Point of View: Chesapeake's McClendon: Leveraging volatility key to unlocking long-lived reserves value

March 24, 2003
The management of Chesapeake Energy Corp., Oklahoma City, has no hesitation playing the contrarian among US natural gas producers, which has resulted in Chesapeake's reputation as an aggressive and dynamic hedger of gas during price swings.

The management of Chesapeake Energy Corp., Oklahoma City, has no hesitation playing the contrarian among US natural gas producers, which has resulted in Chesapeake's reputation as an aggressive and dynamic hedger of gas during price swings.

Aubrey K. McClendon, Chesapeake chairman and CEO, notes that his company made more than $200 million in 2001-02 through its hedging policies.

"We recognized that natural gas prices were unusually high in early 2001. We felt like gas prices at that level—and prices that were being projected out on the future on the New York Mercantile Exchange—at that time probably were not sustainable. We felt like it was time to lock in the higher prices," McClendon said of his formerly bearish strategy.

Currently, Chesapeake is implementing a very bullish hedging policy because its management foresees very strong gas prices in 2003-04. As of Jan. 24, it had hedged 50% of its 2003 gas at $4.60 Mcf and 100% of its 2003 oil at $27.50/bbl.

"We think our mission with hedging is to generate the highest risk-adjusted returns on our capital," said McClendon, who cofounded the company along with Tom L. Ward, president and COO. As of Jan. 9, they owned 14% of the stock, having bought $6 million in open-market purchases since late 2002.

McClendon believes that "Gas prices will continue to stay strong in the years ahead because of the difficulty in finding new reserves of natural gas in North America and the highly favorable environmental benefits of using this fuel."

He calls Chesapeake "really a very simple company" focused on gas in the US Midcontinent.

"We really have only one goal: We want to be the most profitable company in the industry per unit of production. We have a plain and simple financial statement and clean corporate governance. Our growth strategy is a combination of growth through the drillbit and growth through acquisitions."

The long-term outlook for gas producers is bright because they provide a supply-constrained commodity, he said, adding that strong gas prices likely will be accompanied by volatility unmatched by other types of publicly traded companies.

Volatility

"We love volatility. We think gas price volatility is good. We think excessive volatility is even better. We approach this topic with the view that volatility is just a business risk," McClendon said. "A lot of companies have framed this in a titanic battle of good vs. evil, the market being manipulated, the consumers being gouged, and so on."

But he considers volatility "an inevitable outcome that is here to stay. Much of our demand is dictated by what is happening with the weather, and obviously, there is nothing more volatile than that. In addition, supply continues to fall, and population-directed demand growth continues to want to grow at 1-2%/year. So something has to give, and that will be price—we simply have to price away some demand."

Volatility creates opportunities to hedge unusually high prices and to generate unusually high returns, helping Chesapeake "unlock the substantial option value embedded in long-life reserves," he said.

"You are likely to see greater compression of volatility cycles and probably greater amplitudes as well.

"We think this uncertainty in future prices keeps capital out of this industry, which while for individual companies may not be a good thing, but overall for the industry, we think it is great, because it keeps pressure on supply," he said.

Volatile markets give producers the opportunity to sell during high cycles and give consumers the opportunity to buy in down cycles, he said.

US gas supply

McClendon believes that it will be better to be a producer of energy than a consumer of energy during at least the next 5-10 years.

"A couple of years ago, there was a lot of talk about a 30 tcf economy by 2010," he said.

"Back then, we were some of the first to say we didn't see how it could happen. We just did not see how producers in this country could grow their production by 67% over 10 years, which was required.

"We think from a 22 tcf economy today that we're more likely headed to a 19-20 tcf economy than a 25-26 tcf economy by 2006. There is no way to get to 30 tcf by 2010."

Each year will require successively higher prices to destroy more demand, which will in turn become more resistant to destruction, McClendon said.

"We don't really see much coming to the rescue from LNG—maybe in 2005-06. I don't think that it will be enough to put a permanent cap on gas prices," McClendon said. Arctic gas might come to the rescue in 2010, but not any sooner than that, he forecast.

"The great American economic miracle of the past 20 years has been built on a foundation of new technologies and cheap energy. We suspect that might be different in the next cycle," McClendon said.

2003 plans

For the last 4 years, Chesapeake prepared for a declining US gas supply and increasing prices. It positioned itself as the ninth largest independent US gas producer, having long-lived, multipay gas reserves with an average reserves-production ratio of 10-12 years.

"We were able to do it in 1998-2000, when almost everybody thought we were going bankrupt. People weren't spending money in the industry. We were able to go in really underneath the radar screen and put together an asset base in the Midcontinent that we don't think anybody else can duplicate today," he said. "We consider ourselves to be a prospect-rich company in a prospect-poor industry," McClendon said.

This year, Chesapeake plans to invest $475 million in drilling, land, and seismic. About $375 million will go for drilling while $100 million of it will be for land and seismic. The company expects to find 340 bcfe and to produce 190 bcfe of that in 2003.

The Midcontinent is short on gas supply and is long on infrastructure, which leads to strong wellhead prices, low service and midstream costs, and higher profitability per production unit, McClendon said.

"A lot of people are attracted today to companies that have assets in the Rockies and in Canada. They think there is more upside in those areas. The problem with those areas is that they have been perpetually long gas and short infrastructure. As a result, you get low wellhead prices and low returns on investment. Not all Mcfe's are created equal," he said.

He believes Midcontinent reserves are worth 40-50¢/Mcfe more in the ground than are Rockies or San Juan assets, because gas from those regions sells at a bigger discount to Henry Hub prices than does gas from the Midcontinent.

The Midcontinent is large, with a fragmented ownership, which provides Chesapeake with opportunities for small and medium-size acquisitions, McClendon said.

"We are the largest producer in this area, with a 12% market share. The top three companies produce 25% of the gas here (The second and third largest producers in the area, respectively, are BP PLC and Apache Corp.). But if you want to find out who produces 90% of the gas, you have to add another 247 names. There is lots of consolidation yet to accomplish in this area," he noted.

Career highlights

Aubrey K. McClendon has served as chairman, CEO, and a director of Chesapeake Energy Corp. since cofounding the company with Tom L. Ward in 1989.
Employment
McClendon was an independent oil and gas producer in affiliation with Ward from 1982 to 1989.
Education
McClendon graduated from Duke University in 1981.
Organizations
McClendon is a member of the board of visitors of the Fuqua School of Business at Duke University.