Chesapeake Energy 2010 Annual Report Download - page 128

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
Natural Gas Imbalances. We follow the “sales method” of accounting for our natural gas revenue whereby
we recognize sales revenue on all natural gas sold to our purchasers, regardless of whether the sales are
proportionate to our ownership in the property. An asset or a liability is recognized to the extent that we have
an imbalance in excess of the remaining natural gas reserves on the underlying properties. The natural gas
imbalance net position at December 31, 2010 and 2009 was a liability of $7 million.
Marketing Gathering and Compression Sales. Chesapeake takes title to the natural gas it purchases from
other working interest owners in operated wells, arranges for transportation and delivers the natural gas to third
parties, at which time revenues are recorded. Chesapeake’s results of operations related to its natural gas and
oil marketing activities are presented on a “gross” basis, because we act as a principal rather than an agent.
Gathering and compression revenues consist of fees recognized for the gathering, treating and compression of
natural gas. Revenues are recognized when the service is performed and are based upon non-regulated rates
and the related gathering, treating and compression volumes. All significant intercompany accounts and
transactions have been eliminated.
Service Operations Revenue. We have drilling rig and trucking operations which primarily service
Chesapeake-operated drilling operations. Revenues are recognized when the service is performed. All
significant intercompany accounts and transactions have been eliminated.
Hedging
Chesapeake uses commodity price and financial risk management instruments to mitigate our exposure to
price fluctuations in natural gas and oil and changes in interest rates and foreign exchange rates. Results of
natural gas and oil derivative transactions are reflected in natural gas and oil sales and results of interest rate
and foreign exchange rate hedging transactions are reflected in interest expense.
We have established the fair value of our derivative instruments utilizing established index prices, volatility
curves and discount factors. These estimates are compared to our counterparty values for reasonableness.
Derivative transactions are subject to the risk that counterparties will be unable to meet their obligations. Such
non-performance risk is considered in the valuation of our derivative instruments, but to date has not had a
material impact on the values of our derivatives. The values we report in our financial statements are as of a
point in time and subsequently change as these estimates are revised to reflect actual results, changes in
market conditions and other factors.
Accounting guidance for derivative instruments and hedging activities establishes accounting and reporting
standards requiring that derivative instruments (including certain derivative instruments embedded in other
contracts) be recorded at fair value and included in the consolidated balance sheet as assets or liabilities. The
accounting for changes in the fair value of a derivative instrument depends on the intended use of the
derivative and the resulting designation, which is established at the inception of a derivative. For derivative
instruments designated as cash flow hedges, changes in fair value, to the extent the hedge is effective, are
recognized in other comprehensive income until the hedged item is recognized in earnings. Any change in the
fair value resulting from ineffectiveness is recognized immediately in natural gas and oil sales. For interest rate
derivative instruments designated as fair value hedges, changes in fair value are recorded on the consolidated
balance sheets as assets (liabilities), and the debt’s carrying value amount is adjusted by the change in the fair
value of the debt subsequent to the initiation of the derivative. Differences between the changes in the fair
values of the hedged item and the derivative instrument, if any, represent gains or losses on ineffectiveness
and are reflected currently in interest expense. Hedge effectiveness is measured at least quarterly based on
the relative changes in fair value between the derivative contract and the hedged item over time. Changes in
fair value of contracts that do not qualify as hedges or are not designated as hedges are also recognized
currently in earnings. Cash settlements of our derivative arrangements are generally classified as operating
cash flows unless the derivative contains a significant financing element at contract inception, in which case
these cash settlements are classified as financing cash flows in the accompanying consolidated statement of
cash flows.
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