Markets help independent producer pursue value-creation 'hat trick'

Today's oil and gas business environment offers the independent producer a triple scoring opportunity rarely seen before.

Reasonable acquisition and development costs, record-low capital costs, and unprecedented futures prices present true value-creation opportunities for those willing and able to use hedging strategies to lock in sustained rates of return.

These three favorable conditions of the market enable Chesapeake Energy to pursue what I call a "hat trick" of value creation with a simple, focused growth strategy.

Balanced between drilling and acquisitions, Chesapeake's strategy concentrates on natural gas that can be found or acquired in US onshore areas that are long on infrastructure and short on Bureau of Land Management and Indian lands, excess environmental regulation, and restrictive drilling or operating seasons. Today, these areas are the Midcontinent (including a recently announced Ark-La-Tex acquisition), the New Mexico portion of the Permian basin, and South Texas/Texas Gulf Coast.

Encouraged by natural gas prices that are high by the standards of recent years, Chesapeake maintains a drilling program that's among the country's most active, yet modulated. At this writing, the company was operator of 51 wells on which drilling was under way.

To ensure a continuous program, balanced between developmental and deep exploratory drilling, we invest $100-150 million/year in 3D seismic surveys and additional acreage. This investment, of course, does not generate immediate returns. It does, however, provide for a multiyear inventory of future locations and growth in ultimately proved reserves.

Modulation results from the balance between exploratory and development drilling and from the spending to maintain a healthy inventory of future drilling locations. The continuity enhances efficiency by eliminating wide swings in personnel and vendor-support requirements.

In addition to drilling, Chesapeake actively pursues acquisitions rather than waiting for sellers to "skate" to our end of the ice to score.

Our acquisition department includes more than 20 professionals led by a 20-year veteran, Doug Jacobson. We frequently pursue an acquisition target for months, sometimes years, before concluding a transaction.

Being in the market at all times, actively evaluating and bidding on assets or companies, not only gives us the knowledge of what asset clearing prices are but also causes potential sellers to consider Chesapeake first.

Capital costs favorable

A strategy involving the continuous pursuit of quality drilling and acquisition opportunities obviously benefits when capital costs are as low as they are now.

Chesapeake accessed the long-term debt markets in mid-May, issuing $300 million of new 10-year maturity notes for 7.5%. Recently we amended our revolving credit facility to extend maturity to 5 years and to increase the size to $500 million. We pay just 150 basis points over LIBOR (London interbank offered rate), or about 3.5%/year. Earlier in 2004 we issued more $600 million of common and preferred equity.

This environment of record-low interest rates encourages Chesapeake and other producers to be more aggressive in pursuing acquisitions. Long-life gas properties, particularly, can be attractively financed at spreads previously reserved for drilling projects, with a substantially lower risk profile.

Private-equity investors, significant commercial-bank interest, and robust public debt and equity markets have combined to provide record liquidity and capital opportunities to the oil and gas sector.

The hat trick

The third value creator that Chesapeake actively takes advantage of is hedging.

We have worked for years to cultivate extensive counter-party hedging arrangements. Today, Chesapeake can hedge up to 1 tcf of gas for as long as 5 years with companies such as Deutsche Bank, Morgan Stanley, Goldman Sachs, BNP, and UBS. All of these arrangements are carefully structured to provide ample protection against margin calls caused by extreme volatility.

A recent example of how hedging can reduce risk and significantly increase returns is our Laredo acquisition, a $200 million transaction that closed in October 2003.

We hedged 100% of projected production volumes at $5.76/Mcfe for 14 months. This was over $1/Mcfe higher than the price deck we used in making the acquisition and increased returns by almost 8%.

In a more recent transaction, Chesapeake hedged 100% of the acquisition volumes for all of 2004 and 2005. We estimate this allowed us to recoup 44% of our acquisition price in 24 months, at which time 85% of the reserves acquired will remain. Rates of return were increased to well over 20%.

A favorable balance of business conditions thus combines with Chesapeake's balanced program of steady acquisition and drilling, financed with long-term capital at attractive rates, with returns locked in through a prudent hedging program, to produce a hat trick of value creation. ogfj

The author