Back on June 30th I wrote a seemingly bearish post on how Chesapeake Energy (CHK: chart) was making a public offering to not only pay for a Barnett Shale acquisition, but also to pay off debt.  While I can tolerate issuing shares for asset acquisitions, the fact that they were using the offering to pay off debt really turned me off to the company.

Last Friday, Chesapeake held their conference call (conference call MP3) for the second quarter results and issued financial results for that quarter through a press release.

After listening to the conference call, it appears that the acquisitions for the company are over and they are shifting to manufacturing gas on those recent acquisitions.

Some highlights from the conference call and Q2 results:

• Net income of $0.82 per fully diluted share
• Increase in EPS of 64% year over year
• Production up for 20th consecutive quarter
• Chesapeake expects organic growth of 10% in 2007

Aubrey McClendon stated that production was up 26% in the second quarter year over year, and of that 26%, 55% was through acquisitions and 45% was through the drill bit.

On hedging, McClendon stated that:

“…we have taken virtually all commodity price risk out of the Chesapeake business model for the second half of 2006 and have significantly reduced such risk in 2007 and 2008.”

Chesapeake has hedged 91% of their gas in the second half of 2006 at $9.71/mcf, 72% hedged in 2007 at $9.88/mcf and 57% of the 2008 production hedged at $9.37/mcf.

On Chesapeake’s size, McClendon mentioned that:

“We are America’s 200th largest publicly traded company and yet we are one of the top 30 shorted stocks in America. I presume this is because we have the largest exposure in the industry to potentially lower gas prices.”

This is a very valid concern considering that 91% of Chesapeake’s production is natural gas.

While I like the aggressiveness of Chesapeake’s acquisitions and their position in the market, and am encouraged that they are moving from an acquisition mode to manufacturing mode, I still can’t help feel a little misguidance from the executives to issue shares to pay off debt.

In addition, Aubrey hit the nail on the head when he suggested they have the largest risk in the industry to lower gas prices.  While they hold very attractive hedge contracts through 2008, the biggest risk in the industry is supply capacity.

As the strategic reserves build, the pipeline pressures rise, requiring more compression to pump gas to market.

A continued build in supply could curtail production such that many gas wells be required to be shut in.  Evidently Chesapeake acknowledges this possibility through the following statement in their press release:

“Please note that the company’s production forecast for 2006 excludes any provision for possible production curtailments that the industry and Chesapeake may experience as a result of high pipeline pressures and/or early filling of U.S. natural gas storage facilities.”

McClendon also commented about this scenario in the conference call, stating they haven’t seen any pipeline pressures that would be cause for shutting in Chesapeake wells, but they are seeing pipeline pressure rise.

Naturally, the eyes of Chesapeake’s management will be on natural gas storage reports going into fall, but for the time being, it appears that the storage situation is still robust, and baring a strong hurricane season those supply numbers may force involuntary shut in of many wells.

As in many industries, timing is everything, and while Chesapeake has the most upside potential in the oil patch, they also possess the most risk.  Weather forecasts and electricity demand, hurricane activity and later on energy required through the winter will determine the success of their acquisition strategy.

Additional Resources
Chesapeake Website
Chesapeake Chart
Conference Call Download
Second Quarter Results Press Release
Natural Gas Inventory (EIA)

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