After reading over Chesapeake’s annual report, I bought some more shares the other day and thought I would highlight some passages here.  In particular, I was intrigued by the CEO’s discussion of their business strategy and the value/risk inherent in the CHK stock.  Don't forget, the CEO truly believes in what he says because he continues to gobble up millions of dollars worth of shares.  The following is a long read, but well worth it.



Business Strategy:

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 technology.

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.

Stock - Value and Risk:
 

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-104 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 riskadjusted returns in the industry right here at CHK.