30 octubre 2006

Chesapeake Annual Report 2005 - GROWTH, VALUE AND OPPORTUNITY

Utilizado en Chesapeake (CHK), im-presionante

In 2005, Chesapeake:

  • Was one of the top financial and operating performers among exploration and production companies;
  • Increased average daily production 30% to 1,284 mmcfe and delivered 12% organic production growth;
  • Increased proved reserves by 53% to 7.5 tcfe through both acquisitions and the drillbit;
  • Replaced 659% of its production, with a drillbit finding and development cost of $1.74 per mcfe and a total reserve replacement cost of $2.40 per mcfe;
  • Was the most active driller of new wells in the U.S., drilling 902 operated wells and participating in another 1,066 nonoperated wells, utilizing an average rig count of 73 operated rigs and 66 non-operated rigs;
  • Was one of the most active consolidators in the industry, investing $4.9 billion in acquisitions of oil and gas properties for the year and $10.3 billion since 1998;
  • Increased its industry leading inventories of U.S. onshore acreage and 3-D seismic data to 7.9 million net acres and 11.6 million acres, respectively;
  • More than doubled its market capitalization and enterprise value to $14 billion and $20 billion, respectively; and
  • Generated a 94% total return to common shareholders and increased the total return to common shareholders since its IPO in 1993 to nearly 2.300%

Chesapeake's business strategy
is probably the easiest to understand among all large-cap public
exploration and production (E&P) companies. We grow onshore in
the U.S. through a balance of drilling and acquisitions, we regionally
consolidate to achieve economies of scale, we focus almost exclusively
on finding and producing natural gas and we work proactively to
mitigate risk. By executing this strategy effectively, Chesapeake
became America's top performing stock during the past seven years.

In addition to the simplicity of our business strategy, our early
recognition of evolving trends in natural gas markets and our
willingness to seize opportunities have distinguished Chesapeake
among its peers. Back in 1998 and early 1999, when natural gas
was exceptionally cheap (frequently selling for less than $1.25 per
mmbtu), most industry and government observers predicted that the
U.S. natural gas market would increase from 22 tcf to 30 tcf per year
by 2010 and that natural gas prices would remain low indefinitely.
After examining the fundamentals of the North American natural
gas market, we arrived at a very different conclusion and began
repositioning the company to pursue a contrarian strategy based on
the following beliefs about the U.S. natural gas industry beyond the
year 2000:
• production depletion rates would accelerate;
• finding, development and operating costs would increase;
• demand would gradually move away from more cost-sensitive
industrial demand to less cost-sensitive electrical power
generation demand; and
• production would soon reach a peak from which there would
be no recovery, regardless of higher prices or improved

These trends became evident when we studied U.S. oil production
history and then predicted that U.S. natural gas production would
likely follow a similar bell-shaped curve of ramping up to a historic
peak (1970 for oil, 2001 for natural gas) and then slowly but steadily
declining thereafter. We also reasoned that the major oil companies
would begin withdrawing from the search for increasingly scarce
natural gas reserves in North America and refocus their natural gas
strategies on building global natural gas franchises around more
abundant worldwide natural gas reserves that could be transformed
into liquefied natural gas (LNG).
As the majors began de-emphasizing their search for new natural
gas reserves in U.S., we felt certain the 35% of U.S. natural gas
production the majors represented would decline at a rate that would
surprise many industry observers. In fact, over the past five years,
the majors' U.S. natural gas production has declined by a stunning
one-third. It also seemed clear to us that the smaller independent
E&P companies would not be able to increase their own natural gas
production enough to overcome the majors' production declines.
Accordingly, we decided that Chesapeake should position itself
to be a first mover to take advantage of this opportunity. To that end,
we adopted four objectives:
• acquire all of the existing natural gas production and reserves
we could afford;
• lease all the potentially natural gas productive acreage we
could identify;
• hire all of the talented landmen, geoscientists and engineers
we could find; and
• focus exclusively onshore in the U.S., safely away from
hurricanes and geopolitical unrest.
Over the past eight years, we have accomplished all of these
objectives. Meanwhile, with the help of higher oil prices, natural gas
prices have risen to levels 600-800% greater than they were in 1998
and early 1999. More importantly, assuming normal weather patterns,
natural gas demand is likely to exceed supply and continued natural
gas price strength is probable for years to come. As a result of
anticipating these trends and getting ahead of our competition,
Chesapeake is very well-positioned for success in the years ahead.


With this context in mind, I now focus on the centerpiece of this letter –
a discussion of why we believe Chesapeake offers the best combination
of growth, value and opportunity in the industry.

GROWTH First and foremost, Chesapeake is a growth
company. At the time of our IPO in 1993 when we only produced
10 mmcfe per day, we were clearly a growth through the drillbit
company in an industry focused primarily on acquisitions. Even
though our production is now 150 times larger, we remain a growth
through the drillbit company. In 2005, our organic growth (that is,
through the drillbit) was 12%, which is exactly what our five-year
average organic growth rate has been and which we believe is the
highest in the U.S. mid and large-cap E&P sector during
that period

Such an achievement is truly extraordinary considering the scale
of our company today is five times larger than it was five years ago.
Clearly the law of large numbers has not caught up with Chesapeake
in the way many have predicted over the years. I would also note that
Chesapeake's 2005 fourth quarter marked our 18th consecutive
quarter of sequential U.S. production growth and our 16th consecutive
year of production growth.
How did Chesapeake deliver top-tier organic growth in 2005? It
was a combination of anticipation, preparation and execution. We
correctly determined in 1998 and early 1999 the future would reward
companies that anticipated the impending U.S. natural gas production
shortfall. We then prepared for the opportunity by hiring hundreds
of the most talented landmen, geoscientists and engineers we could
find and by making acquisitions of producing properties, companies
and unproved leasehold.
Our consistent approach has enabled us to build a 7.8 tcfe gas-
focused reserve base (7.5 tcfe as of December 31, 2005) and a diverse
portfolio of more than 28,000 drillsites on 8.4 million net acres
onshore in the U.S. This represents more than a ten-year inventory
of future drilling and growth opportunities.
It is important to note that our growth has not come at the expense
of returns. In 2005 for example, we increased our reserves by 53%,
our operating cash flow by 73% and our earnings per fully diluted
share by 64%. In addition, our return on average common equity
during the year was 25%. The market applauded those achievements
and during 2005 our stock price increased by 92%, bringing our
total return to shareholders since our IPO in 1993 to nearly 2,300%,
or a compound annual stock price increase of 28%. We believe that
is the second best performance in the industry during the past
13 years.
Looking forward, Chesapeake's remarkable record of growth
should continue into 2006 and beyond. We plan to organically grow
our production and proved reserves by 10% this year, and if the past
is any indication, acquisitions are likely to add at least another 15%
to our production growth. Although acquisitions are difficult to forecast,
our track record as a value-added regional consolidator and our ability
to secure solid returns through hedging would suggest there will
be ample opportunities to make further accretive acquisitions
to complement the $1 billion of acquisitions we have made to date
in 2006.

VALUE I would next like to discuss the tremendous value
that we believe is embedded in Chesapeake's stock. Using year-end
2005 NYMEX prices of $10.08 per mmbtu of gas and $61.11 per bbl
of oil, Chesapeake's proved reserves have a PV-10 value of $23
billion. In addition, we have 8.4 million net acres of leasehold on
which we have identified 28,000 locations that we believe contain
unproved reserves of 8.8 tcfe. We believe these are worth somewhere
between $5 and $10 billion. Furthermore, we believe our non-E&P
assets have a value of nearly $2 billion.
Therefore using year-end oil and natural gas price assumptions,
the asset value Chesapeake has built for investors equals $30-35
billion. When debt and other liabilities of about $7 billion are subtracted,
the remaining shareholder value is $23-28 billion, or $50-60 per fully
diluted share. Over the years, our stock price has generally moved in
tandem with the net asset value (NAV) we create, so I have full
confidence in the market's ability to keep up with the company's
steadily increasing NAV per share.
No discussion about value would be complete without the topic
of risk mitigation. My job, and the job of our senior management
team, is to create and deliver the highest risk-adjusted returns possible
to our investors. I often believe that many investors do not fully
appreciate how much risk there is in this industry and how well we
manage it at Chesapeake. For example, in 2006 when natural gas
prices are widely expected to decline to below $6 per mmbtu by late
summer because of this past winter's record warmth, we have hedged
71% of our 2006 natural gas production at $9.43 per mmbtu, 36%
of our 2007 natural gas production at $9.85 per mmbtu and 22% of
our 2008 natural gas production at $9.10 per mmbtu (excluding
CNR hedges).
Additionally, we are the only E&P company that has significantly
hedged its exposure to rising service costs by building drilling rigs
and investing in related service industry providers. To date, these
investments have appreciated in value by roughly $250 million. We
now own 32 rigs outright and have an additional 25 on order, which
should account for approximately 60% of the rigs we plan to operate
a year from now. Rig ownership is proving to be an extremely valuable
competitive advantage in both acquisitions and in operations.
Moreover, in a time of increasing geopolitical unrest around the
world, the prospect of asset loss in many areas of the world to arbitrary
tax and royalty changes or even outright contract cancellation by
foreign governments is a serious concern faced by all major integrated
oil companies and many large independent E&P companies. Except
for occasional chatter about a windfall profits tax in the U.S.,
Chesapeake's assets are safe from such political risks.
I also emphasize that Chesapeake's assets are all high and dry
onshore in the U.S. In a time of what appears to be a cycle of greater
hurricane activity in the Gulf of Mexico, many investors may not fully
appreciate the very high risks that Gulf of Mexico operators and
investors may face in hurricane seasons to come.
Not having access to rigs to develop our assets or owning assets
subject to confiscation by some foreign potentate or suffering damage
from hurricanes are risks to which we have no exposure. That is why,
dollar for dollar, we believe investors can achieve the very best risk-
adjusted returns in the industry right here at CHK.

OPPORTUNITY Now let's talk about opportunity. Much
earlier than most companies, in fact as far back as 1998 and 1999,
Chesapeake's management team anticipated changing industry
conditions and quickly recognized the trends that have driven
remarkable increases in oil and natural gas prices during the past
eight years. We also recognized the need to develop the building
blocks of future value creation in the E&P business – people, land
and science.
During the past eight years we have aggressively captured
opportunities in each of these critical areas. For example, before
talented people became scarce in this industry, we were hiring them
by the hundreds. Before prospects and leases became scarce, we
built a system of prospect generation and leasehold acquisition that
is second to none in the industry. And finally, when others were
reluctant to invest in science and new ideas, we aggressively entered
into virtually every major natural gas resource play in the U.S. east
of the Rockies.
Chesapeake has significantly strengthened its technical capabilities
during the past eight years by dramatically increasing its land,
geoscience and engineering staff to more than 600 employees. In
total, the company now has more than 3,500 employees, of which
approximately 70% work in the company's E&P operations and 30%
work in the company's oilfield service operations. These people are
a highly valued (and much coveted) resource and we are proud they
have chosen Chesapeake as their professional home.
During the past eight years, we have invested more than $3 billion
in new leasehold and 3-D seismic data and now own the largest
inventories in the U.S. of onshore leasehold (8.4 million net acres)
and 3-D seismic data (11.6 million acres). As a result, we believe
Chesapeake has unparalleled opportunities for future value creation.