Chesapeake Energy Corp. has "plenty of liquidity" and will be able to weather the economic storm by neutralizing capital expenditures (capex) over the next two years, CEO Aubrey McClendon told investors Monday. Even with flat spending, the Oklahoma City-based natural gas driller expects to achieve 5-10% production growth in 2009 and 10-15% gains in 2010.

To operate "cash neutral," Chesapeake will slash 2009 and 2010 capex by a combined $2.9 billion, or 31%. The leasehold and acquisition budget over the next two years also has been reduced by 78%, or a combined $2.2 billion. 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, he said, "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...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. That gives us an enormous competitive advantage."

Properties more likely to see rigs pulled out are in other parts of Chesapeake's massive U.S. leasehold, McClendon said. In any case, Chesapeake's costs in about 50% of the partnership rigs will be fully or partially paid for by its joint venture partners. The drilling carries are expected to save the company $1.2 billion of capex in 2009 and $1.1 billion in 2010.

The company plans to monitor oil and natural gas markets and economic conditions and if need be, it "will further adjust its drilling and leasing activity levels if needed," said the CEO. In any case, Chesapeake is forecasting U.S. producers likely will drop 600-750 rigs over the next few months (see related story).

"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."

Chesapeake expects to add 2.5 Tcfe of proved reserve additions from $3.0 billion of net drilling capex, which would imply a production replacement rate of more than 250% and a drillbit finding and development (F&D) cost of $1.20/MMcfe. Around 1.1 Tcfe of the forecasted proved reserve additions would come from Chesapeake's interests in its three shale joint ventures and are based on $500 million net in drilling capex, at a drillbit F&D cost of 45 cents/Mcfe. Chesapeake is targeting to have proved reserves of 13.5-14.0 Tcfe net by year-end 2009.

To create more value and enhance liquidity, the company also plans to "selectively monetize" some mature assets and undeveloped leasehold. It now is in discussions to sell some of its operated producing assets in the Anadarko and Arkoma basins using another volumetric production payment (VPP) transaction. In this transaction, which would be its fourth VPP, Chesapeake plans to sell by the end of this month producing assets with proved reserves of 100 Bcfe and current net production of 55 MMcfe/d for $450 million, or $4.50/Mcfe. Chesapeake would retain future drilling rights on the properties.

Also on the short list for sale are Chesapeake's assets in South Texas, which it wants to sell through another VPP. The company now anticipates selling the producing assets, which hold 80 Bcfe of proved reserves with net production of 70 MMcfe/d for $450 million, or $5.60/Mcfe. That sale is anticipated to close by the end of March.

In addition, discussions with multiple parties are under way to sell either a minority investment or partial sale of its midstream operations. The Barnett Shale of Texas, whose midstream operations are more mature than in other parts of the country, probably would be included in that sale, McClendon said.

Over the past month Chesapeake also restructured its hedging position and it 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.

Addressing what has happened to Chesapeake's share price, which has tumbled from the $70s to end last week trading around $11/share, McClendon admitted that he had been "very disappointed with the share price for months...We've been questioned about whether we are capable managers. And honestly, it's easier to speed up a machine than to slow it down...This is the fourth time in the last four months that we've reduced our spending plans. There is uncertainty in the U.S. economy, and if conditions require us to reduce drilling further, we will do so. We have been highly successful in monetizing our assets this year, and we still expect to have more VPP over the next couple of years. We strong believe we will have more partners to participate in our leasehold position...and we'll still grow at least 5% in 2009."

McClendon said management has been asked several times about why Chesapeake's stock has suffered more than its peer group.

"Why does this stock price trade at $11-12/share given its obvious value?" he asked. "There are false rumors that Chesapeake does not have sufficient liquidity to be a going concern, and that is the only reason that investors would value our proved reserves, our leasehold as being somehow worth less than $15 billion. It's remarkable...We are not going to run out of money. I turn your attention once again to our strong asset value and low finding costs."

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 Daily GPI, Dec. 2).

"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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