Chesapeake Energy 1996 Annual Report Download - page 61

CHESAPEAKE EN5
10. FINANCIAL INSTRUMENTS AND
HEDGING ACTIVITIES
The company has only limited involvement with de-
rivative financial instruments, as defined in Statement of
Financial Accounting Standards No. 119 "Disclosure
About Derivative Financial Instruments and Fair Value
of Financial Instruments" and does not use them for trad-
ing purposes. The company's objective is to hedge a por-
tion of its exposure to price volatility from producing
crude oil and natural gas. These arrangements may ex-
pose the company to credit risk from its counter-parties
and to basis risk.
Hedging Activities
Periodically the company utilizes hedging strategies
to hedge the price of a portion of its future oil and gas
production. These strategies include swap arrangements
that establish an index-related price above which the com-
pany pays the hedging partner and below which the com-
pany is paid by the hedging partner, the purchase of in-
dex-related puts that provide for a "floor" price to the
company to be paid by the counter-party to the extent
the price of the commodity is below the contracted floor,
and basis protection swaps.
As of June 30, 1996, the company had established
NYMEX-based crude oil swap agreements for 1,000 Bbl
per day forJuly 1, 1996 through August 31, 1996 at an
average price of $17.85 per Bbl. The counter-party has
the option exercisable monthly for an additional 1,000
Bbl per day for the period July 1, 1996 through Decem-
ber 31, 1996 to cause a swap if the price exceeds an aver-
age $17.74 per Bbl. The actual settlements for July and
August resulted in a $0.5 million payment to the counter-
party. The company estimates, based on NYMEX prices
as of August 30, 1996, that the effect of the September
through December hedges would be a $0.4 million pay-
ment to the counter-party.
The company has purchased Houston Ship Channel
put options which guarantee the company an average floor
price of $2.2 l/Mmbru for 20,000 Mmbtu per day for
the period of November 1, 1996 through February 28,
1997. The average cost of these puts was $0.14 per
Mmbtu.
As ofJune 30, 1996, the company had NYMEX-based
natural gas swaps and NYMEX/Houston Ship Channel
Basis swaps for the months ofJuly through October 1996.
These transactions resulted in payments to the company's
IC OR P0 RAT I ON
counter-party of approximately $2 million for the month
of July 1996 and $1.5 million for the month of August
1996. The company estimates, based on NYMEX prices
as of August 30, 1996, that the effect of the September
and October hedges would be a $0.2 million payment to
the counter-party.
Concentration of Credit Risk
Financial instruments which potentially subject the
company to concentrations of credit risk consist princi-
pally of trade receivables. The company's accounts receiv-
able are primarily from purchasers of oil and natural gas
products and exploration and production companies
which own interests in properties operated by the com-
pany. The industry concentration has the potential to
impact the company's overall exposure to credit risk, ei-
ther positively or negatively, in that the customers may
be similarly affected by changes in economic, industry or
other conditions. The company generally requires letters
of credit for receivables from customers which are not
considered investment grade, unless the credit risk can
otherwise be mitigated.
Fair Value of Financial Instruments
The following disclosure of the estimated fair value of
financial instruments is made in accordance with the re-
quirements of Statement of Financial Accounting Stan-
dards No. 107, "Disclosures About Fair Value of Finan-
cial Instruments". The estimated fair value amounts have
been determined by the company using available market
information and valuation methodologies. Considerable
judgment is required in interpreting market data to de-
velop 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 items comprising current as-
sets and current liabilities approximate fair values due to
the short-term maturities of these instruments. The com-
pany estimates the fair value of its long-term, fixed-rate
debt using quoted market prices. The company's carry-
ing amount for such debt at June 30, 1996 and 1995 was
$255.6 million and $135.2 million, respectively, com-
pared to approximate fair values of $261.2 million and
$137.8 million, respectively. The carrying value of other
long-term debt approximates its fair value as interest rates
are primarily variable, based on prevailing marker rates.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS