The demand for Chesapeake Energy's contingency convertible notes was so great that it upsized the offer by another $700 million, says Marc Rowland, executive vice president and chief financial officer.

On May 27, Oklahoma City-based Chesapeake Energy Corp.’s debt offering of senior notes and contingent convertible senior notes raised $2 billion, some $700 million more than expected, in one of the largest debt offerings of any independent E&P in the U.S. to date.

View Chesapeake's Financings Report.

The size of the offering came as no surprise to insiders, because raising the bar is what Chesapeake does. What’s more, it has regularly tapped capital markets as it has grown to become a producer of some 2 billion cubic feet of gas per day.

Chesapeake operates more drilling rigs than any other independent by a factor of two. During the first quarter, it drilled 478 gross (400 net) operated wells and participated in 422 gross (48 net) wells operated by others, with a success rate of 100%.

“We are currently operating 149 rigs, mostly tailor-made for our operations. The next most-active company is either running 68 or 69 rigs. No company has operated more than 125 since Exxon Corp. and Amoco Oil Co. in the mid-1980s, so it’s really an unprecedented level of drilling activity,” says Marc Rowland, executive vice president and chief financial officer of the $46-billion-enterprise-value E&P.

“We don’t believe anyone drills more shale wells or more horizontal wells or more deep wells than Chesapeake.”

To support this aggressive drilling program, and in light of higher per-well reserve-recovery expectations and decreasing per-well costs in its shale plays, the company plans to increase its capital expenditures for 2008 and 2009. This mega-debt-deal is one way to fund that capex through public markets.

The producer had planned to fund capex from cash flow, borrowings under its credit revolver, previously announced producing-property monetization and the sale of a minority interest in a private partnership of the company’s midstream assets.

Although a departure from its previously announced plans, Chesapeake now believes the potential incremental financial returns available from speeding up its capital spending will far exceed the expected capital costs.

The market appears to agree.

“We launched two separate traunches of debt,” Rowland says. “The original amounts were listed as $800 million and $500 million. The demand for these contingent convertible notes was so great that we decided, rather than coming back to the market again soon, we should take advantage of the strong demand and attractive pricing to upsize the offering.”

To answer the demand, Chesapeake offered $800 million of senior notes and $1.2 billion in contingent convertible notes at 2.25%. The latter are convertible into a combination of cash and common stock at an initial conversion price of about $85.89, equivalent to an initial conversion rate of some 11.6 common shares per $1,000 principal amount of convertible notes. The convertible notes will mature at the end of 2038 and are not redeemable by Chesapeake before December 15, 2018.

Chesapeake intends to use the proceeds, together with proceeds from its concurrent public offering of senior notes, for general corporate purposes, to fund the redemption of its 7.75% senior notes and pay down its revolving credit facility, thus providing substantial dry powder on its $3.5-billion revolver.

Banc of America Securities LLC, Barclays Capital, Credit Suisse, Goldman, Sachs & Co. and UBS Investment Bank were joint book-running managers for the convertible notes offering.

“We weren’t sure what the market demand would be for each of the notes,” says Rowland. “It was part of our marketing strategy to start with a smaller offer.”

So why the overwhelming market response? “The market clearly had great response to the offer, but there could be any number of reasons for that. I suspect there was a shortage of convertible paper like this in the market. I also suspect that, in general, demand for equity-like investor instruments, and this is partially equity-oriented, is strong,” he says.

In fact, Chesapeake itself has eliminated much of its convertible paper in the form of preferred stock since January 2007, so investors were anxious to get into that type of paper, says Rowland.

“All of the proceeds initially of $2.18 billion, including the greenshoe, went to repay our revolving credit facility. Then, simultaneously with pricing we originally planned in the offering memorandum, we issued a call notice for about $300 million of our 7.75% notes. So ultimately, when those come in sometime in July, we can use the revolving credit facility to pay those notes off,” he says.

In addition to the debt financing, Chesapeake plans to complete assets sales worth about $5 billion by 2010, a strategy based on timing and commodity prices. It already is in the process of selling all of its Oklahoma Woodford shale assets. Chesapeake expects to raise about $1.5 billion from that.

All these financial deals are meant to fund the company’s stepped-up drilling pace. “Commodity prices are hitting new levels every day,” says Rowland. “By drilling new acreage at an all-in cost of about $2.50, and selling the gas for as much as $8 per thousand cubic feet or more into either a volumetric production payment (VPP) structure or into a straight asset sale, and by reinvesting that money into developing the millions of acres we have remaining, we can make a lot of money for our investors.”

VPP

In late 2007, Chesapeake also sold $1.1 billion in gas rights via a VPP to affiliates of UBS AG and DB Energy Trading LLC, a subsidiary of Deutsche Bank AG.

Under the deal, these purchasers receive a steady stream of gas totaling 208 billion cubic feet equivalent (Bcfe) during the next 15 years from 4,000 wells in Appalachia. Chesapeake will continue to operate the wells and pay production costs and taxes. It retains the right to drill deeper in said wells to find additional gas, which it would control.

The company also completed a second VPP in early May 2008. It included long-lived assets in Texas, Oklahoma and Kansas with proved reserves of 94 Bcfe (less than 1% of its total proved reserves) and net production of 47 million cubic feet per day.

The price tag was $623 million ($6.63 per thousand cubic feet). Chesapeake will maintain drilling rights below current production intervals. Additional VPPs are likely toward the end of this year and in 2009. In total, the company intends to raise some $2 billion via VPPs.

Meanwhile, Chesapeake plans to remain predominately a gas producer. “We don’t plan any major strategy changes but we are always looking to fine tune at the edge to improve what we do. Right now the plan is to invest in acreage, drill that and hedge forward through VPP or production sales, and return that cash into our business at very high rates of return,” he says.

Today, Chesapeake is the largest unconventional-gas-resource player in the U.S., holding some 13.9 million net acres of onshore leasehold and 20 million acres of 3-D seismic data.

“We are the third-largest overall gas producer in the U.S.,” says Jeffrey L. Mobley, senior vice president of investor relations and research. “Anadarko (Petroleum Corp.) briefly caught up to us in the first quarter of this year, but given that Independence Hub is down, we’ll be the largest independent when second-quarter results are reported.

“It’s highly likely that during the second or third quarters, Chesapeake will be the largest producer of gas in the U.S.”

Mobley refers to the Independence Trail Pipeline that transports gas from the Anadarko-operated Independence Hub processing platform in the deepwater Gulf of Mexico. A leak in the pipeline was discovered in early April, but it was being returned to service at press time.

“Being the largest producer of anything in the U.S. is something that is noteworthy,” says Mobley.

“We are excited about it. It’s not necessarily our goal or objective, but it’s been a natural evolution of the steady execution of our business model over the past decade.”

Fracturing

Chesapeake is also the largest holder of U.S. onshore 3-D seismic data, using it to find new reserves and manage its drilling program to avoid hazards and stay in zone.

It also uses passive microseismic to record frac energy pumped into formations to determine the direction of the frac job, the exposure of surrounding rock and the length and depth of the frac job.

“We have a private venture to sponsor the further development of wireless seismic technology, which would allow potentially less expensive and more remote sourcing of seismic signals,” says Rowland.

The producer also owns a proprietary technology research center, including some 25 geoscientists that focus on processing shales, and a reservoir technology center focused on cutting-edge future development. Chesapeake also owns 20% of privately owned Frac Tech Services based in Cisco, Texas, and one of the largest fracture-stimulation companies in the U.S.

Going forward, Chesapeake’s strategy is to continue to grow through the drillbit and stay onshore the U.S.

“We don’t do deep water in the Gulf. We are not in Canada, and not around the world anywhere else. This is a U.S.-based drilling company with a U.S.-based product that is sold to Americans. We don’t have any plans to go offshore,” says Rowland.

“Early on, we focused on U.S. onshore gas plays. That focus has allowed us to pursue a program that has made us the largest and also the best at what we do.”

Chesapeake operates in the Midcontinent, South Texas, Texas Gulf Coast and ArkLaTex regions, Appalachia, the Permian and Delaware basins, and the Fort Worth Barnett, Fayetteville, Haynesville and Marcellus shales.

Raymond James & Associates recently raised its price target on Chesapeake by $10 to $60 per share. “The raise was due to a higher outlook on natural gas prices and the producer’s position in the Haynesville shale,” says analyst Wayne Andrews.