them at about double that level. So far...we have sold VPPs for proceeds of $2.3 billion. The reserve volumes sold were 395 Bcf.

"So we monetized these assets for cash at $5.90/Mcfe and took the cash and reinvested it in our gas manufacturing machine that today is consistently developing reserves at around $2/Mcfe," he noted. "If we can find it for $2 and the stock market only values it at $3, and we can sell it for nearly $6 through a VPP and still keep the...reserve, what's not to like about that?"

For income tax purposes the VPPs are treated as loans, "so there is no cash income tax leakage from the transaction," said McClendon. "Furthermore, the proceeds from those VPPs go into our full cost pool as credit, and so as we offset an approximate $2.50/Mcfe, current DD&A [depreciation, depletion and amortization] rate with about $6/Mcfe VPP proceeds, you'll see that these VPPs will reduce our DD&A rate going forward and enhance our profitability and improve our returns on capital. In all likelihood we will sell another $500 million VPP in the second half of this year and probably $1 billion to $2 billion worth next year as well."

Transactions similar to the PXP deal also will allow Chesapeake to monetize its assets, McClendon explained.

"To date our total investment in the Haynesville is around $4 billion, so by selling 20% for $3.3 billion we have recouped 80% of our cost, lowered our per acre average cost by 77% from $7,100 per net acre to $1,600 per net acre, and established a remaining value of about $22 per share for the remaining 80% of this unique asset," he said. "This transaction reduced our risk, lowered our cost, aggressively advanced present value creation forward, and has provided valuation transparency for this enormous asset. In time we believe this acreage will be worth at least $50,000 per net acre to us or $37 per share."

Besides partnerships in the Fayetteville and Marcellus shales, Chesapeake wants to pursue a joint venture in it West Texas shale play "because we have recently drilled a series of excellent wells there," he said. "In the past, once we found gas we only had one way to make money from it and that was to sell the gas over time as the well gradually depleted. Now, however, we have developed a way to accelerate that process and that's by selling off a portion of our new plays to partners at very attractive prices. Similarly to the VPPs, as the sale proceeds go into our full cost pool as credits well in excess of our costs incurred to date, our future DD&A rates should decline as well, which will lead to higher profitability and greater returns on capital.

"Just at the time other companies are experiencing rising finding costs and higher DD&A rates, Chesapeake will be headed in the opposite direction."

"The whole point in doing these monetizations is to get out of the equity issuance business. The problem for us is that we had this enormous mismatch this year between the cash needs of what we had to get done in the Haynesville and how to get these asset monetizations done. In the first half of the year basically we had to spend or commit to spend around $4 billion for the Haynesville.

"At the same time, we were ramping up leasing in the Marcellus and the Barnett [shales] as well...So we just had an enormous mismatch...of cash flows this year, which required us to go out and kind of underpin the fundamental financial strength of the company with equity. We are moving to a time frame where we are going to be generating cash as a result of these asset monetization programs, and I don't see another shale play on the horizon that has any kind of capital demand, anything remotely close to what we had to go through with the Haynesville this year."

In related news, Chesapeake is soon to begin drilling a well in downtown Fort Worth, TX, to access gas from the Barnett Shale. The Trinidad Rig would drill a well behind a warehouse on the southern edge of the downtown area in a project approved by the city last year (see NGI, Oct. 15, 2007). Drilling would be done in a westerly direction away from the downtown area, according to the company.

By using the downtown site, Chesapeake expect to be able to secure gas underneath several downtown locations, including city hall and the Fort Worth Convention Center. Four other downtown sites also are marked for future drilling, but the projects are not expected to negatively impact transportation or any businesses, the company said.

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