10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X]  Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2009

[  ]  Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                  to                 

Commission File No. 1-13726

Chesapeake Energy Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

Oklahoma   73-1395733
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

6100 North Western Avenue

Oklahoma City, Oklahoma

  73118
(Address of principal executive offices)   (Zip Code)

(405) 848-8000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [X] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [X] No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [X]    Accelerated filer [  ]    Non-accelerated filer [  ]    Smaller reporting company [  ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [  ] No [X]

As of November 4, 2009, there were 647,707,733 shares of our $0.01 par value common stock outstanding.

 

 

 


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2009

 

PART I.   

Financial Information

  
          Page
Item 1.   

Condensed Consolidated Financial Statements (Unaudited):

  
  

Condensed Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008

   1
  

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2009 and 2008

   3
  

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008

   4
  

Condensed Consolidated Statements of Equity for the Nine Months Ended September 30, 2009 and 2008

   6
  

Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2009 and 2008

   7
  

Notes to Condensed Consolidated Financial Statements

   8
Item 2.   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   43
Item 3.   

Quantitative and Qualitative Disclosures About Market Risk

   62
Item 4.   

Controls and Procedures

   69
PART II.   

Other Information

  
Item 1.   

Legal Proceedings

   70
Item 1A.   

Risk Factors

   70
Item 2.   

Unregistered Sales of Equity Securities and Use of Proceeds

   70
Item 3.   

Defaults Upon Senior Securities

   70
Item 4.   

Submission of Matters to a Vote of Security Holders

   70
Item 5.   

Other Information

   70
Item 6.   

Exhibits

   71


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     September 30, 
2009
     December 31, 
2008
 
           (Adjusted)  
     ($ in millions)  
ASSETS   

CURRENT ASSETS:

    

Cash and cash equivalents

   $ 520      $ 1,749   

Accounts receivable, net

     1,298        1,324   

Short-term derivative instruments

     538        1,082   

Other

     152        137   
                

Total Current Assets

     2,508        4,292   
                

PROPERTY AND EQUIPMENT:

    

Natural gas and oil properties, at cost based on full-cost accounting:

    

Evaluated natural gas and oil properties

     33,513        28,965   

Unevaluated properties

     9,708        11,379   

Less: accumulated depreciation, depletion and amortization of natural gas and oil properties

     (22,489     (11,866
                

Total natural gas and oil properties, at cost based on full-cost accounting

     20,732        28,478   
                

Other property and equipment:

    

Natural gas gathering systems and treating plants

     3,307        2,717   

Buildings and land

     1,656        1,513   

Drilling rigs and equipment

     610        430   

Natural gas compressors

     301        184   

Other

     538        482   

Less: accumulated depreciation and amortization of other property and equipment

     (766     (496
                

Total other property and equipment

     5,646        4,830   
                

Total Property and Equipment

     26,378        33,308   
                

OTHER ASSETS:

    

Investments

     422        444   

Long-term derivative instruments

     89        261   

Other assets

     322        288   
                

Total Other Assets

     833        993   
                

TOTAL ASSETS

   $ 29,719      $ 38,593   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS – (Continued)

(Unaudited)

 

     September 30, 
2009
     December 31, 
2008
 
           (Adjusted)  
     ($ in millions)  
LIABILITIES AND EQUITY   

CURRENT LIABILITIES:

    

Accounts payable

   $ 932      $ 1,611   

Short-term derivative instruments

     28        66   

Accrued liabilities

     838        880   

Deferred income taxes

     172        358   

Income taxes payable

     1        108   

Revenues and royalties due others

     392        431   

Accrued interest

     151        167   
                

Total Current Liabilities

     2,514        3,621   
                

LONG-TERM LIABILITIES:

    

Long-term debt, net

     12,073        13,175   

Deferred income tax liabilities

     1,316        4,200   

Asset retirement obligations

     282        269   

Long-term derivative instruments

     256        111   

Other liabilities

     449        200   
                

Total Long-Term Liabilities

     14,376        17,955   
                

CONTINGENCIES AND COMMITMENTS (Note 3)

    

EQUITY:

    

Chesapeake stockholders’ equity:

    

Preferred stock, $0.01 par value, 20,000,000 shares authorized:

    

4.50% cumulative convertible preferred stock, 2,558,900 shares issued and outstanding as of September 30, 2009 and December 31, 2008, entitled in liquidation to $256 million

     256        256   

5.00% cumulative convertible preferred stock (series 2005B), 2,095,615 shares issued and outstanding as of September 30, 2009 and December 31, 2008, entitled in liquidation to $209 million

     209        209   

5.00% cumulative convertible preferred stock (series 2005), 5,000 shares issued and outstanding as of September 30, 2009 and December 31, 2008, entitled in liquidation to $1 million

     1        1   

6.25% mandatory convertible preferred stock, 0 shares and 143,768 shares issued and outstanding as of September 30, 2009 and December 31, 2008, respectively, entitled in liquidation to $0 and $36 million

            36   

4.125% cumulative convertible preferred stock, 0 and 3,033 shares issued and outstanding as of September 30, 2009 and December 31, 2008, respectively, entitled in liquidation to $0 and $3 million

            3   

Common stock, $0.01 par value, 1,000,000,000 shares and 750,000,000 shares authorized, 645,273,711 and 607,953,437 shares issued at September 30, 2009 and December 31, 2008, respectively

     6        6   

Paid-in capital

     11,981        11,680   

Retained earnings (deficit)

     (737     4,569   

Accumulated other comprehensive income (loss), net of tax of ($167) million and ($163) million, respectively

     274        267   

Less: treasury stock, at cost; 766,554 and 657,276 common shares as of September 30, 2009 and December 31, 2008, respectively

     (12     (10
                

Total Chesapeake Stockholders’ Equity

     11,978        17,017   

Noncontrolling interest

     851          
                

Total Equity

     12,829        17,017   
                

TOTAL LIABILITIES AND EQUITY

   $ 29,719      $ 38,593   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

         Three Months Ended    
September 30,
        Nine Months Ended    
September 30,
 
           2009                 2008                 2009                 2008        
           (Adjusted)           (Adjusted)  
     ($ in millions except per share data)  

REVENUES:

        

Natural gas and oil sales

   $ 1,187      $ 6,408      $ 3,681      $ 5,587   

Marketing, gathering and compression sales

     575        1,038        1,660        2,934   

Service operations revenue

     49        45        139        127   
                                

Total Revenues

     1,811        7,491        5,480        8,648   
                                

OPERATING COSTS:

        

Production expenses

     218        239        670        658   

Production taxes

     25        87        71        250   

General and administrative expenses

     95        108        259        288   

Marketing, gathering and compression expenses

     546        1,014        1,569        2,864   

Service operations expense

     49        37        136        104   

Natural gas and oil depreciation, depletion and amortization

     295        480        1,037        1,518   

Depreciation and amortization of other assets

     62        48        177        124   

Impairment of natural gas and oil properties and other assets

     86               9,721          

Loss on sale of other property and equipment

     38               38          

Restructuring costs

                   34          
                                

Total Operating Costs

     1,414        2,013        13,712        5,806   
                                

INCOME (LOSS) FROM OPERATIONS

     397        5,478        (8,232     2,842   
                                

OTHER INCOME (EXPENSE):

        

Other income (expense)

     (30     (12     (25     (23

Interest expense

     (43     (34     (52     (186

Impairment of investments

                   (162       

Loss on exchanges of Chesapeake debt

     (17     (31     (19     (31
                                

Total Other Income (Expense)

     (90     (77     (258     (240
                                

INCOME (LOSS) BEFORE INCOME TAXES

     307        5,401        (8,490     2,602   
                                

INCOME TAX EXPENSE (BENEFIT):

        

Current income taxes

            193        1        196   

Deferred income taxes

     115        1,886        (3,185     806   
                                

Total Income Tax Expense (Benefit)

     115        2,079        (3,184     1,002   
                                

NET INCOME (LOSS)

     192        3,322        (5,306     1,600   

Net income (loss) attributable to noncontrolling interest

                            
                                

NET INCOME (LOSS) ATTRIBUTABLE TO CHESAPEAKE

     192        3,322        (5,306     1,600   

Preferred stock dividends

     (6     (6     (18     (27

Loss on conversion/exchange of preferred stock

            (25            (67
                                

NET INCOME (LOSS) AVAILABLE TO CHESAPEAKE COMMON STOCKHOLDERS

   $ 186      $ 3,291      $ (5,324   $ 1,506   
                                

EARNINGS (LOSS) PER COMMON SHARE:

        

Basic

   $ 0.30      $ 5.94      $ (8.78   $ 2.88   

Assuming dilution

   $ 0.30      $ 5.62      $ (8.78   $ 2.76   

CASH DIVIDEND DECLARED PER COMMON SHARE

   $ 0.075      $ 0.075      $ 0.225      $ 0.2175   

WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING (in millions):

        

Basic

     619        554        606        523   

Assuming dilution

     626        588        606        557   

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Nine Months Ended
September 30,
 
          2009          2008  
           (Adjusted)  
     ($ in millions)  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

NET INCOME (LOSS)

   $ (5,306   $ 1,600   

ADJUSTMENTS TO RECONCILE NET INCOME (LOSS) TO CASH PROVIDED BY OPERATING ACTIVITIES:

    

Depreciation, depletion and amortization

     1,214        1,642   

Deferred income tax expense (benefit)

     (3,185     806   

Impairments

     9,883          

Loss on sale of other property and equipment

     38          

Unrealized (gains) losses on derivatives

     295        (89

Realized (gains) losses on financing derivatives

     (53     59   

Stock-based compensation

     104        100   

Accretion of discount on contingent convertible notes

     60        57   

Restructuring costs

     12          

Loss from equity investments

     32        34   

Loss on exchanges of Chesapeake debt

     19        31   

Other

     8        5   

Change in assets and liabilities

     10        142   
                

Cash provided by operating activities

     3,131        4,387   
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Exploration and development of natural gas and oil properties

     (2,767     (4,621

Acquisitions of natural gas and oil companies, proved and unproved properties and leasehold, net of cash acquired

     (1,371     (7,691

Proceeds from sales of volumetric production payments

     408        1,210   

Proceeds from divestitures of proved and unproved properties and leasehold

     1,321        4,666   

Additions to other property and equipment

     (1,362     (1,969

Additions to investments

     (40     (61

Proceeds from sale of drilling rigs and equipment

            46   

Proceeds from sale of compressors

     68        114   

Proceeds from sale of other assets

     89        21   

Proceeds from sale of investments

            2   
                

Cash used in investing activities

     (3,654     (8,283
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Proceeds from credit facilities borrowings

     5,563        12,831   

Payments on credit facilities borrowings

     (7,866     (11,307

Proceeds from issuance of senior notes, net of offering costs

     1,346        2,136   

Proceeds from issuance of common stock, net of offering costs

            2,598   

Cash paid to repurchase Chesapeake debt

            (312

Cash paid for common stock dividends

     (135     (106

Cash paid for preferred stock dividends

     (18     (29

Proceeds from sale of noncontrolling interest in midstream joint venture

     588          

Derivative settlements

     19        (146

Net increase (decrease) in outstanding payments in excess of cash balance

     (305     210   

Proceeds from mortgage of building

     54          

Proceeds from financing of real estate surface assets

     145          

Excess tax benefit from stock-based compensation

            42   

Other

     (97     (58
                

Cash provided (used in) by financing activities

     (706     5,859   
                

Net increase (decrease) in cash and cash equivalents

     (1,229     1,963   

Cash and cash equivalents, beginning of period

     1,749        1   
                

Cash and cash equivalents, end of period

   $ 520      $ 1,964   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)

(Unaudited)

 

 

     Nine Months Ended
September 30,
          2009         2008
          (Adjusted)
     ($ in millions)

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION OF CASH PAYMENTS FOR:

     

Interest, net of $467 million and $390 million of capitalized interest, respectively

   $ 111    $ 133

Income taxes, net of refunds received

   $ 176    $ 5

SUPPLEMENTAL SCHEDULE OF SIGNIFICANT NON-CASH INVESTING AND FINANCING ACTIVITIES:

As of September 30, 2009 and 2008, dividends payable on our common and preferred stock were $52 million and $48 million, respectively.

For the nine months ended September 30, 2009 and 2008, natural gas and oil properties were adjusted by a nominal amount and $13 million, respectively, for net income tax liabilities related to acquisitions.

For the nine months ended September 30, 2009 and 2008, natural gas and oil properties were adjusted by ($77) million and ($3) million, respectively, as a result of an increase (decrease) in accrued exploration and development costs.

For the nine months ended September 30, 2009 and 2008, other property and equipment were adjusted by ($31) million and $23 million, respectively, as a result of an increase (decrease) in accrued costs.

We recorded non-cash asset additions (reductions) to natural gas and oil properties of ($3) million and $6 million for the nine months ended September 30, 2009 and 2008, respectively, for asset retirement obligations.

We recorded non-cash asset additions to natural gas gathering systems of $3 million and $6 million for the nine months ended September 30, 2009 and 2008, respectively, for asset retirement obligations.

On March 31, 2009, we converted all of our outstanding 4.125% Cumulative Convertible Preferred Stock (3,033 shares) into 182,887 shares of common stock.

On June 15, 2009, we converted all of our outstanding 6.25% Mandatory Convertible Preferred Stock (143,768 shares) into 1,239,538 shares of common stock.

During the nine months ended September 30, 2009, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $238 million in aggregate principal amount for an aggregate of 6,707,321 shares of our common stock in privately negotiated exchanges.

During the nine months ended September 30, 2009, we issued 24,822,832 shares of common stock, valued at $429 million, for the purchase of proved and unproved properties and leasehold pursuant to an acquisition shelf registration statement.

During the nine months ended September 30, 2008, holders of our 5.0% Cumulative Convertible Preferred Stock (Series 2005B) exchanged 3,654,385 shares for 10,443,642 shares of common stock in privately negotiated exchanges.

During the nine months ended September 30, 2008, a holder of our 4.5% Cumulative Convertible Preferred Stock exchanged 891,100 shares for 2,227,750 shares of common stock in a privately negotiated exchange.

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EQUITY

(Unaudited)

 

     Nine Months Ended
September 30,
 
          2009          2008  
           (Adjusted)  
     ($ in millions)  

PREFERRED STOCK:

    

Balance, beginning of period

   $ 505      $ 960   

Exchange of common stock for 143,768 and 0 shares of 6.25% preferred stock

     (36       

Exchange of common stock for 3,033 and 29 shares of 4.125% preferred stock

     (3       

Exchange of common stock for 0 and 891,100 shares of 4.50% preferred stock

            (89

Exchange of common stock for 0 and 3,654,385 shares of 5.00% preferred stock (series 2005B)

            (366
                

Balance, end of period

     466        505   
                

COMMON STOCK:

    

Balance, beginning of period

     6        5   

Issuance of 24,822,832 and 0 shares of common stock for the purchase of proved and unproved properties and leasehold

              

Issuance of 0 and 51,750,000 shares of common stock

            1   

Exchange of 6,707,321 and 0 shares of common stock for convertible notes

              

Exchange of 1,422,425 and 12,673,135 shares of common stock for preferred stock

              
                

Balance, end of period

     6        6   
                

PAID-IN CAPITAL:

    

Balance, beginning of period

     11,680        7,532   

Issuance of 24,822,832 shares and 0 shares of common stock for the purchase of proved and unproved properties and leasehold

     420          

Issuance of 0 and 51,750,000 shares of common stock

            2,698   

Issuance of 2.25% contingent convertible senior notes due 2038

            345   

Exchange of 6,707,321 and 0 shares of common stock for convertible notes

     164          

Exchange of 1,422,425 and 12,673,135 shares of common stock for preferred stock

     39        454   

Stock-based compensation

     140        124   

Exercise of stock options

     3        8   

Offering expenses

            (113

Dividends on common stock

     (138       

Dividends on preferred stock

     (17       

Allocation of joint venture capital to Global Infrastructure Partners

     (263       

Tax benefit (reduction in tax benefit) from exercise of stock-based compensation

     (47     42   
                

Balance, end of period

     11,981        11,090   
                

RETAINED EARNINGS (DEFICIT):

    

Balance, beginning of period

     4,569        4,145   

Net income (loss)

     (5,306     1,600   

Dividends on common stock

            (115

Dividends on preferred stock

            (15
                

Balance, end of period

     (737     5,615   
                

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):

    

Balance, beginning of period

     267        (11

Hedging activity

     (60     54   

Investment activity

     67        1   
                

Balance, end of period

     274        44   
                

TREASURY STOCK – COMMON:

    

Balance, beginning of period

     (10     (6

Purchase of 115,430 and 87,056 shares for company benefit plans

     (2     (3

Release of 6,152 and 1,098 shares for company benefit plans

              
                

Balance, end of period

     (12     (9
                

TOTAL CHESAPEAKE STOCKHOLDERS’ EQUITY

     11,978        17,251   
                

NONCONTROLLING INTEREST:

    

Sale of noncontrolling interest in midstream joint venture

     588          

Allocation of joint venture capital to Global Infrastructure Partners

     263          
                

Balance, end of period

     851          
                

TOTAL EQUITY

   $ 12,829      $ 17,251   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
        2009          2008          2009              2008      
         (Adjusted)           (Adjusted)  
   ($ in millions)  

Net income (loss)

   $ 192      $ 3,322      $ (5,306   $ 1,600   

Other comprehensive income (loss), net of income tax:

        

Change in fair value of derivative instruments, net of income taxes of $38 million, $728 million, $372 million and ($105) million

     62        1,187        609        (170

Reclassification of (gain) loss on settled contracts, net of income taxes of ($144) million, $65 million, ($377) million, and $117 million

     (236     104        (617     189   

Ineffective portion of derivatives qualifying for cash flow hedge accounting, net of income taxes of $2 million, ($29) million, ($31) million and $20 million

     5        (46     (52     34   

Unrealized (gain) loss on investments, net of income taxes of $4 million, ($16) million, $14 million and $1 million

     6        (27     24        1   

Reclassification of loss on investments, net of income taxes of $0, $0, $26 million and $0

                   43          
                                

Comprehensive income (loss) attributable to Chesapeake stockholders

     29        4,540        (5,299     1,654   
                                

Comprehensive income attributable to noncontrolling interest

                            
                                

Comprehensive income (loss)

   $ 29      $ 4,540      $ (5,299   $ 1,654   
                                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation and Summary of Significant Accounting Policies

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements of Chesapeake Energy Corporation and its subsidiaries have been prepared in accordance with the instructions to Form 10-Q as prescribed by the Securities and Exchange Commission (SEC). Chesapeake’s annual report on Form 10-K for the year ended December 31, 2008 (“2008 Form 10-K”) includes certain definitions and a summary of significant accounting policies and should be read in conjunction with this Form 10-Q. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto for the year ended December 31, 2008 contained in our Current Report on Form 8-K dated June 25, 2009. All material adjustments (consisting solely of normal recurring adjustments) which, in the opinion of management, are necessary for a fair statement of the results for the interim periods have been reflected. The results for the three and nine months ended September 30, 2009 are not necessarily indicative of the results to be expected for the full year. This Form 10-Q relates to the three and nine months ended September 30, 2009 (the “Current Quarter” and the “Current Period”, respectively) and the three and nine months ended September 30, 2008 (the “Prior Quarter” and the “Prior Period”, respectively). Any material subsequent events have been considered for disclosure through November 9, 2009, the filing date of this Form 10-Q.

Change in Accounting Principle

On January 1, 2009, we adopted and applied retrospectively the provisions of Accounting Standards Codification (ASC), 470-20 Debt with Conversion and Other Options. As a result, our prior year condensed consolidated financial statements have been retrospectively adjusted. See Note 6 for additional information on the application of this accounting principle.

Oil and Natural Gas Properties – Ceiling Test

We review the carrying value of our natural gas and oil properties under the full-cost accounting rules of the SEC on a quarterly basis. This quarterly review is referred to as a ceiling test. Under the ceiling test, capitalized costs, less accumulated amortization and related deferred income taxes, may not exceed an amount equal to the sum of the present value of estimated future net revenues (including the impact of cash flow hedges) less estimated future expenditures to be incurred in developing and producing the proved reserves, less any related income tax effects. Any excess of the net book value, less deferred income taxes, is written off as an expense. Under SEC regulations, the excess above the ceiling is not expensed (or is reduced) if, subsequent to the end of the period, but prior to the release of the financial statements, natural gas and oil prices increase sufficiently such that an excess above the ceiling would have been eliminated (or reduced) if the increased prices were used in the calculations.

In calculating future net revenues, prices and costs used are those as of the end of the appropriate quarterly period except where different prices are fixed and determinable from applicable contracts for the remaining term of those contracts, including the effects of derivatives qualifying as cash flow hedges. Our qualifying cash flow hedges as of September 30, 2009, which consisted of swaps and collars, covered 126 bcfe and 74 bcfe in 2009 and 2010, respectively. Our natural gas and oil hedging activities are discussed in Note 2 of these condensed consolidated financial statements. Based on spot prices for natural gas and oil of $3.30 per mcf and $70.21 per barrel, respectively, as of September 30, 2009, these cash flow hedges increased the full-cost ceiling by $968 million, thereby reducing any potential ceiling test write-down by the same amount before the effect of income taxes.

As of September 30, 2009, our ceiling test calculation indicated an impairment of our natural gas and oil properties of approximately $1.2 billion, net of tax. Based on natural gas and oil prices at November 4, 2009 of $4.49 per mcf and $80.64 per barrel, respectively, as well as the corresponding adjusted impact from our cash flow hedges of $738 million, we no longer had an impairment. Therefore, we were not required to record a write-down of our natural gas and oil properties under the full-cost method of accounting in the Current Quarter.

As of March 31, 2009, capitalized costs of natural gas and oil properties exceeded the estimated present value of future net revenues from our proved reserves, net of related income tax considerations, resulting in a write-down in the carrying value of natural gas and oil properties of $6.0 billion, net of tax.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Critical Accounting Policies

We consider accounting policies related to hedging, natural gas and oil properties, income taxes and business combinations to be critical policies. These policies are summarized in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2008 Form 10-K.

 

2. Financial Instruments and Hedging Activities

Natural Gas and Oil Derivatives

Our results of operations and operating cash flows are impacted by changes in market prices for natural gas and oil. To mitigate a portion of the exposure to adverse market changes, we have entered into various derivative instruments. These instruments allow us to predict with greater certainty the effective natural gas and oil prices to be received for our hedged production. Although derivatives often fail to achieve 100% effectiveness for accounting purposes, we believe our derivative instruments continue to be highly effective in achieving our risk management objectives. As of September 30, 2009 and December 31, 2008, our natural gas and oil derivative instruments were comprised of the following types of instruments:

 

   

Swaps: Chesapeake receives a fixed price and pays a floating market price to the counterparty for the hedged commodity.

 

   

Collars: These instruments contain a fixed floor price (put) and ceiling price (call). If the market price exceeds the call strike price or falls below the put strike price, Chesapeake receives the fixed price and pays the market price. If the market price is between the put and the call strike price, no payments are due from either party. On occasion, we make a three-way collar by selling an additional put option with the collar in exchange for a more favorable strike price on the collar. This eliminates the counterparty’s downside exposure below the second put option.

 

   

Knockout swaps: Chesapeake receives a fixed price and pays a floating market price. The fixed price received by Chesapeake includes a premium in exchange for the possibility to reduce the counterparty’s exposure to zero, in any given month, if the floating market price is lower than certain pre-determined knockout prices.

 

   

Cap-swaps: Chesapeake receives a fixed price and pays a floating market price. The fixed price received by Chesapeake includes a premium in exchange for a “cap” limiting the counterparty’s exposure. In other words, there is no limit to Chesapeake’s exposure but there is a limit to the downside exposure of the counterparty.

 

   

Call options: Chesapeake receives a premium from the counterparty in exchange for the sale of a call option. If the market price exceeds the fixed price of the call option, Chesapeake pays the counterparty such excess. If the market price settles below the fixed price of the call option, no payment is due from either party.

 

   

Put options: Chesapeake receives a premium from the counterparty in exchange for the sale of a put option. If the market price falls below the fixed price of the put option, Chesapeake pays the counterparty such shortfall. If the market price settles above the fixed price of the put option, no payment is due from either party.

 

   

Basis protection swaps: These instruments are arrangements that guarantee a price differential to NYMEX for natural gas from a specified delivery point. For non-Appalachian Basin basis protection swaps, which typically have negative differentials to NYMEX, Chesapeake receives a payment from the counterparty if the price differential is greater than the stated terms of the contract and pays the counterparty if the price differential is less than the stated terms of the contract. For Appalachian Basin basis protection swaps, which typically have positive differentials to NYMEX, Chesapeake receives a payment from the counterparty if the price differential is less than the stated terms of the contract and pays the counterparty if the price differential is greater than the stated terms of the contract.

All of our derivative instruments are net settled based on the difference between the fixed-price payment and the floating-price payment, resulting in a net amount due to or from the counterparty.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The estimated fair values of our natural gas and oil derivative instruments as of September 30, 2009 and December 31, 2008 are provided below. The associated carrying values of these instruments are equal to the estimated fair values.

 

     September 30, 2009     December 31, 2008  
     Volume Hedged        Fair Value        Volume Hedged        Fair Value     
           ($ in millions)           ($ in millions)  

Natural gas (bbtu):

        

Fixed-price natural gas swaps

   192,026      $ 344      466,800      $ 863   

Fixed-price natural gas collars

   127,290        205      457,715        402   

Fixed-price natural gas knockout swaps

   95,010        53      532,660        141   

Natural gas call options

   522,165        (125   551,555        (178

Natural gas put options

   (82,200     (43   (73,000     (39

Natural gas basis protection swaps

   140,328        (45   219,487        93   
                            

Total natural gas

   994,619      $ 389      2,155,217      $ 1,282   
                            

Oil (mbbls):

        

Fixed-price oil swaps

   (230          (310     31   

Fixed-price oil collars

               730        5   

Fixed-price oil knockout swaps

   7,860        50      12,248        19   

Fixed-price oil cap-swaps

               362        3   

Oil call options

   11,515        (55   19,355        (35
                            

Total oil

   19,145      $ (5   32,385      $ 23   
                            

Total estimated fair value(a)

     $ 384        $ 1,305   
                    

 

 

(a) After adjusting for $392 million and $736 million of unrealized premiums, the value to be realized for these derivatives as of September 30, 2009 and December 31, 2008 was $776 million and $2.041 billion, respectively.

Pursuant to ASC 815, certain derivatives qualify for designation as cash flow hedges. Following these provisions, changes in the fair value of derivative instruments designated as cash flow hedges, to the extent they are effective in offsetting cash flows attributable to the hedged risk, are recorded in accumulated other comprehensive income until the hedged item is recognized in earnings as the physical transactions being hedged occur. Any change in fair value resulting from ineffectiveness is currently recognized in natural gas and oil sales as unrealized gains (losses). Changes in the fair value of non-qualifying derivatives that occur prior to their maturity (i.e., temporary fluctuations in value) are reported currently in the condensed consolidated statements of operations as unrealized gains (losses) within natural gas and oil sales. Realized gains (losses) are included in natural gas and oil sales in the month of related production.

Chesapeake enters into counter-swaps from time to time for the purpose of locking-in the value of a swap. Under the counter-swap, Chesapeake receives a floating price for the hedged commodity and pays a fixed price to the counterparty. The counter-swap is 100% effective in locking-in the value of a swap since subsequent changes in the market value of the swap are entirely offset by subsequent changes in the market value of the counter-swap. Generally, at the time Chesapeake enters into a counter-swap, Chesapeake removes the original swap’s designation as a cash flow hedge and classifies the original swap as a non-qualifying hedge under ASC 815. The reason for this new designation is that collectively the swap and the counter-swap no longer hedge the exposure to variability in expected future cash flows. Instead, the swap and counter-swap effectively lock-in a specific gain or loss that will be unaffected by subsequent variability in natural gas and oil prices. Any locked-in gain or loss is recorded in accumulated other comprehensive income and reclassified to natural gas and oil sales in the month of related production.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The components of natural gas and oil sales for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period are presented below.

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008      2009       2008   
     ($ in millions)  

Natural gas and oil sales

   $ 785      $ 2,036      $ 2,280      $ 5,961   

Realized gains (losses) on natural gas and oil derivatives

     687        (246     1,802        (454

Unrealized gains (losses) on non-qualifying natural gas and oil derivatives

     (278     4,543        (484     134   

Unrealized gains (losses) on ineffectiveness of cash flow hedges

     (7     75        83        (54
                                

Total natural gas and oil sales

   $ 1,187      $ 6,408      $ 3,681      $ 5,587   
                                

Based upon the market prices at September 30, 2009, we expect to transfer approximately $340 million (net of income taxes) of the gain included in the balance in accumulated other comprehensive income to net income (loss) during the next 12 months in the related month of production. All transactions hedged as of September 30, 2009 are expected to mature by December 31, 2022.

We began 2009 with six secured hedging facilities, each of which permitted us to enter into cash-settled natural gas and oil commodity transactions, valued by the counterparty, for up to a stated maximum value. Outstanding transactions under each of the facilities were collateralized by certain of our natural gas and oil properties that did not secure any of our other obligations. On June 11, 2009, we entered into a multi-counterparty hedge facility with 13 counterparties that have committed to provide approximately 3.9 tcfe of trading capacity and an aggregate mark-to-market capacity of $10.4 billion under the terms of the facility. The new multi-counterparty facility was intended to consolidate and replace the six secured hedge facilities. As of September 30, 2009, there were trades outstanding on three of the six secured hedge facilities with a fair value of $86 million, and trades covering 122.9 bcfe had been novated into the multi-counterparty facility. As of November 6, 2009, all remaining trades had been novated and pledged collateral transferred to the multi-counterparty facility, resulting in 905.7 bcfe hedged and collateral value of approximately $4.1 billion. These trades will continue to be subject to pre-existing exposure fees, if any, but we are not required to pay an exposure fee for any new trades in the multi-counterparty facility.

The multi-counterparty facility allows us to enter into cash-settled natural gas and oil price and basis hedges with the counterparties. Our obligations under the multi-counterparty facility are secured by natural gas and oil proved reserves, the value of which must cover the fair value of the transactions outstanding under the facility by at least 1.65 times, and guarantees by our subsidiaries that also guarantee our corporate revolving bank credit facility and indentures. The counterparties’ obligations under the facility must be secured by cash or short-term U.S. Treasury instruments to the extent that any mark-to-market amounts they owe to Chesapeake exceed defined thresholds. The maximum volume-based trading capacity under the facility is governed by the expected production of the pledged reserve collateral, and volume-based trading limits are applied separately to price and basis hedges. In addition, there are volume-based sub-limits for natural gas and oil hedges. Chesapeake has significant flexibility with regard to releases and/or substitutions of pledged reserves, provided that certain collateral coverage and other requirements are met. The facility does not have a maturity date. Counterparties to the agreement have the right to cease trading with the company on a prospective basis as long as obligations associated with any existing trades in the facility continue to be satisfied in accordance with the terms of the agreement.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

To mitigate our exposure to the fluctuation in prices of diesel fuel which is used in our exploration and development activities, we have entered into diesel swaps from October 2009 to March 2010 for a total of 19,800,000 gallons with an average fixed price of $1.58 per gallon. Chesapeake pays the fixed price and receives floating price. The fair value of these swaps as of September 30, 2009 was an asset of $6 million.

Interest Rate Derivatives

To mitigate our exposure to volatility in interest rates related to our senior notes and bank credit facilities, we enter into interest rate derivatives. As of September 30, 2009 and December 31, 2008, our interest rate derivative instruments were comprised of the following types of instruments:

 

   

Swaps: Chesapeake enters into fixed-to-floating interest rate swaps (we receive a fixed interest rate and pay a floating market rate) to mitigate our exposure to changes in the fair value of our senior notes. We enter into floating-to-fixed interest rate swaps (we receive a floating market rate and pay a fixed interest rate) to manage our interest rate exposure related to our bank credit facilities borrowings.

 

   

Collars: These instruments contain a fixed floor rate (floor) and a ceiling rate (cap). If the floating rate is above the cap, we have a net receivable from the counterparty and if the floating rate is below the floor, we have a net payable to the counterparty. If the floating rate is between the floor and the cap, there is no payment due from either party. Collars are used to manage our interest rate exposure related to our bank credit facilities borrowings.

 

   

Call options: Occasionally we sell call options for a premium when we think it is more likely that the option will expire unexercised. The option allows the counterparty to terminate an open swap at a specific date.

 

   

Swaptions: Occasionally we sell an option to a counterparty for a premium which allows the counterparty to enter into a swap with us on a specific date.

The notional amount of debt hedged and the estimated fair value of our interest rate derivatives outstanding as of September 30, 2009 and December 31, 2008 are provided below.

 

     September 30, 2009     December 31, 2008  
         Notional      
Amount
        Fair Value               Notional      
Amount
        Fair Value      
   ($ in millions)  

Interest rate

        

Swaps

   $ 3,325      $ (74   $ 1,575      $ 88   

Collars

     250        (8     800        (35

Call options

     250        (9     750        (105

Swaptions

                   750        (10
                                

Totals

   $ 3,825      $ (91   $ 3,875      $ (62
                                

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

For interest rate derivative instruments designated as fair value hedges (in accordance with ASC 815), changes in fair value are recorded on the condensed consolidated balance sheets as assets (liabilities), and the debt’s carrying value amount is adjusted by the change in the fair value of the debt subsequent to the initiation of the derivative. Changes in the fair value of non-qualifying derivatives that occur prior to their maturity (i.e., temporary fluctuations in value) are currently reported in the condensed consolidated statements of operations as unrealized gains (losses) within interest expense.

Gains or losses from interest rate derivative transactions are reflected as adjustments to interest expense in the condensed consolidated statements of operations. The components of interest expense for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period are presented below.

 

     Three Months Ended
September 30,
     Nine Months Ended 
September 30,
 
   2009     2008     2009     2008  
   ($ in millions)  

Interest expense on senior notes

   $ 195      $ 171      $ 572      $ 472   

Interest expense on credit facilities

     18        23        47        83   

Capitalized interest

     (153     (166     (467     (390

Realized (gains) losses on interest rate derivatives

     (7     5        (19     1   

Unrealized (gains) losses on interest rate derivatives

     (20     (8     (106     (9

Amortization of loan discount and other

     10        9        25        29   
                                

Total interest expense

   $ 43      $ 34      $ 52      $ 186   
                                

Our qualifying interest rate swaps are considered 100% effective and therefore no ineffectiveness was recorded for the periods presented above.

Gains and losses related to terminated qualifying interest rate derivative transactions will be amortized as an adjustment to interest expense over the remaining term of the related senior notes. Over the next eleven years we will be realizing $109 million in gains related to such trades.

Foreign Currency Derivatives

On December 6, 2006, we issued €600 million of 6.25% Euro-denominated Senior Notes due 2017. Concurrent with the issuance of the euro-denominated senior notes, we entered into a cross currency swap to mitigate our exposure to fluctuations in the euro relative to the dollar over the term of the notes. Under the terms of the cross currency swap, on each semi-annual interest payment date, the counterparties pay Chesapeake €19 million and Chesapeake pays the counterparties $30 million, which yields an annual dollar-equivalent interest rate of 7.491%. Upon maturity of the notes, the counterparties will pay Chesapeake €600 million and Chesapeake will pay the counterparties $800 million. The terms of the cross currency swap were based on the dollar/euro exchange rate on the issuance date of $1.3325 to €1.00. Through the cross currency swap, we have eliminated any potential variability in Chesapeake’s expected cash flows related to changes in foreign exchange rates and therefore the swap qualifies as a cash flow hedge under ASC 815. The fair value of the cross currency swap is recorded on the condensed consolidated balance sheet as an asset of $44 million at September 30, 2009. The euro-denominated debt in notes payable has been adjusted to $878 million at September 30, 2009 using an exchange rate of $1.4630 to €1.00.

Additional Disclosures About Derivative Instruments and Hedging Activities

In accordance with ASC 815 and ASC 210, to the extent that a legal right of set-off exists, Chesapeake nets the value of its derivative arrangements with the same counterparty in the accompanying condensed consolidated balance sheets. Derivative instruments reflected as current in the condensed consolidated balance sheet represent the estimated fair value of derivatives scheduled to settle over the next twelve months based on market prices/rates as of the balance sheet date. The derivative settlement amounts are not due until the month in which the related underlying hedged transaction occurs.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Pursuant to ASC 815, the following table sets forth the fair value of each classification of derivative instrument as of September 30, 2009 on a gross basis without regard to same-counterparty netting:

 

     September 30, 2009  
     Balance Sheet Location    Fair Value  
            ($ in millions)    

ASSET DERIVATIVES:

     

Derivatives designated as hedging instruments under ASC 815:

     

Commodity contracts

   Short-term derivative instruments    $ 378   

Commodity contracts

   Long-term derivative instruments      25   

Foreign exchange contracts

   Long-term derivative instruments      44   
           

Total

        447   
           

Derivatives not designated as hedging instruments under ASC 815:

     

Commodity contracts

   Short-term derivative instruments      237   

Commodity contracts

   Long-term derivative instruments      51   

Interest rate contracts

   Long-term derivative instruments      10   
           

Total

        298   
           

LIABILITY DERIVATIVES:

     

Derivatives designated as hedging instruments under ASC 815:

     

Commodity contracts

   Short-term derivative instruments      (5

Interest rate contracts

   Long-term derivative instruments      (30
           

Total

        (35
           

Derivatives not designated as hedging instruments under ASC 815:

     

Commodity contracts

   Short-term derivative instruments      (73

Commodity contracts

   Long-term derivative instruments      (223

Interest rate contracts

   Short-term derivative instruments      (27

Interest rate contracts

   Long-term derivative instruments      (44
           

Total

        (367
           

Total derivative instruments

      $ 343   
           

A consolidated summary of the effect of derivative instruments on the condensed consolidated statements of operations for the three and nine months ended September 30, 2009 is provided below, separating fair value, cash flow and non-qualifying derivatives (as defined by ASC 815).

The following table presents the gain (loss) recognized in net income (loss) for instruments designated as fair value derivatives ($ in millions):

 

Fair Value Derivatives

  

Location of Gain (Loss)

     Three Months Ended  
September 30, 2009
      Nine Months Ended   
September 30, 2009

Interest rate contracts

   Interest expense(a)    $ 13    $ 31
                

 

 

(a) Interest expense on the hedged items for the Current Quarter and the Current Period was $33 million and $66 million, respectively, which is included in interest expense on the condensed consolidated statement of operations.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The following table presents the pre-tax gain (loss) recognized in, and reclassified from, accumulated other comprehensive income (AOCI) and recognized in net income (loss), including any hedge ineffectiveness, for derivative instruments designated as cash flow derivatives ($ in millions):

 

Cash Flow Derivatives

  

Location of Gain (Loss)

     Three Months Ended  
September 30, 2009
       Nine Months Ended   
September 30, 2009
 

Gain (Loss) Recognized in AOCI (Effective Portion)

       

Commodity contracts

   AOCI    $ 107      $ 819   

Foreign exchange contracts

   AOCI      1        79   
                   
      $ 108      $ 898   
                   

Gain (Loss) Reclassified from AOCI (Effective Portion)

       

Commodity contracts

   Natural gas and oil sales    $ 381      $ 994   

Foreign exchange contracts

   Other income               
                   
      $ 381      $ 994   
                   

Gain (Loss) Recognized (Ineffective Portion)(a)

       

Commodity contracts

   Natural gas and oil sales    $ (7   $ 83   

Foreign exchange contracts

   Other income               
                   
      $ (7   $ 83   
                   

 

 

(a) The amount of gain (loss) recognized in net income (loss) represents the ineffective portion of our cash flow derivatives.

The following table presents the gain (loss) recognized in net income (loss) for instruments not qualifying as cash flow or fair value derivatives ($ in millions):

 

Non-Qualifying Derivatives

  

Location of Gain (Loss)

     Three Months Ended  
September 30, 2009
      Nine Months Ended   
September 30, 2009

Commodity contracts

   Natural gas and oil sales    $ 28    $ 324

Interest rate contracts

   Interest expense      14      94
                
  

Total

   $ 42    $ 418
                

Concentration of Credit Risk

A significant portion of our liquidity is concentrated in derivative instruments that enable us to hedge a portion of our exposure to natural gas and oil price and interest rate volatility. These arrangements expose us to credit risk from our counterparties. To mitigate this risk, we enter into derivative contracts only with investment-grade rated counterparties deemed by management to be competent and competitive market makers, and we attempt to limit our exposure to non-performance by any single counterparty. On September 30, 2009, our commodity and interest rate derivative instruments were spread among 14 counterparties. Additionally, our multi-counterparty secured hedging facility described above requires our counterparties to secure their natural gas and oil hedging obligations in excess of defined thresholds. We now use this facility for all of our commodity hedging.

Other financial instruments which potentially subject us to concentrations of credit risk consist principally of investments in equity instruments and accounts receivable. Our accounts receivable are primarily from purchasers of natural gas and oil and exploration and production companies which own interests in properties we operate. This industry concentration has the potential to impact our overall exposure to credit risk, either positively or negatively, in that our customers may be similarly affected by changes in economic, industry or other conditions. We monitor the creditworthiness of all our counterparties. We generally require letters of credit for receivables from customers which are judged to have sub-standard credit, unless the credit risk can otherwise be mitigated. During the Current Quarter and the Current Period, we recognized a nominal amount and $13 million, respectively, of bad debt expense related to potentially uncollectible receivables.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

3. Contingencies and Commitments

Litigation

On February 25, 2009, a putative class action was filed in the U.S. District Court for the Southern District of New York against the company and certain of its officers and directors along with certain underwriters of the company’s July 2008 common stock offering. Following the appointment of a lead plaintiff and counsel, the plaintiff filed an amended complaint on September 11, 2009 alleging that the registration statement for the offering contained material misstatements and omissions and seeking damages under Sections 11, 12 and 15 of the Securities Act of 1933 of an unspecified amount and rescission. The action was transferred to the U.S. District Court for the Western District of Oklahoma on October 13, 2009. A derivative action was also filed in the District Court of Oklahoma County, Oklahoma on March 10, 2009 against the company’s directors and certain of its officers alleging breaches of fiduciary duties relating to the disclosure matters alleged in the securities case.

On March 26, 2009, a shareholder filed a petition in the District Court of Oklahoma County, Oklahoma seeking to compel inspection of company books and records relating to compensation of the company’s CEO. On August 20, 2009, the court denied the inspection demand, dismissed the petition and entered judgment in favor of Chesapeake. The shareholder is appealing the court’s ruling.

Three derivative actions were filed in the District Court of Oklahoma County, Oklahoma on April 28, May 7, and May 20, 2009 against the company’s directors alleging breaches of fiduciary duties relating to compensation of the company’s CEO and alleged insider trading, among other things, and seeking unspecified damages, equitable relief and disgorgement. These three derivative actions were consolidated and a Consolidated Derivative Shareholder Petition was filed on June 23, 2009. Chesapeake is named as a nominal defendant. Chesapeake filed a motion to dismiss the petition on August 7, 2009. The court has not set a date to hear the motion.

It is inherently difficult to predict the outcome of litigation, and we are currently unable to estimate the amount of any potential liabilities associated with the foregoing cases, which are all in preliminary stages.

Chesapeake is also involved in various other lawsuits and disputes incidental to its business operations, including commercial disputes, personal injury claims, claims for underpayment of royalties, property damage claims and contract actions. With regard to the latter, several mineral or leasehold owners have filed lawsuits against us seeking specific performance to require us to acquire their oil and natural gas interests and pay acreage bonus payments, damages based on breach of contract and/or, in certain cases, punitive damages based on alleged fraud. The company has satisfactorily resolved several of the suits but some remain pending. The remaining leasehold acquisition cases are in various stages of discovery. The company believes that it has substantial defenses to the claims made in all these cases.

The company records an associated liability when a loss is probable and the amount is reasonably estimable. Although the outcome of litigation cannot be predicted with certainty, management is of the opinion that no pending or threatened lawsuit or dispute incidental to its business operations is likely to have a material adverse effect on the company’s consolidated financial position, results of operations or cash flows. The final resolution of such matters could exceed amounts accrued, however, and actual results could differ materially from management’s estimates.

Employment Agreements with Officers

Chesapeake has employment agreements with its chief executive officer, chief operating officer, chief financial officer and other executive officers, which provide for annual base salaries, various benefits and eligibility for bonus compensation. The agreement with the chief executive officer expires on December 31, 2013 unless extended. The term of the agreement is automatically extended for one additional year on each December 31 unless the company provides 30 days notice of non-extension. The agreement contains a cap on cash salary and bonus compensation for the next five years at 2008 levels. In the event of termination of employment without cause, the chief executive officer’s base compensation (defined as base salary plus bonus compensation received during the preceding 12 months) and benefits would continue during the remaining term of the agreement. The chief executive officer is entitled to receive a payment in the amount of three times his base compensation upon the happening of certain events following a change of control. The agreement further provides that any stock-based awards held by the chief executive officer and deferred compensation will immediately become 100% vested upon termination of employment without cause, incapacity, death or retirement at or after age 55. The agreement also provides for a one-time $75 million well cost incentive award with a five-year clawback. The well cost incentive award was fully applied against the CEO’s obligations under the Founder Well Participation Program as of March 31, 2009. The

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

agreements with the chief operating officer, chief financial officer and other executive officers expire on September 30, 2012. The agreements with our COO, CFO and other executive vice presidents contain a cap on cash salary for the three-year term of the agreement. In addition, annual cash bonuses will not exceed the sum of the individual EVP’s cash bonus compensation for (a) the last half of 2008 and (b) the first half of 2009. These agreements provide for the continuation of salary for one year in the event of termination of employment without cause or death and, in the event of a change of control, a payment in the amount of two times the executive officer’s base compensation. These executive officers are entitled to receive a lump sum payment equal to 26 weeks of cash salary following termination of employment as a result of incapacity. Any stock-based awards held by such executive officers will immediately become 100% vested upon termination of employment without cause, a change of control, death or retirement at or after age 55. The agreements also provide for a 2008 incentive award payable in four equal annual installments, the first of which was paid on September 30, 2009. The payment of each installment of the award is subject to the individual’s continued employment on the date of payment, except that the unpaid installments of the award would be accelerated and paid in lump sum in the event of a change of control or a termination by the executive for good reason, as defined in the agreements.

Environmental Risk

Due to the nature of the natural gas and oil business, Chesapeake and its subsidiaries are exposed to possible environmental risks. Chesapeake has implemented various policies and procedures to avoid environmental contamination and risks from environmental contamination. Chesapeake conducts periodic reviews, on a company-wide basis, to identify changes in our environmental risk profile. These reviews evaluate whether there is a contingent liability, its amount, and the likelihood that the liability will be incurred. The amount of any potential liability is determined by considering, among other matters, incremental direct costs of any likely remediation and the proportionate cost of employees who are expected to devote a significant amount of time directly to any possible remediation effort. We manage our exposure to environmental liabilities on properties to be acquired by identifying existing problems and assessing the potential liability. Depending on the extent of an identified environmental problem, Chesapeake may exclude a property from the acquisition, require the seller to remediate the property to our satisfaction, or agree to assume liability for the remediation of the property. Chesapeake has historically not experienced any significant environmental liability, and is not aware of any potential material environmental issues or claims at September 30, 2009.

Rig Leases

In a series of transactions in 2006, 2007 and 2008, our drilling subsidiaries sold 83 drilling rigs and related equipment for $677 million and entered into a master lease agreement under which we agreed to lease the rigs from the buyer for initial terms of seven to ten years for lease payments of approximately $95 million annually. The lease obligations are guaranteed by Chesapeake and its other material restricted subsidiaries. These transactions were recorded as sales and operating leasebacks and any related gain or loss is being amortized to service operations expense over the lease term. Under the rig leases, we can exercise an early purchase option after six or seven years or on the expiration of the lease term for a purchase price equal to the then fair market value of the rigs. Additionally, we have the option to renew the rig lease for a negotiated renewal term at a periodic lease payment equal to the fair market rental value of the rigs as determined at the time of renewal. Commitments related to rig lease payments are not recorded in the accompanying condensed consolidated balance sheets. As of September 30, 2009, the minimum aggregate future rig lease payments were approximately $539 million. As of September 30, 2009, Chesapeake’s drilling subsidiary had committed to acquire one rig by the end of 2009 and had incurred costs of $9 million as of that date. The total remaining cost of the rig is estimated to be approximately $5 million. Our intent is to sell and lease back owned rigs when acceptable leasing arrangements are available to us.

Compressor Leases

In a series of transactions in 2007, 2008 and 2009, our compression subsidiary sold a significant portion of its compressor fleet, consisting of 1,685 compressors, for $372 million and entered into a master lease agreement. The term of the agreement varies by buyer ranging from seven to ten years for aggregate lease payments of approximately $47 million annually. The lease obligations are guaranteed by Chesapeake and its other material restricted subsidiaries. These transactions were recorded as sales and operating leasebacks and any related gain or loss is being amortized to marketing, gathering and compression expenses over the lease term. Under the leases, we can exercise an early purchase option after five to nine years or we can purchase the compressors at expiration of the lease for the fair market value at the time. In addition, we have the option to renew the lease for negotiated new terms at the expiration of the lease. Commitments related to compressor lease payments are not recorded in the accompanying condensed consolidated balance sheets. As of September 30, 2009, the minimum aggregate future

 

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(Unaudited)

 

compressor lease payments were approximately $355 million. As of September 30, 2009, 218 new compressors were on order for approximately $92 million. Our intent is to sell and lease back owned compressors when acceptable leasing arrangements are available to us.

Real Estate Surface Asset Leases

In April 2009, we financed 113 real estate surface assets in the Barnett Shale area in and around Fort Worth, Texas for approximately $145 million and entered into a 40-year master lease agreement under which we agreed to lease the sites for approximately $15 million to $27 million annually. These lease transactions were recorded as a financing lease and the cash received was recorded with an offsetting long-term liability on the condensed consolidated balance sheet. As of September 30, 2009, the minimum aggregate future lease payments were approximately $862 million. Chesapeake has the option to repurchase up to a specified number of assets at any time during the term of the lease.

Transportation Contracts

Chesapeake has various firm pipeline transportation service agreements with expiration dates ranging from 2009 to 2099. These commitments are not recorded in the accompanying condensed consolidated balance sheets. Under the terms of these contracts, we are obligated to pay demand charges as set forth in the transporter’s Federal Energy Regulatory Commission (FERC) gas tariff. In exchange, the company receives rights to flow natural gas production through pipelines located in highly competitive markets. The aggregate amounts of such required demand payments as of September 30, 2009, excluding demand charges for pipeline projects that are currently seeking regulatory approval, were as follows ($ in millions):

 

2009

   $ 60

2010

     231

2011

     251

2012

     240

2013

     222

After 2013

     1,278
      

Total

   $         2,282
      

Drilling Contracts

Currently, Chesapeake has contracts with various drilling contractors to lease approximately 20 rigs with terms of one to three years. These commitments are not recorded in the accompanying condensed consolidated balance sheets. As of September 30, 2009, the aggregate drilling rig commitment was approximately $175 million.

Natural Gas and Oil Purchase Obligations

Our midstream segment regularly commits to purchase natural gas from other owners in our properties and such commitments typically are short-term in nature. We have also committed to purchasers of our volumetric production payment transactions (VPPs) that we will purchase natural gas and oil associated with the VPPs. Our VPP purchase commitments are based on market prices at the time of production and extend over 11 to 15 year terms. As of September 30, 2009, we were obligated to purchase 468 bcfe under the terms of the VPPs. We resell the natural gas and oil we purchase at market prices.

Other Commitments

In the Current Period, we financed one of our buildings for approximately $54 million with a five-year term loan which has a floating rate of prime plus 275 basis points. At our option, we may prepay in full without penalty beginning in year four. The payment obligation is guaranteed by Chesapeake.

We own a 49% interest in Mountain Drilling Company, a company that specializes in hydraulic drilling rigs which are designed for drilling in urban areas. Due to a meaningful decline in the overall activity in the drilling market and poor operating performance of Mountain Drilling Company, we determined that an impairment had occurred and we fully impaired our investment at March 31, 2009. Chesapeake has an agreement to lend Mountain Drilling Company up to $19 million. At September 30, 2009, Mountain Drilling owed Chesapeake $19 million under this agreement.

 

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We invested in Ventura Refining and Transmission LLC in early 2007 in an effort to improve the market for our oil and condensate production in western Oklahoma. Due to worsening economic conditions, the lack of third party credit available to Ventura and poor operating performance in the second half of 2008, management determined that an impairment had occurred and we wrote off our investment at December 31, 2008. During the Current Period, we paid an additional $17 million to fund various costs associated with Ventura’s operations. These payments were expensed as incurred.

 

4. Net Income Per Share

ASC 260, Earnings Per Share, requires presentation of “basic” and “diluted” earnings per share, as defined, on the face of the statements of operations for all entities with complex capital structures. ASC 260 requires a reconciliation of the numerator and denominator of the basic and diluted EPS computations. The following securities and associated adjustments to net income comprised of dividends and loss on conversions/exchanges were not included in the calculation of diluted earnings per share, as the effect was antidilutive:

 

     Shares    Net Income
    Adjustments    
         (in millions)         ($ in millions)

Three Months Ended September 30, 2009:

     

Common stock equivalent of our preferred stock outstanding:

     

5.00% cumulative convertible preferred stock (series 2005)

      $

5.00% cumulative convertible preferred stock (series 2005B)

   5    $ 3

4.50% cumulative convertible preferred stock

   6    $ 3

Three Months Ended September 30, 2008:

     

Common stock equivalent of our preferred stock outstanding prior to conversion:

     

5.00% cumulative convertible preferred stock (series 2005B)

   1    $ 13

4.50% cumulative convertible preferred stock

   1    $ 12

Nine Months Ended September 30, 2009:

     

Employee stock options

   1    $

Restricted stock

   5    $

Common stock equivalent of our preferred stock outstanding:

     

5.00% cumulative convertible preferred stock (series 2005)

      $

5.00% cumulative convertible preferred stock (series 2005B)

   5    $ 8

4.50% cumulative convertible preferred stock

   6    $ 9

Common stock equivalent of our preferred stock outstanding prior to conversion:

     

4.125% cumulative convertible preferred stock

      $

6.25% mandatory convertible preferred stock

   1    $ 1

Nine Months Ended September 30, 2008:

     

Common stock equivalent of our preferred stock outstanding prior to conversion:

     

5.00% cumulative convertible preferred stock (series 2005B)

   5    $ 62

4.50% cumulative convertible preferred stock

   2    $ 14

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

For the Current Period there was no difference between basic weighted average shares outstanding, which are used in computing basic EPS, and diluted weighted average shares, which are used in computing EPS assuming dilution as a result of the net loss to common stockholders.

Reconciliations for the Current Quarter, Prior Quarter and Prior Period are as follows:

 

     Income
  (Numerator)  
   Shares
(Denominator)
       Per Share    
Amount
     (in millions, except per share data)

Three Months Ended September 30, 2009:

        

Basic EPS:

        

Income available to Chesapeake common stockholders

   $ 186    619    $ 0.30
                  

Effect of Dilutive Securities

        

Employee stock options

        1   

Restricted stock

        6   
              

Diluted EPS income available to Chesapeake common stockholders and assumed conversions

   $ 186    626    $ 0.30
                  

Three Months Ended September 30, 2008:

        

Basic EPS:

        

Income available to Chesapeake common stockholders

   $ 3,291    554    $ 5.94
                  

Effect of Dilutive Securities

        

Assumed conversion as of the beginning of the period of preferred shares outstanding during the period:

        

Common shares assumed issued for 4.50% cumulative convertible preferred stock

     3    6   

Common shares assumed issued for 5.00% cumulative convertible preferred stock (series 2005B)

     3    5   

Common shares assumed issued for 6.25% mandatory convertible preferred stock

        1   

Effect of contingent convertible senior notes outstanding during the period

     9    13   

Employee stock options

        2   

Restricted stock

        7   
              

Diluted EPS income available to Chesapeake common stockholders and assumed conversions

   $ 3,306    588    $ 5.62
                  

Nine Months Ended September 30, 2008:

        

Basic EPS:

        

Income available to Chesapeake common stockholders

   $ 1,506    523    $ 2.88
                  

Effect of Dilutive Securities

        

Assumed conversion as of the beginning of the period of preferred shares outstanding during the period:

        

Common shares assumed issued for 4.50% cumulative convertible preferred stock

     8    6   

Common shares assumed issued for 5.00% cumulative convertible preferred stock (series 2005B)

     8    5   

Common shares assumed issued for 6.25% mandatory convertible preferred stock

     2    1   

Effect of contingent convertible senior notes outstanding during the period

     12    13   

Employee stock options

        2   

Restricted stock

        7   
              

Diluted EPS income available to Chesapeake common stockholders and assumed conversions

   $ 1,536    557    $ 2.76
                  

 

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(Unaudited)

 

5. Stockholders’ Equity, Restricted Stock and Stock Options

Common Stock

The following is a summary of the changes in our common shares issued for the nine months ended September 30, 2009 and 2008:

 

             2009                    2008        
     (in thousands)

Shares issued at January 1

   607,953    511,648

Stock option exercises

   429    1,473

Restricted stock issuances (net of forfeitures)

   3,940    4,352

Convertible note exchanges

   6,707   

Preferred stock conversions/exchanges

   1,422    12,673

Common stock issued for the purchase of proved and unproved properties and leasehold

   24,823   

Common stock issuances

      51,750
         

Shares issued at September 30

   645,274    581,896
         

During the Current Period, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $238 million in aggregate principal amount for an aggregate of 6,707,321 shares of our common stock in privately negotiated exchanges.

During the Current Period, we issued 24,822,832 shares of common stock, valued at $429 million, for the purchase of proved and unproved properties and leasehold pursuant to an acquisition shelf registration statement.

Preferred Shares

The following is a summary of the changes in our preferred shares outstanding for the nine months ended September 30, 2009 and 2008:

 

         4.50%        5.00%
  (2005B)  
      5.00% 
  (2005)  
        6.25%           4.125%    
     (in thousands)  

Shares outstanding at January 1, 2009

   2,559      2,096      5      144      3   

Conversion/exchange of preferred for common stock

                  (144   (3
                              

Shares outstanding at September 30, 2009

   2,559      2,096      5             
                              

Shares outstanding at January 1, 2008

   3,450      5,750      5      144      3   

Conversion/exchange of preferred for common stock

   (891   (3,654               
                              

Shares outstanding at September 30, 2008

   2,559      2,096                     5      144      3   
                              

On March 31, 2009, we converted all of our outstanding 4.125% Cumulative Convertible Preferred Stock (3,033 shares) into 182,887 shares of common stock pursuant to the company’s mandatory conversion rights.

On June 15, 2009, we converted all of our outstanding 6.25% Mandatory Convertible Preferred Stock (143,768 shares) into 1,239,538 shares of common stock pursuant to the company’s mandatory conversion rights.

During the Prior Period, holders of our 5.0% Cumulative Convertible Preferred Stock (Series 2005B) exchanged 3,654,385 shares for 10,443,642 shares of common stock in privately negotiated exchanges.

During the Prior Period, a holder of our 4.50% Cumulative Convertible Preferred Stock exchanged 891,000 shares for 2,227,750 shares of our common stock in a privately negotiated transaction.

Dividends

Dividends declared on our common stock and preferred stock are reflected as adjustments to retained earnings to the extent a surplus of retained earnings will exist after giving effect to the dividends. To the extent retained earnings are insufficient to fund the distributions, such payments constitute a return of contributed capital rather than earnings and are accounted for as a reduction to paid-in capital.

 

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Stock-Based Compensation

Chesapeake’s stock-based compensation programs consist of restricted stock and stock options issued to employees and non-employee directors. To the extent compensation cost relates to employees directly involved in natural gas and oil exploration and development activities, such amounts are capitalized to natural gas and oil properties. Amounts not capitalized are recognized as general and administrative expenses, production expenses, marketing, gathering and compression expenses, service operations expense or restructuring costs. We recorded the following stock-based compensation during the Current Quarter, the Prior Quarter, the Current Period and the Prior Period:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008
     ($ in millions)

Natural gas and oil properties

   $ 27    $ 30    $ 85    $ 81

General and administrative expenses

     22      26      60      66

Production expenses

     8      8      26      22

Marketing, gathering and compression expenses

     4      3      12      8

Service operations expense

     2      2      6      4

Restructuring costs

               9     
                           

Total

   $ 63    $ 69    $ 198    $ 181
                           

Restricted Stock. Chesapeake regularly issues shares of restricted common stock to employees and to non-employee directors. The fair value of the awards issued is determined based on the fair market value of the shares on the date of grant. This value is amortized over the vesting period, which is generally four or five years from the date of grant for employees and three years for non-employee directors.

A summary of the changes in unvested shares of restricted stock during the Current Period is presented below:

 

     Number of
Unvested
 Restricted Shares 
    Weighted-Average
Grant-Date

Fair Value
     (in thousands)      

Unvested shares as of January 1, 2009

   21,622      $ 38.85

Granted

   7,956      $ 18.61

Vested

   (8,944   $ 36.51

Forfeited

   (930   $ 35.14
        

Unvested shares as of September 30, 2009

   19,704      $ 31.91
        

The aggregate intrinsic value of restricted stock vested during the Current Period was approximately $186 million based on the stock price at the time of vesting.

As of September 30, 2009, there was $509 million of total unrecognized compensation cost related to unvested restricted stock. The cost is expected to be recognized over a weighted average period of 2.58 years.

The vesting of certain restricted stock grants results in state and federal income tax benefits related to the difference between the market price of the common stock at the date of vesting and the date of grant. During the Current Quarter and the Current Period, we recognized a reduction in tax benefits related to restricted stock of $36 million and $48 million, respectively. During the Prior Quarter and the Prior Period, we recognized excess tax benefits related to restricted stock of $18 million and $27 million, respectively. The reduction in tax benefits and the excess tax benefits were recorded as adjustments to additional paid-in capital and deferred income taxes.

 

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Stock Options. Prior to 2006, we granted stock options under several stock compensation plans. Outstanding options expire ten years from the date of grant and all are currently fully vested.

The following table provides information related to stock option activity during the Current Period:

 

    Number of
Shares
Underlying
Options
    Weighted
Average
Exercise Price

   Per Share   
    Weighted
Average
Contract
 Life in Years 
    Aggregate
Intrinsic
Value(a)

($ in millions)
 
    (in thousands)                    

Outstanding at January 1, 2009

  2,802      $ 8.13      3.59      $ 23   

Exercised

  (429   $ 7.36        $ 7   

Expired

  (11   $ 6.47       
           

Outstanding at September 30, 2009

  2,362      $ 8.28      2.96      $ 48   
           

Exercisable at September 30, 2009

  2,362      $ 8.28      2.96      $ 48   
           

 

 

(a) The intrinsic value of a stock option is the amount by which the current market value or the market value upon exercise of the underlying stock exceeds the exercise price of the option.

During the Current Quarter, the Prior Quarter, the Current Period and the Prior Period, we recognized excess tax benefits related to stock options of $1 million, $3 million, $1 million and $15 million, respectively, which were recorded as adjustments to additional paid-in capital and deferred income taxes.

 

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6. Senior Notes and Revolving Bank Credit Facilities

Our total debt consisted of the following at September 30, 2009 and December 31, 2008:

 

    September 30,
2009
     December 31, 
2008
 
          (Adjusted)  
    ($ in millions)  

7.5% Senior Notes due 2013

  $ 364      $ 364   

7.625% Senior Notes due 2013

    500        500   

7.0% Senior Notes due 2014

    300        300   

7.5% Senior Notes due 2014

    300        300   

6.375% Senior Notes due 2015

    600        600   

9.5% Senior Notes due 2015

    1,425          

6.625% Senior Notes due 2016

    600        600   

6.875% Senior Notes due 2016

    670        670   

6.25% Euro-denominated Senior Notes due 2017(a)

    878        835   

6.5% Senior Notes due 2017

    1,100        1,100   

6.25% Senior Notes due 2018

    600        600   

7.25% Senior Notes due 2018

    800        800   

6.875% Senior Notes due 2020

    500        500   

2.75% Contingent Convertible Senior Notes due 2035(b)

    451        451   

2.5% Contingent Convertible Senior Notes due 2037(b)

    1,378        1,378   

2.25% Contingent Convertible Senior Notes due 2038(b)

    888        1,126   

General corporate revolving bank credit facility

    1,618        3,474   

CMD revolving bank credit facility

           460   

CMP revolving bank credit facility

    12          

Discount on senior notes(c)

    (991     (1,094

Interest rate derivatives(d)

    80        211   
               

Total notes payable and long-term debt

  $ 12,073      $       13,175   
               

 

 

(a) The principal amount shown is based on the dollar/euro exchange rate of $1.4630 to €1.00 and $1.3919 to €1.00 as of September 30, 2009 and December 31, 2008, respectively. See Note 2 for information on our related cross currency swap.

 

(b) The holders of our contingent convertible senior notes may require us to repurchase, in cash, all or a portion of their notes at 100% of the principal amount of the notes on any of four dates that are five, ten, fifteen and twenty years before the maturity date. The notes are convertible, at the holder’s option, prior to maturity under certain circumstances into cash and, if applicable, shares of our common stock using a net share settlement process. One such triggering circumstance is when the price of our common stock exceeds a threshold amount during a specified period in a fiscal quarter. Convertibility based on common stock price is measured quarter by quarter. In the third quarter of 2009, the price of our common stock was below the threshold level for each series of the contingent convertible senior notes during the specified period and, as a result, the holders do not have the option to convert their notes into cash and common stock in the fourth quarter of 2009 under this provision. The notes are also convertible, at the holder’s option, during specified five-day periods if the trading price of the notes is below certain levels determined by reference to the trading price of our common stock. In general, upon conversion of a contingent convertible senior note, the holder will receive cash equal to the principal amount of the note and common stock for the note’s conversion value in excess of such principal amount. We will pay contingent interest on the convertible senior notes after they have been outstanding at least ten years, under certain conditions. We may redeem the convertible senior notes once they have been outstanding for ten years at a redemption price of 100% of the principal amount of the notes, payable in cash. The optional repurchase dates, the common stock price conversion threshold amounts and the ending date of the first six-month period contingent interest may be payable for the contingent convertible senior notes are as follows:

 

Contingent

Convertible

        Senior Notes        

  

Repurchase Dates

   Common Stock
Price Conversion
      Thresholds      
 

    Contingent Interest    

First Payable

(if applicable)

2.75% due 2035

      November 15, 2015, 2020, 2025, 2030    $ 48.81  

May 14, 2016

2.5% due 2037

      May 15, 2017, 2022, 2027, 2032    $ 64.36  

November 14, 2017

2.25% due 2038

      December 15, 2018, 2023, 2028, 2033    $ 107.36  

June 14, 2019

 

(c) Discount at December 31, 2008 is adjusted for the retrospective application of the provisions of ASC 470-20, Debt with Conversion and Other Options. Discount at September 30, 2009 and December 31, 2008 included $859 million and $1.009 billion, respectively, associated with the equity component of our contingent convertible senior notes.

 

(d) See Note 2 for discussion related to these instruments.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Senior Notes

Our senior notes are unsecured senior obligations of Chesapeake and rank equally in right of payment with all of our existing and future senior indebtedness and rank senior in right of payment to all of our future subordinated indebtedness. Our senior note obligations are guaranteed by certain of our wholly-owned subsidiaries. See Note 13 for condensed consolidating financial information regarding our guarantor and non-guarantor subsidiaries. We may redeem the senior notes, other than the contingent convertible senior notes, at any time at specified make-whole or redemption prices. Senior notes issued before July 2005 are governed by indentures containing covenants that limit our ability and our restricted subsidiaries’ ability to incur additional indebtedness; pay dividends on our capital stock or redeem, repurchase or retire our capital stock or subordinated indebtedness; make investments and other restricted payments; incur liens; enter into sale/leaseback transactions; create restrictions on the payment of dividends or other amounts to us from our restricted subsidiaries; engage in transactions with affiliates; sell assets; and consolidate, merge or transfer assets. Senior notes issued after June 2005 are governed by indentures containing covenants that limit our ability and our subsidiaries’ ability to incur certain secured indebtedness; enter into sale/leaseback transactions; and consolidate, merge or transfer assets.

Chesapeake Energy Corporation is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. As of September 30, 2008, our obligations under our outstanding senior notes and contingent convertible notes were fully and unconditionally guaranteed, jointly and severally, by all of our wholly-owned restricted subsidiaries, other than minor subsidiaries, on a senior unsecured basis. In October 2008, we restructured our midstream operations. As a result, beginning in the fourth quarter of 2008, our wholly-owned midstream subsidiaries having significant assets and operations do not guarantee our outstanding senior notes.

During the Current Period, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $238 million in aggregate principal amount for an aggregate of 6,707,321 shares of our common stock in privately negotiated exchanges.

No scheduled principal payments are required under our senior notes until 2013 when $864 million is due.

On January 1, 2009, we adopted and applied retrospectively the provisions of ASC 470-20, Debt with Conversion and Other Options. We have three debt issuances affected by this change: our 2.75% Contingent Convertible Senior Notes due 2035, our 2.5% Contingent Convertible Senior Notes due 2037 and our 2.25% Contingent Convertible Senior Notes due 2038. ASC 470-20 requires us to account for the liability and equity components of our convertible debt instruments separately and to reflect interest expense at the interest rate of similar nonconvertible debt at the time of issuance (6.86%, 8.0% and 8.0%, respectively). Additionally, debt issuance costs are required to be allocated in proportion to the liability and equity components and accounted for as debt issuance costs and equity issuance costs, respectively. The allocation to the equity component of the convertible notes was $845 million (net of tax) at December 31, 2008. The accretion of the resulting discount on the debt is recognized as a part of interest expense, thereby increasing the amount of interest expense required to be recognized with respect to such instruments. Given the increase in our overall effective interest rate after adoption of ASC 470-20, we also capitalized additional interest which largely offset the increase in interest expense.

The following table summarizes the effect of the change in accounting principle related to our contingent convertible notes on the condensed consolidated balance sheet:

 

    December 31, 2008
   Previously 
Reported
  Adjustment       Adjusted 
  ($ in millions)

Unevaluated properties

  $ 11,216   $ 163      $ 11,379

Other long-term assets

  $ 1,007   $ (14   $ 993

Long-term debt, net

  $ 14,184   $ (1,009   $ 13,175

Deferred income tax liability

  $ 3,763   $ 437      $ 4,200

Paid-in-capital

  $ 10,835   $ 845      $ 11,680

Retained earnings

  $ 4,694   $ (125   $ 4,569

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The following table summarizes the effect of the change in accounting principle related to our contingent convertible notes on the condensed consolidated statements of operations ($ in millions, except per share data):

 

     Previously
Reported
    Adjustment     Adjusted  

Three Months Ended September 30, 2008:

      

Depreciation and amortization of other assets

   $ 48      $      $ 48   

Interest expense

   $ 48      $ (14   $ 34   

Income tax expense (benefit)

   $ 2,074      $ 5      $ 2,079   

Net income (loss)

   $ 3,313      $ 9      $ 3,322   

Weighted average common and common equivalent shares outstanding – assuming dilution (in millions)

     588               588   

Earnings (loss) per common share:

      

Basic

   $ 5.93      $ 0.01      $ 5.94   

Diluted

   $ 5.61      $ 0.01      $ 5.62   
     Previously
    Reported    
      Adjustment           Adjusted      

Nine Months Ended September 30, 2008:

      

Depreciation and amortization of other assets

   $ 125      $ (1   $ 124   

Interest expense

   $ 212      $ (26   $ 186   

Income tax expense (benefit)

   $ 991      $ 11      $ 1,002   

Net income (loss)

   $ 1,584      $ 16      $ 1,600   

Weighted average common and common equivalent shares outstanding – assuming dilution (in millions)

     557               557   

Earnings (loss) per common share:

      

Basic

   $ 2.85      $ 0.03      $ 2.88   

Diluted

   $ 2.73      $ 0.03      $ 2.76   

 

The following table summarizes the effect of the change in accounting principle related to our contingent convertible notes on the condensed consolidated statement of cash flows for the nine months ended September 30, 2008 ($ in millions):

   

     Previously
Reported
    Adjustment     Adjusted  

Nine Months Ended September 30, 2008:

      

Cash flows provided by operating activities

   $ 4,305      $ 82      $ 4,387   

Cash flows used in investing activities

   $ (8,201   $ (82   $ (8,283

Cash flows provided by financing activities

   $ 5,859      $      $ 5,859   

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Bank Credit Facilities

We utilize three bank credit facilities, described below, as sources of liquidity.

 

    General
Corporate
    Credit Facility    
  CMD
    Credit Facility    
  CMP
    Credit Facility    
    ($ in millions)

Borrowing capacity

  $ 3,500   $ 250   $ 500

Maturity date

    November 2012     September 2012     September 2012

Borrowers

   
 
 
 
Chesapeake
Exploration, L.L.C.
and Chesapeake
Appalachia, L.L.C.
   
 
 
 
Chesapeake
Midstream
Operating, L.L.C.
(CMO)
   
 
 
 
Chesapeake
Midstream
Partners, L.L.C.
(CMP)

Facility structure

   
 
Senior secured
revolving
   
 
Senior secured
revolving
   
 
Senior secured
revolving

Amount outstanding as of September 30, 2009

  $ 1,618       $ 12

Letters of credit outstanding as of September 30, 2009

  $ 11        

Our credit facilities do not contain material adverse change or adequate assurance covenants. Although the applicable interest rates under our general corporate credit facility fluctuate slightly based on our long-term senior unsecured credit ratings, none of our credit facilities contain provisions which would trigger an acceleration of amounts due under the facilities or a requirement to post additional collateral in the event of a downgrade of our credit ratings.

General Corporate Credit Facility

Our $3.5 billion syndicated revolving bank credit facility is used for general corporate purposes. Borrowings under the facility are secured by certain producing natural gas and oil properties and bear interest at our option at either (i) the greater of the reference rate of Union Bank, N.A. or the federal funds effective rate plus 0.50%, both of which are subject to a margin that varies from 0.00% to 0.75% per annum according to our senior unsecured long-term debt ratings, or (ii) the London Interbank Offered Rate (LIBOR), plus a margin that varies from 1.50% to 2.25% per annum according to our senior unsecured long-term debt ratings. The collateral value and borrowing base are determined periodically. The unused portion of the facility is subject to a commitment fee of 0.50%. Interest is payable quarterly or, if LIBOR applies, it may be payable at more frequent intervals.

The credit facility agreement contains various covenants and restrictive provisions which limit our ability to incur additional indebtedness, make investments or loans and create liens. The credit facility agreement requires us to maintain an indebtedness (excluding discount on senior notes) to total capitalization ratio (as defined) not to exceed 0.70 to 1 and an indebtedness to EBITDA ratio (as defined) not to exceed 3.75 to 1. As defined by the credit facility agreement, our indebtedness to total capitalization ratio was 0.41 to 1 and our indebtedness to EBITDA ratio was 3.48 to 1 at September 30, 2009. If we should fail to perform our obligations under these and other covenants, the revolving credit commitment could be terminated and any outstanding borrowings under the facility could be declared immediately due and payable. Such acceleration, if involving a principal amount of $10 million ($50 million in the case of our senior notes issued after 2004), would constitute an event of default under our senior note indentures, which could in turn result in the acceleration of a significant portion of our senior note indebtedness. The credit facility agreement also has cross default provisions that apply to other indebtedness of Chesapeake and its restricted subsidiaries with an outstanding principal amount in excess of $75 million.

The facility is fully and unconditionally guaranteed, on a joint and several basis, by Chesapeake and all of our other wholly-owned restricted subsidiaries.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CMD Credit Facility

Our Chesapeake Midstream Development, L.P. (CMD) $250 million syndicated revolving bank credit facility is used to fund capital expenditures to build natural gas gathering and other systems for our drilling program and for general corporate purposes associated with our midstream operations. Borrowings under the CMD credit facility are secured by all of the assets of the wholly-owned subsidiaries (the restricted subsidiaries) of CMD, itself a wholly-owned subsidiary of Chesapeake, and bear interest at our option at either (i) the greater of the reference rate of Wells Fargo Bank, National Association, the federal funds effective rate plus 0.50%, and the one-month LIBOR plus 1.00%, all of which would be subject to a margin that varies from 2.00% to 2.75% per annum according to the most recent indebtedness to EBITDA ratio (as defined) or (ii) the LIBOR plus a margin that varies from 3.00% to 3.75% per annum according to the most recent indebtedness to EBITDA ratio (as defined). The unused portion of the facility is subject to a commitment fee of 0.50% per annum according to the most recent indebtedness to EBITDA ratio (as defined). Interest is payable quarterly or, if LIBOR applies, it may be paid at more frequent intervals.

The CMD credit facility agreement contains various covenants and restrictive provisions which limit the ability of CMD and its restricted subsidiaries to incur additional indebtedness, make investments or loans and create liens. The credit facility agreement requires maintenance of an indebtedness to EBITDA ratio (as defined) not to exceed 3.50 to 1, and an EBITDA (as defined) to interest expense coverage ratio of not less than 3.00 to 1. As defined by the credit facility agreement, our indebtedness to EBITDA ratio was 0.01 to 1 and our EBITDA to interest expense coverage ratio was 6.62 to 1 at September 30, 2009. If CMD or its restricted subsidiaries should fail to perform their obligations under these and other covenants, the revolving credit commitment could be terminated and any outstanding borrowings under the CMD facility could be declared immediately due and payable. The CMD credit facility agreement also has cross default provisions that apply to other indebtedness CMD and its restricted subsidiaries may have with an outstanding principal amount in excess of $15 million.

CMP Credit Facility

Our Chesapeake Midstream Partners, L.L.C. (CMP) $500 million syndicated revolving bank credit facility was established concurrent with the midstream joint venture we formed on September 30, 2009 (see Note 8 for discussion regarding the midstream joint venture). As a result of that transaction, our existing CMD credit facility was amended and restated. Borrowings under the CMP credit facility are secured by all of the assets of the companies organized under CMP, which is 50% owned by Chesapeake and 50% owned by our joint venture partner Global Infrastructure Partners, and bear interest at our option at either (i) the greater of the reference rate of Wells Fargo Bank, National Association, the federal funds effective rate plus 0.50%, and the one-month LIBOR plus 1.00%, all of which would be subject to a margin that varies from 2.00% to 2.75% per annum according to the most recent indebtedness to EBITDA ratio (as defined) or (ii) the LIBOR plus a margin that varies from 3.00% to 3.75% per annum according to the most recent indebtedness to EBITDA ratio (as defined). The unused portion of the facility is subject to a commitment fee of 0.50% per annum according to the most recent indebtedness to EBITDA ratio (as defined). Interest is payable quarterly or, if LIBOR applies, it may be paid at more frequent intervals.

The CMP credit facility agreement contains various covenants and restrictive provisions which limit the ability of CMP and its subsidiaries to incur additional indebtedness, make investments or loans and create liens. The credit facility agreement requires maintenance of an indebtedness to EBITDA ratio (as defined) not to exceed 3.50 to 1, and an EBITDA (as defined) to interest expense coverage ratio of not less than 3.00 to 1. As defined by the credit facility agreement, our indebtedness to EBITDA ratio was 0.09 to 1 and our EBITDA to interest expense coverage ratio was 17.49 to 1 at September 30, 2009. If CMP or its subsidiaries should fail to perform their obligations under these and other covenants, the revolving credit commitment could be terminated and any outstanding borrowings under the CMP facility could be declared immediately due and payable. The CMP credit facility agreement also has cross default provisions that apply to other indebtedness CMP and its subsidiaries may have with an outstanding principal amount in excess of $15 million.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

7. Segment Information

In accordance with ASC 280, Segment Reporting, we have two reportable operating segments. Our exploration and production operational segment and natural gas and oil midstream segment are managed separately because of the nature of their products and services. The exploration and production segment is responsible for finding and producing natural gas and oil. The midstream segment is responsible for marketing, gathering and compression of natural gas and oil primarily from Chesapeake-operated wells. We also have drilling rig and trucking operations which are responsible for providing drilling rigs primarily used on Chesapeake-operated wells and trucking services utilized in the transportation of drilling rigs on both Chesapeake-operated wells and wells operated by third parties. Our drilling rig and trucking service operations are presented in “Other Operations” in the table below.

Management evaluates the performance of our segments based upon income (loss) before income taxes. Revenues from the midstream segment’s sale of natural gas and oil related to Chesapeake’s ownership interests are reflected as exploration and production revenues. Such amounts totaled $716 million, $1.591 billion, $2.009 billion and $4.667 billion for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period. The following table presents selected financial information for Chesapeake’s operating segments.

 

     Exploration
and Production
       Midstream        Other
   Operations   
     Intercompany 
Eliminations
      Consolidated  
Total
 
     ($ in millions)   

Three Months Ended September 30, 2009:

          

Revenues

   $ 1,187      $ 1,291      $ 69      $ (736   $ 1,811   

Intersegment revenues

            (716     (20     736          
                                        

Total revenues

   $ 1,187      $ 575      $ 49      $      $ 1,811   
                                        

Income (loss) before income taxes

   $ 431      $ (111   $ (19   $ 6      $ 307   
                                        

Three Months Ended September 30, 2008 (Adjusted):

          

Revenues

   $ 6,408      $ 2,629      $ 164      $ (1,710   $ 7,491   

Intersegment revenues

            (1,591     (119     1,710          
                                        

Total revenues

   $ 6,408      $ 1,038      $ 45      $      $ 7,491   
                                        

Income (loss) before income taxes

   $ 5,384      $ 19      $ 21      $ (23   $ 5,401   
                                        

Nine Months Ended September 30, 2009:

          

Revenues

   $ 3,681      $ 3,669      $ 338      $ (2,208   $ 5,480   

Intersegment revenues

            (2,009     (199     2,208          
                                        

Total revenues

   $ 3,681      $ 1,660      $ 139      $      $ 5,480   
                                        

Income (loss) before income taxes

   $ (8,354   $ (82   $ (53   $ (1   $ (8,490
                                        

Nine Months Ended September 30, 2008 (Adjusted):

          

Revenues

   $ 5,587      $ 7,601      $ 467      $ (5,007   $ 8,648   

Intersegment revenues

            (4,667     (340     5,007          
                                        

Total revenues

   $ 5,587      $ 2,934      $ 127      $      $ 8,648   
                                        

Income (loss) before income taxes

   $ 2,555      $ 49      $ 67      $ (69   $ 2,602   
                                        

As of September 30, 2009:

          

Total assets

   $ 25,612      $ 7,240      $ 624      $ (3,757   $ 29,719   

As of December 31, 2008 (Adjusted):

          

Total assets

   $ 35,415      $ 3,416      $ 465      $ (703   $ 38,593   

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

8. Midstream Joint Venture

On September 30, 2009, we formed a joint venture with Global Infrastructure Partners (GIP), a New York-based private equity fund, to own and operate natural gas midstream assets. As part of the transaction, Chesapeake contributed certain natural gas gathering and processing assets to a new entity, Chesapeake Midstream Partners, L.L.C. (CMP), and GIP purchased a 50% interest in CMP. Chesapeake retained the remaining 50% interest in CMP and received a $588 million cash distribution from CMP. The assets we contributed to the joint venture were substantially all of our midstream assets in the Barnett Shale and also the majority of our non-shale midstream assets in the Arkoma, Anadarko, Delaware and Permian Basins. The financial results of CMP will be consolidated and GIP’s 50% ownership interest is reflected as a noncontrolling interest as of September 30, 2009 in our consolidated financial statements.

CMP will focus on unregulated business activities in service to both Chesapeake and third-party natural gas producers and its revenues will be generated almost entirely from fixed fee-based arrangements for gathering, compression, dehydration and treating services. CMP has entered into various agreements with Chesapeake, including a long-term gas gathering agreement at rates consistent with current market pricing. CMP will operate the contributed assets. Certain Chesapeake employees will provide services to CMP through an employee secondment agreement. In return for certain cost reimbursements, CMP will utilize various support functions within Chesapeake, including accounting, human resources and information technology.

Subsidiaries of our wholly-owned subsidiary CMD will continue to operate our midstream assets outside of the CMP joint venture. These include natural gas gathering assets in the Fayetteville Shale, Haynesville Shale, Marcellus Shale and other areas in Appalachia.

Concurrent with GIP’s funding of its interest in the joint venture, CMP closed a new $500 million secured revolving bank credit facility to partially fund capital expenditures associated with the building of additional natural gas gathering systems and for general corporate purposes. Additionally, we amended and restated the existing midstream lending agreement to reduce the total capacity from $460 million to $250 million, among other changes. This separate secured revolving bank credit facility supports CMD’s continuing midstream activities. These facilities are described in Note 6.

In the Current Quarter, we recorded an $82 million impairment of certain of the gathering systems contributed to CMP prior to the formation of the joint venture, and we expensed $4 million of debt issuance costs associated with the portion of our $460 million credit facility that was reduced to $250 million. The combined impairment of $86 million was included in impairment of natural gas and oil properties and other assets on our condensed consolidated statement of operations. Additionally, an estimated post-closing adjustment related to the joint venture transaction was recorded in the Current Quarter and is expected to be finalized by December 31, 2009.

The $851 million noncontrolling interest included in our consolidated equity at September 30, 2009 represents GIP’s 50% interest in the net assets of CMP, which were recorded by CMP at Chesapeake’s historical cost basis. This noncontrolling interest includes the $588 million GIP contributed in exchange for a 50% ownership interest in CMP plus $263 million of Chesapeake equity allocated to GIP pursuant to ASC 810 in order to properly reflect GIP’s 50% interest in the carrying value of CMP’s net assets.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

9. Natural Gas and Oil Properties

Volumetric Production Payment

On August 4, 2009, we sold certain Chesapeake-operated long-lived producing assets in South Texas in our fifth volumetric production payment transaction (VPP) for proceeds of $370 million. The assets included proved reserves of approximately 68 bcfe and net production (at the time of sale) of approximately 55 mmcfe per day. For accounting purposes, cash proceeds from this transaction were reflected as a reduction of natural gas and oil properties with no gain or loss recognized and our proved reserves were reduced accordingly.

Joint Ventures

In August 2009, we amended our Haynesville Shale joint venture agreement with Plains Exploration & Production Company (PXP). As part of the amendment, PXP accelerated the payment of its remaining joint venture drilling carries as of September 30, 2009 in exchange for an approximate 10% reduction in the total amount of drilling carry obligations due to Chesapeake and we received cash of $1.1 billion instead of an estimated $1.23 billion in remaining carried drilling costs that PXP would have paid over the next three years under the original agreement. In addition, Chesapeake and PXP agreed to terminate a previous joint venture amendment that granted PXP a one-time option in June 2010 to avoid paying the last $800 million of the drilling carry obligations by conveying 50% of its Haynesville Shale assets to Chesapeake.

During the Current Period, we received the benefit of approximately $959 million in drilling carries associated with the Haynesville ($350 million), Fayetteville ($524 million) and Marcellus ($85 million) joint ventures.

Divestitures

During the Current Period, we sold non-core natural gas and oil assets for proceeds of $278 million.

 

10. Restructuring

In the Current Period, we restructured our Charleston, West Virginia-based Eastern Division from a regional corporate headquarters to a regional field office consistent with the business model the company uses elsewhere in the country. As a result, we consolidated the management of our Eastern Division land, legal, accounting, information technology, geoscience and engineering departments into our corporate offices in Oklahoma City. The costs of the reorganization include termination benefits, consolidating or closing facilities and relocating employees. In addition, we had certain other workforce reductions that resulted in termination benefits. We expect virtually all costs associated with our restructuring to be paid by year-end 2009.

A summary of Chesapeake’s restructuring charges is presented below ($ in millions):

 

    Restructuring
 Costs Through 
September 30,
2009
    Restructuring  
Costs To Be
Incurred
  Total
  Restructuring  
Costs

Restructuring Costs:

     

Termination and relocation costs

  $ 20   $ 2   $ 22

Acceleration of restricted stock awards

    9         9

Other associated costs

    3         3
                 

Total Restructuring Costs

  $ 32   $ 2   $ 34
                 

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

11. Investments

At September 30, 2009, investments accounted for under the equity method totaled $388 million and investments accounted for under the cost method totaled $34 million. Following is a summary of our investments:

 

            Carrying Value
     Approximate 
% Owned
     Accounting   
Method
  September 30,
2009
   December 31, 
2008
            ($ in millions)

Frac Tech Services, Ltd.(a)

  20%   Equity   $ 242   $ 223

Chaparral Energy, Inc.(b)(c)

  32%   Equity     107     152

DHS Drilling Company(b)

  47%   Equity         19

Sierra Mid-Con, L.P.

  49%   Equity     14     12

Gastar Exploration Ltd.(b)

  17%   Cost     33     11

Mountain Drilling Company(b)

  49%   Equity         9

Other

  —      Cost/Equity     26     18
               
      $ 422   $ 444
               

 

 

(a) The carrying value of our investment in Frac Tech is in excess of our underlying equity in net assets by approximately $145 million as of September 30, 2009. This excess amount is attributed to certain intangibles associated with the specialty services provided by Frac Tech and is being amortized over the estimated life of the intangibles.

 

(b) Our investees have been impacted by the dramatic slowing of the worldwide economy and the tightening of the credit markets in the fourth quarter of 2008 and into 2009. The economic weakness has resulted in significantly reduced oil and natural gas prices leading to a meaningful decline in the overall level of activity in the markets served by our investees. Associated with the weakness in performance of certain of the investees, as well as an evaluation of their financial condition and near-term prospects, we recognized during the Current Period that an other than temporary impairment had occurred on March 31, 2009 on the following investments: Chaparral Energy of $51 million, DHS Drilling Company of $19 million, Gastar Exploration Ltd. of $70 million and Mountain Drilling Company of $9 million. We have monitored and will continue to monitor the performance of our investments and it is reasonably possible that we may experience additional impairments, although we do not believe that our exposure to future charges would be material to our condensed consolidated results of operations.

 

(c) The carrying value of our investment in Chaparral is in excess of our underlying equity in net assets by approximately $46 million as of September 30, 2009. This excess is attributed to the natural gas and oil reserves held by Chaparral and is being amortized over the estimated life of these reserves based on a unit of production rate.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

12. Fair Value Measurements

Effective January 1, 2008, we adopted ASC 820, Fair Value Measurements and Disclosures for our financial assets and liabilities measured on a recurring basis. Our nonfinancial assets and liabilities became subject to the statement effective January 1, 2009. This statement establishes a framework for measuring the fair value of assets and liabilities and expands disclosures about fair value measurements.

ASC 820 defines fair value as the amount that would be received from the sale of an asset or paid for the transfer of a liability in an orderly transaction between market participants, i.e., an exit price. To estimate an exit price, a three-level hierarchy is used. The fair value hierarchy prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or a liability, into three levels. Level 1 inputs are unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 2 inputs are inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the financial asset or liability and have the lowest priority. Chesapeake uses appropriate valuation techniques based on available inputs, including counterparty quotes, to measure the fair values of its assets and liabilities. Counterparty quotes are generally assessed as a Level 3 input.

The following table provides fair value measurement information for financial assets (liabilities) measured at fair value on a recurring basis as of September 30, 2009:

 

    Quoted
Prices in
Active
Markets
     (Level 1)     
    Significant
Other
   Observable   
Inputs
(Level 2)
     Significant
 Unobservable 
Inputs
(Level 3)
    Total
   Fair Value   
 
    ($ in millions)  

Financial Assets (Liabilities):

        

Cash equivalents

  $ 510      $       $      $ 510   

Derivatives, net

  $      $ 351       $ (8   $ 343   

Investments

  $ 33      $       $      $ 33   

Other long-term assets

  $ 30      $       $      $ 30   

Long-term debt

  $      $       $ (2,048   $ (2,048

Other long-term liabilities

  $ (30   $       $      $ (30

The following methods and assumptions were used to estimate the fair values of the assets and liabilities in the table above.

Level 1 Fair Value Measurements

Cash Equivalents. The fair value of cash equivalents is based on quoted market prices.

Investments. The fair value of Chesapeake’s investment in Gastar Exploration Ltd. common stock is based on a quoted market price.

Other Long-Term Assets and Liabilities. The fair value of other long-term assets and liabilities, consisting of obligations under our Deferred Compensation Plan, is based on quoted market prices.

Level 2 Fair Value Measurements

Derivatives. The fair values of our natural gas, oil and diesel swaps are measured internally using established index prices and other sources. These values are based upon, among other things, futures prices and time to maturity. Derivative transactions are also subject to the risk that counterparties will be unable to meet their obligations. Such non-performance risk is considered in the valuation of our derivative instruments, but to date has not had a material impact on the values of our derivatives.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Level 3 Fair Value Measurements

Derivatives. The fair value of our derivative instruments, excluding natural gas, oil and diesel swaps, have been established utilizing established index prices, volatility curves, discount factors and options pricing models. These estimates are compared to our counterparty values for reasonableness. Derivative transactions are also subject to the risk that counterparties will be unable to meet their obligations. Such non-performance risk is considered in the valuation of our derivative instruments, but to date has not had a material impact on the values of our derivatives.

Debt. The fair value of certain of our long-term debt is based on the face amount of that debt along with the value of the related interest rate swaps. The interest rate swap values are based on estimates provided by our respective counterparties and reviewed internally for reasonableness using future interest rate curves and time to maturity.

A summary of the changes in Chesapeake’s assets (liabilities) classified as Level 3 measurements during the Current Period is presented below:

 

         Derivatives                   Debt                           Total            
     ($ in millions)      

Balance of Level 3 as of January 1, 2009

   $ 292          $ (1,470   $ (1,178 )     

Total gains (losses) (realized/unrealized):

      

Included in earnings(a)

     566            (128     438       

Included in other comprehensive income (loss)

     123                   123       

Purchases, issuances and settlements

     (989 )          (450 )(b)      (1,439 )     

Transfers in and out of Level 3

                         
                        

Balance of Level 3 as of September 30, 2009

   $ (8 )        $ (2,048   $ (2,056 )     
                        

 

 

(a)
     Natural Gas
        and Oil Sales        
    Interest
            Expense            
 
     ($ in millions)  

Total gains (losses) related to derivatives included in earnings for the period

   $ 398      $ 168   

Change in unrealized gains (losses) relating to assets still held at reporting date

   $ (380   $ 149   
    

 

(b) Amount represents a reduction in debt now recorded at fair value as a result of interest rate swaps that were terminated in the Current Period.

Fair Value of Other Financial Instruments

The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of ASC 825, Financial Instruments. We have determined the estimated fair values by using available market information and valuation methodologies. Considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts.

The carrying values of financial instruments comprising current assets and current liabilities approximate fair values due to the short-term maturities of these instruments. We estimate the fair value of our long-term debt and our convertible preferred stock primarily using quoted market prices. Our carrying amounts for such debt, excluding the impact of interest rate derivatives, at September 30, 2009 and December 31, 2008 were $11.9 billion and $13.0 billion, respectively, compared to approximate fair values of $11.7 billion and $10.5 billion, respectively. The carrying amounts for our convertible preferred stock as of September 30, 2009 and December 31, 2008 were $466 million and $505 million, respectively, compared to approximate fair values of $402 million and $294 million, respectively.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

13. Condensed Consolidating Financial Information

Chesapeake Energy Corporation is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. As of September 30, 2008, our obligations under our outstanding senior notes and contingent convertible senior notes listed in Note 6 were fully and unconditionally guaranteed, jointly and severally, by all of our wholly-owned subsidiaries, other than minor subsidiaries, on a senior unsecured basis. Since October 2008, following the restructuring of our non-Appalachian midstream operations, certain of our wholly-owned subsidiaries having significant assets and operations have not guaranteed our outstanding notes. The CMD credit facility and the CMP credit facility referred to in Note 6 each contain a covenant restricting the payment of dividends or distributions or the making of loans to Chesapeake.

Set forth below are condensed consolidating financial statements for Chesapeake Energy Corporation (the “parent”) on a stand-alone, unconsolidated basis, and its combined guarantor and combined non-guarantor subsidiaries as of September 30, 2009 and December 31, 2008 and for the three and nine months ended September 30, 2009 and 2008. The financial information may not necessarily be indicative of results of operations, cash flows or financial position had the subsidiaries operated as independent entities.

CONDENSED CONSOLIDATING BALANCE SHEET

AS OF SEPTEMBER 30, 2009

($ in millions)

 

            Parent            Guarantor
   Subsidiaries   
    Non-Guarantor
Subsidiaries
      Eliminations         Consolidated    

CURRENT ASSETS:

          

Cash and cash equivalents

   $      $ 363      $ 157      $      $ 520   

Other

     9        1,831        208        (60     1,988   
                                        

Total Current Assets

     9        2,194        365        (60     2,508   
                                        

PROPERTY AND EQUIPMENT:

          

Natural gas and oil properties, at cost based on full-cost accounting

            20,527        205               20,732   

Other property and equipment

            2,820        2,826               5,646   
                                        

Total Property and Equipment

            23,347        3,031               26,378   
                                        

Other assets

     201        608        24               833   

Investments in subsidiaries and intercompany advance

     3,738        244               (3,982       
                                        

TOTAL ASSETS

   $ 3,948      $ 26,393      $ 3,420      $ (4,042   $ 29,719   
                                        

CURRENT LIABILITIES:

          

Current liabilities

   $ 211      $ 2,231      $ 133      $ (61   $ 2,514   

Intercompany payable (receivable) from parent

     (19,118     17,091        2,012        15          
                                        

Total Current Liabilities

     (18,907     19,322        2,145        (46     2,514   
                                        

LONG-TERM LIABILITIES:

          

Long-term debt, net

     10,443        1,618        12               12,073   

Deferred income tax liabilities

     311        860        159        (14     1,316   

Other liabilities

     123        855        9               987   
                                        

Total Long-Term Liabilities

     10,877        3,333        180        (14     14,376   
                                        

EQUITY:

          

Chesapeake stockholders’ equity

     11,978        3,738        244        (3,982     11,978   

Noncontrolling interest

                   851               851   
                                        

Total Equity

     11,978        3,738        1,095        (3,982     12,829   
                                        

TOTAL LIABILITIES AND EQUITY

   $ 3,948      $ 26,393      $ 3,420      $ (4,042   $ 29,719   
                                        

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING BALANCE SHEET

AS OF DECEMBER 31, 2008

(Adjusted)

($ in millions)

 

            Parent            Guarantor
   Subsidiaries   
    Non-Guarantor
Subsidiaries
      Eliminations         Consolidated    

CURRENT ASSETS:

          

Cash and cash equivalents

   $      $ 1,749      $      $      $ 1,749   

Other

     13        2,392        169        (31     2,543   
                                        

Total Current Assets

     13        4,141        169        (31     4,292   
                                        

PROPERTY AND EQUIPMENT:

          

Natural gas and oil properties, at cost based on full-cost accounting

            28,474        4               28,478   

Other property and equipment

            2,481        2,349               4,830   
                                        

Total Property and Equipment

            30,955        2,353               33,308   
                                        

Other assets

     140        838        15               993   

Investments in subsidiaries and intercompany advance

     8,452        143               (8,595       
                                        

TOTAL ASSETS

   $ 8,605      $ 36,077      $ 2,537      $ (8,626   $ 38,593   
                                        

CURRENT LIABILITIES:

          

Current liabilities

   $ 257      $ 3,324      $ 131      $ (91   $ 3,621   

Intercompany payable (receivable) from parent

     (18,274     16,636        1,578        60          
                                        

Total Current Liabilities

     (18,017     19,960        1,709        (31     3,621   
                                        

LONG-TERM LIABILITIES:

          

Long-term debt, net

     9,241        3,474        460               13,175   

Deferred income tax liabilities

     438        3,543        219               4,200   

Other liabilities

     (74     648        6               580   
                                        

Total Long-Term Liabilities

     9,605        7,665        685               17,955   
                                        

EQUITY:

          

Chesapeake stockholders’ equity

     17,017        8,452        143        (8,595     17,017   

Noncontrolling interest

                                   
                                        

Total Equity

     17,017        8,452        143        (8,595     17,017   
                                        

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 8,605      $ 36,077      $ 2,537      $ (8,626   $ 38,593   
                                        

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

($ in millions)

 

            Parent            Guarantor
   Subsidiaries   
    Non-Guarantor
Subsidiaries
      Eliminations         Consolidated    

Three Months Ended September 30, 2009:

          

REVENUES:

          

Natural gas and oil sales

   $      $ 1,184      $ 3      $      $ 1,187   

Marketing, gathering and compression sales

            504        126        (55     575   

Service operations revenue

            49                      49   
                                        

Total Revenues

            1,737        129        (55     1,811   
                                        

OPERATING COSTS:

          

Production expenses

            217        1               218   

Production taxes

            25                      25   

General and administrative expenses

            86        9               95   

Marketing, gathering and compression expenses

            517        54        (25     546   

Service operations expense

            49                      49   

Natural gas and oil depreciation, depletion and amortization

            293        2               295   

Depreciation and amortization of other assets

     1        36        26        (1     62   

Impairment of natural gas and oil properties and other assets

                   86               86   

Loss on sale of other property and equipment

                   38               38   

Restructuring costs

                                   
                                        

Total Operating Costs

     1        1,223        216        (26     1,414   
                                        

INCOME (LOSS) FROM OPERATIONS

     (1     514        (87     (29     397   
                                        

OTHER INCOME (EXPENSE):

          

Other income (expense)

     175        (30            (175     (30

Interest expense

     (161     (57            175        (43

Loss on exchanges of Chesapeake debt

     (17                          (17

Equity in net earnings of subsidiary

     195        (72            (123       
                                        

Total Other Income (Expense)

     192        (159            (123     (90
                                        

INCOME (LOSS) BEFORE INCOME TAXES

     191        355        (87     (152     307   

INCOME TAX EXPENSE (BENEFIT)

     (1     160        (33     (11     115   
                                        

NET INCOME (LOSS)

     192        195        (54     (141     192   

Net income (loss) attributable to noncontrolling interest

                                   
                                        

NET INCOME (LOSS) ATTRIBUTABLE TO CHESAPEAKE COMMON STOCKHOLDERS

   $ 192      $ 195      $ (54   $ (141   $ 192   
                                        

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

(Adjusted)

($ in millions)

 

            Parent            Guarantor
   Subsidiaries   
    Non-Guarantor
Subsidiaries
     Eliminations         Consolidated    

Three Months Ended September 30, 2008:

           

REVENUES:

           

Natural gas and oil sales

   $      $ 6,408      $  —    $      $ 6,408   

Marketing, gathering and compression sales

            994        87      (43     1,038   

Service operations revenue

            45                    45   
                                       

Total Revenues

            7,447        87      (43     7,491   
                                       

OPERATING COSTS:

           

Production expenses

            239                    239   

Production taxes

            87                    87   

General and administrative expenses

            104        4             108   

Marketing, gathering and compression expenses

            984        34      (4     1,014   

Service operations expense

            37                    37   

Natural gas and oil depreciation, depletion and amortization

            480                    480   

Depreciation and amortization of other assets

     (1     36        12      1        48   
                                       

Total Operating Costs

     (1     1,967        50      (3     2,013   
                                       

INCOME (LOSS) FROM OPERATIONS

     1        5,480        37      (40     5,478   
                                       

OTHER INCOME (EXPENSE):

           

Other income (expense)

     186        (19     7      (186     (12

Interest expense

     (160     (60          186        (34

Loss on exchanges of Chesapeake debt

     (31                        (31

Equity in net earnings of subsidiary

     3,324        2             (3,326       
                                       

Total Other Income (Expense)

     3,319