Chesapeake Energy 2010 Annual Report Download - page 149

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
9. Financial Instruments and Hedging Activities
Natural Gas and Oil Derivatives
Our results of operations and operating cash flows are impacted by changes in market prices for natural
gas and oil. 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 natural gas and
oil prices to be received for our hedged production. Although derivatives often fail to achieve 100%
effectiveness for accounting purposes, we believe our derivative instruments continue to be highly effective in
achieving our risk management objectives. As of December 31, 2010 and 2009, our natural gas and oil
derivative instruments were comprised 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 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.
• 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 price, 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 collar. This eliminates the counterparty’s downside exposure
below the second put option.
• 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.
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.
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