Chesapeake Energy 2010 Annual Report Download - page 108

counterparties in exchange for 2010, 2011 and 2012 natural gas swaps with fixed prices above the then current
market price. This effectively allowed us to sell out-year volatility through call options at terms acceptable to us
in exchange for natural gas swaps with fixed prices in excess of the market price for natural gas at that time.
Additionally, we sell call options when we would be satisfied to sell our production at the price being capped by
the call strike or believe it to be more likely than not that the future natural gas or oil price will stay below the
call strike price plus the premium we will receive.
We determine the volume we may potentially hedge by reviewing the company’s estimated future
production levels, which are derived from extensive examination of existing producing reserve estimates and
estimates of likely production (risked) from new drilling. Production forecasts are updated at least monthly and
adjusted if necessary to actual results and activity levels. We do not hedge more volumes than we expect to
produce, and if production estimates are lowered for future periods and hedges are already executed for some
volume above the new production forecasts, the hedges are reversed. The actual fixed hedge price on our
derivative instruments is derived from bidding and the reference NYMEX price, as reflected in current NYMEX
trading. The pricing dates of our derivative contracts follow NYMEX futures. All of our derivative instruments
are net settled based on the difference between the fixed price as stated in the contract and the floating-price
payment, resulting in a net amount due to or from the counterparty.
We adjust our derivative positions in response to changes in prices and market conditions as part of an
ongoing dynamic process. We review our derivative positions continuously and if future market conditions
change and prices have fallen to levels we believe could jeopardize the effectiveness of a position, we will
mitigate such risk by either doing a cash settlement with our counterparty, restructuring the position, or by
entering into a new swap that effectively reverses the current position (a counter-swap). The factors we
consider in closing or restructuring a position before the settlement date are identical to those we reviewed
when deciding to enter into the original derivative position. Gains or losses related to closed positions will be
realized in the month of related production based on the terms specified in the original contract.
In 2009, we restructured many of our contracts that included knockout features as commodity prices
decreased. The knockouts were typically restructured into straight swaps or collars based on strip prices at the
time of the restructure. In the latter half of 2010, we restructured a portion of our call options by lowering the
strike price on call options sold for 2012 through 2015 and used the value to buy back call options for the same
periods. This increased our capacity to hedge additional volumes.
As of December 31, 2010, our natural gas and oil derivative instruments consisted of the following:
• 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.
• 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 certain
pre-determined knockout prices.
• 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.
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