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Chesapeake Goes Cash Neutral to Weather Economic Storm

Aware that the company's share price was treading near single-digit territory and on the hook for some admittedly poor business decisions, Chesapeake Energy Corp. CEO Aubrey McClendon came out swinging last week, telling energy analysts and investors that the company has "plenty of liquidity" and will weather the economic storm by neutralizing capital expenditures (capex) over the next two years. Even with flat spending, the Oklahoma City-based natural gas driller still expects to achieve 5-10% production growth in 2009 and 10-15% gains in 2010.

However, the gains will not come without some losses, McClendon said during a conference call.

To operate "cash neutral," Chesapeake slashed projected 2009 and 2010 capex by a combined $2.9 billion, or 31%. The planned leasehold and acquisition budget over the next two years was reduced by 78%, or a combined $2.2 billion. All of those reductions are on top of others taken in just the past six months. In total, since July 31 the producer has reduced its planned 2009 and 2010 drilling, leasehold and acquisition budget by $9.8 billion, or 58%, to $7.2 billion.

"Everything you want to see happen to balance the [gas] market is under way right now," McClendon told investors. "Assuming the economy stays where it is, lower gas prices will stimulate demand...It's been a crazy year, a brutal year for investors and for natural gas, but over the next three, four, five years, people will make a whole lot of money being long natural gas rather than short."

Since August, "Chesapeake has steadily reduced its drilling and leasing activities in anticipation of a worsening U.S. economy, lower natural gas and oil prices and limited capital markets," he said. "The company is now utilizing approximately 130 operated rigs, down from a peak of 158 operated rigs in August, and we plan to further reduce the operated rig count to 110 to 115 rigs early in the first quarter." Chesapeake, like many of its peers, has begun laying down rigs in several gas plays across the country -- but it won't reduce the rig count in every play.

The producer has three joint ventures in which its partners pay all or most of the drilling expenses as long as Chesapeake retains a certain rig count. In the Fayetteville Shale joint venture with BP plc, Chesapeake's drilling commitment is to stay "above 20" rigs, said McClendon. "If we go below that, they have the right to drill the wells themselves. Unlikely as it is, it is incredibly unlikely that we would drop rigs that are costing us nothing..." The Haynesville Shale joint venture, in which Plains Exploration & Production Co. pays for some of the costs, has no specific drilling requirement, "but we have the motivation to drill as quickly as possible to encourage the rate of return..."

In its third joint venture, StatoilHydro ASA agreed to pay 75% of the costs for the Marcellus Shale joint venture, McClendon noted. Four rigs are running in that play today and Chesapeake plans to add two more rigs per month in the play. "These are yearly 'use it or lose it' concepts there, but they carry forward. We're very confident of our ability to capture the carry there," he said.

"We don't pay a partner unless we slow down drilling, but we have no incentive to slow down drilling in those areas. We have a huge advantage over every other company in that if we wanted to cut our rig count to 50, we could do that and spend only $500 million a year, and almost keep our reserves flat by doing that." The drilling carries are expected to save the company $1.2 billion of capex in 2009 and $1.1 billion in 2010.

"Theoretically, we [U.S. producers] could take the rig count to zero today, and after a lag of three to six months, we would end up with production 40% lower than where we are today," McClendon said. "One thing people are probably not thinking about as carefully as they should be is that gas, as it has been ascending in production in the United States to 58 Bcf/d from 52, is that incrementally, all of that is coming from new plays. When you consider that 50% of the wells are newer than 30 months old, this decrease in the rig count will likely accelerate in the next two months, which will balance the gas market by the beginning of the injection season in 2009. That assumes the economy stays weak and the chance that it doesn't get a whole lot weaker. When the rigs go down, production will fall pretty quickly thereafter."

To create more value and enhance liquidity, the company also plans to "selectively monetize" some mature assets and undeveloped leasehold, including operated producing assets in the Anadarko and Arkoma basins and in South Texas. In addition, discussions with multiple parties are under way to sell a stake in some midstream operations. The Barnett Shale of Texas, whose midstream operations are more mature than in other parts of the country, probably would be included, McClendon said.

During the conference call, a financial analyst said it appeared the company would have to "perpetually sell" assets to fund its drilling program. The CEO was quick to disagree.

"Embedded in your question is the presumption that assets can't be sold," McClendon said. "Tens of billions of dollars are sold every year in this industry. I'm surprised that you find it hard to believe that there is not a ready market for the type and quality of assets that we have. We'll make more money selling leaseholds than we ever will drilling wells...[B]y the time this year is over we will have monetized an amount of assets that will exceed $10 billion. If you include the carries with that, we have made an 80% profit margin on that going forward. I think absolutely I want the challenge, and I want the organization to have the challenge to be able to find $1 billion of assets a year, $1.5 billion of assets a year...

"There's some presumption in your question that we have no capability of throttling back our business. We've already cut back $4.7 billion of expected capex just in the last month. If gas prices go to $5, if they go $4, if they go to $3, we'll cut back. We are completely capable of laying [down rigs] and we will do that. We are completely capable of driving down a lease price. We are completely capable of saying 'no' to a lease...Every time we lose money on hedges we tend to make money for the next six to eight quarters and then we get a chance to do it all over again. Remember we lose money when there's a gas price spike, and that happened in the first and second quarter of this year. We lost money on hedges. We're going to make money in the second half of ''08 and in '09 and probably '10."

Chesapeake restructured its hedging position and now has 76% of its anticipated 2009 gas production hedged through swaps and collars at an average swap and floor price of $8.20/Mcf, including only 12% of its anticipated production hedged through swaps with knockout provisions, most of which is concentrated in the last three months of 2009.

The CEO took the blame for two Security and Exchange Commission (SEC) filings made the day before Thanksgiving, which indicated Chesapeake would sell stock to generate up to $1.8 billion (see NGI, Dec. 8).

"In retrospect those filings were a mistake, and I apologize and ask forgiveness for them," he said. "The intent was to provide for broad flexibility...but obviously that message was not understood or believed. We are correcting that mistake immediately." The company planned to terminate the shelf offering Monday and does not plan to issue any shares under the equity distribution program. Chesapeake also is amending its acquisition shelf statement filing to reduce the common share offering to 25 million shares from 50 million, which tentatively would be used over the next few months to resolve "certain Haynesville Shale leasehold" disputes.

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