A noted Midcontinent gas consolidator, Chesapeake Energy Corp. had been looking at expansion into the Appalachian Basin since 2002. At the time, Columbia Natural Resources LLC was an attractive target for a friendly bid. But CNR's owner, utility company Nisource Inc., had signed a large forward-sales contract for CNR's production. "We would have had to produce gas for three years with no revenue, and for any public E&P company trying to explain the numbers, it would have been almost impossible," says Aubrey McClendon, Chesapeake chief executive. Meanwhile, former CNR managers-Henry Harmon, Dick Beardsley and others-who had left the company upon Nisource's hostile takeover of it in 2000, had formed Triana Energy Holdings LLC in 2001 with private-equity funding from Morgan Stanley Capital Partners that was later spun out as Metalmark Capital LLC. "Most of us had been there when we started CNR in 1985," Harmon, Triana president and chief executive, says. Upon Nisource's takeover of Columbia Energy Group, it stated that it would sell the E&P part of the business, so Harmon and team waited. Eventually, Nisource did put the business unit for sale, and Triana was there at the head of the line. "I knew we could do some pretty special things there," Harmon says. "First, we reorganized the drilling program and were able to add about 200 billion cubic feet equivalent (Bcfe) to proved reserves as we paid down about 90% of the forward-sale overhang." The same forward-sales contract, involving some 90 Bcf of gas, that kept buyers of CNR other than Triana away, had also burdened Nisource. "We were able to work through that, supported by knowledgeable debt and private equity financial partners," Harmon says. But by mid-year 2005, Harmon and team had fulfilled most of the contract and were looking either to tap public capital sources or exit. "We were looking at the public capital market as one outlet," he says. Meanwhile, the company was receiving buy-out offers. "Those got to be numerous, so we ran two tracks-an IPO or an exit-to see what played out the greatest value. At that point, we opened a data room." McClendon and team had been in touch with CNR management through the years. Chesapeake liked the Appalachian Basin's long and prolific history of gas production, and the size-three times Oklahoma-thus offering expansion opportunities, McClendon says. "Second, we saw a fair number of similarities to Oklahoma. The age of rock is about the same," he adds. Also larger companies had been withdrawing from Appalachia for decades. "We saw an unconsolidated basin-a handful of large companies and then lots of smaller companies." Chesapeake also liked the basin's remaining exploration potential. "We thought there was a chance, armed with the kind of exploration capabilities we have, to find some more gas there." A bonus: Appalachian gas sells for a premium of up to 50 cents per million Btu to the Nymex price. And, the gas has a high energy content. Together, these mean Chesapeake's new Appalachian production is receiving $2 to $3 per thousand cubic feet (Mcf) more than western U.S. gas. Among Appalachian targets, CNR was particularly attractive, and McClendon was ready last year with a strong bid. "Columbia was available and had scale. We've entered other basins by putting together a series of small acquisitions. Our study of Appalachia convinced us we needed to be there in size." Chesapeake's offer was valued at some $2.95 billion, consisting of $2.2 billion in cash and a $750-million balance on the underwater gas hedges and the forward-sales contract. For that, it gained some 2.5 trillion cubic feet of gas equivalent (Tcfe) of proved, probable and possible reserves, of which 1.1 Tcfe are proved, in West Virginia, Kentucky, Ohio, Pennsylvania and New York. The sales contract was finally fulfilled in February. Production upon Harmon and team's exit was some 125 million equivalent per day. The proved reserves-to-production index is 23 years. The assets come with more than 1,300 proved undeveloped locations, more than 6,000 probable and more than 1,800 possible, or nearly 10,000 potential drilling sites altogether. Chesapeake estimates the drilling inventory is more than 15 years. The purchase put Chesapeake at 7.5 Tcfe of proved reserves and 16.3 Tcfe of proved, probable and possible (92% gas; 100% onshore), and land-holdings grew to 8.8 million net acres. Straight up, the purchase price was $2.68 per proved Mcfe. After allocating $175 million of the deal value to midstream assets and $500 million to unevaluated leasehold, Chesapeake reports a price of $2.20 per proved Mcfe. It adds that it estimates its all-in cost of acquiring and developing the 2.5 Tcfe of total reserves will be about $2.79 per Mcfe. Chesapeake locked in some of the deal economics, hedging some 100 Bcf at an average price of $10.76 per million Btu. McClendon says the average is higher that what was used in developing the bid. Triana and Metalmark fared exceptionally well in the transaction. Triana had purchased CNR in 2003 for only $330 million plus assumption of the forward-sales contracts. The return on investment, on a gross basis, was nearly 8 to 1, says John Moon, Metalmark managing director. But the run-up wasn't just from improved commodity prices, he adds. Harmon and team put a great deal of work into CNR. "This is an asset that, when Triana acquired it, was clearly undermanaged. While some of the value there was created by improving prices, you don't create 8-1 type of value simply through movements in commodity price. In fact, much of our price exposure was hedged." The forward-sales contract was a hurdle CNR management overcame. "Columbia had the liability to deliver gas on a schedule," Moon says. "These guys did a tremendous job of managing it through a very sensitive time in the company's history-and created value. This story is as much about management and sound operations as it is about an asset that was well bought and well sold." One producer active in U.S. M&A, including in the Appalachian Basin, says, "Chesapeake's purchase of Triana/CNR was the most impactful deal of 2005. It has changed Chesapeake in many ways, and it has changed the Appalachian Basin." Another says Chesapeake's entry into the basin follows the format of its 2004 purchase of North Louisiana operator Greystone Petroleum LLC. "Chesapeake can expand in these two previously noncore areas using these companies as their 'consultants.' Both appear to be win-win solutions." Harmon saw much more potential from CNR but it was time to exit. "The private-equity role had pretty well run its course, and there was no need for the company to be capital-restrained going forward," he says. "Chesapeake wanted to invest. Meanwhile, Columbia had nearly 4 million acres and it needed a lot of capital. To put it in Chesapeake's hands was the right decision. After 25 years with the company, I'm fine with stepping away." Chesapeake, meanwhile, is just getting its feet wet there. "We have 3.5 million acres in the basin now," McClendon says, "and the third-largest gas-production position. We want to enhance that with bolt-on strategic acquisitions, but for now we're getting our new team in place, getting our hands around all the play types, and of course, local rules and customs." The basin has very few horizontal wells or wells drilled below 15,000 feet, and few wells have been cored, "leaving a great opportunity for Chesapeake to apply new scientific approaches to gas development in the region." Harmon speaks well of Metalmark's involvement in Triana, which continues and is being rebuilt. "Their knowledge of our industry was outstanding. And, they were confident investors. They didn't react to short-run cycles in the business. They allowed us to take some important, measured risks, and they didn't interfere with the day-to-day operations. We leave CNR, and everyone is still smiling at one another." Harmon and team will continue to be active in the Appalachian Basin, he adds. "Appalachia is a place that has never been fully appreciated, and it's right here close to these northeastern markets. There's a lot of running room left, and we have as much energy for this as we've ever had. Appalachia is the most developed, least explored basin in the U.S." Less than 1% of the 400,000 Appalachian wells drilled to date have been deeper than 7,500 feet. And, Metalmark is ready to back Triana again. "If you like unconventional resources, you've got to love Appalachia," Moon says. "The gas is richer, and the infrastructure is there. It feeds into attractive eastern markets that pay up for gas, and up until recently, the competition had been limited to utilities and mom-and-pop operators. We certainly wish Chesapeake well. There's plenty of room for everybody in Appalachia." McClendon disagrees. "We're hoping everyone continues to stay away from Appalachia," he quips. "All of Houston should continue to focus on the Rockies." The Rockies are over-romanticized, he adds. "I don't like to be in areas that are long gas and short pipe. That leads to a lot of gas-on-gas competition, expanded differentials and lower returns on investment." Moon wasn't surprised Chesapeake was the winning bidder. "Aubrey is well-known in the industry for his foresight, and I think this will prove to be yet another feather in his already-full cap. He is somebody who clearly gets the value of the Appalachian Basin." While Appalachia seems to be a detour for Chesapeake, it's not, McClendon says. "Our strategy is a very conscious one that has avoided what we don't know how to do, which is explore for gas offshore and overseas and in areas that have a lot of risk, particularly misunderstood or misappreciated risk. Our strategy is really not very exciting-we're just simple people doing simple things, all the while trying to make the best risk-adjusted returns we can for our investors. For us the focus will remain onshore in the U.S., east of the Rockies."