Dear Fellow Shareholders,
2010 was a very important year of transition and achievement for Chesapeake, a year in which we initiated three very important strategic shifts: from asset gathering to asset harvesting, from focusing exclusively on natural gas to a balanced focus on natural gas and liquids and from having a leveraged balance sheet to one worthy of an investment grade rating.
2010 also marked a truly transformative year for our industry. We and a handful of our peers enhanced our capabilities to find and produce significant new resources of oil and natural gas liquids (collectively, “liquids”) in unconventional formations. Chesapeake and these other companies combined creativity, innovation and technology to reinvent the way that our industry explores for and produces natural gas and liquids.
Furthermore, 2010 was the year when global energy companies more fully recognized the importance of these developments and the tremendous opportunities that have emerged in the U.S. Through a wide variety of transactions, including several led by Chesapeake, the global energy industry made it clear that the assets owned by Chesapeake and some of its peers are the most attractive in the world. This realization has already increased the value of high-quality unconventional assets in the U.S. and, in time, should lead to higher stock prices for the leading U.S. onshore E&P companies, especially Chesapeake. Simply put, the global energy industry is beating a path to our door, and we are welcoming it with open arms.
Before we move ahead, I want to emphasize that even though 2010 was a year of transition and achievement, our stock price was essentially unchanged. Nevertheless, it was still a very strong year for the company operationally and financially. Here are the year’s highlights for your review:
- Average daily natural gas and oil production increased 14% from 2.5 billion cubic feet of natural gas equivalent (bcfe) in 2009 to 2.8 bcfe in 2010;
- Proved natural gas and oil reserves increased 20% in 2010, from 14.3 trillion cubic feet of natural gas equivalent (tcfe) to 17.1 tcfe;
- Reserve replacement for 2010 reached 375% at a drilling, completion and net acquisition cost of only $0.76 per thousand cubic feet of natural gas equivalent (mcfe)(1);
- Realized hedging gains were $2.1 billion;
- Revenues increased 22% to $9.4 billion;
- Adjusted ebitda(2) increased 15% to $5.1 billion;
- Operating cash flow(2) increased 5% to $4.5 billion; and
- Adjusted earnings per fully diluted share(2) increased 16% to $2.95.
STRONG PARTNERS
Over the past few years, in addition to gathering the industry’s best assets, Chesapeake has also built the industry’s finest collection of global energy partners and energy stock investors. We have now entered into transactions with PXP, BP, Statoil, Total, CNOOC and BHP Billiton. Collectively, we have sold these companies certain assets for total consideration of $20.5 billion in the form of cash and drilling and completion carries for which our net cost was only $6.1 billion resulting in overall value creation of $14.4 billion. While these transactions have been very rewarding to our buyers, they have been truly outstanding for Chesapeake, providing us an attractive source of capital, a reduction of risk, a quick recovery of our leasehold investment in new plays and a much greater ability to capture a large resource base with decades of highly profitable drilling opportunities.
In addition, we are the only U.S. E&P company that has attracted to its stock ownership roster some of the world’s leading government-sponsored investors: Temasek Holdings (Singapore), China Investment Corporation, Korea Investment Corporation and Abu Dhabi Investment Authority. Along with our largest shareholder, Memphis, Tennessee-based Southeastern Asset Management (12%), these shareholders are some of the world’s largest and most astute investors, and who also happen to manage some of the world’s largest pools of capital and have a very long-term investment horizon. Their support is an important validation of our strategy.
SHORT-TERM PAIN FOR LONG-TERM GAIN
Despite this all-star lineup of global partners and investors, some other investors have not yet fully recognized the benefits of our industry leadership in acquiring unconventional natural gas and liquids assets. Whether it was our leveraged balance sheet during recent tough recessionary times, our heavy focus on natural gas during a time of persistent market pessimism about natural gas prices or our large capital investments in undeveloped liquids-rich leasehold undertaken to enable Chesapeake to remain an industry leader in the years ahead, it is clear that we were less popular in the stock market in 2010 than we were in 2009, when our stock price increased by 60%.
We anticipated that some market unpopularity in 2010 would likely be the price we would pay as we positioned Chesapeake to be the leader not only in unconventional U.S. natural gas, but also in unconventional U.S. liquids. However, now that we have largely completed the investments needed to accomplish this transition to a portfolio balanced with liquids, the rebound in our stock price could be sharp as investors begin to focus more clearly on Chesapeake’s three-way transition from an asset gatherer to an asset harvester, from less natural gas exposure to more liquids exposure and from a leveraged balance sheet to one worthy of an investment grade rating.
Accordingly, in early January 2011, we announced our “25/25 Plan,” a two-year plan designed to reduce our long-term debt by 25% while still growing the company’s production by 25%. We designed this plan to articulate very clearly the benefits of becoming an asset harvester vs. an asset gatherer — namely, lower debt and higher returns on capital. The market has received this plan with favor to date as our stock price is already up 30% in the first quarter of 2011. In addition, having recently closed the sale of our Fayetteville Shale assets to BHP Billiton and recently initiated tender offers for repayment of at least $2.0 billion of our long-term debt, we are already close to accomplishing the 25% long-term debt reduction portion of our 25/25 Plan. Now we will focus on delivering the other part of the equation, 25% growth in production by year-end 2012.
Beyond the next two years, there will be many other benefits of the three-way transition we began in 2010. In fact, we are increasingly confident that we can double our cash flow and net income by year-end 2015. By accomplishing these goals and also having our historic trading multiples expand a bit, we are hopeful that we can achieve a $100 stock price by year-end 2015, perhaps creating the need for a “100/15” plan in the process! Clearly it would be an ambitious goal, and to achieve it we will need the world’s economy to continue growing, China and other emerging economies to continue their rapidly growing thirst for oil and natural gas, our new plays to meet expectations, oil prices to remain strong and natural gas prices not to weaken from where they are today.
However, Chesapeake’s growth from here on will be very mechanical with our “factories” (meaning both our individual wells and our large plays) needing only four inputs for success: land, science, people and capital. We now have gathered enough of these four inputs so that our factories can run in harvest mode for decades to come, which hopefully can lead to a $100 stock price by year-end 2015. Again, this would be a very considerable achievement, but your management team enjoys big challenges and we look forward to discussing it further with you in the quarters ahead.
GREAT ASSETS = A GREAT FUTURE
The very significant upward trajectory of value creation that Chesapeake is on today is primarily driven by the quality of our assets, which feature dominant positions in 16 of the 20 most important major unconventional natural gas and liquids plays in the U.S. — the Barnett, Haynesville, Bossier, Marcellus, Eagle Ford, Pearsall, Niobrara and Utica shales and the Granite Wash, Cleveland, Tonkawa, Mississippian, Bone Spring, Avalon, Wolfcamp and Wolfberry tight sands and fractured carbonates. Having only missed the Bakken Shale play in the Williston Basin, having passed on the Cana Shale play in Oklahoma and having sold out of the Woodford and Fayetteville shale plays in Oklahoma and Arkansas (for overall value creation of $5.4 billion), Chesapeake’s unrivaled position in the 16 other major U.S. unconventional plays is remarkable and unprecedented and should form the foundation of further substantial value creation for Chesapeake’s shareholders for decades to come.
The gathering of these assets has been hard work for our employees and management team, and during 2010 it stretched our balance sheet and tested the patience of some of our shareholders. What is clear now, however, is that we have created a tremendous storehouse of value and an abundance of opportunities for bountiful harvests for years to come for our shareholders.
Given the importance of these 16 unconventional plays, I have provided below a brief summary of our position in each of them:
Barnett Shale — Discovered in the 1990s, the Barnett is the granddaddy of all U.S. shale plays. Chesapeake acquired its first assets in the Barnett in 2001, and in 2005 we began aggressively leasing in the core of the play in Johnson and Tarrant counties. Today we own approximately 220,000 net leasehold acres, on which we estimate we could drill up to 2,300 future net wells in addition to our 965 net wells currently producing. We are currently using 18 rigs to develop this inventory of drillsites and our gross operated production in the Barnett recently set a record of more than 1.3 bcfe per day.
Our most important development in the Barnett Shale during 2010 was closing the joint venture agreement on 25% of our assets in the Barnett to Paris-based Total, the fifth-largest oil company in the world. Total paid $2.25 billion in cash and drilling carries for its 25% stake in the Barnett, and we are extremely proud to have Total as one of our premier joint venture partners.
Haynesville Shale — The Haynesville Shale in Northwest Louisiana and East Texas is the shale play of which we are most proud (to date) because it was discovered by Chesapeake’s own geoscientists and engineers. We conducted our geoscientific investigation of the Haynesville in 2005–06 and tested our theories through drilling in 2007. In 2008 we formed an innovative joint venture agreement with our well-respected industry partner, Houston-based Plains Exploration & Production Company, to which we sold 20% of our Haynesville (and Bossier) assets for approximately $3.2 billion in cash and drilling carries.
The Haynesville Shale is now the nation’s largest producing natural gas shale play, having just recently passed the Barnett Shale in production (in last year’s letter, I incorrectly estimated it would take until 2014 for the Haynesville to reach this achievement, a testament to the play’s enormous productive potential). Ultimate recoveries from the Haynesville could exceed 250 tcfe, likely making it one of the five largest natural gas fields in the world. Today, we are producing from more than 260 net wells in the Haynesville on our 530,000 net leasehold acres, are currently drilling with 35 rigs and estimate we could drill up to 6,300 additional net wells in the years ahead. Our gross operated production in the Haynesville recently set a record of nearly 1.6 bcfe per day.
Bossier Shale — This shale overlies about one-third of our Haynesville acreage and is the first of our two “sleeper” natural gas shale plays. The reason is that in Louisiana, leases often restrict the lessee (i.e., the producer) to only holding future drilling rights down through the deepest formation drilled. Because the Bossier lies above the Haynesville, horizontal wells drilled just to the Bossier may not always hold Haynesville rights. Therefore, Chesapeake and other producers have been drilling aggressively to hold all rights through the Haynesville before the initial three-year term of a typical lease expires. As a result, there has not been much drilling to the Bossier to date. However, once our leases are held by production (HBP) by Haynesville drilling (we expect to be largely complete with HBP drilling by year-end 2011 and completely finished by year-end 2012), we will begin developing the Bossier Shale more aggressively in 2013. In the Bossier play, we own 205,000 net leasehold acres and estimate we could drill up to 2,600 net wells in the years ahead.
Marcellus Shale — We first became aware of the Marcellus in 2005 when we were negotiating our $2.2 billion acquisition of Appalachia’s second-largest natural gas producer, Columbia Natural Resources, LLC. In 2007 we aggressively accelerated our Marcellus leasehold acquisition efforts and began to prepare for our first drilling activities. By early 2008, we had determined the Marcellus could be prospective over an area of approximately 15 million net acres (approximately five times larger than the prospective Haynesville core area and 10 times larger than the Barnett core area).
After acquiring 1.8 million net leasehold acres, we entered into a joint venture agreement in late 2008 with Oslo-based Statoil, one of the largest and most respected European energy companies. In this transaction, we sold Statoil 32.5% of our Marcellus assets for $3.375 billion in cash and drilling carries. Today, having sold 32.5% of our original 1.8 million net leasehold acres, we have returned to owning 1.7 million net leasehold acres in the play and are the industry’s leading leasehold owner, largest producer and most active developer. We are producing from more than 100 net wells in the Marcellus on our 1.7 million net acres, are currently drilling with 32 rigs and estimate we could drill up to 21,000 additional net wells in the years ahead.
Colony and Texas Panhandle Granite Wash — These liquids-rich plays generate the company’s highest returns (routinely more than 100%) and provided the inspiration for the company to find other liquids-rich plays in 2010. The Granite Wash, and other plays with liquids-rich gas production streams, provide the strongest economics in the industry today because they possess the best of both worlds: high-volume natural gas production along with significant volumes of highly valued liquids that dramatically increase investment returns.
We are producing from approximately 150 net Granite Wash wells, are currently drilling with 16 rigs and estimate we could drill up to 1,700 additional net wells on our 215,000 net leasehold acres in the years ahead. Based on current NYMEX futures prices for natural gas and oil, each Granite Wash well should generate approximately $11.5 million of present value (or up to an undiscounted total of $19.5 billion for all 1,700 wells), making it obvious why finding, leasing and developing more unconventional liquids-rich plays was Chesapeake’s number one priority for 2010. We were very successful with these new play efforts, the most notable of which are described in the sections below.
Eagle Ford Shale — This South Texas shale is distinctive from the other shale plays described above because it has three components: an oil play, a wet natural gas play and a dry natural gas play. During 2009–10, Chesapeake acquired approximately 600,000 Eagle Ford net leasehold acres, all of which were in the liquids-rich portions of the play. Our initial wells were very successful, and in late 2010 we sold 33.3% of our assets in the play to Beijing-based Chinese National Offshore Oil Company (CNOOC) for $2.2 billion in cash and drilling carries. This was CNOOC’s first investment in the U.S. onshore E&P industry, and we are proud that it chose Chesapeake as its first U.S. onshore partner. We are currently drilling with 16 rigs in this play and expect to accelerate our drilling to 40 rigs by year-end 2013. We believe our 470,000 net leasehold acre position could support the drilling of up to 5,500 additional net wells in the years ahead.
Pearsall Shale — This shale underlies most of our Eagle Ford acreage and is the second “sleeper” of our natural gas shale plays. We have two rigs dedicated to testing this formation, and our first few wells have significantly exceeded our expectations. This formation is found about 3,000–4,000 feet deeper than the Eagle Ford and so for the play to become competitive with our other natural gas shale plays, we will need natural gas prices to strengthen from where they are today. We believe this will likely occur in 2013 at the latest. We believe our 350,000 net acre Pearsall leasehold position could support the drilling of up to 3,000 additional net wells.
Niobrara Shale — The Niobrara is a two-basin play, covering substantial portions of both the Powder River Basin of east-central Wyoming and the DJ Basin of southeastern Wyoming and northeastern Colorado. During 2008–10, Chesapeake acquired approximately 800,000 net leasehold acres in these two liquids-rich basins, and in early 2011 we sold 33.3% of our assets in the play to CNOOC for approximately $1.3 billion in cash and drilling carries. This was CNOOC’s second investment with Chesapeake and its second investment in the U.S. onshore E&P industry. We are currently drilling with five rigs in this play and expect to accelerate our drilling to 15 rigs by year-end 2013. We believe our leasehold position could support the drilling of up to 7,600 additional net wells.
Cleveland, Tonkawa and Mississippian Plays — These three liquids-rich plays of the Anadarko Basin should become significant contributors to our growth in the years ahead. The Cleveland and Tonkawa plays are tight sandstones located in western Oklahoma and the eastern Texas Panhandle, and they provide returns that are some of the very best in the company. We have acquired approximately 600,000 net leasehold acres prospective for these plays and have drilled 75 net wells to date. We are currently using eight rigs and believe our leasehold could support the drilling of up to an additional 3,700 net wells.
The Mississippian fractured carbonate is primarily an oil play and is located on the Anadarko Basin shelf of northern Oklahoma and southern Kansas. We have acquired approximately 900,000 net leasehold acres prospective for this play and have drilled 40 net wells to date. We are currently using four rigs and believe our leasehold could support the drilling of up to an additional 6,000 net wells. This is an area where we anticipate bringing in a joint venture partner later in 2011 or in early 2012.
Bone Spring, Avalon, Wolfcamp and Wolfberry Plays — These four liquids-rich plays of the Permian Basin should also become significant contributors to our growth in the years ahead. To date, we have acquired approximately 560,000 net leasehold acres that we believe are prospective for these plays and have drilled 155 net wells. We are currently using eight rigs and believe our leasehold could support the drilling of up to an additional 4,400 net wells.
Utica Shale — Chesapeake has high hopes for this emerging shale play in eastern Ohio, especially because it would become the fourth large unconventional play (along with the Haynesville and Bossier shales and the Mississippian carbonate) that Chesapeake has discovered. In addition, we believe the play will have three distinct components (oil, wet natural gas and dry natural gas), similar to the components of the Eagle Ford Shale. We have made a large commitment to this play and have acquired approximately 1.2 million net leasehold acres and expect to increase this total to as much as 1.5 million net leasehold acres in the coming months. We are currently using three rigs to evaluate the play and believe our leasehold could support the drilling of up to 12,000 net wells. This is an area where we anticipate bringing in a joint venture partner late in 2011 or early in 2012.
OUR PEOPLE
Great assets cannot exist without great people, so we take great pride in hiring, training, motivating, rewarding and retaining what we regard as the best employees in the industry. From our beginning 22 years ago with 10 employees in Oklahoma City to employing more than 10,000 people across 15 states today, Chesapeake has always focused on building first-class human resources within a distinctive corporate culture. Talk to Chesapeake employees and you will note genuine pride and great enthusiasm about the company and the critical role that we play in delivering increasing quantities of clean and affordable American natural gas and valuable and reliable liquids to energy consumers across the country.
Chesapeake employees are distinctive in other ways as well. They are much younger than the industry average, with half of our almost 4,000 Oklahoma City-based headquarters employees 33 years old or younger. Their enthusiasm and willingness to learn create an atmosphere of vitality and energy at Chesapeake, important ingredients of our distinctive culture. These attributes, along with a vibrant and attractive corporate headquarters campus, low levels of bureaucracy, great assets and a well-executed corporate strategy combine to create our culture of success and innovation.
This has generated extremely positive external feedback as Chesapeake was recently recognized for the fourth consecutive year as one of the FORTUNE 100 Best Companies to Work For®(3) in the U.S. In fact, we moved up to #32 overall and #1 in our industry — we are very proud of having created and sustained what is now considered the best place to work in all of the U.S. energy production industry.
In addition, we were honored in December 2010 at the 12th Annual Platts Global Energy Awards as finalists for CEO of the Year, Community Development Program of the Year, Deal of the Year, Energy Producer of the Year and the Industry Leadership Award. Chesapeake was one of only two companies selected as a finalist in five or more categories. The company was also honored in 2010 with a Certificate of Recognition for our military reserve recruiting efforts, named a 2010 Best Diversity Company by Engineering & Information Technology Magazine and recognized for Best Investor Relations in Energy Sector and Best Investor Relations Website at the 2010 IR Magazine U.S. Awards.
RECENT EVENTS AND A BETTER WAY FORWARD
You may be aware that I have been outspoken in attempting to persuade our country’s political leadership to recognize that the discovery of vast resources of unconventional natural gas and oil in the U.S. is a complete game changer for our country from an economic, national security and environmental perspective. After two years of my best efforts and the efforts of many others in the industry, most notably T. Boone Pickens, I am pleased to report that we have apparently finally convinced President Barack Obama and Congressional leadership to recognize that the energy path America is on today is completely unsustainable. There appears to be growing recognition that it is spectacularly dangerous for America to continue importing 9 million barrels of oil per day and exporting more than $1 billion per day in national wealth to oil exporting countries.
America’s undiminished appetite for foreign oil has created the largest wealth transfer in the history of the world. The political leadership in Washington, D.C., has not seemed overly concerned about this issue until recently. However, after President Obama’s recent speech calling for a new energy future with greater natural gas usage and increased domestic oil production as two of its primary attributes, it is encouraging to see our political leadership finally grasp that natural gas stands alone as the only affordable, scalable and immediately available alternative to foreign oil and that U.S. oil production can be increased significantly in the years ahead.
The events of the past few months have unmistakably driven home the fact that it is insanity to rely on the Middle East to provide our economy’s lifeline of oil. This should be especially obvious when one realizes that during the next 10 years, America will likely export at least another $4 trillion in national wealth to oil exporters around the world. Clearly, our country must demand from its leaders a new and more sustainable energy future.
The good news, however, is that America can now secure a new energy future thanks to Chesapeake and a handful of other leading U.S. E&P companies that have reinvented the process of finding natural gas and oil during the past five years. In doing so, we have discovered twice the resources of natural gas in the U.S. that Saudi Arabia possesses in oil. Furthermore, these same few companies that led the unconventional natural gas revolution have in just the past two years also reinvented the way in which we can find large new oil resources onshore in the U.S. In fact, I believe the U.S. can possibly increase its production of oil from the current 5.8 million barrels per day by 30–50% during the next 5–10 years, thereby potentially reaching the President’s 2025 goal of reducing foreign oil imports by 33%, 5–10 years earlier than hoped.
The combination of these vast new discoveries of unconventional natural gas and liquids provides America with a unique future pathway toward greater energy independence, an industrial renaissance, economic rejuvenation and greater national security. I remain fully confident that the marketplace understands this and that over time the U.S. will more fully embrace and utilize clean, affordable, abundant American natural gas and increased domestic oil production as the best alternatives to burning environmentally challenged coal and expensive and dangerous foreign oil.
There is now a clear road ahead toward a more sustainable, affordable, dynamic and independent future if America embraces the remarkable gift of energy abundance that Chesapeake has helped discover in the U.S. You have my commitment, and the commitment of more than 10,000 other Chesapeake employees, that every day we are working hard to create shareholder value and a better future for our communities, our states and our country through the continued discovery and development of unconventional natural gas and liquids.
Best regards,
Aubrey K. McClendon
Chairman and Chief Executive Officer
April 15, 2011
(1) Reserve replacement is calculated by dividing net reserve additions from all sources by actual production for the corresponding period. We calculate drilling and net acquisition cost per mcfe by dividing total drilling and net proved property acquisition costs incurred during the year (excludes certain costs primarily related to net unproved property acquisitions, geological and geophysical costs and deferred taxes related to corporate acquisitions) by total proved reserve additions excluding price-related revisions.
(2) A non-GAAP financial measure, as defined below. Please refer to the Investors section of our website at www.chk.com for reconciliations of non-GAAP financial measures to comparable financial measures calculated in accordance with generally accepted accounting principles.
• Adjusted ebitda is net income (loss) before interest expense, income tax expense (benefit), and depreciation, depletion and amortization expense, as adjusted to remove the effects of certain items that management believes affect the comparability of operating results.
• Operating cash flow is cash provided by operating activities before changes in assets and liabilities.
• Adjusted earnings per fully diluted share is net income (loss) per share available to Chesapeake common stockholders, assuming dilution, as adjusted to remove the effects of certain items that management believes affect the comparability of operating results.
(3) FORTUNE 100 Best Companies to Work For® listed in the magazine’s February 7, 2011 issue.