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Chesapeake's Updated 4Q Guidance Reflects Hedging Gains

Chesapeake Energy Corp. updated its 4Q2006 guidance to reflect gains from lifting a portion of its oil and natural gas hedges and to include debt and equity offerings in the past two weeks. For 2007, the Oklahoma City-based producer has hedged about 27% of its gas output and 66% of its oil production.

In a Securities and Exchange Commission Form 8-K filing, Chesapeake revised its guidance to include changes to its hedging positions, a $600 million senior note offering and an offering for 30 million shares of common stock.

In 4Q2006, Chesapeake estimates oil and gas production will fall between 151.5-153-5 Bcfe, which includes 139-141 Bcf of gas; daily output is estimated at 1,658 MMcfe/d. For full-year 2006, Chesapeake estimates output of 578-580 Bcfe, which includes 527-529 Bcf of gas. Daily production for 2006 is estimated at 1,586 MMcfe/d.

Next year, production is expected to be between 665-675 Bcfe, which includes 614-624 Bcf of gas. Daily production in 2007 is expected to be around 1,836 MMcfe. In 2008, Chesapeake estimates production at 747-757 Bcfe, which includes 696-706 Bcf of gas. Daily production in 2008 will be around 2,055 MMcfe/d.

To calculate its realized hedging effects, Chesapeake estimated New York Mercantile Exchange (Nymex) gas prices for 2006 at $7.24/Mcf. In 2007 and 2008, Nymex prices are estimated at around $7.50/Mcf.

CEO Aubrey McClendon, who has been a canny prognosticator for the Oklahoma City-based company, said Chesapeake has been challenged by the warming North American weather patterns.

"The trend during the past 10 years has been towards warmer winters and warmer summers," McClendon said at the recent Deloitte 2006 Oil & Gas Conference in Houston. "This is not a good trend for North American natural gas producers, even though it takes three times as much energy to cool a room as to heat it."

However, Chesapeake has been more successful than many by mitigating price volatility through hedging.

"Our mantra is 'hedge, hedge, hedge' to mitigate gas price volatility risks and to maximize gas price optionality," McClendon said. "We will continue to mitigate away...Gas price volatility is the key to unlocking the value of the multiple options that are embedded in long-lived gas reserves."

Christopher Edmonds of RealMoney.com said Chesapeake is actually predicting a more normal winter season, compared with the warmer weather patterns of the past few years, which would mean colder temperatures.

"It should be noted that not all meteorologists share the bullishness of Chesapeake's forecasters," Edmonds wrote. "In fact, popular consensus suggests that the El Nino conditions should actually create another moderate winter. However, the El Nino impact looks like it will be too late and too weak to really have a meaningful effect.

"If correct, the Chesapeake forecast should bode well for natural-gas drilling activity, mitigating concerns that exploration and development activity will slow and put pressure on rig utilization, rates and driller profits."

Standard & Poor's Ratings Services (S&P) on Monday affirmed its "BB" credit rating on Chesapeake and revised the outlook to positive from stable. However, analyst David Lundberg warned that Chesapeake's move into the top investment-grade tier may be delayed because of its debt-financed acquisitions. At the end of 3Q2006, Chesapeake carried $7.9 billion in debt and $2 billion in preferred stock.

"Any potential rating upgrade to investment grade would require time, probably at least two years, not only due to the significant deleveraging that would be required, but also due to the confidence needed in management's willingness to operate under more stringent financial constraints," said Lundberg. "If Chesapeake instead pursues largely debt-financed acquisitions causing financial leverage metrics to worsen, or if operating performance worsens, a negative ratings action could result."

Friedman, Billings, Ramsey & Co. Inc. (FBR) analysts David M. Khani and Andrew Coleman raised their 4Q2006 earnings per share estimate to $1.06 from 71 cents "as a result of gains realized from lifting a portion of the company's hedges. Realized gains from lifted hedges are forecasted to contribute roughly $460 million to revenues..."

Despite its status as the No. 1 driller in the United States, the FBR analysts said Chesapeake still has the potential to lose leases "because the company's significant leasehold acreage may not all be drillable before individual leases expire." Chesapeake, they noted, has relied, "in large part, on its acquisition strategy. With commodity prices softening, net margins on future deals could face near-term pressure."

At year-end 2005, Chesapeake had 7.521 Tcfe of proved reserves in the United States. Of this amount, gas comprised 90%, with 26% classified as proved undeveloped.

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