Point of View: Chesapeake drilling for gas with focus on US Midcontinent

Chesapeake Energy Corp. plans to stay the course in 2005 with a business strategy that its cofounders developed during the late 1990s: Actively drill for natural gas primarily in the US Midcontinent.

At a time when many producers find themselves "prosperous financially but somewhat prospect-constrained," Chesapeake Chairman and CEO Aubrey K. McClendon said, the Oklahoma City-based independent has a competitive advantage in the form of its 3.5-million-acre net leasehold inventory, 9-million-acre inventory of 3D seismic data, and ranking as the nation's most active driller.

Chesapeake invested more than $800 million in land, leasehold, and 3D seismic surveys during the last 6 years to accumulate a portfolio that will take 7-10 years to drill. The company also doubled its team of geologists and engineers during the last 3 years.

Currently, Chesapeake has 70 rigs under contract on wells it operates, McClendon said, noting that Chesapeake has 50% more rigs drilling than Ana- darko Petroleum Corp., the second most active US driller.

"We were among the earliest companies to anticipate and believe in this new world of high oil and gas prices," McClendon said. "We actively planned for it, and we are built to prosper in it. Now, it's just a matter of taking advantage of it and executing the strategy that we put in place 6 years ago."

Chesapeake completed its initial public offering in February 1993. In the past 11 years the stock has been the second top performer among the top 20 E&P companies, trailing only Fort Worth-based XTO Energy Inc., he said.

Aggressive drilling

From a base of 4 bcfe of production in 1993, Chesapeake expects its 2005 production will reach 400 bcfe. Currently, 80% of the company's production comes from the Midcontinent. The rest comes from the Permian basin, South Texas, Texas Gulf Coast, and the Ark-La-Tex region of northern Louisiana.

"We will continue to be aggressive drillers in an industry that doesn't explore much anymore, particularly onshore," McClendon said. "During 2004, we expect to drill between 500 and 600 operated wells by utilizing about 70 rigs on company-operated prospects and by participating in another 400-500 wells drilled by other operators."

The company is also is the nation's most active driller of deep wells. "We have more rigs than anybody else targeting depths below 15,000 ft," McClendon said.

"We are going to stay focused on continuing to build what we think is the dominant franchise here in the Midcontinent with regard to gas exploration and production."

Chesapeake produces from more than 17,000 wells, most of which are long-life assets in areas where the company has expertise, he noted. Although the company explores across the Midcontinent, McClendon sees the deep Anadarko basin in western Oklahoma as the company's most exciting play.

"This has been the premier area for us during the past 3-4 years and will remain so. We have about 20 rigs active in the deep Anadarko basin. We are responsible for about 30% of the drilling in all of Oklahoma. When you combine our nonoperated drilling with our operated drilling, we receive about 60% of all the drilling reports that get generated every morning in the state and 12% of all the drilling reports generated across the nation. That is a serous competitive advantage."

He believes Chesapeake is on track to post double-digit production growth with the drill bit in 2004, 2005, and in 2006.

Chesapeake has added production of more than 400 MMcfd of gas equivalent with the drillbit since January 2001. Production grew via drilling by 9% in 2001, 7% in 2002, and 18% in 2003 and is expected to increase by 12% in 2004.

"We will spend about $1.3 billion next year drilling wells, again all onshore and primarily gas in our same tight geographic focus, again 80% in the Midcontinent," McClendon said. The 2004 exploration and development budget is $1.1 billion.

Chesapeake has achieved higher returns through drilling than through acquisitions, debt reduction, and stock repurchases.

Acquisitions

The company has bought almost $4.5 million worth of properties in the last 6 years, yet no individual transaction has been bigger than $500 million, and most deals have been in the range of $25-250 million each.

"We will continue to make niche acquisitions. They are easier to digest, and we think we get a better value," McClendon said. "Even though we are a company today that could easily make a $1-3 billion acquisition, it's not really what we are trying to accomplish."

He expects Chesapeake to spend $2 billion on acquisitions during 2004. "We like to have a constant program of being on the lookout for opportunities up to $500 million."

McClendon shies away from buying public companies because their valuations ascribe value to probable and possible reserves.

On Chesapeake's acquisitions strategy, he said: "We don't mind paying for PUDs [proved undeveloped reserves] but would prefer to get most of the upside for a very low price—that's tough to do with public companies and, for that matter, with most deals. I would guess our hit rate on deals is less than 20%. We're very careful on reserve projections but relatively aggressive on future price assumptions. That way if we ever do a bad deal, it will my fault—not some geologist or engineer who got carried away on reserve projections.

"We want to make sure that we take advantage of the opportunities that we see out there.

"At the same time, we don't want to wear out our welcome with investors in terms of issuing new equity and debt at a time when people are not in the mood for that."

When its focus was on the Austin Chalk of Central Texas in the mid-1990s, Chesapeake focused primarily on growth rather than profitability. But profitability has been the priority for the last 6 years.

"Growth takes care of itself if you are adequately profitable," McClendon said.

His goal is for Chesapeake to become the most profitable company in the industry per unit of production. Chesapeake typically ranks in the top five in that category, and it expects to rank there again in 2004.

Volatility, gas prices

McClendon sees his biggest challenge also as his biggest opportunity: managing price volatility and trying to determine what's a price spike and what's not.

The company has had 100% of its production hedged for the last 3 months and has about 85% of its gas production hedged during the fourth quarter at $5.82/Mcf on the New York Mercantile Exchange. In 2005, about 30% of its production is hedged at $5.96/Mcf on NYMEX. Still, Chesapeake bases its drilling economics on $4-4.50/Mcf NYMEX prices.

"We love oil and gas price volatility. It's exciting, and it gives us an opportunity to sell our gas occasionally for more than what it may be worth, and it gives consumers a chance occasionally to buy gas for less than what it may be worth. The trick is knowing what it is worth, anticipating and acting on price spikes, and that's not always easy," he said.

Chesapeake believes prices will remain high for longer than most analysts, investors, or government policymakers have suggested.

"We view that just as we have been in a long cycle—20 years—of low oil and gas prices, we likely are in a cycle that has some longevity to it where oil and gas prices will be quite a bit higher," McClendon said.

"It's really pretty basic, it seems to us: For 20 years the US and the world have over-invested in everything that consumes energy and under-invested in everything that makes or moves energy. We believe there is a rebalancing under way in which our industry's long-suffering shareholders are going to greatly benefit, while energy consumers will be giving back some or all of their low-cost energy savings they have enjoyed during the past 20 years."

McClendon expects NYMEX oil and gas prices to average at least $35/bbl and $5.50/Mcf or higher for the long term, with volatility increasing.

"You have got declining gas production in the US and a growing economy that wants more clean-burning natural gas. But it is not there to burn, and so you have to balance the market by having the price go up every year until LNG can balance the market, and that is at least 5 years away, if ever, in our view," he said.

Robust prices enable US independents to focus on how to enjoy a boom rather than how to survive a bust, he added.

"I am very encouraged that everybody seems to be pretty sober, and nobody is going crazy with the drillbit. So service costs remain relatively restrained, and profitability remains high. All the company managements that have waited for this time are to be congratulated," he said.

"The challenge is what do you do now? For us, it's time to continue to redouble our efforts here in the US looking for new reserves of natural gas."