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Chesapeake Energy Sitting Pretty -- and Cheap, Says CEO

Chesapeake Energy Corp., the nation's third-largest independent gas producer, Wednesday received top honors from a major business magazine for its management's capabilities. CEO Aubrey McClendon recently spoke with NGI about what he sees ahead in the unconventional gas patch.

"Those [companies] that were early to recognize that gas prices were structurally higher for years to come and recognized what could happen when you put horizontal drilling and horizontal drilling completion technology to work on some shales and tight sands across the country, those companies will be differential performers for years, if not decades, to come," McClendon said.

Forbes magazine would seem to agree. Chesapeake was named to Forbes' Platinum 400 list of "America's Best Big Companies" and was further identified as the best managed company in the "Oil & Gas Operations" category in the magazine's Jan. 8 issue. Chesapeake ranked 34th on the Platinum 400 list based on its 40% five-year total return as computed by Forbes. In addition, the magazine complimented the company's leadership for "their knack for snapping up promising acreage."

And Chesapeake has been a prolific acquirer. In November 2005 the company closed its acquisition of Columbia Natural Resources LLC and certain affiliated entities from Triana Energy Holdings, picking up an Appalachian presence (see Daily GPI, Nov. 17, 2005). This followed Chesapeake's partnering with Gastar Exploration Ltd. in the Deep Bossier play in the Hilltop prospect area of East Texas (see Daily GPI, Sept. 20, 2005). In April of the same year Chesapeake announced it was in the process of purchasing 289 Bcfe of proved gas and oil reserves and another 277 Bcfe of probable and possible reserves in the Permian Basin, South Texas and East Texas from four small independent production companies (see Daily GPI, April 13, 2005).

Last year Chesapeake picked up up 39,000 net acres of Barnett Shale leasehold in Johnson and Tarrant counties, TX, along with 30 MMcfe/d of current production and $55 million worth of midstream assets in an $845 million cash deal with Four Sevens Oil Co. Ltd. and its partner Sinclair Oil Corp. Chesapeake also spent $87 million to buy 28,000 net acres of leasehold in the same area from other sellers (see Daily GPI, June 6, 2006).

Apparently sated, in July of last year McClendon pushed away his plate. "The industry's acreage land grab of the last five years is largely over," he proclaimed in a July 2006 conference call. "Virtually every conventional and unconventional gas resource play in the U.S. is totally locked up. The winners for the next 10 to 20 years have already been chosen and the losers will pay the price for years to come for being left behind" (see Daily GPI, July 31, 2006).

At the time McClendon touted the company's 10-year drilling inventory. When he spoke with NGI in late December he pointed out that Chesapeake had doubled its rig count from 65 to 130 in the previous year. "We were one of the greatest consumers of rigs in '06, and we kind of skewed the statistics. We will not be skewing the statistics in '07. We'll probably top out at 150 or so operated rigs."

Half of those 130 rigs have been drilling horizontal wells and more than half have been operating in unconventional reservoirs. Indeed, Chesapeake is among the companies leading the charge to turn the unconventional into conventional. The Barnett Shale is maturing before the industry's eyes. What has been learned in the Barnett should be useful to some degree as the industry develops the Woodford and Fayetteville shale plays.

"It seems to me that [the shales are] a little like coalbed methane in the sense that everybody rushes out and captures coalbed methane assets and today five years later, is coalbed methane a growth sector in our gas production base? The answer is 'no.' Once you figure out that coalbed produces you know where the coalbeds are and you go hit them and some of them work better than others, and we found that San Juan [Basin] works best of all...and the Wyodak in Wyoming. Other than that we haven't had that many successes," McClendon said.

The question for the shale plays and players is whether anything will come close to tier 1 Barnett in Tarrant and Johnson counties, TX, he said. There's more gas in West Texas, but whether it can be extracted economically remains to be seen.

"Five years ago our break-even [gas] price was half what it is today," McClendon said. "I'm not suggesting that our break-even price will double in the next five years, but it's not clear to me how you get costs to go down from here as I believe five years from now the Barnett will likely be in steep decline and every other unconventional field that we're looking at today may be as well.

"That to me makes it easy to look out at 2012, 2011 and 2010 because the producer in five years will not be able to keep production flat if he's confronted with the predicted futures prices." Lately, the futures curve has been offering 2012 prices below today's break-even price of $6.00-6.50, McClendon said. "If you add in the cost of doing some exploration and trying to grow a little bit, my guess is it's probably closer to $7 to $7.50 on a longer-term basis."

What's missing from the onshore U.S. scene is the major producers, particularly in unconventional plays, or so it would seem. Conoco did buy Burlington Resources (see Daily GPI, Dec. 14, 2005) and Chevron bought Unocal (see Daily GPI, Aug. 3, 2005). But what's next? Exxon and Shell have dipped their toes in unconventional plays. But would a major international company buy one of America's super-independents?

"If you were to ask me to list from one to five the major companies and their likelihood of doing that: Conoco, Shell, Chevron, BP, Exxon," said McClendon. "With Nos. 1 and 2, give it a 50% chance and No. 5 I'd give it a negative 50% chance.

"I listen to what Exxon says and I find it incredible that they would come back onshore North America in a big way.

"On the other hand, if I was running Conoco I would say, 'Hey, I did Burlington...We didn't do Burlington just to do Burlington. We did Burlington to consolidate the North American natural gas industry.' I don't know [Conoco CEO] Jim Mulva. Shell, I hear periodic rumors that they're on the prowl."

If a major were to go after a large-cap independent, it would be welcome news for the share prices of companies like Chesapeake, which at around 28 bucks is trading near the bottom of its 52-week range of $26.81-35.57.

McClendon said the large independents "have never been more undervalued simply because the lines between proved undeveloped reserves (PUD) and probables and possibles is now such a fine, blurred line...At the time when there is no difference between a probable and a PUD, or there's only a 10 or 20% difference between a probable and a PUD in a place like tier 1 Barnett, you have companies with enormous inventories of assets that are absolutely incredibly cheap right now because public company investors...are focused more on the value of proved assets.

"I guess it would change if somebody came in and paid a big multiple for an EOG [Resources Inc.] or an XTO [Energy Inc.] or a Chesapeake. I think those are the three companies that I would identify on the large-cap side of having the biggest exposure. You'd have to have an M&A event to rerate the stocks."

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