For the next two to three years there’s probably not more than 1.5 BCF per day of incremental pipeline capacity out of the Haynesville, much of which Chesapeake has tied up. In the meantime, major new transmission pipelines will be planned and will be built to serve rapidly growing southeastern markets but Chesapeake does not believe people should model for the Haynesville to be producing more than 1.5 BCF per day by more than three years from today.
This pipeline constraint along with slowing growth from the Barnett over the next few years and very little incremental growth possible for the next two to three years in the Rockies and ongoing declines in the Gulf of Mexico and in Canada plus increasing demand from the US power sector should be sufficient to prevent a US gas glut from developing and gas prices will generally settle in an average range of $9.00 to $11.00 per MMBTU at Henry Hub pricing.
Roughly 30% of today’s US gas production comes from wells placed in service in the past year and 40% of current gas production comes from wells less than two years old.
Should gas prices decline further, Chesapeake would see less drilling and therefore less production growth, if any, as these aggressive first and second year declines kick in.
By all accounts production gains in 2008 have been extraordinary running somewhat greater than 4 BCF a day above last year’s levels.
There have been two one-time production gains that have accounted for about 50% of that increase - the Rockies Express Pipeline and the Independent Sub. Taking those two one-time events away, what is left is organic gains of around 2 BCF to 2.5 BCF per day. These gains are likely to be about the same to slightly less in 2009 and 2010 and demand can grow quickly enough absorb these additional volumes in the years ahead.
Business Strategy Evolution:
Starting about 10 years ago Chesapeake became very bullish about natural gas prices and created an aggressive business strategy focused on building a very significant asset base of US natural gas especially in unconventional reservoirs. However, during the past year a powerful new aspect of the business strategy started to develop. Chesapeake has now become a seller of assets occasionally rather than just a developer of assets.
The company believes that if gas prices are likely to remain relatively flat for a while in the $9.00 to $11.00 range, then it makes sense to bring some of the more distant present value forward and monetize it at today’s attractive prices.
Chesapeake has chosen two ways of advancing this present value forward:
The first is through volumetric production payments or VPPs. They give Chesapeake the ability to monetize some of the low declined mature gas assets that are valued in the stock market of Chesapeake at less than $3.00 per MCFE and monetize them at about double that level. So far, including a third VPP Chesapeake should close on later today or Monday, the company has sold VPPs for proceeds of $2.3 billion. The reserve volumes sold were 395 BCFs.
Chesapeake monetizes these assets for cash at $5.90 per MCFE and took the cash and reinvested it in the gas manufacturing machine that today is consistently developing reserves at around $2.00 per MCFE. So if Chesapeake can find it for $2.00 and the stock market only values it at $3.00 and the company can sell it for nearly $6.00 through a VPP and still keep the tail reserve.
In addition, for income tax purposes these VPPs are treated as loans so there is no cash income tax leakage from the transaction. Furthermore, the proceeds from those VPPs go into the company’s full cost pool as credit and so as Chesapeake offsets an approximate $2.50 per MCFE current DD&A rate with about $6.00 per MCFE VPP proceeds, you’ll see that these VPPs will reduce the DD&A rate going forward and enhance the company’s profitability and improve returns on capital. In all likelihood Chesapeake will sell another $500 million VPP in the second half of this year and probably $1 billion to $2 billion worth next year as well.
The second part of this new aspect to the company’s business plan is demonstrated by the recent transaction Chesapeake entered into with PXP in the Haynesville.
In that transaction Chesapeake sold 20% of its 550,000 net acres for $3.3 billion, half in cash up front and half over time in the next few years. To date the total investment in the Haynesville is around $4 billion so by selling 20% for $3.3 billion Chesapeake has recouped 80% of its cost, lowered per acre average cost by 77% from $7,100 per net acre to $1,600 per net acre, and established a remaining value of about $22 per share for remaining 80% of this unique asset. This transaction reduced the risk, lowered the cost, aggressively advanced present value creation forward, and has provided valuation transparency for this enormous asset. In time this acreage will be worth at least $50,000 per net acre to Chesapeake or $37.00 per share.
Last week there was an announcement of a transaction in the Barnett that valued non-producing high quality Tarrant County leaseholds at more than $50,000 per net acre.
If it happened in the Barnett, it will happen in the Haynesville over time.
The next two areas for potential partnerships will likely be in the Fayetteville and in the Marcellus. Chesapeake is also planning to pursue one in the West Texas shale play because the company has recently drilled a series of excellent wells there. So in the past, once Chesapeake found gas it only had one way to make money from it and that was to sell the gas over time as the well gradually depleted. Now, however, Chesapeake has developed a way to accelerate that process and that’s by selling off a portion of the company’s new plays to partners at very attractive prices.
Similarly to the VPPs as the sale proceeds go into the company’s full cost pool as credits well in excess of the costs incurred to date, the future DD&A rates should decline as well which will lead to higher profitability and greater returns on capital. Just at the time other companies are experiencing rising finding costs and higher DD&A rates, Chesapeake will be headed in the opposite direction.
Barnett:
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