Falling Prices Prompt Chesapeake to Shut In 125-150 MMcf/d of Production

With October futures plummeting to a daily low of $4.07 on expiration day Wednesday while December futures remained just over $7, Oklahoma City-based Chesapeake Energy decided it was a pretty good time to announce the shut in of 125-150 MMcf/d, which represents the bulk of the third largest independent producer's remaining unhedged production.

Effective on Oct 1, the company plans to temporarily shut-in a net 100 MMcf/d of production in various areas of operation in the southwestern United States until natural gas prices "recover from recently depressed levels." Chesapeake would not say at what price threshold that supply would be returned to production. The company's current oil and natural gas production totals more than 1,600 MMcfe/d (91% natural gas), so the shut-in amount represents only about 6% of its net production.

"Today's announcement highlights Chesapeake's proactive approach to revenue management," said CEO Aubrey K. McClendon. "Given that we believe today's low natural gas prices have more to do with temporarily high natural gas storage inventories largely caused by last winter's abnormally warm weather and less to do with any return to a structural oversupply of natural gas, Chesapeake has elected to shut-in some of our natural gas production.

"We will monitor market conditions and bring these unhedged natural gas production volumes back on stream as market conditions dictate. As a result, it is likely we will reduce Chesapeake's 2006 fourth quarter production forecast range when we release our 2006 third quarter results."

Chesapeake CFO Jeffery Mobley said although the company is unaware of any other producers that have been shutting in, "we wouldn't be surprised to see other operators doing the same thing. Hopefully if that is the case, we'll see gas prices start to recover somewhat. There's a big difference between October gas and December gas on the futures market. Apparently just a little bit too much is just enough to cause a $2-3 discount."

Analysts at Raymond James & Associates said last week if recent higher-than-average storage injections continue, "then U.S. producers would need to shut in about 10% of their production to rebalance the system over the next two months."

Working gas levels in storage already are near the 3.2 Tcf mark with about seven weeks left in the traditional storage injection season. On Sept. 15, there was 3,177 Bcf of working gas in storage, 12.5% more than the five-year average and 12.6% more than at the same time last year. The Energy Information Administration said in a report last week that its best estimate of total working gas capacity in the United States is 3,593 Bcf, which means working gas levels on Sept. 15 were about 88% of total capacity.

"...[I]t now appears that we will test the limits of U.S. gas storage capacity over the next eight weeks," said Raymond James analyst Marshall Adkins. "Given that we have limited storage capacity, the gas market is facing what most analysts call 'gas on gas' competition. This is the phenomenon where limited gas storage capacity forces producers to shut in production."

The Federal Energy Regulatory Commission (FERC) predicted such an outcome in May because the warm winter and demand destruction due to high prices left so much gas in storage entering the injection season. "As we go through the summer, we will fill storage. [There] will come a point where you can't put anymore in," said Steve Harvey of FERC's Office of Enforcement. "That may well create a summer condition where if there isn't any place to put extra gas...you actually have to start shutting it in."

The conditions that led to the recent price drop took a while to develop, but the first few mild weeks in September and the continuing weakness of the hurricane season seemed to be the "straw that broke the camel's back," consultant Stephen Smith of Stephen Smith Energy Associates said last week. He noted that the mild weather has started to reverse the trend that had taken place late in the summer when record heat took about 500 Bcf out of the gas storage surplus.

Chesapeake has been largely unaffected, however, because prices for the bulk of its production are already locked in. Through Aug. 31, the company has realized $740 million in cash gains from its gas hedges, McClendon said.

"As of [Tuesday's] market close, the mark-to-market gain on our remaining 2006 natural gas hedges was approximately $460 million." He said 92% of the company's production in the second half of this year is hedged at a Nymex futures price of $9.24/MMBtu, 80% of its 2007 gas production is hedged at $9.92/MMBtu and 60% of 2008 gas production is hedged at $9.44/MMBtu. "We currently have a mark-to-market gain of approximately $2.2 billion on our open natural gas hedges," McClendon said.

Copyright 2006 Intelligence Press Inc. All rights reserved. The preceding news report may not be republished or redistributed, in whole or in part, in any form, without prior written consent of Intelligence Press, Inc.


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