U.S.

Shale Gas

Shale GasAbundance or Mirage?

Arthur E. Berman Labyrinth Consulting Services, Inc. Houston, Texas January 20, 2011

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 1

Can shale plays be commercial?

U.S. shale gas plays are commercial failures & the shareholder is the loser. Operators have maintained the illusion of success through production and reserve growth subsidized by debt. High decline rates mean that wells must be continuously drilleddrilling treadmill. The manufacturing model has failed. These are not low-cost plays: the marginal cost of production for most companies is $7.00/Mcf based on SEC 10-K filings over the past 5 years. Reserves have been greatly over-stated & 80% of booked reserves are undeveloped. The value of undeveloped reserves is low (but must be drilled within 5 years). Shareholder equity has been consistently destroyed: quarterly write downs & asset sales while capex is 100-400% of cash flow. Because of good hedge positions, the cost environment has been favorable. This has changed as future strips have fallen in response to over-supply & continued drilling.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 2

Chesapeake is the paragon of U.S. shale gas companies

Downgrade to hold. Earnings quality and management strategy raise concerns. Profligate spending. Desire to take a big stake in every significant resource play. Growing concerns about CHK's earnings quality. Desire to see management cut back on spending. We believe that the company's accounting policies and heavy use of off-balance-sheet leverage add unnecessary complexity and obscure its true financial position.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 3

Energy realities: the journey down the resource pyramid

Unconventional gas plays became important as better plays were exhausted. Tight sandstone & coal-bed methane were developed first. Shale gas is at a lower level on the pyramid. Economics are marginal.

"We sit on 10 [billion] to 15 billion barrels of oil that will change the valuation of this company over time." -- Aubrey McClendon, Dow Jones Newswires, October 14, 2010 He clearly does not understand the pyramid!
Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 4

There never was 100 years of natural gas because of shale plays
Potential Gas Committee (PGC) June 2009 Report misinterpreted. Technically recoverable resources are not reserves. Probable shale gas component is 147 tcf. Thats a lot of gas but it is not 100-years of supply.

There is clearly sufficient North American gas supply to last for a bunch of years; 50 years at least. And there is clearly no need for us to import LNG (liquefied natural gas) for multiple years to come. --Mark Papa, EOG CEO, November 2010 Except that there are only 20 years of supply according to the PGC!

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 5

Shale plays have contracted to a fairway or core area: Haynesville Shale example
The emerging core area includes ~110,000 acres or about 5 Townships. This represents approximately 10% of the play area in Louisiana defined by limits of drilling (1.5 million acres or 65 Townships). A few years ago, this was promoted as the 4th largest gas field in the world, and the largest in North America. All operators claim 6.5-7.5 bcf/well but HKs and Excos wells are 2x higher than CHK and EOGthey cant all be right!

Data from HPDI. Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 6

The Barnett Shale core areas

Core Area

"There was a time you all were told that any of the 17 counties in the Barnett Shale play would be just as good as any other county," McClendon said. "We found out there are about two or two and a half counties where you really want to be. --Bloomberg News October 14, 2009

Core Area

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 7

What defines a core? An area where conditions provide the potential for commercial success
Even within the core, well performance is not uniform. Repeatability is a problem. IPs have improved but costs have increased. Complex natural system, not a factory.

Barnett H Wells 1st Year Cumulative Production Data from HPDI.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 8

Barnett Shale Update: The Tarrant County Core Area

Polygon shows the best of the Tarrant core based on first-year cumulative production. 1,337 horizontal wells analyzed.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 9

The Tarrant County Core Area: type-well cumulative production

Barne8 Tarrant Core Horizontal Type Well Cumula6ve Produc6on
3,500,000 3,000,000 Thousands of Cubic Feet of Gas 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87

Months of Produc6on 2003 2004 2005 2006 2007 2008 2009 2010

No vintage of wells is approaching the 2.3-3.3 bcf range claimed by most operators for an average well. 1.5 bcf is minimum for break even at $6.25/mcf netback in the Barnett Shale. NPV models indicate that at least 70% of NPV in first 5 years. Too early to say much about 2010 or 2009 wells. No clear evidence that more recently drilled wells are better than previously drilled wells.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 10

Vintaged comparison of 20-month cumulative production

Barne8 Core Horizontal Type Wells
20-Month Cumula4ve Produc4on 650,000 Number of Wells 350 300
20-Month Cumula6ve Produc6on (Mcf)

600,000 250 550,000 200 150 100 450,000 50 400,000 2003 2004 2005 2006 2007 2008 2009 Year of First Produc6on 0 Number of Wells

500,000

Best year was 2005. Progressive deterioration of results 2007-2009. 20-month cumulative comparison normalizes the impact of high IP wells that do not maintain high rates.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 11

How are we doing on reaching reserve claims for an average well?

4,000,000

3,500,000

3,000,000 Cumula6ve Produc6on (mcfg)

Range of Operator Average Well Claims

2,500,000

2,000,000

1,500,000

1,000,000

500,000

CHK
0

DVN

ECA

EOG

KWK

XTO

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85

Months of Produc6on

Data from HPDI.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 12

Less than 6% of Barnett horizontal wells have reached economic threshold after 7 years of production

Most of my oil and gas clients require payout in 2-3 years.

Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 13

Barnett Shale: its about NPV, not EUR

Chesapeake Barnett Type Curve Incremental NPV10
90% 80% 70% 60% 50% 40% 30% 20% 10% 10-20 Years 0-10 Years 0-5 Years 0%

Percent of Net Present Value

96% 85% 69%

99%

100%

100%

90% 80% 70% 60% 50% 40% 30%

16%

11% 3%
20-30 Years

20%

1%
30-50 Years 50-65 Years

10% 0%

Produc6on Period

Chesapeake Type Well for the Barnett Play: 69% of value produced in 1st 5 years, and 85% in 1st 10 years, Negligible value added after 20 years yet operators claim significant EUR comes after year 20, Actual Barnett decline rates: 45% of EUR in Year 1, 65% by end of 2nd, 75% by end of 3rd.
Houston SIPES Slide 14

Labyrinth Consul4ng Services, Inc.

Cumulative Percent of Net Present Value

100%

100%

Barnett Shale: testing the 40- To 65-year production life claim

Barnett Wells Producing < 1 MMcf/month or Dry
40% 35% 30% 25% 20% 15% 10% 5% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008

35% 32% 27% 23% 19% 24% 21%

9%

10%

This cut-off only covers the cost of compression. True operating costs are approximately double.
Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 15

Type curves are overly optimistic: probabilistic approach acknowledges uncertainty

EnCana Horizontal Barne8 Wells Decline Data

P25 70,000 P50 P75 MEDIAN MEAN

60,000

50,000 MCF of Gas Per Month

40,000

30,000

20,000

10,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 Months of Produc6on

420 Barnett Shale wells suggest considerable variance in type-curve methodology. Mean over-predicts EUR by 10-15%.
Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 16

Hyperbolic decline model is not supportable: based on non-comparable analogues with permeabilites that are orders of magnitude greater than shale reservoirs

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 17

Hypothesis for Two-Stage Exponential Decline

1st 12 months dominated by induced and major natural fractures (high rate, rapid deple<on) Remainder of well life may be dominate by microfracture permeability weakly connected to shale matrix (lower rate but slower deple<on of larger pore volume)

Boundary Dominated Flow

Long-term bleed rate from matrix may not be sucient to unload liquids from well

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 18

Super-Harmonic Decline: b-exponent >1.0

Super-harmonic decline reflects production from a system of continuously increasing volume of contacted gas-in-place. Berman/Pittinger shale gas analyses indicate late-time boundary dominated flow. Contacted gas-in-place stabilizes after initial year of steep decline. Hyperbolic decline should not model transient/transitional flow before boundary conditions are reached. Hyperbolic exponent > 1.0 generally reflects transient flow and may not be valid. Most SPE papers on decline-curve analysis caution against using b-exponents > 1.0. Root of hyperbole is exaggeration or joke.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 19

Decline rate decreases as the well depletes further down the fracture pyramid

These two levels dominate rst 12 months of producFon

Induced fractures, regional fractures Induced conjugate fractures, clusters of natural fractures Permeability Decreases Microfractures, joints Shale Matrix Adsorbed gas & gas in pores

These two levels dominate decline trend aGer rst 12 months (exponenFal or moderate hyperbolic)

Pore Volume Increases

Labyrinth Consul4ng Services, Inc.

Fracture-enhanced permeability may be sucient to establish boundary-dominated ow within 12 months Houston SIPES

Slide 20

Business results do not support enthusiasm for shale plays: these are not low-cost plays
Selected Company 5 Year Imputed Production Costs/ Mcfe
Weighted Realized Price/Mcfe with Hedges $16.00 $14.00 $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 5 Year Calculated "Break-Even" Price

Data from company reports.

Operator claims of profitability at sub-$5/Mcf gas prices exclude many costs. Interest expense and G&A (overhead), dry hole cost, P&A expense not considered.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 21

These are not low-cost plays: the truth is quietly acknowledged

They doubt that you will notice as the traveling circus moves to liquids-rich plays! CHKs 5-year average break-even cost is $6.50/Mcf (from previous slide).
Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 22

Type curve comparison: Haynesville Shale

Type Well Comparison 1,000,000

Chesapeake Type Curve: EUR = 6.5 Bcf, b=1.1

Monthly Gas Rate, Mscf

100,000

Average of 44 Wells with 12 Months of Production: EUR = 2.4 Bcf, Exponential Decline
10,000 0 1 2 3 4 5 6 7 8 9 10 Months from Start of Produc6on 11 12 13 14

Data from HPDI.

The difference lies in forecasting future decline trends. Particularly the hyperbolic b exponent.
Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 23

Group type curve analysis

Normalized Haynesville Production Rate Decline Average of 44 Wells With 12 Months or More of Data

1,000,000
EUR entirely dependent on b factor EUR = 2.4 Bcf with b = 0.0, EUR = 2.6 Bcf with b = 0.25, EUR = 3.0 Bcf with b = 0.5, EUR = 4.4 Bcf with b = 1.0, EUR = 6.5 Bcf with b = 1.1. Insufficient data to determine b factor from group average

Monthly Gas Rate, Mscf

b=1.1 b=1.0 b=0.5 b=0.25 b=0.0

100,000

EUR=6.5 Bcf EUR=4.4 Bcf EUR=3.0 Bcf

10,000 0 6 12

18 24 30 Months from Start of Produc6on

EUR=2.4 Bcf

EUR=2.6 Bcf

36

42

48

Trust us that the P56.5 bcfcase will be the average EUR!

Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 24

Haynesville Shale Average Cumulative Production by Operator

EXCO CHK 7
Cumulative Production by Operator (Bcfg)

HK-KCS GOODRICH

EP J-W

ECA COMSTOCK

EOG FOREST

6 5 4 3 2 1
0

2.9 1.9 1.7 1.6

1.9 1.5

2.7 2.4

2.9 1.8

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Normalized Months of Production

Data from HPDI.

All operators claim EUR in the 5.0-7.5 bcf range. It is difficult to see how any but Petrohawk and Exco justify their claim. Cheapeakes average well will produce less than 3.0 bcf which is non-commercial (need $8.70/mcf to break even). Yet CHK continues to run 33 rigs in the play!
Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 25

An increase in proved undeveloped reserves (PUD) thanks to SEC changes

Companies exploit new SEC rules to book PUDs

80% of reserves are undeveloped.

Labyrinth Consul4ng Services, Inc. Houston SIPES

Data from company reports.

Slide 26

Discounted value of proved reserves has decreased over time

Realized prices were upwardly adjusted from SEC standard to reflect true monthly & annual prices. Prices reflect hedges.

Data from company reports. Labyrinth Consul4ng Services, Inc. Houston SIPES Slide 27

Pursuit of low-value assets has hurt the shareholder

Data from company reports.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 28

Chesapeake presents its value proposition

From 2009 10-K. It will take almost $9 billion to develop CHKs proved undeveloped reserves. This does not include G&A ($0.38/mcfe) or debt service ($0.88/mcfe). The present value of the estimated future net revenue is just over $1 billion. Would you spend more than $9 billion to net $1 B, or less than 12%? Since we know that half of CHKs reserves that come after Year 20 add no net present value, the true return is probably about $0.5 billion.
Houston SIPES Slide 29

Data from company reports. Labyrinth Consul4ng Services, Inc.

If these shale plays are so profitable, why do their promoters have to write down their assets every quarter?

Based on 2009 10-K SEC filings

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 30

The Big Short & shale gas plays

The companies were allowed to book as profit the expected future value of those loans. The accounting rules allowed them to assume the loans would be repaid. The companies were allowed to book as assets the expected future value of those reserves. The accounting rules allowed them to assume the reserves would be developed. All these subprime lending companies were growing so quickly that they could mask the fact that they had no real earnings. All the shale gas production was growing so quickly that they could mask the fact that they had no real earnings. To maintain the fiction that they were profitable enterprises, they needed more and more capital to create more and more subprime loans. To maintain the fiction that they were profitable enterprises, they needed more and more capital to drill more and more gas wells.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 31

Natural gas abundance or mirage?

The bubble is the landgas is a by-product. Recent Eagle Ford transactions underscore this. Land Grab strategy anticipates growing dependency on natural gas as the primary fuel option for North America. Push out smaller independents that cannot compete for land costs. Force policy decisions in favor of natural gas vs. coal and other options. Future price will be a surprise compared to present claims. Drilling adds value to the land by proving reserves. Near-zero intererest rates always cause bad investments. Drilling will continue as long as there is a market for tradable land & capital is available. The shareholder is the loser & is subsidizing cheap gas.

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 32

Acknowledgments
Mike Bodell Allen Brooks Perry Fischer Robert Gray Jim Halloran IHS Lynn Pittinger Keith Shanley

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 33

U.S. Shale Gas

Shale GasAbundance or Mirage?

Arthur E. Berman Labyrinth Consulting Services, Inc. Houston, Texas January 20, 2011

Labyrinth Consul4ng Services, Inc.

Houston SIPES

Slide 34