Longtime industry basement dweller Chesapeake Energy is finallypulling itself up by its bootstraps with a little help from the gasmarket and Gothic Energy. The company announced on Friday that itplans to buy Gothic, its frequent Midcontinent region drillingpartner, in a stock and cash transaction valued at about $345million.

The deal will make Chesapeake the 10th largest independent gasproducer in the U.S., the company said. It also will increaseChesapeake’s reserves by 25% to 1,600 Bcfe and its daily gasproduction 22% to 450 MMcfe/d. Chesapeake said it expects $10million/year of administrative and operational savings and $15million in non-cash interest savings from retiring Gothic’s $104million in 14% senior discount notes.

“This acquisition fits perfectly with Chesapeake’s businessstrategy of creating value by acquiring and developing low-cost,long-lived natural gas assets onshore in North America, with aprincipal focus in the Midcontinent, while at the same timesteadily improving our balance sheet,” said Chesapeake ChairmanAubrey K. McClendon. “Predominantly all of Gothic’s assets wereonce owned by Amoco Corp. and are among the highest quality gasassets in the U.S. These properties are characterized by very lowoperating costs, long reserve lives, abundant upside opportunitiesand are 96% natural gas.

“The transaction will be accretive to Chesapeake, increasingprojected 2001 ebitda by 24%, projected 2001 cash flow by 23% andprojected 2001 net income by 23%. Considering other announcedtransactions in the industry, we believe Chesapeake will now be the10th largest independent producer of natural gas in the U.S.

“In addition, including the impact of this transaction,projected excess cash flow and the retirement of $170 million ofChesapeake’s outstanding preferred stock (including accrueddividends) to date, we anticipate 400 Bcfe of proved reservesadditions during the year with no net increase in fixedobligations,” McClendon added. “This will result in a significantde-leveraging of our balance sheet. Given projected natural gasprices, further balance sheet improvement should occur in 2001 aswe continue to grow our asset base and reduce our liabilities.”

Analysts see the transaction as a step in the right direction.”I think they finally are going to be able to attract someinstitutional interest,” said Dain Rauscher producer analyst SteveSmith. “They have been in the penalty box since their problemsoccurred in the Austin Chalk in 1997. Their stock price, you’ve gotto remember, was at $35 and went from $35 to less than $1 (actually67 cents/share at the bottom). That was ugly. But for those thatsensed that this thing could be turning it has been a 10-foldincrease.”

Although low gas prices certainly contributed to Chesapeake’swoes, it started really having problems in 1997 when it began toexpand aggressively in the Louisiana Austin Chalk, paying a lot forpoor producing acreage and drilling multiple unsuccessful wells.”They were aggressively drilling about 10 new wells, all in a brandnew experimental area, none of which panned out and that was $5million a pop so that was $50 million for the acreage and $250million down the drain,” said Smith.

Chesapeake decided to put itself on the auction block in July 1998 but ended up finding no buyers (see NGI, July 13, 1998). As a result, it decided to exit the Chalk and return to its roots in the Midcontinent region and was able to secure some fixed-rate debt before its stock price plummeted.

“The story would have paid off sooner except the gas marketweakened on the weather,” Smith noted. “Now that the gas market hascome back and they are having good drilling results and this deallooks further accretive, we’ll be likely taking up our target priceagain,” he said. Smith said his 12-month target on the company ismore than $9/share. Chesapeake’s stock closed up 50 cents on Fridayto $7.50 following the announced purchase of Gothic. Gothic sharesjumped 199% to $1.09.

“It looks like they got a good deal with this one,” said Smith.”$1.05/Mcf for the reserves is a good price, and it appears to beaccretive on all the cash flow measures. That’s not bad.”

Chesapeake will acquire Gothic’s common stock in exchange forfour million shares of Chesapeake’s common stock. Upon closing ofthe transaction, Gothic’s shareholders will own 2.7% ofChesapeake’s common stock. In addition, Chesapeake has recentlypurchased in a series of private transactions 96% of Gothic’s $104million of 14.125% Senior Discount Notes for consideration of $77million, comprised of $22 million in cash and $55 million inChesapeake common stock (7.8 million shares at Chesapeake’s stockprice prior to the announcement Friday).

Including Gothic’s $235 million of senior secured notes, thetotal acquisition cost to Chesapeake will be $345 million. Thisvalues Gothic’s 310 Bcfe of proved reserves at $1.05/Mcfe afterallocation of $20 million of the purchase price to Gothic’sleasehold inventory, 3-D seismic inventory, lease operatingtelemetry system and other assets. Gothic’s proved reserves are 96%gas, 78% proved developed, have an average lifting cost of lessthan $0.20/Mcf, are located exclusively in Chesapeake’s coreMidcontinent operating area and are unhedged after October 2000.Based on current production rates of 80 MMcfe/d (or 30 Bcfe/year),Gothic has an 11 year reserves-to-production index.

“It is obvious that an acquisition of our assets by Chesapeakemade sense strategically, operationally and financially,” saidGothic CEO Michael K. Paulk. “The acquisition will result in asignificant premium for our shareholders, will enable ourbondholders to realize a full return on their investment and helpssolidify Chesapeake’s position as one of the top three producers ofnatural gas in the Midcontinent. Chesapeake’s asset base completelyoverlaps Gothic’s and there will be substantial operational andexploration efficiencies resulting from this combination. Inaddition, Chesapeake will now be the largest owner in two ofOklahoma’s most prolific gas fields, Watonga-Chickasha and Cement,and together with its existing large ownership position in Bradley,the Golden Trend and Knox, Chesapeake will have built the premierexploration platform in the Midcontinent.”

Gothic’s previously announced plan of restructuring, whichcontemplated the redemption of Chesapeake’s holdings of Gothic’spreferred and common stock for oil and gas properties and otherconsiderations, the exchange of the $104 million senior discountnote issue for 94% of Gothic’s equity and an equity rights offeringof $15 million, has been terminated in anticipation of thistransaction.

Although the boards of both companies have approved thetransaction, it still is subject to regulatory and shareholderapproval. Completion of the transaction is expected by year-end.Gothic has agreed to provide Chesapeake with a $10 million break-upfee in the event the transaction is not completed.

Rocco Canonica

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