10-Q 1 d240402d10q.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, 2011

[  ]    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 2, 2011, there were 659,266,080 shares of our common stock, $0.01 par value, outstanding.

 

 

 


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2011

 

PART I.   

Financial Information

  

          Page  

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited):

  
  

Condensed Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010

     1     
  

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2011 and 2010

     2     
  

Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September  30, 2011 and 2010

     3     
  

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010

     4     
  

Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September  30, 2011 and 2010

     6     
  

Notes to Condensed Consolidated Financial Statements

     7     

Item 2.

  

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

     49     

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     73     

Item 4.

  

Controls and Procedures

     81     
PART II.   

Other Information

  

Item 1.

  

Legal Proceedings

     82     

Item 1A.    

  

Risk Factors

     83     

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     84     

Item 3.

  

Defaults Upon Senior Securities

     84     

Item 4.

  

(Removed and Reserved)

     84     

Item 5.

  

Other Information

     84     

Item 6.

  

Exhibits

     85     


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

    September 30,
2011
    December 31,
2010
 
    ($ in millions)  

CURRENT ASSETS:

   

Cash and cash equivalents

  $ 111      $ 102   

Accounts receivable

    2,737        1,974   

Short-term derivative instruments

    5        947   

Deferred income tax asset

    474        139   

Other current assets

    143        104   
 

 

 

   

 

 

 

Total Current Assets

    3,470        3,266   
 

 

 

   

 

 

 

PROPERTY AND EQUIPMENT:

   

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

   

Evaluated natural gas and oil properties

    39,955        38,952   

Unevaluated properties

    16,421        14,469   

Natural gas gathering systems and treating plants

    1,836        1,545   

Other property and equipment

    4,531        3,726   
 

 

 

   

 

 

 

Total Property and Equipment, at Cost

    62,743        58,692   
 

 

 

   

 

 

 

Less: accumulated depreciation, depletion and amortization

    (27,605     (26,314
 

 

 

   

 

 

 

Total Property and Equipment, Net

    35,138        32,378   
 

 

 

   

 

 

 

OTHER ASSETS:

   

Investments

    1,166        1,208   

Other long-term assets

    348        327   
 

 

 

   

 

 

 

Total Other Assets

    1,514        1,535   
 

 

 

   

 

 

 

TOTAL ASSETS

  $ 40,122      $ 37,179   
 

 

 

   

 

 

 

CURRENT LIABILITIES:

   

Accounts payable

  $ 2,844      $ 2,069   

Short-term derivative instruments

    136        15   

Accrued interest

    106        191   

Other current liabilities

    3,109        2,215   
 

 

 

   

 

 

 

Total Current Liabilities

    6,195        4,490   
 

 

 

   

 

 

 

LONG-TERM LIABILITIES:

   

Long-term debt, net

    11,789        12,640   

Deferred income tax liabilities

    3,524        2,384   

Long-term derivative instruments

    1,502        1,693   

Asset retirement obligations

    313        301   

Other long-term liabilities

    501        407   
 

 

 

   

 

 

 

Total Long-Term Liabilities

    17,629        17,425   
 

 

 

   

 

 

 

CONTINGENCIES AND COMMITMENTS (Note 3)

   

STOCKHOLDERS’ EQUITY:

   

Preferred Stock, $0.01 par value, 20,000,000 shares authorized: 7,251,515 and 7,254,515 shares outstanding

    3,062        3,065   

Common stock, $0.01 par value, 1,000,000,000 shares authorized, 660,852,092 and 655,251,275 shares issued

    7        7   

Paid-in capital

    12,128        12,194   

Retained earnings

    1,234        190   

Accumulated other comprehensive income (loss), net of tax of $65 million and $102 million

    (106     (168

Less: treasury stock, at cost; 1,338,448 and 1,221,299 common shares

    (27     (24
 

 

 

   

 

 

 

Total Stockholders’ Equity

    16,298        15,264   
 

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

  $ 40,122      $ 37,179   
 

 

 

   

 

 

 

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

 

1


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
    2011     2010     2011     2010  
    ($ in millions, except per share data)  

REVENUES:

       

Natural gas and oil sales

  $ 2,402      $ 1,639      $ 4,688      $ 4,698   

Marketing, gathering and compression sales

    1,422        883        3,844        2,520   

Oilfield services revenue

    153        59        376        173   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Revenues

    3,977        2,581        8,908        7,391   
 

 

 

   

 

 

   

 

 

   

 

 

 

OPERATING COSTS:

       

Production expenses

    282        231        782        652   

Production taxes

    50        34        140        119   

General and administrative expenses

    151        125        410        340   

Marketing, gathering and compression expenses

    1,392        851        3,744        2,429   

Oilfield services expense

    118        52        287        154   

Natural gas and oil depreciation, depletion and amortization

    423        378        1,147        1,025   

Depreciation and amortization of other assets

    75        56        206        159   

Losses on sales of other property and equipment

    3        17        3        17   

Other impairments

           20        4        20   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Costs

    2,494        1,764        6,723        4,915   
 

 

 

   

 

 

   

 

 

   

 

 

 

INCOME FROM OPERATIONS

    1,483        817        2,185        2,476   
 

 

 

   

 

 

   

 

 

   

 

 

 

OTHER INCOME (EXPENSE):

       

Interest expense

    (4     (3     (37     (12

Earnings on investments

    28        151        100        190   

Losses on purchases or exchanges of debt

           (59     (176     (130

Impairment of investments

           (16            (16

Other income

    4        17        9        12   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Other Income (Expense)

    28        90        (104     44   
 

 

 

   

 

 

   

 

 

   

 

 

 

INCOME BEFORE INCOME TAXES

    1,511        907        2,081        2,520   
 

 

 

   

 

 

   

 

 

   

 

 

 

INCOME TAX EXPENSE (BENEFIT):

       

Current income taxes

    (1     (1     11        4   

Deferred income taxes

    590        350        801        966   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Income Tax Expense

    589        349        812        970   
 

 

 

   

 

 

   

 

 

   

 

 

 

NET INCOME

    922        558        1,269        1,550   
 

 

 

   

 

 

   

 

 

   

 

 

 

Preferred stock dividends

    (43     (43     (128     (68
 

 

 

   

 

 

   

 

 

   

 

 

 

NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

  $ 879      $ 515      $ 1,141      $ 1,482   
 

 

 

   

 

 

   

 

 

   

 

 

 

EARNINGS PER COMMON SHARE:

       

Basic

  $ 1.38      $ 0.81      $ 1.79      $ 2.35   

Diluted

  $ 1.23      $ 0.75      $ 1.69      $ 2.24   

CASH DIVIDEND DECLARED PER COMMON SHARE

  $ 0.0875      $   0.075      $     0.25      $   0.225   

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

       

Basic

    638        632        636        631   

Diluted

    753        744        752        692   

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

 

2


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

      Three Months Ended  
September 30,
      Nine Months Ended  
September 30,
 
    2011     2010     2011     2010  
    ($ in millions)  

Net income

  $ 922      $ 558      $ 1,269      $ 1,550   

Other comprehensive income, net of income tax:

       

Change in fair value of derivative instruments, net of income taxes of $44 million, $39 million, $133 million and $153 million

    72        65        218        251   

Reclassification of gain on settled contracts, net of income taxes of ($49) million, ($68) million, ($88) million and ($203) million

    (80     (112     (144     (333

Ineffective portion of derivatives qualifying for cash flow hedge accounting, net of income taxes of $2 million, ($2) million, ($5) million and $8 million

    3        (3     (8     12   

Unrealized gain (loss) on marketable securities, net of income taxes of ($1) million, $1 million, ($2) million and ($4) million

    (1     1        (4     (7
 

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

  $   916      $   509      $ 1,331      $ 1,473   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

 

 

 

 

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

 

3


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

          Nine Months Ended      
September  30,
 
    2011     2010  
    ($ in millions)  

CASH FLOWS FROM OPERATING ACTIVITIES:

   

NET INCOME

  $ 1,269      $ 1,550   

ADJUSTMENTS TO RECONCILE NET INCOME TO CASH PROVIDED BY OPERATING ACTIVITIES:

   

Depreciation, depletion and amortization

    1,353        1,184   

Deferred income tax expense

    801        966   

Unrealized (gains) losses on derivatives

    456        (45

Stock-based compensation

    119        111   

Accretion of discount on contingent convertible notes

           58   

Gains on investments

    (19     (120

Losses on purchases or exchanges of debt

    5        29   

Losses on sales of other property and equipment

    3        17   

Impairment of investments

           16   

Other impairments

    4        20   

Other

    7        12   

Changes in assets and liabilities

    (274     173   
 

 

 

   

 

 

 

Cash provided by operating activities

    3,724        3,971   
 

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

   

Drilling and completion costs on proved and unproved properties

    (5,345     (3,718

Acquisitions of proved and unproved properties

    (3,773     (4,217

Proceeds from divestitures of proved and unproved properties

    6,357        3,107   

Additions to other property and equipment

    (1,416     (968

Proceeds from sales of other assets

    682        328   

Proceeds from (additions to) investments

    126        (113

Deposits on acquisitions

           (95

Acquisition of drilling company

    (339       

Other

    (7     11   
 

 

 

   

 

 

 

Cash used in investing activities

    (3,715     (5,665
 

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

   

Proceeds from credit facilities borrowings

      11,914          10,458   

Payments on credit facilities borrowings

    (12,057     (9,863

Proceeds from issuance of senior notes, net of offering costs

    977        1,967   

Proceeds from issuance of preferred stock, net of offering costs

           2,562   

Cash paid to purchase debt

    (2,015     (3,434

Cash paid for common stock dividends

    (151     (142

Cash paid for preferred stock dividends

    (128     (49

Cash received on financing derivatives

    1,085        436   

Net increase in outstanding payments in excess of cash balance

    489        116   

Other

    (114     (55
 

 

 

   

 

 

 

Cash provided by financing activities

           1,996   
 

 

 

   

 

 

 

Net increase in cash and cash equivalents

    9        302   

Cash and cash equivalents, beginning of period

    102        307   
 

 

 

   

 

 

 

Cash and cash equivalents, end of period

  $ 111      $ 609   
 

 

 

   

 

 

 

 

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

4


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)

(Unaudited)

 

          Nine Months Ended      
September  30,
 
    2011     2010  
    ($ in millions)  

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION OF NET CASH PAYMENTS (REFUNDS) FOR:

   

Interest, net of capitalized interest

  $    18      $ 103   

Income taxes, net of refunds received

  $ (25   $ (291

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

As of September 30, 2011 and 2010, dividends payable on our common and preferred stock were $99 million and $90 million, respectively.

For the nine months ended September 30, 2011 and 2010, natural gas and oil properties were adjusted by $148 million and $116 million, respectively, as a result of an increase in accrued costs.

For the nine months ended September 30, 2011 and 2010, other property and equipment were adjusted by $90 million and ($6) million, respectively, as a result of an increase (decrease) in accrued costs.

As of September 30, 2011 and 2010, we had recorded $173 million and $317 million, respectively, as a result of various accrued liabilities related to the purchase of proved and unproved properties and other assets.

During the nine months ended September 30, 2010, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $11 million in aggregate principal amount for an aggregate of 298,500 shares of our common stock in privately negotiated exchanges.

On September 30, 2011, 3,000 shares of our outstanding 5.75% Cumulative Convertible Non-Voting Preferred Stock were converted into 111,111 shares of common stock pursuant to the holder’s conversion rights.

On May 3, 2010, we converted all 5,000 shares of our outstanding 5.00% Cumulative Convertible Preferred Stock (Series 2005) into 20,774 shares of common stock pursuant to the company’s mandatory conversion rights.

 

 

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

 

5


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Unaudited)

 

        Nine Months Ended    
September 30,
 
    2011     2010  
    ($ in millions)  

PREFERRED STOCK:

   

Balance, beginning of period

  $ 3,065      $ 466   

Issuance of 0 and 1,500,000 shares of 5.75% preferred stock

           1,500   

Issuance of 0 and 1,100,000 shares of 5.75% preferred stock (series A)

           1,100   

Exchange of 3,000 and 5,000 shares of preferred stock for common stock

    (3     (1
 

 

 

   

 

 

 

Balance, end of period

    3,062        3,065   
 

 

 

   

 

 

 

COMMON STOCK:

   

Balance, beginning of period

    7        6   

Exchange of convertible notes for 0 and 298,500 shares of common stock

             

Exchange of preferred stock for 111,111 and 20,774 shares of common stock

             

Stock-based compensation

           1   
 

 

 

   

 

 

 

Balance, end of period

    7        7   
 

 

 

   

 

 

 

PAID-IN CAPITAL:

   

Balance, beginning of period

    12,194        12,146   

Stock-based compensation

    120        172   

Purchase of contingent convertible notes

    (123       

Exchange of convertible notes for 0 and 298,500 shares of common stock

           8   

Exchange of 3,000 and 5,000 shares of preferred stock for common stock

    3        1   

Exercise of stock options

    2        2   

Offering expenses

           (39

Reduction in tax benefit from stock-based compensation

    (5     (13

Dividends on common stock

    (48     (95

Dividends on preferred stock

    (15     (44
 

 

 

   

 

 

 

Balance, end of period

    12,128        12,138   
 

 

 

   

 

 

 

RETAINED EARNINGS (DEFICIT):

   

Balance, beginning of period

    190        (1,261

Net income

    1,269        1,550   

Cumulative effect of accounting change, net of income taxes of $89 million

           (142

Dividends on common stock

    (112     (47

Dividends on preferred stock

    (113     (43
 

 

 

   

 

 

 

Balance, end of period

    1,234        57   
 

 

 

   

 

 

 

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):

   

Balance, beginning of period

    (168     102   

Hedging activity

    66        (70

Investment activity

    (4     (7
 

 

 

   

 

 

 

Balance, end of period

    (106     25   
 

 

 

   

 

 

 

TREASURY STOCK – COMMON:

   

Balance, beginning of period

    (24     (15

Purchase of 191,153 and 179,140 shares for company benefit plans

    (5     (4

Release of 74,004 and 6,963 shares for company benefit plans

    2          
 

 

 

   

 

 

 

Balance, end of period

    (27     (19
 

 

 

   

 

 

 

NONCONTROLLING INTEREST:

   

Balance, beginning of period

           897   

Deconsolidation of investment in Chesapeake Midstream Partners

           (897
 

 

 

   

 

 

 

Balance, end of period

             
 

 

 

   

 

 

 

TOTAL STOCKHOLDERS’ EQUITY

  $ 16,298      $ 15,273   
 

 

 

   

 

 

 

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

 

6


Table of Contents

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 (“Chesapeake” or the “company”) 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, 2010 (2010 Form 10-K) includes certain definitions and a summary of significant accounting policies and should be read in conjunction with this Form 10-Q. 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 accompanying condensed consolidated financial statements of Chesapeake include the accounts of our direct and indirect wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. The results for the three and nine months ended September 30, 2011 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, 2011 (the “Current Quarter” and the “Current Period”, respectively) and the three and nine months ended September 30, 2010 (the “Prior Quarter” and the “Prior Period”, respectively).

Cumulative Effect of Accounting Change

Effective January 1, 2010, in accordance with new authoritative guidance for variable interest entities, we ceased consolidating our 50/50 midstream joint venture with Global Infrastructure Partners within our financial statements and began to account for the joint venture under the equity method (see Note 9). Adoption of this new guidance resulted in an after-tax cumulative effect charge to retained earnings of $142 million, which is reflected in our condensed consolidated statement of equity for the Prior Period. This charge reflects the difference between the carrying value of our initial investment in the joint venture, which was recorded at carryover basis as an entity under common control, and the fair value of our equity in the joint venture as of the formation date.

Critical Accounting Policies

We consider accounting policies related to hedging, natural gas and oil properties and income taxes to be critical policies. These policies are summarized in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2010 Form 10-K.

 

2. Derivative and Hedging Activities

Natural Gas and Oil Derivatives

Our results of operations and 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, 2011 and December 31, 2010, our natural gas and oil derivative instruments consisted 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.

 

   

Call Options: Chesapeake sells call options in exchange for a premium from the counterparty. At the time of settlement, if the market price exceeds the fixed price of the call option, Chesapeake pays the counterparty such excess and if the market price settles below the fixed price of the call option, no payment is due from either party.

 

7


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

   

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

 

   

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 a certain pre-determined knockout price.

 

   

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.

The estimated fair values of our natural gas and oil derivative instruments as of September 30, 2011 and December 31, 2010 are provided below. The associated carrying values of these instruments are equal to the estimated fair values.

 

    September 30, 2011     December 31, 2010  
         Volume               Fair Value               Volume               Fair Value       
          ($ in millions)           ($ in millions)  

Natural gas (bbtu):

       

Fixed-price swaps

         $        1,035,134      $ 1,307   

Call options

    1,499,285        (554     1,477,742        (701

Put options

    (16,560     (27     (51,220     (59

Basis protection swaps

    98,885        (44     173,691        (55
 

 

 

   

 

 

   

 

 

   

 

 

 

Total natural gas

    1,581,610        (625     2,635,347        492   
 

 

 

   

 

 

   

 

 

   

 

 

 

Oil (mbbl):

       

Fixed-price swaps

    2,808        11        4,385        (31

Call options

    89,243        (946     64,226        (1,129

Fixed-price knockout swaps

    1,008        20        1,827        19   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total oil

    93,059        (915     70,438        (1,141
 

 

 

   

 

 

   

 

 

   

 

 

 

Total estimated fair value

    $ (1,540     $ (649
   

 

 

     

 

 

 

Pursuant to accounting guidance for derivatives and hedging, certain derivatives qualify for designation as cash flow hedges. Following this guidance, 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. 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 within natural gas and oil sales.

 

8


Table of Contents

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,
 
    2011     2010     2011     2010  
    ($ in millions)  

Natural gas and oil sales

  $ 1,427      $ 1,074      $ 3,892      $ 3,243   

Gains (losses) on natural gas and oil derivatives

    980        560        783        1,475   

Gains (losses) on ineffectiveness of cash flow hedges

    (5     5        13        (20
 

 

 

   

 

 

   

 

 

   

 

 

 

Total natural gas and oil sales

  $ 2,402      $ 1,639      $ 4,688      $ 4,698   
 

 

 

   

 

 

   

 

 

   

 

 

 

Based upon the market prices at September 30, 2011, we expect to transfer approximately $87 million (net of income taxes) of gain included in accumulated other comprehensive income to net income (loss) during the next 12 months in the related month of production. All derivatives as of September 30, 2011 are expected to mature by December 31, 2022.

We have a multi-counterparty secured hedging facility with 18 counterparties that have committed to provide approximately 6.5 tcfe of hedging capacity for commodity price derivatives and 6.5 tcfe for basis derivatives with an aggregate mark-to-market capacity of $17.5 billion under the terms of the facility. As of September 30, 2011, we had hedged under the facility 2.0 tcfe of our future production with price derivatives and 0.1 tcfe with basis derivatives. The multi-counterparty facility allows us to enter into cash-settled natural gas, oil and natural gas liquids price and basis hedges with the counterparties. Our obligations under the multi-counterparty facility are secured by 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 certain 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 hedging capacity under the facility is governed by the expected production of the pledged reserve collateral, and volume-based hedging limits are applied separately to price and basis hedges. In addition, there are volume-based sub-limits for natural gas, oil and natural gas liquids 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 entering into hedges with the company on a prospective basis as long as obligations associated with any existing transactions in the facility continue to be satisfied in accordance with the terms of the agreement.

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 2011 to December 2012 for a total of 60 million gallons with an average fixed price of $2.99 per gallon. Chesapeake pays the fixed price and receives a floating price. The fair value of these swaps as of September 30, 2011 was a liability of $16 million.

 

9


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Interest Rate Derivatives

To mitigate a portion of 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, 2011 and December 31, 2010, our interest rate derivative instruments consisted 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.

 

   

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 a pre-determined open swap on a specific date.

 

   

Swaptions: Occasionally we sell an option to a counterparty for a premium which allows the counterparty to enter into a pre-determined 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, 2011 and December 31, 2010 are provided below.

 

    September 30, 2011     December 31, 2010  
    Notional
Amount
    Fair
Value
    Notional
Amount
    Fair
Value
 
    ($ in millions)  

Interest rate:

       

Swaps

  $ 1,050      $ (46   $ 1,900      $ (54

Call options

               —        250             (2

Swaptions

    300               500        (13
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,350      $ (46   $ 2,650      $ (69
 

 

 

   

 

 

   

 

 

   

 

 

 

For interest rate derivative instruments designated as fair value hedges, the fair values of the hedges are recorded on the condensed consolidated balance sheets as assets or liabilities, with corresponding offsetting adjustments to the debt’s carrying value. Our qualifying interest rate swaps are considered 100% effective and therefore no ineffectiveness was recorded for the periods presented below. Changes in the fair value of non-qualifying interest rate derivatives that occur prior to their maturity (i.e., temporary fluctuations in value) are currently reported in the condensed consolidated statements of operations 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,
 
    2011     2010     2011     2010  
    ($ in millions)  

Interest expense on senior notes

  $ 152      $ 167      $ 494      $ 550   

Interest expense on credit facilities

    18        18        49        42   

(Gains) losses on interest rate derivatives

                  19        (81

Amortization of loan discount and other

    8        3        30        26   

Capitalized interest

    (174     (185     (555     (525
 

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

  $ 4      $ 3      $ 37      $ 12   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

10


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

We have terminated certain fair value hedges related to senior notes. Gains and losses related to these terminated hedges will be amortized as an adjustment to interest expense over the remaining term of the related senior notes. Over the next nine years, we will recognize $30 million in gains related to such transactions.

Foreign Currency Derivatives

In December 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 cross currency swaps to mitigate our exposure to fluctuations in the euro relative to the dollar over the term of the notes. In May 2011, we purchased and subsequently retired 256 million in aggregate principal amount of these senior notes following a tender offer, and we simultaneously unwound the cross currency swaps for the same principal amount. As a result, we reclassified a loss of $38 million from accumulated other comprehensive income to the condensed consolidated statement of operations, $20 million of which related to the unwound notional amount and was included in losses on purchases or exchanges of debt, and $18 million of which related to future interest associated with the unwound principal and was included in interest expense. Under the terms of the remaining cross currency swaps, on each semi-annual interest payment date, the counterparties pay Chesapeake 11 million and Chesapeake pays the counterparties $17 million, which yields an annual dollar-equivalent interest rate of 7.491%. Upon maturity of the notes, the counterparties will pay Chesapeake 344 million and Chesapeake will pay the counterparties $459 million. The terms of the cross currency swaps were based on the dollar/euro exchange rate on the issuance date of $1.3325 to 1.00. Through the cross currency swaps, we have eliminated any potential variability in Chesapeake’s expected cash flows related to changes in foreign exchange rates and therefore the swaps qualify as cash flow hedges. The fair values of the cross currency swaps are recorded on the condensed consolidated balance sheet as a liability of $31 million at September 30, 2011. The euro-denominated debt in long-term debt has been adjusted to $463 million at September 30, 2011 using an exchange rate of $1.3449 to 1.00.

Additional Disclosures Regarding Derivative Instruments and Hedging Activities

In accordance with accounting guidance for derivatives and hedging, 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 sheets represent the estimated fair value of derivatives scheduled to settle over the next twelve months based on market prices/rates as of the respective balance sheet dates. The derivative settlement amounts are not due until the month in which the related underlying hedged transaction occurs. Cash settlements of our derivative instruments are generally classified as operating cash flows unless the derivative contains a significant financing element at contract inception, in which case these cash settlements are classified as financing cash flows in the accompanying condensed consolidated statements of cash flows.

 

11


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The following table presents the fair value and location of each classification of derivative instrument as disclosed in the condensed consolidated balance sheets as of September 30, 2011 and December 31, 2010 on a gross basis without regard to same-counterparty netting:

 

          Fair Value  
    

Balance Sheet Location

     September 30,  
2011
      December 31,  
2010
 
          ($ in millions)  

Asset Derivatives:

       

Derivatives designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments    $      $ 307   

Commodity contracts

   Long-term derivative instruments             12   
     

 

 

   

 

 

 

Total

            319   
     

 

 

   

 

 

 

Derivatives not designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments      73        921   

Commodity contracts

   Long-term derivative instruments      36        229   
     

 

 

   

 

 

 

Total

     109        1,150   
     

 

 

   

 

 

 

Liability Derivatives:

       

Derivatives designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments             (59

Interest rate contracts

   Long-term derivative instruments             (25

Foreign currency contracts

   Long-term derivative instruments      (31     (43
     

 

 

   

 

 

 

Total

     (31     (127
     

 

 

   

 

 

 

Derivatives not designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments      (204     (222

Commodity contracts

   Long-term derivative instruments      (1,461     (1,837

Interest rate contracts

   Short-term derivative instruments             (15

Interest rate contracts

   Long-term derivative instruments      (46     (29
     

 

 

   

 

 

 

Total

     (1,711     (2,103
     

 

 

   

 

 

 

Total derivative instruments

   $ (1,633   $ (761
     

 

 

   

 

 

 

 

12


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

A consolidated summary of the effect of derivative instruments on the condensed consolidated statements of operations for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period is provided below, separating fair value, cash flow and non-qualifying derivatives.

Fair Value Hedges

The following table presents the gain (loss) recognized in the condensed consolidated statements of operations for instruments designated as fair value derivatives:

 

$000 $000 $000 $000 $000
          Three Months Ended
September 30,
     Nine Months Ended
September 30,
 

  Fair Value Derivatives    

  

 Location of Gain (Loss) 

   2011      2010      2011      2010  
          ($ in millions)  

   Interest rate contracts

   Interest expense(a)    $ 3       $ 3       $ 14       $ 16   
     

 

 

    

 

 

    

 

 

    

 

 

 
              

 

(a)

Interest expense on items hedged during the Current Quarter, the Prior Quarter, the Current Period and the Prior Period was $2 million, $0, $23 million and $15 million, respectively, which is included in interest expense on the condensed consolidated statements of operations.

Cash Flow Hedges

The following table presents the pre-tax gain (loss) recognized in, and reclassified from, accumulated other comprehensive income (AOCI) related to instruments designated as cash flow derivatives:

 

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

Cash Flow Derivatives        

  

Location of Gain (Loss)  

   2011     2010     2011     2010  
          ($ in millions)  

Gain (Loss) Recognized in AOCI (Effective Portion)

           

Commodity contracts

   AOCI    $ 122      $ 94      $ 372      $ 458   

Foreign currency contracts

   AOCI      (1     5        (34     (34
     

 

 

   

 

 

   

 

 

   

 

 

 
      $ 121      $ 99      $ 338      $ 424   
     

 

 

   

 

 

   

 

 

   

 

 

 

Gain (Loss) Reclassified from AOCI
(Effective Portion)

           

Commodity contracts

   Natural gas and oil sales    $ 129      $ 179      $ 270      $ 535   

Foreign currency contracts

   Interest expense                    (18       

Foreign currency contracts

   Loss on purchase of debt                    (20       
     

 

 

   

 

 

   

 

 

   

 

 

 
      $ 129      $ 179      $ 232      $ 535   
     

 

 

   

 

 

   

 

 

   

 

 

 

Gain (Loss) Recognized in Income

           

Commodity contracts

           

Ineffective portion

   Natural gas and oil sales    $ (5   $ 5      $ 13      $ (20

Amount initially excluded from effectiveness testing

   Natural gas and oil sales             (3     22        (75
     

 

 

   

 

 

   

 

 

   

 

 

 
      $ (5   $ 2      $ 35      $ (95
     

 

 

   

 

 

   

 

 

   

 

 

 

 

 

13


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Non-Qualifying Derivatives

The following table presents the gain (loss) recognized in the condensed consolidated statements of operations for instruments not qualifying as cash flow or fair value derivatives:

 

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

Derivative Contracts            

  

Location of Gain (Loss)    

     2011      2010      2011      2010  
            ($ in millions)  

Commodity contracts

  

Natural gas and oil sales

     $ 851       $ 384       $ 491       $ 1,015   

Interest rate contracts

  

Interest expense

       (3      (3      (14      65   
       

 

 

    

 

 

    

 

 

    

 

 

 
  

  Total

     $ 848       $ 381       $ 477       $ 1,080   
       

 

 

    

 

 

    

 

 

    

 

 

 

Credit Risk

Derivative instruments that enable us to hedge a portion of our exposure to natural gas and oil prices and interest rate volatility 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, 2011, our commodity and interest rate derivative instruments were spread among 12 counterparties. Additionally, our multi-counterparty secured hedging facility described above includes 11 of our counterparties which are required to secure their natural gas and oil derivative obligations in excess of defined thresholds. We use this facility for all of our natural gas, oil and natural gas liquids derivatives.

 

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. On September 2, 2010, the court denied the defendants’ motion to dismiss, and on August 1, 2011, the plaintiffs filed a motion for class certification. Discovery in the case is proceeding. We are currently unable to assess the probability of loss or estimate a range of potential loss associated with the case. A derivative action was also filed in the District Court of Oklahoma County, Oklahoma on March 10, 2009 against certain current and former directors and officers of the company asserting breaches of fiduciary duties relating to alleged material omissions in the registration statement for the July 2008 offering. The derivative action is stayed pursuant to stipulation. A second derivative action relating to the July 2008 offering was filed against certain current and former directors and officers of the company in the U.S. District Court for the Western District of Oklahoma on September 6, 2011. This action also asserts breaches of fiduciary duties with respect to alleged material omissions in the offering registration statement. Chesapeake is named as a nominal defendant in both derivative actions.

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, among other things, breaches of fiduciary duties relating to the 2008 compensation of the company’s CEO 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’s motion to dismiss was granted on February 26, 2010, and the Oklahoma Court of Civil Appeals affirmed the dismissal on August 26, 2011. The plaintiffs filed a petition

 

14


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

for writ of certiorari with the Oklahoma Supreme Court on September 13, 2011. On November 1, 2011, the company entered into a Stipulation and Agreement of Settlement (the “Stipulation”) setting forth the terms of a proposed settlement between the parties in this derivative action, as well as in an inspection demand case requesting books and records relating to the company’s December 2008 employment agreement with its CEO. The inspection demand case, currently on appeal at the Oklahoma Court of Civil Appeals, was filed initially on March 26, 2009 in the District Court of Oklahoma County, Oklahoma, and the plaintiff’s petition for writ of mandate to compel inspection was denied on September 2, 2009. On November 1, 2011, the District Court of Oklahoma County, Oklahoma entered an order preliminarily approving settlement of the two cases in accordance with the Stipulation filed November 1, 2011. The settlement, if approved by the court, will not have a material effect on the company’s consolidated financial position, results of operations or cash flows, and the litigation will be dismissed with prejudice against all defendants. The order also approved distribution of a notice of settlement to Chesapeake shareholders and set a hearing date to consider final approval of the settlement for January 30, 2012. The appeals of both the consolidated derivative case and the inspection demand case have been stayed pending court approval of the settlement.

On September 6 and 8, 2011, in separate derivative actions filed in the U.S. District Court for the Western District of Oklahoma against certain of the company’s current and former directors, two shareholders have alleged that the company’s directors have waived the demand requirement for derivative actions or wrongfully refused their demands that the board take certain actions related to executive compensation and, as a result, each of these shareholders asserts he is entitled to seek relief on behalf of the company.

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, various mineral or leasehold owners have filed lawsuits against us seeking specific performance to require us to acquire their natural gas and oil 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 successfully defended a number of these cases in various courts, has settled others and believes that it has substantial defenses to the claims made in those pending at the trial court and on appeal.

The company records an associated liability when a loss is probable and the amount is reasonably estimable. Based on management’s current assessment, we are of the opinion that no pending or threatened lawsuit or dispute incidental to the company’s business operations is likely to have a material adverse effect on its 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.

Environmental Risk

Due to the nature of the natural gas and oil business, Chesapeake and its subsidiaries are exposed to environmental risks. Chesapeake has implemented various policies and procedures to reduce and mitigate such environmental risks. 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. 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, 2011. There is, however, an enforcement action pending against us related to compliance with Clean Water Act permitting requirements in West Virginia, and the Pennsylvania Department of Environmental Protection has issued compliance orders with respect to alleged violations of the Pennsylvania Clean Streams Law related to the construction of a well pad and erosion and sediment control associated with another pad site. The Pennsylvania Department of Environmental Protection has also issued a notice of violation alleging violations of the state’s Oil and Gas Act, Clean Streams Law and Solid Waste Management Act relating to a well control incident. While we

 

15


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

anticipate these actions will result in monetary sanctions, we do not expect that they will have a material adverse effect on the company’s consolidated financial position, results of operations or cash flows.

Rig Leases

In a series of transactions since 2006, our drilling subsidiaries have sold 93 drilling rigs (net of one repurchased rig) and related equipment for $802 million and entered into master lease agreements under which we agreed to lease the rigs from the buyer for initial terms of five to ten years. The lease obligations are guaranteed by Chesapeake and certain of its subsidiaries. These transactions were recorded as sales and operating leasebacks and any related gain or loss is amortized to oilfield services expense over the lease term. Under the leases, we can exercise an early purchase option or we can purchase the rigs at the expiration of the lease for the fair market value at the time. In addition, in most cases we have the option to renew the lease for negotiated new terms at the expiration of the lease. Commitments related to rig lease payments are not recorded in the accompanying condensed consolidated balance sheets. As of September 30, 2011, the minimum aggregate undiscounted future rig lease payments were approximately $481 million.

Compressor Leases

Through various transactions since 2007, our compression subsidiary has sold 2,542 compressors (net of six repurchased units), a significant portion of its compressor fleet, for $635 million and entered into a master lease agreement. The term of the agreement varies by buyer ranging from four to ten years. The lease obligations are guaranteed by Chesapeake and certain of its subsidiaries. These transactions were recorded as sales and operating leasebacks and any related gain or loss is amortized to marketing, gathering and compression expenses over the lease term. Under the leases, we can exercise an early purchase option or we can purchase the compressors at the expiration of the lease for the fair market value at the time. In addition, in most cases 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, 2011, the minimum aggregate undiscounted future compressor lease payments were approximately $496 million.

Gathering, Processing and Transportation Agreements

We have contractual commitments with midstream service companies and pipeline carriers for future gathering, processing and transportation of natural gas and liquids to move certain of our production to market. Working interest owners who are selling with us under our marketing agreements will reimburse us for some of these costs. While we expect to have sufficient production to fully utilize the committed capacity, we can pursue a release of any unused capacity to others, thus potentially reducing our future commitment. Commitments related to gathering, processing and transportation agreements are not recorded in the accompanying condensed consolidated balance sheets.

The aggregate undiscounted commitments under our gathering, processing and transportation agreements, excluding any reimbursement from working interest owners, are presented below.

 

    September 30,
2011
     ($ in millions) 

2011

    $ 233  

2012

      1,026  

2013

      1,170  

2014

      1,168  

2015

      1,213  

2016 - 2099

      6,878  
   

 

 

 

Total

    $     11,688  
   

 

 

 

 

16


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Drilling Contracts

Chesapeake has contracts with various drilling contractors to lease approximately 64 rigs with terms ranging from four months to three years. These commitments are not recorded in the accompanying condensed consolidated balance sheets. As of September 30, 2011, the aggregate undiscounted minimum future drilling rig commitment was approximately $494 million.

Natural Gas and Oil Purchase Obligations

Our marketing 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 purchase any natural gas and oil associated with certain volumetric production payment transactions. The purchase commitments are based on market prices at the time of production, and the purchased natural gas and oil is resold.

Net Acreage Maintenance Commitments

Under the terms of our joint venture agreements with certain of our partners (Statoil, Total and CNOOC), we are required to extend, renew or replace certain expiring joint leasehold, at our cost, to ensure that the net acreage is maintained in certain designated areas for certain designated time periods.

Other Obligations

In April 2011, we entered into a master frac services agreement with Frac Tech Services, LLC, under which we agreed to a structured fee for the exclusive use of a portion of Frac Tech’s pressure pumping fleets through December 31, 2014.

In July 2011, we agreed to invest $150 million in newly issued convertible promissory notes of Clean Energy Fuels Corp. (Nasdaq:CLNE), based in Seal Beach, California. The investment is being made in three equal $50 million promissory notes, the first of which was issued on July 11, 2011, with the remaining notes scheduled to be issued in June 2012 and June 2013. The notes bear interest at the annual rate of 7.5%, payable quarterly, and are convertible at our option into shares of Clean Energy’s common stock at a 22.5% conversion premium, resulting in a conversion price of $15.80 per share. See Note 9 for further discussion of this investment.

In July 2011, we agreed to invest $155 million in preferred equity securities of Sundrop Fuels, Inc., a privately held cellulosic biofuels company based in Louisville, Colorado. The first $35 million tranche of our investment was funded on July 11, 2011 and the remaining tranches of preferred equity investment will be scheduled around certain funding and operational milestones that are expected to be reached over the next two years. See Note 9 for further discussion of this investment.

 

17


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

4. Net Income Per Share

Accounting guidance for earnings per share (EPS) requires presentation of “basic” and “diluted” earnings per share on the face of the statements of operations for all entities with complex capital structures as well as a reconciliation of the numerator and denominator of the basic and diluted EPS computations.

For the Current Quarter, the Prior Quarter, the Current Period and the Prior Period, all outstanding securities that were convertible into common stock were included in the calculation of diluted EPS.

A reconciliation of basic EPS and diluted EPS for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period is as follows:

 

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

Three Months Ended September 30, 2011:

            

Basic EPS

  $      879           638       $ 1.38   
 

 

   

 

    

 

 

 

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 5.75% cumulative convertible preferred stock

       21           56      

Common shares assumed issued for 5.75% cumulative convertible preferred stock (series A)

       16           39      

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

       3           5      

Common shares assumed issued for 4.50% cumulative convertible preferred stock

       3           6      

Unvested restricted stock

                 8      

Outstanding stock options

                 1      
 

 

   

 

    

Diluted EPS

  $      922           753       $         1.23   
 

 

   

 

    

 

 

 

Three Months Ended September 30, 2010:

            

Basic EPS

  $      515           632       $ 0.81   
 

 

   

 

    

 

 

 

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 5.75% cumulative convertible preferred stock

       21           56      

Common shares assumed issued for 5.75% cumulative convertible preferred stock (series A)

       16           40      

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

       3           5      

Common shares assumed issued for 4.50% cumulative convertible preferred stock

       3           6      

Unvested restricted stock

                 4      

Outstanding stock options

                 1      
 

 

   

 

    

Diluted EPS

  $      558           744       $ 0.75   
 

 

   

 

    

 

 

 

 

18


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

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

Nine Months Ended September 30, 2011:

           

Basic EPS

  $     1,141           636       $ 1.79   
 

 

   

 

    

 

 

 

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 5.75% cumulative convertible preferred stock

      64           56      

Common shares assumed issued for 5.75% cumulative convertible preferred stock (series A)

      47           39      

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

      8           5      

Common shares assumed issued for 4.50% cumulative convertible preferred stock

      9           6      

Unvested restricted stock

                9      

Outstanding stock options

                1      
 

 

   

 

    

Diluted EPS

  $     1,269           752       $         1.69   
 

 

   

 

    

 

 

 

Nine Months Ended September 30, 2010:

           

Basic EPS

  $     1,482           631       $ 2.35   
 

 

   

 

    

 

 

 

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 5.75% cumulative convertible preferred stock

      28           24      

Common shares assumed issued for 5.75% cumulative convertible preferred stock (series A)

      23           20      

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

      8           5      

Common shares assumed issued for 4.50% cumulative convertible preferred stock

      9           6      

Unvested restricted stock

                5      

Outstanding stock options

                1      
 

 

   

 

    

Diluted EPS

  $     1,550           692       $ 2.24   
 

 

   

 

    

 

 

 

 

19


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(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, 2011 and 2010:

 

         2011                2010      
     (in thousands)  

Shares issued at January 1

     655,251           648,549   

Restricted stock issuances (net of forfeitures)

     5,096           6,108   

Stock option exercises

     394           354   

Convertible note exchanges

               299   

Preferred stock conversions/exchanges

     111           21   
  

 

 

      

 

 

 

Shares issued at September 30

     660,852           655,331   
  

 

 

      

 

 

 

In the Prior Period, we privately exchanged approximately $11 million in aggregate principal amount of our 2.25% Contingent Convertible Senior Notes due 2038 for an aggregate of 298,500 shares of our common stock valued at approximately $9 million. The difference between the allocated debt value of the notes that were exchanged and the fair value of the common stock issued resulted in a $2 million loss (including a nominal amount of deferred charges associated with the exchanges).

Preferred Stock

The following reflects our preferred shares outstanding for the nine months ended September 30, 2011 and 2010:

 

        5.75%        5.75% (A)         4.50%         5.00%
  (2005B)  
     5.00%
   (2005)   
 
     (in thousands)  

Shares outstanding at January 1, 2011

     1,500        1,100         2,559         2,096           

Conversion of preferred into common stock

     (3                               
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Shares outstanding at September 30, 2011

     1,497        1,100         2,559         2,096           
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Shares outstanding at January 1, 2010

                    2,559         2,096         5   

Preferred stock issuances

     1,500        1,100                           

Conversion of preferred into common stock

                                    (5
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Shares outstanding at September 30, 2010

     1,500        1,100         2,559         2,096           
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

In the Current Period, 3,000 shares of our outstanding 5.75% Cumulative Convertible Non-Voting Preferred Stock were converted into 111,111 shares of common stock pursuant to the holder’s conversion rights.

In the Prior Period, we issued 600,000 shares of 5.75% Cumulative Convertible Non-Voting Preferred Stock, par value $0.01 per share and liquidation preference $1,000 per share, in a private placement for net proceeds of approximately $594 million. We issued an additional 900,000 shares of 5.75% Cumulative Convertible Non-Voting Preferred Stock on June 18, 2010, upon the exercise of the purchasers’ option to place the additional shares, for net proceeds of approximately $877 million.

In the Prior Period, we issued 1,100,000 shares of 5.75% Cumulative Convertible Non-Voting Preferred Stock (Series A), par value $0.01 per share and liquidation preference $1,000 per share, in a private placement for net proceeds of approximately $1.091 billion.

 

20


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

In the Prior Period, we converted all 5,000 shares of our outstanding 5.00% Cumulative Convertible Preferred Stock (Series 2005) into 20,774 shares of common stock pursuant to the company’s mandatory conversion rights.

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.

Dividends on our outstanding preferred stock are payable quarterly. We may pay dividends on our 5.00% Cumulative Convertible Preferred Stock (Series 2005B) and our 4.50% Cumulative Convertible Preferred Stock in cash, common stock or a combination thereof, at our option. Dividends on both series of our 5.75% Cumulative Convertible Non-Voting Preferred Stock are payable only in cash.

Stock-Based Compensation

Chesapeake’s stock-based compensation program consists of restricted stock, and prior to 2006 stock options, issued to employees and non-employee directors. We recognize in our financial statements the cost of employee services received in exchange for awards of equity instruments based on the fair value of the equity instruments at the date of the grant. To the extent compensation cost relates to employees directly involved in natural gas and oil acquisition, exploration and development activities, such amounts are capitalized to natural gas and oil properties. Amounts not capitalized to natural gas and oil properties are recognized as general and administrative expenses, production expenses, marketing, gathering and compression expenses or oilfield services expense. 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,
 
     2011      2010      2011      2010  
     ($ in millions)  

Natural gas and oil properties

   $ 30       $ 30       $ 90       $ 95   

General and administrative expenses

     24         21         71         63   

Production expenses

     8         9         26         27   

Marketing, gathering and compression expenses

     5         5         14         13   

Oilfield services expense

     3         2         8         7   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $         70       $         67       $         209       $         205   
  

 

 

    

 

 

    

 

 

    

 

 

 

Restricted Stock. Chesapeake began issuing shares of restricted common stock to employees in January 2004 and to non-employee directors in July 2005. 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.

 

21


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

A summary of the changes in unvested shares of restricted stock for the nine months ended September 30, 2011 is presented below.

 

     Number  of
Unvested
Restricted
Shares
    Weighted Average
Grant-Date
Fair Value
     (in thousands)       

Unvested shares as of January 1, 2011

     21,375      $ 28.68

Granted

     9,321      $ 28.44

Vested

     (10,033   $ 31.88

Forfeited

     (749   $ 27.37
  

 

 

   

Unvested shares as of September 30, 2011

     19,914      $ 27.01
  

 

 

   

The aggregate intrinsic value of restricted stock vested during the Current Period was approximately $289 million based on the stock price at the time of vesting.

As of September 30, 2011, there was $397 million of total unrecognized compensation cost related to unvested restricted stock. The cost is expected to be recognized over a weighted average period of approximately three years.

The vesting of certain restricted stock grants could result 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, the Prior Quarter, the Current Period and the Prior Period, we recognized reductions in tax benefits related to restricted stock of $7 million, $14 million, $8 million and $15 million, respectively, which were recorded as adjustments to additional paid-in-capital and deferred income taxes.

Stock Options. We granted stock options prior to 2006 under several stock compensation plans. Outstanding options expire ten years from the date of grant and vested over a four-year period. All of our outstanding stock options are fully vested and exercisable.

The following table provides information related to stock option activity for the nine months ended September 30, 2011:

 

     Number of
Shares
Underlying
Options
  Weighted
Average
Exercise
Price
Per Share
   Weighted
Average
Contract
Life in
Years
   Aggregate
Intrinsic
Value(a)
     (in thousands)              ($ in millions)

Outstanding at January 1, 2011

            1,808       $   8.90          2.03        $     31  

Exercised

       (483 )     $   6.88            
    

 

 

               

Outstanding and exercisable at September 30, 2011

       1,325       $   9.64          1.53        $     21  
    

 

 

               

 

(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.

There is no remaining unrecognized compensation cost related to unvested stock options.

 

22


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

During the Current Quarter, the Prior Quarter, the Current Period and the Prior Period, we recognized excess tax benefits related to stock options of a nominal amount, $1 million, $3 million and $2 million, respectively, which were recorded as adjustments to additional paid-in capital and deferred income taxes.

 

6. Debt

Our long-term debt consisted of the following at September 30, 2011 and December 31, 2010:

 

    September 30,
2011
    December 31,
2010
 
    ($ in millions)  

7.625% senior notes due 2013

  $ 464      $ 500   

9.5% senior notes due 2015

    1,265        1,425   

6.25% euro-denominated senior notes due 2017(a)

    463        796   

6.5% senior notes due 2017

    660        1,100   

6.875% senior notes due 2018

    474        600   

7.25% senior notes due 2018

    669        800   

6.625% senior notes due 2020

    1,300        1,400   

6.875% senior notes due 2020

    500        500   

6.125% senior notes due 2021

    1,000          

2.75% contingent convertible senior notes due 2035(b)

    396        451   

2.5% contingent convertible senior notes due 2037(b)

    1,168        1,378   

2.25% contingent convertible senior notes due 2038(b)

    346        752   

Corporate revolving bank credit facility

    3,236        3,612   

Midstream revolving bank credit facility

    327        94   

Discount on senior notes(c)

    (509     (777

Interest rate derivatives(d)

    30        9   
 

 

 

   

 

 

 

Total long-term debt

  $ 11,789      $ 12,640   
 

 

 

   

 

 

 

 

(a)

The principal amount shown is based on the exchange rate of $1.3449 to 1.00 and $1.3269 to 1.00 as of September 30, 2011 and December 31, 2010, respectively. See Note 2 for information on our related foreign currency derivatives.

 

(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 2011, 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 2011 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 in which contingent interest may be payable for the contingent convertible senior notes are as follows:

 

23


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Repurchase Dates Repurchase Dates Repurchase Dates

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

   $      48.62   

    May 14, 2016

2.5% due 2037

  

  May 15, 2017, 2022, 2027, 2032

   $      64.16   

    November 14, 2017

2.25% due 2038

  

  December 15, 2018, 2023, 2028, 2033

   $    107.36   

    June 14, 2019

 

(c)

Included in this discount is $460 million at September 30, 2011 and $711 million at December 31, 2010 associated with the equity component of our contingent convertible senior notes. This discount is based on an effective yield method.

 

(d)

See Note 2 for further discussion related to these instruments.

Senior Notes

Our senior notes are unsecured senior obligations of Chesapeake and rank equally in right of payment with all of our other existing and future senior indebtedness and rank senior in right of payment to all of our future subordinated indebtedness. Chesapeake is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. Our senior note obligations are guaranteed by certain of our wholly owned subsidiaries, excluding Chesapeake Midstream Development, L.P. (CMD) and its subsidiaries and, beginning in the 2011 fourth quarter, Chesapeake Oilfield Services, L.L.C. and its subsidiaries (see Note 13 for this subsequent event). See Note 11 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. Our senior notes 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.

We are required 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. These rates for 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 are 6.86%, 8.0% and 8.0%, respectively.

 

24


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

In May 2011, we completed and settled tender offers to purchase the following senior notes and contingent convertible senior notes in order to reduce the amount of our outstanding indebtedness. We funded the purchase of the notes with a portion of the net proceeds we received from the sale of our Fayetteville Shale assets which is described in Note 8.

 

     Principal
Amount
     Purchased     
 
     ($ in millions)  

7.625% senior notes due 2013

   $         36   

9.5% senior notes due 2015

     160   

6.25% euro-denominated senior notes due 2017(a)

     380   

6.5% senior notes due 2017

     440   

6.875% senior notes due 2018

     126   

7.25% senior notes due 2018

     131   

6.625% senior notes due 2020

     100   
  

 

 

 

Total senior notes

     1,373   
  

 

 

 

2.75% contingent convertible senior notes due 2035

     55   

2.5% contingent convertible senior notes due 2037

     210   

2.25% contingent convertible senior notes due 2038

     266   
  

 

 

 

Total contingent convertible senior notes

     531   
  

 

 

 

Total

   $ 1,904   
  

 

 

 

 

(a)

We purchased 256 million in aggregate principal amount of our euro-denominated senior notes which had a value of $380 million based on the exchange rate of $1.4821 to 1.00. Simultaneously with our purchase of the euro-denominated senior notes, we unwound cross currency swaps for the same principal amount. See Note 2 for additional information.

We paid $2.058 billion in cash for the tender offers described above and recorded associated losses of approximately $174 million. The losses included $154 million in cash premiums, $20 million of deferred charges, $160 million of note discounts and $2 million of interest rate hedging losses, offset by $162 million of the equity component of the contingent convertible notes.

During the Current Period, we repurchased $140 million in aggregate principal amount of our 2.25% Contingent Convertible Senior Notes due 2038 for approximately $128 million. Associated with these repurchases, we recognized a loss of $2 million in the Current Period.

During the Current Period, we issued $1.0 billion principal amount of 6.125% Senior Notes due 2021 in a registered public offering. We used the net proceeds of $977 million from the offering to repay indebtedness outstanding under our corporate revolving bank credit facility.

During the Prior Period, we redeemed in whole for an aggregate redemption price of approximately $1.366 billion, plus accrued interest, approximately $364 million in principal amount of our outstanding 7.50% Senior Notes due 2013, $300 million in principal amount of our 7.50% Senior Notes due 2014 and approximately $670 million in principal amount of our 6.875% Senior Notes due 2016. Associated with the redemptions, we recognized a loss of $69 million in the Prior Period.

 

25


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

During the Prior Period, we redeemed in whole for a redemption price of approximately $619 million, plus accrued interest, all $600 million in principal amount of our 6.375% Senior Notes due 2015. Associated with the redemption, we recognized a loss of $19 million in the Prior Period.

During the Prior Period, we filed a shelf registration statement on Form S-3 with the SEC for the offering from time to time of debt securities.

During the Prior Period, we completed a public offering of $2.0 billion aggregate principal amount of senior notes for net proceeds of approximately $1.967 billion. The offering consisted of $600 million of 6.875% Senior Notes due 2018 and $1.4 billion of 6.625% Senior Notes due 2020. Both series were priced at par.

During the Prior Period, we completed tender offers to purchase for cash $245 million of 7.00% Senior Notes due 2014, $567 million of 6.625% Senior Notes due 2016 and $582 million of 6.25% Senior Notes due 2018. Following the completion of these tender offers, we redeemed the remaining $55 million of 7.00% Senior Notes due 2014, $33 million of 6.625% Senior Notes due 2016 and $18 million of 6.25% Senior Notes due 2018 based on the redemption provisions in the indentures. Associated with the tender offers and redemptions, we recognized a loss of $40 million in the Prior Period.

During the Prior Period, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $11 million in aggregate principal amount for an aggregate of 298,500 shares of our common stock in privately negotiated exchanges. Associated with these exchanges, we recognized a loss of $2 million in the Prior Period.

No scheduled principal payments are required under our senior notes until 2013 when $464 million is due.

Bank Credit Facilities

As of September 30, 2011, we utilized two revolving bank credit facilities, described below, as sources of liquidity.

 

Corporate Credit Corporate Credit
     Corporate
Credit Facility(a)
   Midstream
Credit Facility(b)
     ($ in millions)

Facility structure

   Senior secured revolving    Senior secured revolving

Maturity date

   December 2015    June 2016

Borrowing capacity

   $      4,000      $       600(c)

Amount outstanding as of September 30, 2011

   $      3,236      $      327   

Letters of credit outstanding as of September 30, 2011

   $           60      $        —   

 

 

(a)

Borrower is Chesapeake Exploration, L.L.C.

 

(b)

Borrower is Chesapeake Midstream Operating, L.L.C.

 

(c)

The decrease in operating income following the sale of our Haynesville Springridge gathering system in December 2010 and the sale of our Fayetteville gathering system in March 2011 caused the borrowing capacity under the facility to be limited to $440 million as of September 30, 2011.

Our credit facilities do not contain material adverse change or adequate assurance covenants. Although the applicable interest rates under our corporate credit facility fluctuate slightly based on our long-term senior unsecured credit ratings, neither of our credit facilities contains 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.

 

26


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Corporate Credit Facility

Our $4.0 billion syndicated revolving bank credit facility is used for general corporate purposes. Borrowings under the facility are secured by natural gas and oil proved reserves 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 0.50% to 1.25% per annum according to our senior unsecured long-term debt ratings, or (ii) the Eurodollar rate, which is based on 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% per annum. 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 and require us to maintain an indebtedness to total capitalization ratio and an indebtedness to EBITDA ratio, in each case as defined in the agreement. We were in compliance with all covenants under the agreement at September 30, 2011. 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 $50 million or more, 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 $125 million.

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

Midstream Credit Facility

Our $600 million midstream syndicated revolving bank credit facility is used to fund capital expenditures to build natural gas gathering and other systems in support of our drilling program and for general corporate purposes associated with our midstream operations. Borrowings under the midstream 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 are subject to a margin that varies from 1.00% to 1.75% per annum or (ii) the Eurodollar rate, which is based on the LIBOR plus a margin that varies from 2.00% to 2.75% per annum. The unused portion of the facility is subject to a commitment fee that varies from 0.375% to 0.50% per annum. Both margins and commitment fees are determined according to the most recent leverage ratio described below. Interest is payable quarterly or, if LIBOR applies, it may be payable at more frequent intervals.

The midstream 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 agreement requires maintenance of a leverage ratio based on the ratio of indebtedness to EBITDA and an interest coverage ratio based on the ratio of EBITDA to interest expense, in each case as defined in the agreement. The leverage ratio increases during any three-quarter period, beginning in the quarter in which CMD makes a material disposition of assets to our master limited partnership midstream affiliate, Chesapeake Midstream Partners, L.P. We were in compliance with all covenants under the agreement at September 30, 2011. 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 facility could be declared immediately due and payable. The midstream credit facility agreement also has cross default provisions that apply to other indebtedness CMD and its restricted subsidiaries may have from time to time with an outstanding principal amount in excess of $15 million.

 

27


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Other Financings

In 2009, we financed 113 real estate surface assets in the Barnett Shale area 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. This lease transaction was recorded as a financing lease and the cash received was recorded with an offsetting long-term liability on the condensed consolidated balance sheet. Chesapeake exercised its option to repurchase two of the assets in 2010 and one of the assets in 2011. As of September 30, 2011, we had 110 assets remaining and the obligation is recorded in other long-term liabilities on our condensed consolidated balance sheets.

In 2009, we financed our regional Barnett Shale headquarters building in Fort Worth, Texas for net proceeds of 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. This obligation is recorded in other long-term liabilities on our condensed consolidated balance sheets.

 

7. Segment Information

In accordance with accounting guidance for disclosures about segments of an enterprise and related information, we have two reportable operating segments. Our exploration and production operating segment and natural gas and oil marketing, gathering and compression operating segment are managed separately because of the nature of their products and services. The exploration and production operating segment is responsible for finding and producing natural gas and oil. The marketing, gathering and compression operating segment is responsible for marketing, gathering and compression of natural gas and oil primarily from Chesapeake-operated wells. We also have contract drilling, oilfield trucking, oilfield rental and other oilfield service operations which are responsible for providing services for both Chesapeake-operated wells and wells operated by third parties. Our contract drilling, oilfield trucking, oilfield rental and other oilfield service operations are included in “Other Operations” in the following table:

 

28


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Management evaluates the performance of our segments based upon income (loss) before income taxes. Revenues from the sale of natural gas and oil related to Chesapeake’s ownership interests by the marketing, gathering and compression operating segment are reflected as exploration and production revenues. Such amounts totaled $1.324 billion, $1.045 billion, $3.739 billion and $2.978 billion for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period, respectively. The following table presents selected financial information for Chesapeake’s operating segments.

 

Intercompany Intercompany Intercompany Intercompany Intercompany
     Exploration
and
Production
     Marketing,
Gathering
and
Compression
    Other
Operations
    Intercompany
Eliminations
    Consolidated
Total
 
     ($ in millions)  

Three Months Ended
September 30, 2011:

           

Revenues

   $         2,402       $         2,746      $         343      $ (1,514   $ 3,977   

Intersegment revenues

             (1,324     (190     1,514          
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

   $ 2,402       $ 1,422      $ 153      $      $ 3,977   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Income before
income taxes

   $ 1,496       $ 79      $ 23      $ (87   $ 1,511   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Three Months Ended
September 30, 2010:

           

Revenues

   $ 1,639       $ 1,928      $ 187      $ (1,173   $ 2,581   

Intersegment revenues

             (1,045     (128     1,173          
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

   $ 1,639       $ 883      $ 59      $      $ 2,581   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before
income taxes

   $ 822       $ 96      $ (7   $ (4   $ 907   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Nine Months Ended
September 30, 2011:

           

Revenues

   $ 4,688       $ 7,583      $ 866      $ (4,229   $         8,908   

Intersegment revenues

             (3,739     (490             4,229          
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

   $ 4,688       $ 3,844      $ 376      $      $ 8,908   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Income before
income taxes

   $ 2,007       $ 239      $ 66      $ (231   $ 2,081   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Nine Months Ended
September 30, 2010:

           

Revenues

   $ 4,698       $ 5,498      $ 538      $ (3,343   $ 7,391   

Intersegment revenues

             (2,978     (365     3,343          
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

   $ 4,698       $ 2,520      $ 173      $      $ 7,391   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before
income taxes

   $ 2,401       $ 152      $ (32   $ (1   $ 2,520   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

As of September 30 2011:

           

Total assets

   $ 35,991       $ 3,885      $ 1,604      $ (1,358   $ 40,122   

As of December 31, 2010:

           

Total assets

   $ 33,560       $ 3,458      $ 854      $ (693   $ 37,179   

 

29


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

8. Acquisitions and Divestitures

Acquisition of Bronco Drilling

In June 2011, we acquired Bronco Drilling Company, Inc. (Nasdaq/GS:BRNC) for an aggregate purchase price of approximately $339 million, or $11.00 per share of Bronco common stock. The acquisition was accounted for as a business combination which, among other things, requires assets acquired and liabilities assumed to be measured at their acquisition date fair values. Pro forma financial information is not presented as it would not be materially different from the information presented in the condensed consolidated statement of income.

The following table summarizes the assets acquired and liabilities assumed:

 

     As of
June 6, 2011
       ($ in millions)  

Current assets

     $ 46  

Drilling rigs and equipment

       287  

Goodwill

       42  

Intangible assets

       10  

Other

       12  
    

 

 

 

Total assets acquired

       397  

Current liabilities

       33  

Long-term liabilities

       1  

Deferred income taxes

       24  
    

 

 

 

Total liabilities assumed

       58  
    

 

 

 

Net assets acquired

     $          339  
    

 

 

 

The acquisition date fair value of the consideration transferred was $339 million in cash. We received carryover tax basis in Bronco’s assets and liabilities because the acquisition was not a taxable transaction under the Internal Revenue Code. Based upon the purchase price allocation, a step-up in basis related to the assets acquired from Bronco resulted in a net deferred tax liability of approximately $24 million. We recorded goodwill of $42 million, which represents the amount of the consideration transferred in excess of the fair values assigned to the individual assets acquired and liabilities assumed. Goodwill is primarily attributable to operational and cost synergies expected to be realized from the acquisition by integrating Bronco’s drilling rigs and assembled workforce. Goodwill was assigned to drilling rig operations which is discussed in Note 7. Goodwill recorded in the acquisition is not subject to amortization but will be tested annually for impairment. None of the goodwill is deductible for tax purposes. The drilling rigs and equipment we acquired from Bronco are now owned by Nomac Drilling, L.L.C., our drilling subsidiary.

Fayetteville Shale Asset Sale

On March 31, 2011, we sold all of our Fayetteville Shale assets in central Arkansas to BHP Billiton Petroleum, a wholly owned subsidiary of BHP Billiton Limited (NYSE:BHP;ASX:BHP), for net proceeds of approximately $4.65 billion in cash. The properties sold consisted of approximately 487,000 net acres of leasehold, net production at closing of approximately 415 million cubic feet of natural gas equivalent per day and midstream assets consisting of approximately 420 miles of pipeline. As part of the transaction, Chesapeake agreed to provide technical and business services for up to one year for BHP Billiton’s Fayetteville properties for an agreed-upon fee. Under full cost accounting rules, we accounted for the sale of our Fayetteville Shale natural gas and oil properties as an adjustment to capitalized costs, with no recognition of gain or loss.

 

30


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Joint Ventures

As of September 30, 2011, we had entered into six significant joint ventures pursuant to which we sold a portion of our leasehold, producing properties and other assets located in six different resource plays and received cash of $6.5 billion and commitments for future drilling and completion cost sharing of $7.7 billion. These transactions have allowed us to recover much or all of our initial leasehold investments and reduce our ongoing capital costs in these plays. For accounting purposes, initial cash proceeds from these joint venture transactions were reflected as a reduction of natural gas and oil properties with no gain or loss recognized. The transactions are detailed below.

 

      Primary      

Play

   Joint
Venture
    Partner(a)     
 

Joint

Venture

Date

   Interest
  Acquired  
  Cash
Proceeds
Received
at Closing
     Total
Drilling
Carries
     Drilling
Carries
  Remaining(b)   
 
                 

($ in millions)

 

Niobrara

   CNOOC   February 2011    33.3%   $ 570       $ 697       $ 607   

Eagle Ford &

Pearsall

   CNOOC   November 2010    33.3%     1,120         1,080         467   

Barnett

   TOT   January 2010    25.0%     800         1,450         471 (c) 

Marcellus

   STO   November 2008    32.5%     1,250         2,125         564   

Fayetteville

   BP   September 2008    25.0%     1,100         800           

Haynesville &

Bossier

   PXP   July 2008    20.0%     1,650         1,508           
         

 

 

    

 

 

    

 

 

 
          $         6,490       $         7,660       $         2,109   
         

 

 

    

 

 

    

 

 

 

 

(a)

Joint venture partners include CNOOC Limited (CNOOC), Total S.A. (TOT), Statoil (STO), BP America (BP) and Plains Exploration & Production Company (PXP).

 

(b)

As of September 30, 2011.

 

(c)

On October 24, 2011, Total accelerated the payment of its remaining joint venture carry in exchange for an approximate 9% reduction to the total amount of drilling carry obligation due to us. See Note 13 for this subsequent event.

During the Current Period and the Prior Period, our drilling and completion costs included the benefit of approximately $1.868 billion and $745 million, respectively, in drilling and completion carries paid by our joint venture partners, CNOOC, Total and Statoil.

During the Current Period and the Prior Period, as part of our joint venture agreements with CNOOC, Total, Statoil and Plains Exploration & Production Company, we sold interests in additional leasehold in the Niobrara, Eagle Ford and Pearsall, Barnett, Marcellus and Haynesville and Bossier shale plays to our joint venture partners for approximately $474 million and $395 million, respectively.

 

31


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Volumetric Production Payments

From time to time, we have monetized certain of our producing assets which are located in more mature producing regions through the sale of volumetric production payments (VPPs). A VPP is a limited-term overriding royalty interest in natural gas and oil reserves that (i) entitles the purchaser to receive scheduled production volumes over a period of time from specific lease interests; (ii) is free and clear of all associated future production costs and capital expenditures; (iii) is nonrecourse to the seller (i.e., the purchaser’s only recourse is to the reserves acquired); (iv) transfers title of the reserves to the purchaser; and (v) allows the seller to retain the remaining reserves, if any, after the scheduled production volumes have been delivered. We retain drilling rights on the properties below currently producing intervals and outside of producing well bores. We also retain all production beyond the specified volumes sold in the transaction.

We have completed the following VPP transactions since 2007:

 

               Proved Reserves         Original

Date of VPP

  

Location

   Proceeds    (at time of sale)    $ / mcfe    Term
          ($ in millions)    (bcfe)         (years)

May 2011

   Mid-Continent      $ 853          177            $    4.82           10  

September 2010

   Barnett Shale        1,150          390            $    2.93           5  

June 2010

   Permian Basin        335          38            $    8.73           10  

February 2010

  

East Texas

and the

Texas Gulf Coast

       180          46            $    3.95           10  

August 2009

   South Texas        370          68            $    5.46           7.5  

December 2008

  

Anadarko and

Arkoma Basins

       412          98            $    4.19           8  

August 2008

   Anadarko Basin        600          93            $    6.38           11  

May 2008

  

Texas, Oklahoma

and Kansas

       622          94            $    6.53           11  

December 2007

  

Kentucky and

West Virginia

       1,100          208            $    5.29           15  
       

 

 

      

 

 

           
        $ 5,622                1,212            $    4.64        
       

 

 

      

 

 

           

For accounting purposes, cash proceeds from these transactions were reflected as a reduction of natural gas and oil properties with no gain or loss recognized, and our proved reserves were reduced accordingly.

 

32


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

9. Investments

At September 30, 2011 and December 31, 2010, we had the following investments:

 

               Carrying Value  
     Approximate    Accounting    September 30,      December 30  
     % Owned    Method    2011      2010  
               ($ in millions)  

Chesapeake Midstream Partners, L.P.

   42%      Equity    $ 696       $ 695   

FTS International, LLC

   30%(a)    Equity      202         311   

Chaparral Energy, Inc.

   20%      Equity      130         133   

Clean Energy Fuels Corp.

   —         Cost      50           

Sundrop Fuels, Inc.

   25%      Equity      35           

Gastar Exploration Ltd.

   10%      Cost      20         29   

Other

   —         Cost/Equity      33         40   
        

 

 

    

 

 

 
         $ 1,166       $ 1,208   
        

 

 

    

 

 

 

 

 

(a)

Formerly Frac Tech International, LLC. Prior to the recapitalization described below, we owned approximately 26% of Frac Tech Holdings, LLC.

Chesapeake Midstream Partners, L.P. 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, and GIP purchased a 50% interest in, a new joint venture entity. 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.

On August 3, 2010, Chesapeake Midstream Partners, L.P. (NYSE:CHKM) completed an initial public offering of 24,437,500 common units representing limited partner interests (including 3,187,500 common units issued pursuant to the exercise of the underwriters’ over-allotment option on August 3, 2010) and received gross offering proceeds of approximately $513 million at an initial offering price of $21.00 per unit less approximately $38 million for underwriting discounts and commissions, structuring fees and offering expenses. As of September 30, 2011, common units owned by public security holders represented 17.7% of all outstanding limited partner interests, and Chesapeake and GIP held 42.3% and 40.0%, respectively, of all outstanding limited partner interests. The limited partners, collectively, have a 98.0% interest in CHKM and the general partner, which is owned and controlled 50/50 by Chesapeake and GIP, has a 2.0% interest in CHKM.

During the Current Period, we recorded positive equity method adjustments of $55 million for our share of CHKM’s income, received cash distributions of $63 million from CHKM and recorded accretion adjustments of $9 million related to our share of equity in excess of cost. The carrying value of our investment in CHKM is less than our underlying equity in net assets by approximately $229 million as of September 30, 2011. This difference is being accreted over 20 years.

 

33


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

FTS International, LLC. FTS International, LLC (FTS), based in Fort Worth, Texas, is the privately held parent company of Frac Tech Services, LLC, which provides pressure pumping and well stimulation to oil and gas companies. On May 6, 2011, there was a change in controlling ownership of FTS’s predecessor, Frac Tech Holdings, L.L.C., which resulted in a recapitalization that increased our equity ownership from 26% to 30%. We also entered into a master frac services agreement that obligates us to use certain services of FTS through 2014. Based on the valuation of the net assets performed by FTS in conjunction with the change in controlling ownership, the carrying value of our investment in FTS is less than our underlying equity in FTS’s net assets by approximately $870 million as of September 30, 2011. We allocated this difference to the tangible and intangible assets of FTS and will accrete the portion attributable to the non-goodwill assets over their estimated lives of nine years.

In the Current Period, we recorded positive equity method adjustments of $104 million for our share of FTS’s income, received cash distributions of $224 million from FTS and recorded accretion adjustments of $11 million.

Clean Energy Fuels Corp. On July 11, 2011, we agreed to invest $150 million in newly issued convertible promissory notes of Clean Energy Fuels Corp. (Nasdaq:CLNE), based in Seal Beach, California. The investment is being made in three equal $50 million promissory notes, the first of which was issued on July 11, 2011, with the remaining notes scheduled to be issued in June 2012 and June 2013. The notes bear interest at the annual rate of 7.5%, payable quarterly, and are convertible at our option into shares of Clean Energy’s common stock at a 22.5% conversion premium, resulting in a conversion price of $15.80 per share. Under certain circumstances following the second anniversary of the issuance of a note, Clean Energy can force conversion of the debt. The entire principal balance of each note is due and payable seven years following issuance. Clean Energy will use our $150 million investment to accelerate its build-out of LNG fueling infrastructure for heavy-duty trucks at truck stops across interstate highways in the U.S.

Sundrop Fuels, Inc. On July 11, 2011, we agreed to invest $155 million in preferred equity securities of Sundrop Fuels, Inc., a privately held cellulosic biofuels company based in Louisville, Colorado. The investment over the next two years will fund construction of a nonfood biomass-based “green gasoline” plant, capable of annually producing more than 40 million gallons of gasoline from natural gas and waste cellulosic material. The investment is intended to accelerate the development of an affordable, stable, room-temperature, natural gas-based fuel for immediate use in automobiles, diesel engine vehicles and aircraft. The first $35 million tranche of our investment was funded on July 11, 2011 and the remaining tranches of preferred equity investment will be scheduled around certain funding and operational milestones that are expected to be reached over the next two years. The full investment will represent 50% of Sundrop Fuels’ equity on a fully diluted basis.

Chaparral Energy, Inc. Chaparral Energy, Inc., based in Oklahoma City, Oklahoma, is a private independent oil and natural gas company engaged in the production, acquisition and exploitation of oil and natural gas properties. The carrying value of our investment in Chaparral is in excess of our underlying equity in net assets by approximately $55 million as of September 30, 2011. 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. In the Current Period, we recorded a $1 million charge related to our share of Chaparral’s net loss and depreciation adjustments of $2 million related to the excess of our cost over our proportionate share of Chaparral’s book equity.

Gastar Exploration Ltd. Gastar Exploration Ltd. (NYSE Amex:GST), based in Houston, Texas, is an independent energy company engaged in the exploration, development and production of natural gas and oil in the U.S. During the Current Period, the common stock price of Gastar decreased from $4.30 per share to $3.00 per share. Our investment in Gastar had a historical cost basis of $89 million as of September 30, 2011.

 

34


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

10. Fair Value Measurements

Certain financial instruments are reported at fair value on the condensed consolidated balance sheets. Under fair value measurement accounting guidance, fair value is defined 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 a market valuation approach based on available inputs and the following methods and assumptions to measure the fair values of its assets and liabilities, which may or may not be observable in the market.

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.

Derivatives. The fair values of our commodity derivatives, interest rate swaps and cross currency swaps are based on third-party pricing models which utilize inputs that are either readily available in the public market, such as natural gas and oil forward curves and discount rates, or can be corroborated from active markets or broker quotes. These values are then compared to the values given by our counterparties for reasonableness. Since commodity, interest rate and cross currency swaps do not include optionality and therefore have no unobservable inputs, they are classified as Level 2. All other derivatives have some level of unobservable input, such as volatility curves, and are therefore classified as Level 3. For interest rate options and swaptions, we use the fair value estimates provided by our respective counterparties. These values are reviewed internally for reasonableness using future interest rate curves and time to maturity. Derivatives are also subject to the risk that counterparties will be unable to meet their obligations. We factor non-performance risk into the valuation of our derivatives using current published credit default swap rates. To date, this 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 related qualifying interest rate swaps.

 

35


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The following table provides fair value measurement information for financial assets (liabilities) measured at fair value on a recurring basis as of September 30, 2011:

 

     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

   $ 111      $      $      $ 111   

Investments

     20                      20   

Other long-term assets

     61                      61   

Other long-term liabilities

     (55                   (55

Derivatives:

        

Commodity assets

            11        98        109   

Commodity liabilities

            (15     (1,650     (1,665

Interest rate liabilities

            (46            (46

Foreign currency liabilities

            (31            (31
  

 

 

   

 

 

   

 

 

   

 

 

 

Total derivatives

            (81     (1,552     (1,633
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 137      $ (81   $ (1,552   $ (1,496
  

 

 

   

 

 

   

 

 

   

 

 

 

The following table provides fair value measurement information for financial assets (liabilities) measured at fair value on a recurring basis as of December 31, 2010:

 

     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

   $ 102      $      $      $ 102   

Investments

     29                      29   

Other long-term assets

     52                      52   

Long-term debt

                   (1,371     (1,371

Other long-term liabilities

     (52                   (52

Derivatives:

        

Commodity assets

            1,364        105        1,469   

Commodity liabilities

            (59     (2,059     (2,118

Interest rate liabilities

                   (69     (69

Foreign currency liabilities

                   (43     (43
  

 

 

   

 

 

   

 

 

   

 

 

 

Total derivatives

            1,305        (2,066     (761
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 131      $ 1,305      $ (3,437   $ (2,001
  

 

 

   

 

 

   

 

 

   

 

 

 

 

36


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

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

 

     Derivatives          Debt       
   Commodity         Interest    
Rate
    Foreign
  Currency  
   
        
     ($ in millions)  

Beginning Balance as of January 1, 2011

   $ (1,954   $ (69   $ (43   $ (1,371

Total gains (losses):

        

Included in earnings (realized)(a)

     (50                     

Included in earnings or change in net assets (unrealized)(a)

     306        21                 

Included in other comprehensive income (loss)

                            

Total purchases, issuances, sales and settlements:

        

Sales

            (6              

Settlements

     146                        

Transfers in and out of Level 3(b )

            54        43        1,371   
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending Balance as of September 30, 2011

   $ (1,552   $      $      $   
  

 

 

   

 

 

   

 

 

   

 

 

 

Beginning Balance as of January 1, 2010

   $ (666   $ (132   $ 43      $ (1,398

Total gains (losses):

        

Included in earnings (realized)(a)

     305        (6              

Included in earnings or change in net assets (unrealized)(a)

     (669     85        (44     32   

Included in other comprehensive income (loss)

     (18            (34       

Total purchases, issuances, sales and settlements:

        

Issuances

                          (700 )(c) 

Sales

            (6              

Settlements

     (142     20               1,250 (c) 

Transfers in and out of Level 3

                            
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending Balance as of September 30, 2010

   $ (1,190   $ (39   $ (35   $ (816
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(a)

Amounts related to commodity derivatives are included in natural gas and oil sales, and amounts related to interest rate and foreign currency derivatives and debt are included in interest expense.

 

(b)

The values related to interest rate and cross currency swaps were transferred from Level 3 to Level 2 as a result of our ability to use data readily available in the public market to corroborate our estimated fair values.

 

(c)

Amount represents an increase or decrease in debt recorded at fair value as a result of new or terminated interest rate swaps.

 

37


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Fair Value of Other Financial Instruments

The following disclosure of the estimated fair value of financial instruments is made in accordance with accounting guidance for 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. Fair value is compared to the carrying value, excluding the impact of interest rate derivatives, in the table below.

 

    September 30, 2011     December 31, 2010  
    Carrying
    Amount     
    Estimated
    Fair  Value    
    Carrying
    Amount     
    Estimated
    Fair  Value    
 
          
    ($ in millions)  

Long-term debt

    $ 11,759               $  12,527                $   12,631              $  13,272         

Convertible preferred stock

    $ 3,062               $ 3,340                $ 3,065              $ 3,019         

 

38


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

11. 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. Our obligations under our outstanding senior notes and contingent convertible senior notes listed in Note 6 are fully and unconditionally guaranteed, jointly and severally, by certain of our wholly owned subsidiaries on a senior unsecured basis. Our midstream subsidiary, CMD, is not a guarantor and is subject to covenants in the midstream revolving bank credit facility referred to in Note 6 that restrict it from paying dividends or distributions or making loans to Chesapeake. Beginning in the 2011 fourth quarter, Chesapeake Oilfield Services, L.L.C. and its subsidiaries will no longer be guarantors under our outstanding senior notes and contingent convertible senior notes. See Note 13 for this subsequent event.

Set forth below are condensed consolidating financial statements for Chesapeake Energy Corporation (parent) on a stand-alone, unconsolidated basis, and its combined guarantor and combined non-guarantor subsidiaries as of September 30, 2011 and December 31, 2010 and for the three and nine months ended September 30, 2011 and 2010. 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, 2011

($ in millions)

 

        Parent         Guarantor
Subsidiaries
    Non-
Guarantor
 Subsidiaries 
    Eliminations     Consolidated  
         
         

CURRENT ASSETS:

         

Cash and cash equivalents

  $      $ 88      $ 23      $      $ 111   

Other

    1        3,194        182        (18     3,359   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Current Assets

    1        3,282        205        (18     3,470   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

PROPERTY AND EQUIPMENT:

         

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

           29,644        4               29,648   

Other property and equipment, net

           3,858        1,632               5,490   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Property and Equipment, Net

           33,502        1,636               35,138   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other assets

    166        900        787        (339     1,514   

Investments in subsidiaries and intercompany advances

    2,371        293               (2,664       
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL ASSETS

  $ 2,538      $ 37,977      $ 2,628      $ (3,021   $ 40,122   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

CURRENT LIABILITIES:

         

Current liabilities

  $ 216      $ 5,704      $ 294      $ (19   $ 6,195   

Intercompany payable to (receivable) from parent

    (22,574     21,331        1,205        38          
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Current Liabilities

    (22,358     27,035        1,499        19        6,195   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

LONG-TERM LIABILITIES:

         

Long-term debt, net

    8,226        3,236        327               11,789   

Deferred income tax liabilities

    341        3,065        156        (38     3,524   

Other liabilities

    31        2,270        353        (338     2,316   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Long-Term Liabilities

    8,598        8,571        836        (376     17,629   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

STOCKHOLDERS’ EQUITY:

         
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Stockholders’ Equity

    16,298        2,371        293        (2,664     16,298   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

  $ 2,538      $ 37,977      $ 2,628      $ (3,021   $ 40,122   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

39


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING BALANCE SHEET

AS OF DECEMBER 31, 2010

($ in millions)

 

         Parent         Guarantor
Subsidiaries
     Non-
Guarantor
  Subsidiaries  
      Eliminations      Consolidated  

CURRENT ASSETS:

            

Cash and cash equivalents

   $      $ 2       $ 100       $      $ 102   

Other

     7        3,065         123         (31     3,164   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total Current Assets

     7        3,067         223         (31     3,266   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

PROPERTY AND EQUIPMENT:

            

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

            27,822         4                27,826   

Other property and equipment, net

            3,246         1,306                4,552   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total Property and Equipment, Net

            31,068         1,310                32,378   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Other assets

     166        669         700                1,535   

Investments in subsidiaries and intercompany advances

     1,217        269                 (1,486       
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

TOTAL ASSETS

   $ 1,390      $ 35,073       $ 2,233       $ (1,517   $ 37,179   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

CURRENT LIABILITIES:

            

Current liabilities

   $ 302      $ 4,082       $ 137       $ (31   $ 4,490   

Intercompany payable to (receivable) from parent

     (23,664     21,955         1,596         113          
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total Current Liabilities

     (23,362     26,037         1,733         82        4,490   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

LONG-TERM LIABILITIES:

            

Long-term debt, net

     8,934        3,612         94                12,640   

Deferred income tax liabilities

     482        1,885         130         (113     2,384   

Other liabilities

     72        2,322         7                2,401   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total Long-Term Liabilities

     9,488        7,819         231         (113     17,425   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

STOCKHOLDERS’ EQUITY:

            
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total Stockholders’ Equity

     15,264        1,217         269         (1,486     15,264   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,390      $ 35,073       $ 2,233       $ (1,517   $ 37,179   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

40


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2011

($ in millions)

 

         Parent         Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
     Eliminations      Consolidated  

REVENUES:

          

Natural gas and oil sales

   $      $ 2,402      $      $      $ 2,402   

Marketing, gathering and compression sales

            1,393        55        (26     1,422   

Oilfield services revenue

            129        24               153   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Revenues

            3,924        79        (26     3,977   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

OPERATING COSTS:

          

Production expenses

            282                      282   

Production taxes

            50                      50   

General and administrative expenses

            143        8               151   

Marketing, gathering and compression expenses

            1,377        30        (15     1,392   

Oilfield services expense

            94        24               118   

Natural gas and oil depreciation, depletion and amortization

            423                      423   

Depreciation and amortization of other assets

            59        16               75   

Losses on sales of other property and equipment

            1        2               3   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Costs

            2,429        80        (15     2,494   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

INCOME (LOSS) FROM OPERATIONS

            1,495        (1     (11     1,483   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

OTHER INCOME (EXPENSE):

          

Interest expense

     (138     (17     (7     158        (4

Earnings on investments

            4        24               28   

Other income

     152        9        1        (158     4   

Equity in net earnings of subsidiary

     914        4               (918       
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Other Income

     928               18        (918     28   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

INCOME BEFORE INCOME TAXES

     928        1,495        17        (929     1,511   

INCOME TAX EXPENSE

     6        581        6        (4     589   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

NET INCOME

   $ 922      $ 914      $ 11      $ (925   $ 922   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

41


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2010

($ in millions)