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Chesapeake Energy: Non-Stop Drilling

This report reflects the research and analysis I've performed on this company. It is provided for informational purposes only and does not constitute personalized financial advice nor an endorsement or solicitation to purchase stock in this or any other company. Please do your own due diligence or hire a financial advisor before making any investment decisions.

From an operational standpoint, Chesapeake's performance this quarter was simply outstanding. For the third largest producer of natural gas to grow both production and reserves at such a rapid pace from a large size is truly noteworthy. The company's current risked potential to proved reserves ratio is 2.1 so there's ample room to run. Perhaps the amazing thing about this is how much room there is -- the company is squatting on 380,000 acres in the Deep Bossier play where Encana has found a monster well and paid $2.5B to acquire 55,000 additional acres. If Chesapeake's land has anywhere near the same potential, this could be a big growth factor.

But this performance comes at a price. The company's debt load has shot up to nearly $11B. Their debt-to-equity is at 0.91 and total-liabities-to-equity is sitting at 1.49, which is a good bit higher from the beginning of the year. Interest expense was up 57% YOY and up 40% just from last quarter. The company reported $715M in EBIT and interest expense of $115B (16% of EBIT).

Management laid out their financing plan for the rest of the year going into early 2008. First, the company will complete their sales & leaseback program. The company also plans on monetizing some mature Appalachian assets by YE 2007 for ~$1.0B. Finally, management aims to monetize their midstream assets with a private MLP, targeting an additional ~$1.0B by Q1 2008. All in all, Chesapeake plans on monetizing $4B of assets by the end of 2009, which combined with increased operating cash flow from higher production and higher credit facilities, should cover their operating costs. The company doesn't project any additional debt increases nor raising equity and should be cash flow positive sometime within the next few years.

While the company's capital structure is a little more aggressive, I think management has a good handle on this tightrope they're walking. They have a good chunk of future production hedged at good levels so cash flow on that front is solid. If they can close on these monetization transactions and increase production and reserves going forward (and they will), everything should work out. If the going gets rough, the company has a lot of flexibility in the capex program to cut back. They've already shut in 3 bcfe of production in the quarter and could shut in more wells, cut staff, etc. if circumstances warrant. McClendon reiterated his point that natural gas supply is robust so management will have to keep on top of their capex to ensure they don't flood the market while maintaining high spending levels.

At this point, I wouldn't bet against McClendon and his team so I think our investment is sitting pretty. I also think that Deep Bossier position could be a real sleeper as well but that's just a hunch so take it for what it's worth. If there is a sharp pullback in upcoming months due to warm winter, oversupply, Mr. Market, etc., it may be a good time to open or add to a position.

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