Chesapeake Energy Corp. CEO Aubrey McClendon, reporting on a disappointing 1Q, said Wednesday the company is cutting its natural gas drilling count to 12 by the third quarter, down from 100 in January 2011 and switching to a liquids focus. He apologized for the "distractions" of recent days as another storm broke over his personal investments that so far have cost him the chairmanship.

Capital spending for 2012 will be higher at $7.5-8 billion, from an earlier guidance this year of $7-7.5 billion -- all in an effort to build liquids production. The bump up is "absolutely required if we are to escape the downward gravitational pull in natural gas prices," the CEO said during a conference call with energy analysts and investors. Despite voluntary gas well curtailments that the company said began in February, daily production in the first three months rose 18% year/year to 3.658 Bcfe from 3.107 Bcfe.

Compared to the numbers a year ago, Chesapeake is no longer a big gas "driller" by any stretch of the imagination. In the first three months of 2011, Chesapeake was running around 100 gas rigs on its U.S. leaseholds. In the most recent quarter it was at 50, and it's now at 38. "In just 90 days, we'll be down to 12," said COO Steve Dixon. "That's a drop of 75%."

Meanwhile, the company ramped up in liquids targets, running 172 rigs late last year, and the "first quarter took the brunt of elevated drilling," said Dixon. "That's already dropped by 18 to 154, and drilling during the year will drop to 125 by the third quarter."

The company's operations were the focus on the lengthy conference call, helmed by McClendon, who was ousted as chairman of the board on Tuesday (see Daily GPI, May 2). He took a few minutes at the beginning of the call to acknowledge the turmoil that his news has caused the company recently.

"I'm deeply sorry for all of the distractions of the past two weeks," McClendon said. "There has been enormous and unprecedented scrutiny of our company, and of me personally. And a great deal of misinformation has been published and uncertainty created...Mother told you not to believe everything you hear and read for good reason..."

Later in the day A representative from Southeastern Asset Management, Chesapeake's largest shareholder, said in a regulatory filing it has converted its 13.6% stake in Chesapeake to "active" from "passive." The filing stated that Southeastern intends to "open discussions" with Chesapeake's management, board and third parties, but it did not specify what those discussions may entail.

Shareholders reacted strongly, sending the share price on Wednesday down by more than 14%, to end the day at $16.73 from $19.60 on Tuesday. Trading volume was above 139.6 million, versus average volume of 20.26 million.

Just a few hours before the call began, Reuters reported that McClendon may have run a private hedge fund for at least four years, from 2004 to 2008, that listed the company's headquarters as its mailing address. The fund traded in contracts for oil and natural gas and other commodities. It was suggested that the hedge fund, reportedly founded by McClendon and SandRidge Energy Inc. CEO (and Chesapeake co-founder Tom Ward), may have influenced McClendon's running of Chesapeake.

The charge, if true, could be far more serious than the earlier revelations of loans to backstop his share of Founder Well Participation Program that gave McClendon the sole contractual right to receive a 2.5% stake in every well the company drills. Chesapeake announced early termination of the program Tuesday when they relieved McClendon of his duties as chairman. The issue is whether a CEO playing the market for himself might be neglecting his obligation to his shareholders to maximize company profits or might be profiting in his trading from advance market knowledge gained in his management position.

"A key issue in all of this is disclosure," said NGI's Patrick Rau, director of Strategy & Research. "The [Securities and Exchange Commission] is a stickler about disclosing any perceived conflict of interest." Rau, a former Wall Street analyst, questioned whether there has been full disclosure, and if not, from whom was the company's compliance unit taking orders.

As to whether McClendon could have influenced the natural gas futures market, "it is generally believed that there is no insider information when it comes to commodities, because commodities markets are as close as it comes to being perfectly competitive. In perfectly competitive markets, all producers are price takers, and therefore cannot impact the price themselves. So while a producer couldn't impact the overall market, he might personally profit from advance information," Rau said. He stressed, however, that there has been no proof nor confirmation of the hedge fund allegations made by Reuters in its lengthy report Wednesday.

Another question is why have shareholders put up with a joint CEO/Chairman for so long. "A CEO should never be in charge of a board of directors. One of the main reasons for an independent board is to provide a check and balance on the CEO," Rau said. He also noted that because Chesapeake co-founder Ward could also have been involved in the hedge fund, "Look for investors to put SandRidge under a tight microscope in the weeks ahead."

A spokesman with the Commodity Futures Trading Commission told NGI that he couldn't discuss investigations and "as a general policy" the agency "doesn't publicize its investigations until they are over." The Internal Revenue Service is looking into the FWPP, and the Securities and Exchange Commission has an informal inquiry underway.

McClendon spoke confidently in the conference call about the bright future for Chesapeake, which includes plans to reduce the natural gas drilling count to 12 by the third quarter, down from 100 in January 2011. At the same time, capital spending for 2012 will be higher at $7.5-8 billion, from an earlier guidance this year of $7-7.5 billion -- all in an effort to build liquids production.

The bump in this year's spending is "absolutely required if we are to escape the downward gravitational pull in natural gas prices." Despite voluntary gas well curtailments that the company said began in February, daily production in the first three months rose 18% year/year to 3.658 Bcfe from 3.107 Bcfe.

Compared to the numbers a year ago, Chesapeake is no longer a big gas "driller" by any stretch of the imagination. In the first three months of 2011, Chesapeake was running around 100 gas rigs on its U.S. leaseholds. In the most recent quarter it was at 50, and it's now at 38. "In just 90 days, we'll be down to 12," said COO Steve Dixon. "That's a drop of 75%."

Meanwhile, the company ramped up in liquids targets, running 172 rigs late last year, and the "first quarter took the brunt of elevated drilling," said Dixon. "That's already dropped by 18 to 154, and drilling during the year will drop to 125 by the third quarter."

It was clear that McClendon was disappointed in the latest quarter's report. He put a lot of the blame on the failure of the company to replace gas hedges that were taken off last fall. The company has routinely taken off oil and gas hedges, then replaced them, but while the oil hedges were put back in place, there never was an opportunity to do the same for gas because of low prices.

"This is the first significant earnings miss in many years and hopefully our last," said McClendon. "The positives are enduring and the negatives are short term in nature."

Chesapeake reported a quarterly loss of $71 million (minus 11 cents/share), which included a hedging loss of $167 million, versus a year-ago loss of $205 million (minus 32 cents). Excluding the one-time gains/losses in the recent quarter, earnings were 18 cents -- still well below Wall Street's 28 cents/share expectations. Revenues totaled $2.42 billion, higher than year-ago sales of $1.61 billion, but off of Wall Street's forecasts of $2.71 billion.

During 1Q2012 liquids output jumped 69% from a year earlier to 113,600 b/d, making up 19% of total production; liquids now comprise around 61% of the unhedged portfolio. In the latest quarter the average price of natural gas was $2.35/Mcf, and for oil it was $67.92/bbl; the realized natural gas equivalent price fell to $4.02/Mcfe from $5.99 a year ago.

Oil and liquids output rose to 250,000 b/d by 2015 from 113,6000 b/d this year. However, weak natural gas prices are making it difficult to fund liquids wells, he said. In February the company said operating cash flow this year would be up to $5.2 billion. Now it expects to reach only about $3 billion.

Chesapeake plans to cut its debt load to $9.5 billion by the end of this year through monetizations of various kinds (asset sales, joint ventures and voluntary production payments) acknowledging that it may run short of money in 2013 if natural gas prices don't rise. The producer still is close to being 85% weighted to gas, and the transition to liquids has been costly and painful, said McClendon. The biggest sale is the Permian Basin portfolio, which may net the company $7-8 billion.

Chesapeake has completed $2.6 billion of asset monetizations to date this year and management said it's on track to complete the $11.5-14 billion total for the year. At the end of March Chesapeake had $12.64 billion in debt, or 40% of its capital, on the balance sheet.

The operator has a huge onshore portfolio from which to pick and choose -- to drill or to monetize, said NGI's Rau.

The fact that Chesapeake has attractive properties to sell is to McClendon's credit. The Chesapeake co-founder started as a landman, and is "really good at identifying and acquiring potentially lucrative acreage positions," Rau said. "Much of Chesapeake's value comes from its ability to beat its competitors to the latest greatest properties. If Aubrey were forced to step down as CEO, it could conceivably have a greater negative long-term impact than the current controversy."

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