In the next 30-45 days large consumers may have the opportunity “to lock in some really low gas prices,” according to Chesapeake Energy Chairman Aubrey K. McClendon, adding that his company is “virtually 100% hedged” during that time period.

Chesapeake is an avid hedger, McClendon told analysts at Lehman Brothers Energy/Power Conference, claiming to have the best hedging track record among E&Ps during the past three years. For the remainder of 2004 about 90% of Chesapeake’s production is hedged “at very high prices,” and about 50% of first quarter 2005 production is hedged at an average of about $6.15.

“Volatility is high and likely to increase. We love gas price volatility; it’s the greatest gift to management,” the Chesapeake chairman said. Volatility provides the “opportunity to hedge unusually high prices that generate unusually high returns.” It also reduces investment in the industry which dampens supply, and enhances the value of long-lived reserves.

McClendon, whose company has a regional focus on the Midcontinent, said the trend line is in producers’ favor, with supply declining 1-2% per year and demand increasing 1-2% per year.

“It’s very hard to come up with a product where the price has tripled over a four year period and there still is not enough supply meet demand,” he said.

The structural forces creating the trend “have not been fixed” and it is likely to continue. McClendon pointed out that of the top seven producers in the U.S. today, five are majors “playing a very different game.” They are no longer interested in North America and have switched their focus to emphasize worldwide resource opportunities. In gas that means LNG.

Once the focus switched, and given the current well decline rates of at least 30% in the first year, it doesn’t take long for their U.S. reserves and production to drop. There’s a “mismatch of time.” Over the last three years domestic operating companies “the size of Chesapeake or Dominion or El Paso or XTO have evaporated inside each of the majors” through depletion. “It’s a lot easier to lose the stuff through depletion than it is to find it or buy it,” McClendon said.

“As long as the majors continue to be okay with double digit yearly declines, it’s going to be very difficult for public and private independents to do much to increase supply in this country.” Out of a recent list of top 20 U.S. gas producers, 14 showed year over year declines in the second quarter. “These are the best gas producers in the industry and 14 of the 20 had production declines.” Chesapeake has been tracking the leaders for the last three years and in the second quarter of 2004 the number of decliners increased to 14 from 13 for the first time.

Out of the 20, Chesapeake is in 11th place, and of the six companies registering increases, only XTO came close to Chesapeake’s 27.6% production increase from the second quarter 2003 to 2Q 2004. The company projects overall 2004 production at 961 MMcfe/d and a 12% increase for 2005 to 1,082 MMcf/d. Its 4.1 Tcf of reserves are 89% natural gas with 74% located in the Mid-Continent.

Chesapeake’s production is up 201% from 300 MMcfe/d three and a half years ago. McClendon dispelled the notion that the company’s growth has been all through acquisitions. During that time 53% of growth has come from the drill bit, he said. Chesapeake rates itself the No.1 driller in the U.S. and the No.1 deep driller, with one/third of its 63 operated rigs targeted below 15,000 feet. Right now “Drilling has the highest returns,” and the company will be putting two/thirds of its excess cash flow into drilling.

Historically, acquisitions have been the larger driver. Since 1998 the company has gained 3.6 Tcfe primarily in 41 significant acquisitions for $1.19/ Mcfe and discovered or developed 1.7 Tcfe for $2.6 billion or $1.56/Mcfe. The company emphasizes development of the properties it acquires, accelerating exploration opportunities and installing efficiencies. Chesapeake has 50 people working on acquisition integration.

Chesapeake estimates returns in the present acquisition environment at 20-25%. Starting with an acquisition with a 10-12% return, the company and adds 2-5% incremental return by eliminating general and administrative expenses and reducing lease operating expenses and renegotiating gas and oil sales contracts. Finding more drilling opportunities can add between 5-20% incremental return and hedging into price spikes can add a 5-10% increment to the return.

McClendon is predicting that the upward trend in costs and prices for the gas industry over the last four to five years will continue “for the next three-four-five years.” Could LNG rock that boat? “We run our company in complete fear of LNG, but at the end of a day, as a practical matter, there’s a lot less to fear there than what some people might have you believe.

“If we were to get a big slug of LNG that didn’t want to go around the world to some other higher-priced place, you would get a pretty immediate drilling response from the industry and equally immediate production decline” because of the high depletion rates. The over-supply would be self-correcting, McClendon believes.

©Copyright 2004 Intelligence Press Inc. All rights reserved. The preceding news report may not be republished or redistributed, in whole or in part, in any form, without prior written consent of Intelligence Press, Inc.