With October futures plummeting to a daily low of $4.07 on expiration day last Wednesday while December futures remained more than $3 higher, Oklahoma City-based Chesapeake Energy decided it was a good time to announce the shut-in of a net 100 MMcf/d of production (125-150 MMcf/d gross), which represents the bulk of the third largest independent producer’s remaining unhedged production.

Effective on Oct 1, the company temporarily shut in its unhedged supply in various areas of operation in the southwestern United States until natural gas prices “recover from recently depressed levels.” Chesapeake would not say at what price threshold that supply would be returned to production. The company’s current oil and natural gas production totals more than 1,600 MMcfe/d (91% natural gas), so the shut-in amount represents only about 6% of its net production.

“Today’s announcement highlights Chesapeake’s proactive approach to revenue management,” said CEO Aubrey K. McClendon. “Given that we believe today’s low natural gas prices have more to do with temporarily high natural gas storage inventories largely caused by last winter’s abnormally warm weather and less to do with any return to a structural oversupply of natural gas, Chesapeake has elected to shut-in some of our natural gas production.

“We will monitor market conditions and bring these unhedged natural gas production volumes back on stream as market conditions dictate. As a result, it is likely we will reduce Chesapeake’s 2006 fourth quarter production forecast range when we release our 2006 third quarter results.”

Chesapeake CFO Jeffery Mobley said although the company is unaware of any other producers that have been shutting in, “we wouldn’t be surprised to see other operators doing the same thing. Hopefully if that is the case, we’ll see gas prices start to recover somewhat. There’s a big difference between October gas and December gas on the futures market. Apparently just a little bit too much is just enough to cause a $2-3 discount.”

Analysts at Raymond James & Associates said two weeks ago that if recent higher-than-average storage injections continue, “then U.S. producers would need to shut in about 10% of their production to rebalance the system over the next two months.”

Working gas levels in storage already are over the 3.2 Tcf mark with about seven weeks left in the traditional storage injection season. On Sept. 22, there was 3,254 Bcf of working gas in storage, 12.2% more than the five-year average and 13.1% more than at the same time last year. The Energy Information Administration said in a recent report that its best estimate of total working gas capacity in the United States is 3,593 Bcf, which means working gas levels on Sept. 22 were about 90.6% of total capacity.

“…[I]t now appears that we will test the limits of U.S. gas storage capacity over the next eight weeks,” said Raymond James analyst Marshall Adkins. “Given that we have limited storage capacity, the gas market is facing what most analysts call ‘gas on gas’ competition. This is the phenomenon where limited gas storage capacity forces producers to shut in production.”

The Federal Energy Regulatory Commission (FERC) predicted such an outcome in May because the warm winter and demand destruction due to high prices left so much gas in storage entering the injection season.

The conditions that led to the recent price drop developed over a long period, but the first few mild weeks in September and the continuing weakness of the hurricane season seemed to be the “straw that broke the camel’s back,” consultant Stephen Smith of Stephen Smith Energy Associates noted recently.

It is unclear at this point how many other producers will follow Chesapeake’s lead. Chris Conway, the chairman of the Natural Gas Supply Association and an executive at ConocoPhillips, said last week that he expects no major shut ins of production but possibly some production deferrals, in which producers delay well completions until prices rebound (see related story). Several other large producers, including Devon, EnCana, Newfield Exploration and Williams told NGI over the last two weeks that they believe the price decline is temporary, and therefore, are not contemplating production shut-ins at this time (see NGI, Sept. 25).

SunTrust Robinson Humphrey energy analyst John Gerdes said Chesapeake has made a “savvy move,” but the chances of making solid gains are “50-50” because December prices would have to remain above $6.50/MMBtu. He said November prices are likely to continue falling, possibly into the $4s. Gerdes said the move is probably only a one- or two-month decision. “If anyone else is going to do this I would expect them to press release it before Monday. Most of these guys sell the bulk of their production in the monthly market and bidweek is ending. If we don’t hear of any more announcements by Monday I would say the window for doing this has closed.”

Despite its decision, Chesapeake has been largely unaffected by the downturn in prices because the bulk of its production is hedged. Through Aug. 31, the company has realized $740 million in cash gains from its gas hedges, McClendon said.

“As of [Tuesday’s] market close, the mark-to-market gain on our remaining 2006 natural gas hedges was approximately $460 million.” He said 92% of the company’s production in the second half of this year is hedged at a Nymex futures price of $9.24/MMBtu, 80% of its 2007 gas production is hedged at $9.92/MMBtu and 60% of 2008 gas production is hedged at $9.44/MMBtu. “We currently have a mark-to-market gain of approximately $2.2 billion on our open natural gas hedges,” McClendon said.

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