Chesapeake Energy 2015 Annual Report Download - page 72

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ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Oil, Natural Gas and NGL Derivatives
Our results of operations and cash flows are impacted by changes in market prices for oil, natural gas 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 protecting short-term cash flow and attempting to mitigate exposure to adverse oil, natural
gas and NGL price changes is to hedge into strengthening oil and natural gas futures markets when prices reach levels
that management believes are 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, oil and natural gas storage inventory levels, industry decline rates for base production
and weather trends.
We use derivative instruments to achieve our risk management objectives, including swaps and options. All of
these are described in more detail below. We typically use swaps for a large portion of the oil and natural gas price
risk we hedge. We have also sold calls, taking advantage of premiums associated with market price volatility. In 2012
and 2013, we bought oil and natural gas calls to, in effect, lock in sold call positions. Due to lower oil, natural gas 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 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 volumes in excess of our share of
forecasted production, and if production estimates were lowered for future periods and derivative instruments are
already executed for some volume above the new production forecasts, the positions would be 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 commodity 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 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 this 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 review 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. 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. Future risk related to counterparties not being able to meet their obligations has been partially
mitigated under our commodity hedging arrangements which require 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 11 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.