Derivative and Hedging Activities

Chesapeake uses commodity derivative instruments to secure attractive pricing and margins on production, to reduce its exposure to fluctuations in future commodity prices and to protect its expected operating cash flow against significant market movements or volatility. Chesapeake also uses derivative instruments to mitigate a portion of our exposure to interest rate and foreign currency exchange rate fluctuations. 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.

Natural Gas and Oil Derivatives

As of December 31, 2013 and 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.

•

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 prices, 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 call option. This eliminates the counterparty’s downside exposure below the second put option strike price.

•

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.

The estimated fair values of our natural gas and oil derivative instrument assets (liabilities) as of December 31, 2013 and 2012 are provided below.



	December 31, 2013				December 31, 2012
	Volume	Fair Value			Volume	Fair Value
		($ in millions)				($ in millions)
Natural gas (tbtu):
Fixed-price swaps	448	$	(23	)	49	$	24
Three-way collars	288	(7		)	—	—
Call options	193	(210		)	193	(240		)
Call swaptions	12	—			—	—
Basis protection swaps	68	3			111	(15		)
Total natural gas	1,009	(237		)	353	(231		)
Oil (mmbbl):
Fixed-price swaps	25.3	(50		)	28.1	68
Call options	42.5	(265		)	73.8	(748		)
Call swaptions	—	—			5.3	(13		)
Basis protection swaps	0.4	1			5.5	—
Total oil	68.2	(314		)	112.7	(693		)
Total estimated fair value		$	(551	)		$	(924	)

The components of natural gas, oil and NGL sales for the years ended December 31, 2013, 2012 and 2011 are presented below.



	Years Ended December 31,
	2013		2012		2011
	($ in millions)
Natural gas, oil and NGL sales	$	6,923	$	5,359	$	5,259
Gains on natural gas, oil and NGL derivatives	129		919		772
Losses on ineffectiveness of cash flow hedges	—		—		(7		)
Total natural gas, oil and NGL sales	$	7,052	$	6,278	$	6,024

We have terminated certain commodity derivative contracts that were previously designated as cash flow hedges for which the hedged production is still expected to occur. See further discussion below under Cash Flow Hedges.

Interest Rate Derivatives

As of December 31, 2013 and 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 December 31, 2013 and 2012 are provided below.



	December 31, 2013					December 31, 2012
	Notional Amount		Fair Value			Notional Amount		Fair Value
			($ in millions)
Interest rate swaps	$	2,250	$	(98	)	$	1,050	$	(35	)

The components of interest expense for the years ended 2013, 2012 and 2011 are presented below.



	Years Ended December 31,
	2013			2012			2011
	($ in millions)
Interest expense on senior notes	$	740		$	732		$	653
Interest expense on credit facilities	38			70			70
Interest expense on term loans	116			173			—
(Gains) losses on interest rate derivatives	58			(7		)	14
Amortization of loan discount, issuance costs and other	91			89			39
Capitalized interest	(816		)	(980		)	(732		)
Total interest expense	$	227		$	77		$	44

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 seven years, we will recognize $14 million in net gains in earnings 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 consolidated balance sheet as an asset of $2 million as of December 31, 2013. The euro-denominated debt in long-term debt has been adjusted to $473 million as of December 31, 2013 using an exchange rate of $1.3743 to €1.00.

Additional Disclosures Regarding Derivative Instruments and Hedging Activities

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



		Fair Value
		December 31,
	Balance Sheet Location	2013			2012
		($ in millions)
Asset Derivatives:
Designated as hedging instruments:
Foreign currency contracts	Long-term derivative instruments	$	2		$	—
Total		2			—

Not designated as hedging instruments:
Commodity contracts	Short-term derivative instruments	29			110
Commodity contracts	Long-term derivative instruments	11			5
Total		40			115

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

Not designated as hedging instruments:
Commodity contracts	Short-term derivative instruments	(231		)	(157		)
Commodity contracts	Long-term derivative instruments	(362		)	(882		)
Interest rate contracts	Short-term derivative instruments	(6		)	—
Interest rate contracts	Long-term derivative instruments	(92		)	(35		)
Total		(691		)	(1,074		)
Total derivative instruments		$	(649	)	$	(979	)

As of December 31, 2013 and 2012, we did not have any cash collateral balances for these derivatives.

The following tables present the netting offsets of derivative assets and liabilities in the consolidated balance sheets as of December 31, 2013 and December 31, 2012:



	December 31, 2013
	Derivative Assets						Derivative Liabilities
	Short- Term			Long- Term			Short- Term			Long- Term
	($ in millions)
Commodity Contracts:
Gross amounts of recognized assets (liabilities)	$	29		$	11		$	(231	)	$	(362	)
Gross amounts offset in the consolidated balance sheet	(29		)	(9		)	29			9
Net amounts of assets (liabilities) presented in the consolidated balance sheet	—			2			(202		)	(353		)
Interest Rate Contracts:
Gross amounts of recognized assets (liabilities)	—			—			(6		)	(92		)
Gross amounts offset in the consolidated balance sheet	—			—			—			—
Net amounts of assets (liabilities) presented in the consolidated balance sheet	—			—			(6		)	(92		)
Foreign Currency Contracts:
Gross amounts of recognized assets (liabilities)	—			2			—			—
Gross amounts offset in the consolidated balance sheet	—			—			—			—
Net amounts of assets (liabilities) presented in the consolidated balance sheet	—			2			—			—

Total derivatives as reported	$	—		$	4		$	(208	)	$	(445	)

	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 balance sheet	(52		)	(3		)	52			3
Net amounts of assets (liabilities) presented in the consolidated balance sheet	58			2			(105		)	(879		)
Interest Rate Contracts:
Gross amounts of recognized assets (liabilities)	—			—			—			(35		)
Gross amounts offset in the consolidated balance sheet	—			—			—			—
Net amounts of assets (liabilities) presented in the consolidated balance sheet	—			—			—			(35		)
Foreign Currency Contracts:
Gross amounts of recognized assets (liabilities)	—			—			—			(20		)
Gross amounts offset in the consolidated balance sheet	—			—			—			—
Net amounts of assets (liabilities) presented in the consolidated balance sheet	—			—			—			(20		)

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

A consolidated summary of the effect of derivative instruments on our consolidated statements of operations for the years ended December 31, 2013, 2012 and 2011 is provided below, separating fair value, cash flow and undesignated derivatives.

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



		Years Ended December 31,
Fair Value Derivatives	Location of Gain (Loss)	2013		2012		2011
		($ in millions)
Interest rate contracts	Interest expense	$	5	$	8	$	16

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



	Years Ended December 31,
	2013						2012						2011
	Before Tax			After Tax			Before Tax			After Tax			Before Tax			After Tax
	($ in millions)
Balance, beginning of period	$	(304	)	$	(189	)	$	(287	)	$	(178	)	$	(291	)	$	(181	)
Net change in fair value	3			2			10			6			368			228
(Gains) losses reclassified to income	32			20			(27		)	(17		)	(364		)	(225		)
Balance, end of period	$	(269	)	$	(167	)	$	(304	)	$	(189	)	$	(287	)	$	(178	)

Approximately $159 million of the $167 million of accumulated other comprehensive loss as of December 31, 2013 represents the net deferred loss associated with commodity derivative contracts that were previously designated as cash flow hedges for which the hedged production is still expected to occur. These amounts will be recognized in earnings in the month in which the originally forecasted hedged production occurs. As of December 31, 2013, we expect to transfer approximately $23 million of net loss included in accumulated other comprehensive income to net income (loss) during the next 12 months. The remaining amounts will be transferred by December 31, 2022. As of December 31, 2013, none of our open commodity derivative instruments were designated as 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:



		Years Ended December 31,
Cash Flow Derivatives	Location of Gain (Loss)	2013			2012		2011
		($ in millions)
Gain (Loss) Recognized in AOCI (Effective Portion):
Commodity contracts	AOCI	$	—		$	—	$	392
Foreign currency contracts	AOCI	3			10		(24		)
		$	3		$	10	$	368
Gain (Loss) Reclassified from AOCI (Effective Portion):
Commodity contracts	Natural gas, oil and NGL sales	$	(32	)	$	27	$	402
Foreign currency contracts	Interest expense	—			—		(18		)
Foreign currency contacts	Loss on purchase of debt	—			—		(20		)
		$	(32	)	$	27	$	364
Gain (Loss) Recognized in Income:
Ineffective portion	Natural gas, oil and NGL sales	$	—		$	—	$	(7	)
Amount initially excluded from effectiveness testing	Natural gas, oil and NGL sales	—			—		22
		$	—		$	—	$	15

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



		Years Ended December 31,
Derivative Contracts	Location of Gain (Loss)	2013			2012			2011
		($ in millions)
Commodity contracts	Natural gas, oil and NGL	$	159		$	892		$	348
Interest rate contracts	Interest expense	(63		)	(1		)	(12		)
Total		$	96		$	891		$	336

Credit Risk

Over-the-counter traded derivative instruments expose us to our counterparties’ credit risk. 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 December 31, 2013, our natural gas, oil and interest rate derivative instruments were spread among 16 counterparties.

Hedging Facility

We have a multi-counterparty secured hedging facility with 16 counterparties that have committed to provide approximately 1.063 bboe of hedging capacity for natural gas, oil and NGL price derivatives and 1.063 bboe for basis derivatives with an aggregate mark-to-market capacity of $17.0 billion under the terms of the facility. As of December 31, 2013, we had hedged under the facility 221 mmboe of our future production with price derivatives and 12 mmboe 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 redetermination 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.