Chesapeake Energy 2012 Annual Report Download - page 78

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Derivatives. Chesapeake uses commodity price and financial risk management instruments to mitigate a portion
of our exposure to price fluctuations in natural gas and oil prices, changes in interest rates and foreign exchange rates.
Recognized gains and losses on derivative contracts are reported as a component of the related transaction. Results
of commodity derivative contracts are reflected in natural gas, oil and NGL sales, and results of interest rate and foreign
exchange rate hedging contracts are reflected in interest expense. The changes in the fair value of derivative instruments
not qualifying, or not elected, for designation as either cash flow or fair value hedges that occur prior to maturity are
reported currently in the consolidated statement of operations as unrealized gains (losses) within natural gas, oil and
NGL sales or interest expense. Cash settlements of our derivative arrangements 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
consolidated statements of cash flows.
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 sheets 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 natural gas,
oil and NGL 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 as natural gas, oil and NGL sales. Any change
in the fair value resulting from ineffectiveness is recognized immediately in natural gas, oil and NGL sales. For interest
rate derivative instruments designated as fair value hedges, changes in fair value, as well as the offsetting changes
in the estimated fair value of the hedged item attributable to the hedged risk, are recognized currently in earnings as
interest expense. 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. See Hedging Activities above and Item 7A. Quantitative and Qualitative
Disclosures About Market Risk for additional information regarding our hedging activities.
One of the primary factors that can have an impact on our results of operations is the method used to value our
derivatives. 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 also 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. Additionally, 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 instruments with the same counterparty in the
accompanying consolidated balance sheets.
Another factor that can impact our results of operations each period is our ability to estimate the level of correlation
between future changes in the fair value of the derivative instruments and the transactions being hedged, both at
inception and on an ongoing basis. This correlation is complicated since energy commodity prices, the primary risk
we hedge, have quality and location differences that can be difficult to hedge effectively. The factors underlying our
estimates of fair value and our assessment of correlation of our derivative instruments are impacted by actual results
and changes in conditions that affect these factors, many of which are beyond our control.
Due to the volatility of natural gas, oil and NGL prices and, to a lesser extent, interest rates and foreign exchange
rates, the Company's financial condition and results of operations can be significantly impacted by changes in the
market value of our derivative instruments. As of December 31, 2012, 2011 and 2010, the fair value of our derivatives
were liabilities of $979 million, $1.719 billion and $761 million, respectively.
Variable Interest Entities. An entity is referred to as a VIE pursuant to accounting guidance for consolidation if it
possesses one of the following criteria: (i) it is thinly capitalized, (ii) the residual equity holders do not control the entity,
(iii) the equity holders are shielded from the economic losses, (iv) the equity holders do not participate fully in the
entity's residual economics, or (v) the entity was established with non-substantive voting interests. We consolidate a
VIE when we have both the power to direct the activities that most significantly impact the activities of the VIE and the
right to receive benefits or the obligation to absorb losses of the entity that could be potentially significant to the VIE.
Along with the VIEs that are consolidated in accordance with these guidelines, we also hold variable interests in other