Saturday, November 5, 2011

Chesapeake Energy Developments (CHK)

Chesapeake Energy (CHK) announced earnings after-hours on Thursday, and it seemed like people (sell side equity research people at least) were unhappy that the company took its natural gas hedges off and that it is spending more money buying land. When it comes to Chesapeake land purchases, you need to think about their track record. This is how CEO Aubrey McClendon described it on the conference call [transcript]:

If you are keeping track, this new JV would make our seventh. We started with the Haynesville in July of 2008, and in the 3 years since then, we have also brought in partners on the Fayetteville, Marcellus, Barnett, Eagle Ford, Niobrara and now into 1 phase of the Utica play.

In these 7 JV areas, the company initially acquired approximately 5.1 million net leasehold acres at a cost of $11.1 billion. That's around $2,200 per net acre overall on average. We then sold 1.5 million of those acres for total consideration of $16.4 billion in cash and carries, meaning we recovered 150% of our total leasehold costs in all the plays combined, while leaving ourselves with 3.6 million net acres in 7 of the nation's very best plays, at a negative leasehold cost of $5.3 billion.

That's about a negative $1,500 per net acre. I really don't think the magnitude or significance of what we have accomplished by owning 3.6 million net acres at a profit of $1,500 per net acre has been fully appreciated. It is quite simply unprecedented in our industry.
Add in the fact that they have $8 billion in hedging gains since 2006 (see page 28 of the latest investor relations presentation). They have an information edge and they mint money. The significance of Chesapeake covering its natural gas hedges was completely missed by the market. More color from Aubrey:
Chesapeake single-handedly has generated almost half of the entire industry's growth in natural gas production. Said another way, a 2% gas market share company in 2000, which was us, grew its production 472% over the past decade, while the other 98% of the industry, 49x bigger than us and represented by more than 10,000 other companies, only grew its collective production 12% during the past decade.

As incredible as that is, it's even more incredible how most natural gas market observers fail to understand the impact of these numbers on future supply demand trends, because for the next 5 years, Chesapeake is planning to keep its gas production essentially flat. Please see Slide 18, which shows our projected annual 10% production increases coming almost entirely from liquids production growth from 2012 through 2015.

Said in the simplest way that I can, natural gas markets during the past 5 years were basically changed single-handedly by the efforts of 1 company. And now I'm telling you, during the next 5 years, it will be very different from now. And the futures curve is currently pricing natural gas, we believe, incorrectly because the same company that helped bring you the gas oversupply is now dedicated to increasing its liquids production, and its gas production will not increase much from here.
Imagine if Aubrey just adopted the Warren Buffett strategy of having a girlfriend who owns a newspaper so you get good press.

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