7.	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 the exposure to adverse market 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 hedged production. We believe our derivative instruments continue to be highly effective in achieving our risk management objectives. As of June 30, 2012 and December 31, 2011, our natural gas, oil and NGL 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, 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 swaptions to counterparties that allow them, on a specific date, to extend an existing fixed-price swap for a certain period of time.

—

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. Our 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.

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, oil and NGL derivative instruments as of June 30, 2012 and December 31, 2011 are provided below.


	June 30, 2012					December 31, 2011
	Volume		Fair Value			Volume		Fair Value
			($ in millions)					($ in millions)

Natural gas (tbtu):
Fixed-price swaps		187	$	1			—	$	—
Call options		1,114		(237	)		1,357		(284	)
Basis protection swaps		140		(32	)		106		(42	)


Total natural gas		1,441		(268	)		1,463		(326	)

Oil (mmbbl):
Fixed-price swaps		10.0		123			14.9		15
Call options		74.6		(770	)		94.7		(1,282	)
Swaptions		11.3		(24	)		7.8		(53	)
Fixed-price knockout swaps		—		—			0.8		7

Total oil		95.9		(671	)		118.2		(1,313	)


Total estimated fair value			$	(939	)			$	(1,639	)

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 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. We have currently elected not to designate any of our qualifying natural gas and oil derivatives as cash flow hedges. Therefore, changes in the fair value of these derivatives for the Current Period are reported in the condensed consolidated statement of operations.

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,
	2012		2011		2012		2011
			($ in millions)

Natural gas, oil and NGL sales	$	1,112	$	1,278	$	2,334	$	2,465
Gains (losses) on natural gas, oil and NGL derivatives		1,005		506		851		(197	)
Gains (losses) on ineffectiveness of cash flow hedges		—		8		—		18

Total natural gas, oil and NGL sales	$	2,117	$	1,792	$	3,185	$	2,286

As of June 30, 2012, we expect to transfer approximately $6 million of net loss included in accumulated other comprehensive income to net income (loss) during the next 12 months in the related month of production. All derivative instruments as of June 30, 2012 are expected to mature by December 31, 2022.

Hedging Facility

We have a multi-counterparty secured hedging facility with 18 counterparties that have committed to provide approximately 6.5 tcfe of hedging capacity for natural gas, oil and NGL 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 June 30, 2012, we had hedged under the facility 1.9 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 and sale/leaseback arrangements. 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, 2012 and December 31, 2011, 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.

•

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 and the estimated fair value of our interest rate derivatives outstanding as of June 30, 2012 and December 31, 2011 are provided below.


	June 30, 2012					December 31, 2011
	Notional Amount		Fair Value			Notional Amount		Fair Value
			($ in millions)
Interest rate:
Swaps	$	1,050	$	(41	)	$	1,050	$	(42	)
Swaptions		250		—			300		—

Totals	$	1,300	$	(41	)	$	1,350	$	(42	)

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,
	2012			2011			2012			2011
				($ in millions)

Interest expense on senior notes	$	185		$	164		$	359		$	342
Interest expense on credit facilities		16			10			37			31
Interest expense on term loans		62			—			62			—
(Gains) losses on interest rate derivatives		(7	)		19			(2	)		18
Amortization of loan discount and other		42			8			42			23
Capitalized interest		(284	)		(176	)		(472	)		(381	)

Total interest expense	$	14		$	25		$	26		$	33

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 $23 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 $48 million at June 30, 2012. The euro-denominated debt in long-term debt has been adjusted to $435 million at June 30, 2012 using an exchange rate of $1.2668 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 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, 2012 and December 31, 2011 on a gross basis without regard to same-counterparty netting:


		Fair Value
		June 30,			December 31,
	Balance Sheet Location	2012			2011
		($ in millions)
Asset Derivatives:
Derivatives not designated as hedging instruments:
Commodity contracts	Short-term derivative instruments	$	131		$	54
Commodity contracts	Long-term derivative instruments		21			1

Total			152			55


Liability Derivatives:
Derivatives designated as hedging instruments:
Foreign currency contracts	Long-term derivative instruments		(48	)		(38	)

Total			(48	)		(38	)


Derivatives not designated as hedging instruments:
Commodity contracts	Short-term derivative instruments		(125	)		(232	)
Commodity contracts	Long-term derivative instruments		(966	)		(1,462	)
Interest rate contracts	Long-term derivative instruments		(41	)		(42	)

Total			(1,132	)		(1,736	)


Total derivative instruments		$	(1,028	)	$	(1,719	)

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 currently 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 in the Current Period.

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


		Three Months Ended June 30,				Six Months Ended June 30,
Fair Value Derivatives	Location of Gain (Loss)	2012		2011		2012		2011
				($ in millions)

Interest rate contracts	Interest expense	$	2	$	5	$	4	$	11

We include the expense on the hedged item (i.e., fixed-rate borrowings) in the same line item – interest expense – as the offsetting gain or loss on the related interest rate swap listed above. For the Current Quarter, the Prior Quarter, the Current Period and the Prior Period, this expense was $0, $9 million, $0 and $21 million respectively.

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,
	2012						2011
	Before Tax			After Tax			Before Tax			After Tax
				($ in millions)

Balance, beginning of period	$	(284	)	$	(176	)	$	(368	)	$	(228	)
Net change in fair value		(5	)		(3	)		220			136
Gains reclassified to income		(17	)		(11	)		(29	)		(18	)

Balance, end of period	$	(306	)	$	(190	)	$	(177	)	$	(110	)


	Six Months Ended June 30,
	2012						2011
	Before Tax			After Tax			Before Tax			After Tax
				($ in millions)

Balance, beginning of period	$	(287	)	$	(178	)	$	(291	)	$	(181	)
Net change in fair value		—			—			217			135
Gains reclassified to income		(19	)		(12	)		(103	)		(64	)

Balance, end of period	$	(306	)	$	(190	)	$	(177	)	$	(110	)

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,
		Three Months Ended June 30,						Six Months Ended June 30,
Cash Flow Derivatives	Location of Gain (Loss)	2012			2011			2012		2011
					($ in millions)
Gain (Loss) Recognized in AOCI (Effective Portion):
Commodity contracts	AOCI	$	—		$	234		$	—	$	250
Foreign currency contracts	AOCI		(5	)		(14	)		—		(33	)

		$	(5	)	$	220		$	—	$	217


Gain (Loss) Reclassified from AOCI (Effective Portion):
Commodity contracts	Natural gas, oil and NGL sales	$	17		$	67		$	19	$	141
Foreign currency contracts	Interest expense		—			(18	)		—		(18	)
Foreign currency contracts	Loss on purchase of debt		—			(20	)		—		(20	)

		$	17		$	29		$	19	$	103


Gain (Loss) Recognized in Income
Commodity contracts:
Ineffective portion	Natural gas, oil and NGL sales	$	—		$	8		$	—	$	18
Amount initially excluded from effectiveness testing	Natural gas, oil and NGL sales		—			—			—		22

		$	—		$	8		$	—	$	40

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 derivatives:


		Three Months Ended					Six Months Ended
		June 30,					June 30,
Derivative Contracts	Location of Gain (Loss)	2012		2011			2012			2011
				($ in millions)

Commodity contracts	Natural gas, oil and NGL sales	$	988	$	439		$	832		$	(360	)
Interest rate contracts	Interest expense		5		(6	)		(2	)		(11	)
Equity contracts	Other income		1		—			—			—

Total		$	994	$	433		$	830		$	(371	)

Credit Risk

Derivative instruments that enable us to manage 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 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. On June 30, 2012, our natural gas, oil, NGL and interest rate derivative instruments were spread among 17 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 the majority of our natural gas, oil, and NGL derivatives.