Chesapeake Energy 2013 Annual Report Download - page 71

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ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Natural Gas, Oil and NGL Derivatives
Our results of operations and cash flows are impacted by changes in market prices for natural gas, oil and NGL.
To mitigate a portion of our exposure to adverse price changes, we have entered into various derivative instruments.
These instruments allow us to predict with greater certainty the effective prices to be received for our share of production.
We believe our derivative instruments continue to be highly effective in achieving our risk management objectives.
Our general strategy for attempting to mitigate exposure to adverse natural gas, oil and NGL price changes is to
hedge into strengthening natural gas and oil futures markets when prices reach levels that management believes are
either unsustainable for the long term, have material downside risk in the short term or provide reasonable rates of
return on our invested capital. Information we consider in forming an opinion about future prices includes general
economic conditions, industrial output levels and expectations, producer breakeven cost structures, liquefied natural
gas trends, natural gas and oil storage inventory levels, industry decline rates for base production and weather trends.
We use a wide range of derivative instruments to achieve our risk management objectives, including swaps,
collars, options and swaptions. All of these are described in more detail below. We typically use swaps for a large
portion of the natural gas and oil price risk we hedge. Swaps are used when the price level is acceptable. We have
also sold calls, taking advantage of market price volatility. We do this when we would be satisfied with the price being
capped by the call strike price or believe it would 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. In the second half of 2011 and in 2012 and 2013, we bought
natural gas and oil calls to, in effect, lock in sold call positions. Due to lower natural gas, oil and NGL prices, we were
able to achieve this at a low cost to us. In some cases, we deferred the payment of the premium on these trades to
the related month of production. Some of our derivatives are deemed to contain, for accounting purposes, a significant
financing element at contract inception and the cash settlements associated with these instruments are classified as
financing cash flows in the accompanying consolidated statements of cash flows.
We determine the volume potentially subject to derivative contracts by reviewing our overall 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 enter into derivative contracts for more volumes than our forecasted
production, and if production estimates are lowered for future periods and derivative instruments are already executed
for some volume above the new production forecasts, the positions are reversed. The actual fixed price on our derivative
instruments is derived from 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
are at levels we believe could jeopardize the effectiveness of a position, we will mitigate such risk by either negotiating
a cash settlement with our counterparty, restructuring the position or entering into a new trade that effectively reverses
the current position. 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 recognized in the month of related production based on the terms specified in the original contract.
We have determined the fair value of our derivative instruments utilizing established index prices, volatility curves
and discount factors. These estimates are compared to counterparty valuations 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. Future risk related to counterparties not being able to meet their obligations has been
partially mitigated under our multi-counterparty secured hedging facility which requires counterparties to post collateral
if their obligations to Chesapeake are in excess of defined thresholds. 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. See Note 18 of the notes to our consolidated financial statements included in
Item 8 of this report for further discussion of the fair value measurements associated with our derivatives.