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Chesapeake Energy's Hedging Strategy Could Generate Billions

To Aubrey McClendon, who runs the country’s second-largest natural-gas producer, the commodity’s downward spiral isn’t a threat. In fact, he says, if gas prices skidded to zero, his company could still make money.

That’s because as the most active user of derivatives to hedge gas prices in his industry, McClendon, the CEO of Chesapeake Energy , has a game plan for creating what he hopes could be billions of dollars in future profits through a series of trades with Wall Street.

“If gas prices go to zero in 2011, it’s great for consumers, it doesn’t bother us, it hurts our competitors,” he explained in an exclusive interview with CNBC. “So once we get hedged, we kind of want lower gas prices.”

Chesapeake’s hedging strategy, parts of which are articulated in investor slides and regulatory filings, is a complex series of trades designed to help protect the company from volatile swings in gas and crude-oil prices, among other things.

As a major gas driller and a growing liquids driller, the company is essentially long gas and oil already. But Chesapeake executives say the hedges help it smooth out periods of low prices—such as the past two years in the natural gas markets, during which prices have slumped to $4.50 from a 2008 high of $13.50—and potentially to juice profits by making estimates of where future gas prices will be and selling counterparties the right to buy gas at those future dates at certain fixed prices.

For instance, the company is now betting that gas prices in the coming years will remain relatively low—no higher than an average price of $5.84 this year, according to company literature, and no higher than an average of $6.19 in 2012.

To lock in those prices, Chesapeake has sold counterparties like Wall Street banks and hedge funds the right to buy gas at those prices, making money in the process through the premiums, or cash those counterparties pay it in order to secure those rights. The driller’s trades are collateralized by its own gas reserves, rather than by cash.

Chesapeake investor presentations boast that the company’s small but aggressive hedging team has created $6 billion in gains—essentially, revenue—since 2001. In the interview with CNBC, McClendon said he hopes to replicate those results in the next “few years.” (The exact results are impossible for a third party to verify because not enough details are disclosed.)

Gary Wade | Stone | Getty Images

Yet some analysts and fellow traders argue that Chesapeake is playing with fire. The company has already bet on gas prices as far into the future as 2020—a date so far ahead, some skeptics say, that the markets are too tough to pinpoint.

“I don’t really like the idea of selling out call options on gas prices and oil prices—mostly gas prices for the long-dated options—10 years out so that I can get more revenue today,” says Phil Weiss, a energy analyst who recently downgraded Chesapeake to a sell rating. “It’s just another way the company is mortgaging its future.”

McClendon counters that “90 percent” of Chesapeake’s hedging activity is focused on the “next eighteen months.” The trades dating to 2020, he said, are “basis hedges” intended to mitigate risk events in regional markets.

Other critics argue that Chesapeake’s hedges, while likely to succeed in the immediate future, will be tough to replicate longer-term.

“In 2011 they’re going to have material hedge gains,” said one energy trader whose company policy prevents him from speaking on the record, “but they’re not going to have that luxury going forward. Because if prices go up, they’re in great shape. But if prices stay depressed, they don’t have the flexibility they did in the past.”

Chesapeake officials acknowledge that if gas prices rise far above the strike prices of the calls they sold—$5.84 and $6.19 for the next two years respectively—they could lose some money. But in that case, say officials, they’d be happy because produced gas could be sold at a higher price.

McClendon himself takes offense at the notion Chesapeake has become a hedge fund—a label Weiss and some traders have recently slapped on the company. “We don’t gamble. We don’t bet. We’re physically long gas,” McClendon says. “All we’re doing is mitigating risk.”

Unlike other gas and drillers, some of whom employ hundreds of dedicated traders, Chesapeake’s hedging team is a party of three: McClendon, newly-appointed chief financial officer Domenic Dell’Osso, and Jeffrey Mobley, the company’s senior vice president of investor relations. Before the team makes a move, its members say, their decision must be unanimous.

Ideas come to them a variety of ways, the three say, including through colleagues in Chesapeake’s treasury and finance departments, suggestions from outside commodities traders, and from a team of meteorologists in Chicago. McClendon hired that group a few years ago to help analyze weather patterns and predict their affect on his markets.

Watch Kate Kelly's TV reports about Chesapeake on Thursday, January 20, on "The Strategy Session" at Noon ET, and "Power Lunch" at 1pm ET. She will explain the company's shift away from natural gas, reveal more details on its hedging program, and report on Carl Icahn’s investment in Chesapeake.

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