Chespeake – 2Q08. Another Quarter, Another Beat. Confidence In Long Term Growth Builds – Pre Call Note

 

(CHK) - July 31, 2008 Close of $50.15  (the stock was actually higher ($50.93) before they announced 1Q results)

In A Nutshell. Chesapeake reported better than expected top and bottom line results with production exceeding the top end of CHK's guidance and CFPS exceeding the top end of the Street's forecast range. Costs were in line with guidance and reserve metrics were again better than expected.  They hit the high points in the main basins and released a little more Haynesville data including the first production projections but we should get a lot more color on the call. They did not talk about their oil shale activities but oil production continues to creep up...hopefully more color on the call there as well but it looks like Aubrey will continue to play that one close to the vest until his acreage is in place or he's outed by a competitor.

The 2Q08 Numbers: 

• EPS of $0.89 (ex items) vs $0.88 expected
• CFPS of $2.77 vs $2.37 expected, beating the top of the range of $1.94 to $2.68
  

• 2Q08 Production of 2.328 Bcfepd (still 92% gas), vs guidance of 2.26 to 2.29 Bcfepd. On an apples to apples basis (netting out the impact of volumetric production payments) this is up 5% sequentially and up 29% from 2Q07.
  

• LOE (lease operating expense) of $1.03 / Mcfe vs guidance of $0.95 to $1.05. Per unit LOE is up 5% from the first quarter but they maintained prior guidance for the out years with assumption being that higher volumes offset increased electricity and other expenses.

 Reserves Update:

• 12.17 Tcfe, up 11.48 Tcfe, up 700 Bcfe from last quarter and up 1.3 Tcfe (1,300 Bcfe ) from year end 2007.
• 1H08 reserve replacement: 410%. This is the amount of reserves they find or acquire relative to the amount they produce.
• Drilling and Net Acquisition F&D: $1.49 / Mcfe.  That's just stunning. During the first half of 2008 they sold reserves for an average of $5.53 / Mcfe in the ground but they bought reserves for a lowly $1.44/Mcfe.
  
• Their drill bit only F&D costs for the first half were $1.89 Mcfe. Again, very strong.
  
• They continue to guide for reserve growth to 13 Tcfe by YE08 and 15 Tcfe YE09. Given recent performance and well results described below these numbers appear to be in the bag.
  

 

CHK Now The Largest Producers of Natural Gas In The U.S. This is worth mentioning only because they are maintaining cost discipline. Growing an E&P company's volumes just for the sake of growth is non-sense. If you don't gain efficiencies out of it, like the ones you obtain, from being the first or second most active driller in the plays you dominate, or generating substantial cash flow which allows you to dominate new plays and obtain first mover status, then why bother being big, especially if you let your costs run wild. In Chesapeake's case, they are obtaining these efficiencies and beating the competition to the core assets before the plays take off....so congrats to Aubrey on obtaining the #1 spot in gas sales.

Transactions Update: Another VPP. CHK float another Volumetric Production Payment, monetizing 93 Bcf of long lived but low upside Anadarko Basis reserves for $605 million or $6.50 per Mcfe. While the ratings agencies may consider this a form of stealth debt, I would point out that they lack an understanding of both time value of money (monetize it now) and a good deal when it is starting in the face. Putting that capital to work in inarguably higher projects like the Haynesville, Fayetteville and other shales makes a world of sense.

 

Volumes Guidance:

• 3Q08: 2.36 Bcfepd, up 1.4% sequentially...given where they saw production volumes are in the Barnett at present, this looks like another easy beat.
• 2008: 2.36 Bcfepd, up 21%. Same as prior guidance. I would point out that they did not reduce annual guidance for the 50 MMcfepd of production that goes away with their sale of their Woodford Shale assets to BP or the 50 MMcfepd of production associated with the Anadarko Basin VPP outlined above.
  
• 2009: 2.81 Bcfgepd, up 19%. Same as prior guidance.
• 2010: 3.34 Bcfepd, also up 19%. Same as prior guidance.

 

Operations Update: The company only provided a handful of highlights.

Barnett Shale: Now producing half a Bcfgpd net; 2008 exit rate climbs

• 2Q08 avg net production of 466 MMcfepd up 13% from the 410 MMcfepd 1Q08 average and up 125% vs 2Q07.
• current production is 500 MMcfepd net (yep, half a Bcfgpd) and they are targeting 675 MMcfepd for a 2008 exit rate. This exit is up from 650 MMcfepd as of the 1Q call.
  
• They have 45 rigs running, up 4 from last quarter and complete a well in the play every 14 or 15 hours.

 

Fayetteville Shale: Booming

• net production averaged 136 MMcfepd in the quarter, up 425% YoY
• currently producing 150 MMcfepd and targeting a year end of "at least" 200 MMcfepd (0.2 Bcfepd)
• operating 17 rigs now and moving to 21 by year end
• no per well economics divulged in the press release this time

 

Haynesville Shale Play: Northwest, LA.  More well results and the first volumes projection.

• Acreage now at  450,000 acres and still acquiring
  
• 11 horizontal wells producing 45 MMcfepd gross, 35 net.
  
• Setting a year end exit rate of "at least" 75 MMcfepd gross
  
• Latest well, the Milton Crow 27-1H, is producing 14 MMcfepd, 5,800 psi on a 24/64 choke, no completion details given and I don't expect to hear much in this regard on the call
• 8 rigs in the play (up from 4 as of last quarter), moving to "at least" 12 by year end. This will put them on track to completing one Haynesville Shale well every five days. Someday, given their history and their confidence in this play, this distance between well completions will be measured in hours as it is now in the Barnett as they move towards their 2010 goal of 60 rigs here.
  
  Marcellus Shale: Soon to "significantly increase drilling activity"
  

• 1.6 million acres now
• Completed 2 horizontal wells during the quarter which are producing at a combined rate of 7 MMcfepd. This is the first rate out of CHK I have seen on the Marcellus although they did say before these are 4 Bcfe type wells and they sound pleased with the results saying they plan to significantly increase drilling activity here in 2008 and 2009.

 

 

Conference Call: Friday, 9 EST.

Conference Call Notes: raw notes

 

CHK CC Notes #1

Heart of the Barnett is only 1.2 mm acres,

2.45 Bcfe for 100 acres increased to 2.65 Bcfe for 55 acres.

Think ultimately produce 60 Tcf of gas from mostly Johnson to Tarrent county. That will take 50 years to produce and the 1 yr decline rate is 65%.

HK CC Notes #2

Comment of Recent Negative Comments on the Haynesville by a friend and competitor (that would be XTO):

CHK saw this coming, others did not. They were lucky to get their hands on a Haynseville.

300 days on the first well on 9/64ths choke with 5 stage frac.

1 well has a mechanical well

3 on 4 months 14 or 16/64 chokes 3 mm/d

the next wells on 2 months

last 2 wells are making combined 20 mm/d

the last well is the best shale well they have drilled in over 2,000 wells . This is the only one with an 8 stage frac.

CHK Notes CC #3

All wells will be now drilled with 8 stage fracs. See all future IP’s likely above 10 MM/d.

Superior gas price: prices were $1.50 higher for Haynesville than Barnett last month.

He is now slamming others for doubting his reserves on the play.

180 Bcf gas in place per section
220 feet across 3 mm acres

They think they will recover 52 Bcf/sq mile, or 29% recover with 8 wells per section.

3 mm acres = 4700 sq miles = 245 Tcfe of recoverable reserves. Says the science reinforced by well data to date makes very confidence.

CHK CC Notes #4

Regarding long term natural gas prices:

Constraints to growth, will require decades to full develop, many companies will develop slowly.

Shale is 11,500 feet on average, 1,000 hp with top drive so rig availability is an issue.

For the next few years, not more than 1.5 Bcfgpd capaicty, much of which is there’s. Don’t see it adding more than 1.5 Bcfgpd within 3 years.

Then consider declines from Gomex and increased electricity demand think gas prices will settle in a range of $9 to $11.

40% of current US gas prices comes from wells placed onstream in the last 2 years.

CHK Notes #5

Production growth has been extraordinary at 4 Bcfgpd YoY. Says half is Rockies Express pipeline and Independence Hub. Sees organic growth around 2 Bcfgpd next year.

CHK CC Notes #6:

VPPs - monetizing low decline, mature assets for about double what the market is valuing them at ($3 vs $6 for the VPP)

Reinvest it for $2 F&D and sell it for $6.

See VPPs of 1 to 2 billion next year, another half billion this year.

CHK CC Notes #7

Deals coming in the Fayetteville and Marcellus and in the West Tx shale play.

Says they have drilled some excellent wells in West Texas.

CHK CC Notes #8

Barnett
775 mm/d gross ; 500 mm/d net
see 700 wells per year for quite some time

seeing 3.8 Bcfe per well in their 2008 drilling vs the 2.65 Bcfe they have come to expect.

Fayetteville
Drilling best wells ever
new 3D, longer laterals
150 mm/d net, 17 rigs
plan to increase to 25 rigs in 2009

Marcellus wells in WV, 2 wells producing 7 mm/d combined EUR of 11 Bcfe
topographic, regulatory, water issues will keep this play down until at least 2011.
Their leases here are held by production and the rest are 10 year leases

They will not be running out of tubulars

Gas thoughts: sees 2 to 2.5 Bcfgpd production growth

Sees the shale and other resource plays are profitable at $8 gas. Conventional plays are at an increasing cost disadvantage…they are always inventing themselves going after these smaller targets and therefore can’t get their costs down and he thinks conventional drilling will come down.

Big basis differential in the mid cont, now 1.50 so those guys are reaping less. I watch this but not as closely as I should and it is a good point.

CHK Q&A Note #2

How does the market unlock your hidden value?

1) stable gas prices
2) negative comments on HS need to get past those. “Not very smart to be doggin’ that play”

We are going to increase our reserves by at least half a Tcfe every quarter and that’s after VPPs and other monetizations which adds 2.5 to 4.0 billion dollars to asset values.

They are going to see decline F&D costs which will be the opposite of most of their competitors due to their first mover action in these plays.

West Texas Update:
completion breakthroughs in vertical wells that are commercial.
Horizontals are quite good as well
They have cracked the code there enough to bring a partner in,
They have > 1 mm acres, lots of play types in the W. Tx Barnett and Woodford.
They continue to drive costs down, mentioned bringing in a “big boy” to develop it.

Oil Shale Play Update:

5 uncoventional oil plays - 4 are shale
1 of the five was producing in March

The non-shale - WEHLU - w. Ok. old abandoned oil play with new horizontals, working well.

They will have the other shales tested by year end.

All of the major pipeline companies have been to see CHK in the last 30 days to see how they can add new takeaway capacity from the Haynesville.

Says his peak thoughts on the Barnett is a little higher than EOG’s thoughts of 5 Bcfgpd by mid 2009.

CHK fighting higher now.

Demand Thoughts From Aubrey:

Regarding demand destruction in the face of recent high prices:

He thinks they saw 2 Bcfgpd go away early in the month and come back as prices fell.

On the supply side: compressors struggle in hot weather…thinks August could show 2 to 3% lower production for the U.S. due to summer heat. Thinks we will see higher demand and the supply struggle give us a series of bullish NG weekly reports.

CNG - US consumes 10 mm boepd in the form of gas. For every 1% of the car and truck fleet that gets converted to CNG it would use 225 Bcf.

No interest in international plays, either in Canada or Europe. Thinks of it like he thinks of the Rockies. Great place to look for gas, hard to make money.

North Gas Supply Scenario. The last 3 years you get a gas price collapse one month prior to the previous year. 2006 was oct, 2007 sept, 2008 Aug.

Everytime we go through one of these draw downs in price, the floor is higher than the last one since coal and other commodities are higher.

Joe Alman question:

see 2 Bcfgpd in Barnett production (gross) by 2012 so they will be taking market share from the Basin.

Kenworth and Peterbuilt are coming out with CNG powered cabs by year end.

NG at current prices costs 1/2 of gasoline for moving cars and trucks. He’s working with Congress to make it happen. Sees a real sense of national urgency.

“made in America, clean, and half the price of gasoline”

CHK - these monetizations will get them out of the equity issuance business. Said they had an enormous mismatch this year due to later close of the VPPs vs the leasing ramp in 3 plays. GOING FORWARD, WE ARE MOVING INTO GENERATING CASH FROM THESE CAPITAL REDEPLOYMENTS. So there’s his sort of pledge not to sell more shares.