Chesapeake Energy continues drilling, hedging - and improving balance sheet

By Paul Deckelman

New York, October 19 - If someone asked you to identify the biggest single natural gas industry driller in the United States, you might say a well-known energy supermajor like ExxonMobil Corp. or Chevron Corp. Not implausible guesses - but you'd still be wrong.

The Number-One driller in the United States in terms of total rigs is Chesapeake Energy Inc.

The Oklahoma City-based company has become the third-largest independent U.S. producer of natural gas, topped only by Anadarko Petroleum Corp. and Devon Energy Corp.

Counting the aforementioned supermajors, utilities and pipeline companies in the mix, Chesapeake is still a respectable Number Seven, just 13 years after it was founded by company chairman and chief executive officer Aubrey K. McClendon and Tom Ward, who formerly served as president and chief operating officer.

A strong growth pattern

Chesapeake has come a long way in such a relatively short time through an aggressive program of acquiring reserves and actively drilling them - "we love to drill," McClendon declared Thursday at a Deutsche Bank Securities conference on energy investment.

"Although we're often seen as an acquisition company," he told conference attendees, "55% of our growth is from the drillbit [i.e. establishing new wells] and just 45% from acquisitions."

The company's growth pace remains strong, and regionally focused in Texas and elsewhere in the Southwest, as well as in the Appalachian regions in the eastern part of the country.

Although natural gas prices have been volatile over the past several years, Chesapeake has continued to move forward. "Our company was probably the earliest to recognize that structural changes were underway in the natural gas markets," McClendon told the conference, and was able to take advantage of that foresight "despite our weak financial position at the time, in 1998 and 1999."

Major improvements since '99

Since those bad old days, Chesapeake has "greatly strengthened" its balance sheet, the company says. Materials released in connection with investor presentations such as the one McClendon made Thursday indicated that while long-term debt stood at about 130% of the company's book capitalization in 1999, that figure has come down substantially as the company has issued common and preferred stock to help fund its acquisitions in the interim, while also using earnings to cut debt. The steepest drop was seen in the first year, as the ratio of debt/capitalization fell to just over 70%, and has continued to come down to around the 40% level in this year's second quarter ended June 30.

Since 1999, the company's credit ratings, as measured by Moody's Investors Service and Standard & Poor's, have steadily improved, from B3/B back then to Ba2/BB currently.

Despite the company's active issuance of debt - it had some $6.33 billion outstanding as of June 30, all of it in the form of bonds, with the company's revolver undrawn - McClendon noted that "our debt has stayed about the same per mcfe [thousand cubic feet of proven gas reserves]," about $1, as those reserves have grown to some 8.3 trillion cubic feet equivalent, through both exploration and new drilling, and acquisitions.

"Over the past seven years, we've steadily improved the balance sheet quality, and will continue to do that, as our margins have increased, as our costs have remained the same," he said.

Chesapeake has managed its debt so that the company now has a staggered long-term debt maturity structure, with no senior notes due until 2013, when a total principal amount of $864 million 7½% and 7 5/8% senior notes come due.

The company expects to generate possibly as much as $25 billion to $30 billion of cash flow from now until that time, giving it the resources to easily repay or refinance the notes. Peak debt repayment obligations will hit in 2015, totaling some $1.59 billion, although it should be noted that $690 million of that is the company's sole outstanding convertible issue, its 2.75% converts, which actually mature in 2035, but which are first putable back to the company in 2015.

Hedges helping financial picture

McClendon also said during his presentation that the company had benefited greatly from hedging - the use of options, collars and other financial tools to protect itself against the downside of gas prices.

"We are a very active hedger," he declared - and because of those hedges, Chesapeake has realized $1.2 billion of cash so far this year and may finish with $1.4 billion of cash attributable to hedging by year end. Some 92% of its production in the second half of the year is hedged, some 80% of next year's and 60% of 2008's, making Chesapeake the top hedger in the industry.

For 2007, "we've taken a lot of volatility away," the CEO declared. He said that were gas prices to fall to $6 per thousand cubic feet equivalent from $7, "that would be a 15% move down - yet we would only lose about 2.5% of our cash flow and net income as a result of our hedging."

At $7 gas, "we'd make another $1.4 billion, next year on hedging, on top of the $1.4 billion we project to make in 2006. So if you include 2008 . . . at $7, on this go-round of hedging, the company should make about $3 billion."

McClendon said the company is also protecting itself from increases in service costs by making its own drilling rigs and doing its own drilling, rather than outsourcing this.

"We recognized early that [the costs] of drilling rigs was going to be a constriction, so we got in the drilling-rig business." The company has some 82 rigs that it is building out, which would make it the sixth-largest producer of drilling rigs in the industry. He said Chesapeake was up "several hundred million [dollars] on that investment, and it provides us with very significant operational and acquisition advantages."

He also said that Chesapeake had made over $100 million on an investment it made in Pioneer Drilling, which it has since sold out, and it had started two other drilling companies "which at some point will get bought or go public," potentially providing big future payoffs.

He said Chesapeake had also "recently invested a significant amount of money" in a privately held formation treatment fracturing company "that we think will also go public, and will also serve as a further hedge to any increase in service costs."

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