Chesapeake Energy 2014 Annual Report Download - page 69

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calculating estimated future net revenues, current prices are calculated as the unweighted arithmetic average of oil
and natural gas prices on the first day of each month within the 12-month period prior to the ending date of the quarterly
period. Costs used are those as of the end of the applicable quarterly period. These prices are utilized except where
different prices are fixed and determinable from applicable contracts for the remaining term of those contracts, including
the effects of derivatives designated as cash flow hedges.
Two primary factors impacting this test are reserve levels and oil and natural gas prices, and their associated
impact on the present value of estimated future net revenues. Revisions to estimates of oil and natural gas reserves
and/or an increase or decrease in prices can have a material impact on the present value of estimated future net
revenues. Any excess of the net book value, less deferred income taxes, is generally written off as an expense. See
Oil and Natural Gas Properties in Note 1 of the notes to our consolidated financial statements included in Item 8 of
this report for further information on the full cost method of accounting.
Derivatives. Chesapeake uses commodity price and financial risk management instruments to mitigate a portion
of our exposure to price fluctuations in oil and natural gas prices, changes in interest rates and foreign exchange rates.
Gains and losses on derivative contracts are reported as a component of the related transaction. Results of commodity
derivative contracts are reflected in oil, natural gas and NGL sales, and results of interest rate and foreign exchange
rate derivative 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 oil, natural gas 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 oil, natural
gas 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 oil, natural gas and NGL sales. Any change
in the fair value resulting from ineffectiveness is recognized immediately in oil, natural gas 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 Derivative Activities above and Item 7A. Quantitative and Qualitative
Disclosures About Market Risk for additional information regarding our derivative 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 counterparty valuations for reasonableness. Derivative
transactions are also subject to the risk that counterparties will be unable to meet their obligations. This 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,
we net the value of our 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.