ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview
Chesapeake's revenue, operating cash flow (exclusive of changes in working capital) and production continued to reach record levels during the six months ended December 31,1997 (the "Transition Period"). However, continuing unfavorable exploration and production results, primarily in the Austin Chalk Trend, together with increases in drilling and equipment costs and declines in oil prices as of December 31, 1997, resulted in downward revisions in estimates of Chesapeake's proved oil and gas reserves and the related present value of the estimated future net revenues from the Company's proved reserves. The Company recorded a $110.0 million asset writedown and a net loss of $31.6 million during the Transition Period. In response to the losses recorded in fiscal 1997 and the Transition Period, Chesapeake significantly revised its business strategy during the Transition Period. These revisions included (i) reducing the size and risk of its exploratory drilling program, especially in the Louisiana Trend, (ii) acquiring significant volumes of long-lived natural gas reserves, particularly in the Mid-Continent region of the U.S., and (iii) building a larger inventory of lower risk drilling opportunities through acquisitions and joint ventures. Further, the Company has reduced its capital expenditure budget for exploration and development to more closely match anticipated cash flow from operations. As part of this revised strategy, the Company has acquired or is in the process of acquiring various proved oil and gas reserves through merger or through purchases of oil and gas properties. Since October 1997, the Company has announced 10 transactions totaling approximately 716 Bcfe of proved reserves (the "Acquisitions"). Of these transactions, one was closed in December 1997, three were closed in the first quarter of 1998, and six are pending. These acquisitions will have the effect of increasing oil and gas production volumes and revenues, decreasing DD&A per Mcfe, and increasing production expenses and interest expense during 1998. In November 1997, Chesapeake received net proceeds of approximately $90 million from its sale of Bayard common stock in the initial public offering of Bayard. Chesapeake recognized a gain on the sale of its Bayard stock of $73.8 million. During the Transition Period, the Company participated in 86 gross (41.1 net) wells, of which 49 gross wells were Company operated. A summary of the Company's drilling activities and capital expenditures by primary operating area is as follows ($ in thousands): Capital Expenditures Leasehold Total
Gross Wells
Net Wells
Drilling
Mid-Continent Region .................... Austin Chalk Trend ...................... All other areas ..........................
18 45 23
11.8 16.0 13.3
$ 64,247 92,524 44,210
$ 2,741 10,465 12,310
$ 66,988 102,989 56,520
Total ...........................
86
41.1
$200,981
$25,516
$226,497
The Company's proved reserves increased 11% to an estimated 448 Bcfe at December 31, 1997, up 45 Bcfe from 403 Bcfe of estimated proved reserves at June 30, 1997 (see Note 11 of Notes to Consolidated Financial Statements in Item 8 and "Results of Operations - Six Months Ended December 31, 1997 and 1996 - Impairment of Oil and Gas Properties"). Due to the numerous uncertainties inherent in drilling for oil and gas, in estimating quantities of proved reserves and in projecting future rates of production and timing of development expenditures, including many factors beyond the control of the Company, there can be no assurance that the Company's estimated proved reserves will not decrease in the future. The Company's strategy for 1998 is to acquire proved oil and gas reserves, primarily in the Mid-Continent and in western Canada, and to continue developing oil and gas assets by drilling. The Company has reduced its capital expenditure budget for exploration and development drilling activities to approximately $225 million and has reduced the Austin Chalk Trend drilling component significantly. Furthermore, the Company has increased its use of 3-D seismic to assist in reducing exploratory risks and increasing economic returns from its 25