Derivative and Hedging Activities

Natural Gas, Oil and NGL Derivatives

Our results of operations and cash flows are impacted by changes in market prices for natural gas, oil and NGL. To mitigate a portion of our exposure to adverse price changes, we have entered into various derivative instruments. These instruments allow us to predict with greater certainty the effective prices to be received for our production. We believe our derivative instruments continue to be highly effective in achieving our risk management objectives. As of June 30, 2013 and December 31, 2012, 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.

•

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


•	Swaptions: Chesapeake sells call swaptions in exchange for a premium that allows a counterparty, on a specific date, to enter into a fixed-price swap for a certain period of time.

•

Basis Protection Swaps: These instruments are arrangements that guarantee a price differential to NYMEX from a specified delivery point. Our natural gas basis protection swaps 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. Our oil basis protection swaps 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.

•

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

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 instrument assets (liabilities) as of June 30, 2013 and December 31, 2012 are provided below.



	June 30, 2013				December 31, 2012
	Volume	Fair Value			Volume	Fair Value
		($ in millions)				($ in millions)
Natural gas (tbtu):
Fixed-price swaps	519	$	94		49	$	24
Call options	193	(227		)	193	(240		)
Call swaptions	12	(1		)	—	—
Basis protection swaps	90	(7		)	111	(15		)
Three-way collars	55	3			—	—
Total natural gas	869	(138		)	353	(231		)
Oil (mmbbl):
Fixed-price swaps	36.8	75			28.1	68
Call options	67.6	(363		)	73.8	(748		)
Call swaptions	5.3	(2		)	5.3	(13		)
Basis protection swaps	0.7	3			5.5	—
Total oil	110.4	(287		)	112.7	(693		)
Total estimated fair value		$	(425	)		$	(924	)

Pursuant to accounting guidance, 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 and locked-in gains and losses of settled designated derivative contracts, are recorded in accumulated other comprehensive income until the hedged item is recognized in earnings. Any change in fair value resulting from ineffectiveness is recognized in natural gas, oil and NGL sales. Changes in the fair value of derivatives not designated as cash flow hedges that occur prior to their maturity (i.e., temporary fluctuations in value) are reported in the condensed consolidated statements of operations within natural gas, oil and NGL sales. As of June 30, 2013, we did not have any natural gas or oil derivatives that were designated as cash flow hedges. Therefore, changes in the fair value of these derivatives are reported in the condensed consolidated statement of operations. See further discussion below under Cash Flow Hedges.

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



	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
	($ in millions)
Natural gas, oil and NGL sales	$	1,869	$	1,112	$	3,464	$	2,334
Gains (losses) on natural gas, oil and NGL derivatives	537		1,005		394		851
Total natural gas, oil and NGL sales	$	2,406	$	2,117	$	3,858	$	3,185

Hedging Facility

We have a multi-counterparty secured hedging facility with 16 counterparties that have committed to provide approximately 6.2 tcfe of hedging capacity for natural gas, oil and NGL price derivatives and 6.2 tcfe for basis derivatives with an aggregate mark-to-market capacity of $16.5 billion under the terms of the facility. As of June 30, 2013, we had hedged under the facility 1.4 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 NGL price and basis derivatives 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 at semi-annual collateral dates and 1.30 times in between those dates, and guarantees by certain subsidiaries that also guarantee our corporate revolving bank credit facility, indentures, term loan and equipment master lease agreements. The counterparties’ obligations under the facility must be secured by cash or short-term U.S. Treasury instruments to the extent that any mark-to-market amounts they owe to Chesapeake exceed defined thresholds. The maximum volume-based trading capacity under the facility is governed by the expected production of the pledged reserve collateral, and volume-based trading limits are applied separately to price and basis derivatives. In addition, there are volume-based sub-limits for natural gas, oil and NGL derivative instruments. Chesapeake has significant flexibility with regard to releases and/or substitutions of pledged reserves, provided that certain requirements are met including maintaining specified collateral coverage ratios as well as maintaining credit ratings with either of the designated rating agencies at or above current levels. The facility does not have a maturity date. Counterparties to the agreement have the right to cease entering into derivative instruments 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.

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 June 30, 2013 and December 31, 2012, our interest rate derivative instruments consisted of 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.

The notional amount and the estimated fair value of our interest rate derivative liabilities as of June 30, 2013 and December 31, 2012 are provided below.



	June 30, 2013					December 31, 2012
	Notional Amount		Fair Value			Notional Amount		Fair Value
			($ in millions)
Interest rate swaps	$	2,100	$	(91	)	$	1,050	$	(35	)

Realized and unrealized 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 June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	($ in millions)
Interest expense on senior notes	$	194		$	185		$	380		$	359
Interest expense on credit facilities	11			16			22			37
Interest expense on term loans	29			62			58			62
(Gains) losses on interest rate derivatives	50			(7		)	54			(2		)
Amortization of loan discount, issuance costs and other	30			42			48			42
Capitalized interest	(210		)	(284		)	(438		)	(472		)
Total interest expense	$	104		$	14		$	124		$	26

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 eight years, we will recognize $16 million in net 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. Under the terms of the remaining cross currency swaps, on each semi-annual interest payment date, the counterparties pay us €11 million and we pay the counterparties $17 million, which yields an annual dollar-equivalent interest rate of 7.491%. Upon maturity of the notes, the counterparties will pay us €344 million and we 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 our expected cash flows related to changes in foreign exchange rates and therefore the swaps are designated as cash flow hedges. The fair values of the cross currency swaps are recorded on the condensed consolidated balance sheet as a liability of $27 million as of June 30, 2013. The euro-denominated debt in long-term debt has been adjusted to $447 million as of June 30, 2013 using an exchange rate of $1.3010 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, we net the value of our 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 hedged transaction occurs. Cash settlements of our derivative instruments are generally classified as operating cash flows unless the derivative is deemed to contain, for accounting purposes, 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.

The following table presents the fair value and location of each classification of derivative instrument disclosed in the condensed consolidated balance sheets as of June 30, 2013 and December 31, 2012 on a gross basis without regard to same-counterparty netting:



		Fair Value
	Balance Sheet Location	June 30, 2013			December 31, 2012
		($ in millions)
Asset Derivatives:
Not designated as hedging instruments:
Commodity contracts	Short-term derivative instruments	$	159		$	110
Commodity contracts	Long-term derivative instruments	61			5
Total		220			115

Liability Derivatives:
Designated as hedging instruments:
Foreign currency contracts	Long-term derivative instruments	(27		)	(20		)
Total		(27		)	(20		)

Not designated as hedging instruments:
Commodity contracts	Short-term derivative instruments	(163		)	(157		)
Commodity contracts	Long-term derivative instruments	(482		)	(882		)
Interest rate contracts	Long-term derivative instruments	(91		)	(35		)
Total		(736		)	(1,074		)
Total derivative instruments		$	(543	)	$	(979	)

All of the Company’s derivative positions are subject to netting arrangements which provide for offsetting of asset and liability positions, as well as related cash collateral if applicable. Such netting arrangements generally do not have restrictions. Under such netting arrangements, the Company offsets the fair value of derivative instruments with cash collateral received or paid for those contracts executed with the same counterparty, which reduces the Company’s total assets and liabilities. As of June 30, 2013 and December 31, 2012, we did not have any cash collateral balances for these derivatives.

The following tables present the netting offsets of derivative assets and liabilities as of June 30, 2013 and December 31, 2012:



	June 30, 2013
	Derivative Assets						Derivative Liabilities
	Short- Term			Long- Term			Short- Term			Long- Term
	($ in millions)
Commodity Contracts:
Gross amounts of recognized assets (liabilities)	$	159		$	61		$	(163	)	$	(482	)
Gross amounts offset in the condensed consolidated statements of financial position	(109		)	(54		)	109			54
Net amounts of assets (liabilities) presented in the statements of financial position	50			7			(54		)	(428		)
Interest Rate Contracts:
Gross amounts of recognized assets (liabilities)	—			—			—			(91		)
Gross amounts offset in the condensed consolidated statements of financial position	—			—			—			—
Net amounts of assets (liabilities) presented in the statements of financial position	—			—			—			(91		)
Foreign Currency Contracts:
Gross amounts of recognized assets (liabilities)	—			—			—			(27		)
Gross amounts offset in the condensed consolidated statements of financial position	—			—			—			—
Net amounts of assets (liabilities) presented in the statements of financial position	—			—			—			(27		)

Total derivatives as reported	$	50		$	7		$	(54	)	$	(546	)



	December 31, 2012
	Derivative Assets						Derivative Liabilities
	Short- Term			Long- Term			Short- Term			Long- Term
	($ in millions)
Commodity Contracts:
Gross amounts of recognized assets (liabilities)	$	110		$	5		$	(157	)	$	(882	)
Gross amounts offset in the consolidated statements of financial position	(52		)	(3		)	52			3
Net amounts of assets (liabilities) presented in the statements of financial position	58			2			(105		)	(879		)
Interest Rate Contracts:
Gross amounts of recognized assets (liabilities)	—			—			—			(35		)
Gross amounts offset in the consolidated statements of financial position	—			—			—			—
Net amounts of assets (liabilities) presented in the statements of financial position	—			—			—			(35		)
Foreign Currency Contracts:
Gross amounts of recognized assets (liabilities)	—			—			—			(20		)
Gross amounts offset in the consolidated statements of financial position	—			—			—			—
Net amounts of assets (liabilities) presented in the statements of financial position	—			—			—			(20		)

Total derivatives as reported	$	58		$	2		$	(105	)	$	(934	)

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 undesignated derivatives.

Fair Value Hedges

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. We have elected not to designate any of our qualifying interest rate derivatives as fair value hedges. Therefore, changes in the fair value of all of our interest rate derivatives that occur prior to their maturity (i.e., temporary fluctuations in value) are reported in the condensed consolidated statements of operations within interest expense.

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



		Three Months Ended June 30,				Six Months Ended June 30,
Fair Value Derivatives	Location of Gain (Loss)	2013		2012		2013		2012
		($ in millions)
Interest rate contracts	Interest expense	$	1	$	2	$	3	$	4

Cash Flow Hedges

A reconciliation of the changes of accumulated other comprehensive income (loss) in the condensed consolidated statements of stockholders’ equity related to our cash flow hedges is presented below.



	Three Months Ended June 30,
	2013						2012
	Before Tax			After Tax			Before Tax			After Tax
	($ in millions)
Balance, beginning of period	$	(287	)	$	(178	)	$	(284	)	$	(176	)
Net change in fair value	2			1			(5		)	(3		)
(Gains) losses reclassified to income	(1		)	(1		)	(17		)	(11		)
Balance, end of period	$	(286	)	$	(178	)	$	(306	)	$	(190	)



	Six Months Ended June 30,
	2013						2012
	Before Tax			After Tax			Before Tax			After Tax
	($ in millions)
Balance, beginning of period	$	(304	)	$	(189	)	$	(287	)	$	(178	)
Net change in fair value	—			—			—			—
(Gains) losses reclassified to income	18			11			(19		)	(12		)
Balance, end of period	$	(286	)	$	(178	)	$	(306	)	$	(190	)

Approximately $168 million of the $178 million of accumulated other comprehensive loss as of June 30, 2013 represents the net deferred loss associated with commodity derivative contracts that were previously designated as cash flow hedges for which the hedged items are still expected to occur. These amounts will be recognized in earnings in the month in which the originally forecasted hedged items occur. As of June 30, 2013, we expect to transfer approximately $21 million of net loss included in accumulated other comprehensive income to net income (loss) during the next 12 months. The remaining amount will be transferred by December 31, 2022. As of June 30, 2013, none of our open commodity derivative instruments were designated as a cash flow hedge.

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 June 30,					Six Months Ended June 30,
Cash Flow Derivatives	Location of Gain (Loss)	2013		2012			2013			2012
		($ in millions)
Gain (Loss) Recognized in AOCI (Effective Portion):
Foreign currency contracts	AOCI	$	2	$	(5	)	$	—		$	—
		$	2	$	(5	)	$	—		$	—
Gain (Loss) Reclassified from AOCI Effective Portion):
Commodity contracts	Natural gas, oil and NGL sales	$	1	$	17		$	(18	)	$	19
		$	1	$	17		$	(18	)	$	19

Undesignated Derivatives

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



		Three Months Ended June 30,					Six Months Ended June 30,
Derivative Contracts	Location of Gain (Loss)	2013			2012		2013			2012
		($ in millions)
Commodity contracts	Natural gas, oil and NGL sales	$	536		$	988	$	412		$	832
Interest rate contracts	Interest expense	(51		)	5		(57		)	(2		)
Equity contracts	Other income	—			1		—			—
Total		$	485		$	994	$	355		$	830

Credit Risk

Derivative instruments that enable us to manage our exposure to natural gas, oil and NGL prices and interest rate volatility expose us to credit risk from our counterparties. To mitigate this risk, we enter into derivative contracts only with counterparties that are rated investment-grade and deemed by management to be competent and competitive market makers, and we attempt to limit our exposure to non-performance by any single counterparty. As of June 30, 2013, our natural gas, oil and interest rate derivative instruments were spread among 15 counterparties. Additionally, counterparties to our multi-counterparty secured hedging facility described previously are required to secure their obligations in excess of defined thresholds. We use this facility for substantially all of our natural gas, oil and NGL derivatives.