Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

[X]

Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended March 31, 2011

 

[  ]

Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                      to                     

Commission File No. 1-13726

Chesapeake Energy Corporation

(Exact name of registrant as specified in its charter)

 

Oklahoma   73-1395733

(State or other jurisdiction of incorporation or organization)

  (I.R.S. Employer Identification No.)
6100 North Western Avenue  
Oklahoma City, Oklahoma   73118

(Address of principal executive offices)

  (Zip Code)

(405) 848-8000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [X] No [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [X] No [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [X]    Accelerated filer [ ]    Non-accelerated filer [ ]    Smaller reporting company [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [ ] No [X]

As of May 3, 2011, there were 657,664,995 shares of our common stock, $0.01 par value, outstanding.

 

 

 


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

INDEX TO FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2011

 

PART I.

Financial Information  
          Page  

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited):

  
  

Condensed Consolidated Balance Sheets as of March 31, 2011 and
December 31, 2010

     1   
  

Condensed Consolidated Statements of Operations for the Three Months Ended
March 31, 2011 and 2010

     2   
  

Condensed Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2011 and 2010

     3   
  

Condensed Consolidated Statements of Stockholders’ Equity for the
Three Months Ended March 31, 2011 and 2010

     5   
  

Condensed Consolidated Statements of Comprehensive Income (Loss) for the
Three Months Ended March 31, 2011 and 2010

     6   
  

Notes to Condensed Consolidated Financial Statements

     7   

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results
of Operations

     41   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     57   

Item 4.

  

Controls and Procedures

     64   
PART II.   

Other Information

  

Item 1.

  

Legal Proceedings

     65   

Item 1A.

  

Risk Factors

     65   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     66   

Item 3.

  

Defaults Upon Senior Securities

     66   

Item 4.

  

(Removed and Reserved)

     66   

Item 5.

  

Other Information

     66   

Item 6.

  

Exhibits

     67   


Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     March 31,
2011
    December 31,
2010
 
     ($ in millions)  

CURRENT ASSETS:

    

Cash and cash equivalents

   $ 849      $ 102   

Accounts receivable

     2,317        1,974   

Short-term derivative instruments

     264        947   

Deferred income tax asset

     2        139   

Other current assets

     112        104   
                

  Total Current Assets

     3,544        3,266   
                

PROPERTY AND EQUIPMENT:

    

Natural gas and oil properties, at cost based on full-cost accounting:

    

  Evaluated natural gas and oil properties

     36,943        38,952   

  Unevaluated properties

     14,200        14,469   

Natural gas gathering systems and treating plants

     1,379        1,545   

Other property and equipment

     3,885        3,726   
                

  Total Property and Equipment, at Cost

     56,407        58,692   
                

    Less: accumulated depreciation, depletion and amortization

     (26,698     (26,314
                

  Total Property and Equipment, Net

     29,709        32,378   
                

OTHER ASSETS:

    

Investments

     1,228        1,208   

Other long-term assets

     319        327   
                

  Total Other Assets

     1,547        1,535   
                

TOTAL ASSETS

   $ 34,800      $ 37,179   
                

CURRENT LIABILITIES:

    

Accounts payable

   $ 2,227      $ 2,069   

Short-term derivative instruments

     216        15   

Accrued interest

     123        191   

Other current liabilities

     2,103        2,215   
                

  Total Current Liabilities

     4,669        4,490   
                

LONG-TERM LIABILITIES:

    

Long-term debt, net

     9,915        12,640   

Deferred income tax liabilities

     2,115        2,384   

Long-term derivative instruments

     2,380        1,693   

Asset retirement obligations

     302        301   

Other long-term liabilities

     424        407   
                

  Total Long-Term Liabilities

     15,136        17,425   
                

CONTINGENCIES AND COMMITMENTS (Note 3)

    

STOCKHOLDERS’ EQUITY:

    

Preferred Stock, $0.01 par value, 20,000,000 shares authorized: 7,254,515 shares issued and outstanding

     3,065        3,065   

Common stock, $0.01 par value, 1,000,000,000 shares authorized, 659,020,115 and 655,251,275 shares issued

     7        7   

Paid-in capital

     12,161        12,194   

Retained earnings

            190   

Accumulated other comprehensive income (loss), net of tax of $130 million and $102 million

     (212     (168

Less: treasury stock, at cost; 1,312,307 and 1,221,299 common shares

     (26     (24
                

  Total Stockholders’ Equity

     14,995        15,264   
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 34,800      $ 37,179   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

     Three Months Ended
March 31,
 
     2011     2010  
     ($ in millions,
except per share data)
 

REVENUES:

    

Natural gas and oil sales

   $ 494      $ 1,898   

Marketing, gathering and compression sales

     1,017        844   

Service operations revenue

     101        56   
                

Total Revenues

     1,612        2,798   
                

OPERATING COSTS:

    

Production expenses

     238        207   

Production taxes

     45        48   

General and administrative expenses

     130        109   

Marketing, gathering and compression expenses

     985        815   

Service operations expense

     77        49   

Natural gas and oil depreciation, depletion and amortization

     358        308   

Depreciation and amortization of other assets

     68        50   

Gains on sales of other property and equipment

     (5       
                

Total Operating Costs

     1,896        1,586   
                

INCOME (LOSS) FROM OPERATIONS

     (284     1,212   
                

OTHER INCOME (EXPENSE):

    

Interest expense

     (7     (25

Earnings from equity investees

     25        13   

Losses on redemptions or exchanges of debt

     (2     (2

Other income

     2        2   
                

Total Other Income (Expense)

     18        (12
                

INCOME (LOSS) BEFORE INCOME TAXES

     (266     1,200   
                

INCOME TAX EXPENSE (BENEFIT):

    

Current income taxes

     6          

Deferred income taxes

     (110     462   
                

Total Income Tax Expense (Benefit)

     (104     462   
                

NET INCOME (LOSS)

     (162     738   

Preferred stock dividends

     (43     (6
                

NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS

   $ (205   $ 732   
                

EARNINGS (LOSS) PER COMMON SHARE:

    

Basic

   $ (0.32   $ 1.17   

Diluted

   $ (0.32   $ 1.14   

CASH DIVIDEND DECLARED PER COMMON SHARE

   $ 0.075      $ 0.075   

WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING (in millions):

    

Basic

     634        630   

Diluted

     634        647   

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three Months Ended
March  31,
 
     2011     2010  
     ($ in millions)  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

NET INCOME (LOSS)

   $ (162   $ 738   

ADJUSTMENTS TO RECONCILE NET INCOME (LOSS) TO CASH PROVIDED BY OPERATING ACTIVITIES:

    

Depreciation, depletion and amortization

     426        358   

Deferred income tax expense (benefit)

     (110     462   

Unrealized (gains) losses on derivatives

     1,188        (342

Stock-based compensation

     40        32   

Accretion of discount on contingent convertible notes

     20        19   

Gains on sales of other property and equipment

     (5       

Gains on equity investments

     (5     (13

Losses on redemptions or exchanges of debt

     2        2   

Other

     10        5   

Change in assets and liabilities

     (663     (78
                

Cash provided by operating activities

     741        1,183   
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Exploration and development of natural gas and oil properties

     (1,692     (1,020

Acquisitions of proved and unproved properties

     (1,281     (1,030

Additions to other property and equipment

     (431     (279

Proceeds from divestitures of proved and unproved properties

     5,182        1,224   

Proceeds from sales of other assets

     428        56   

Other

     (3     35   
                

Cash provided by (used in) investing activities

     2,203        (1,014
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Proceeds from credit facilities borrowings

     3,617        2,924   

Payments on credit facilities borrowings

     (7,323     (2,944

Proceeds from issuance of senior notes, net of offering costs

     977          

Cash paid to redeem debt

     (128       

Cash paid for common stock dividends

     (48     (47

Cash paid for preferred stock dividends

     (43     (6

Cash received on financing derivatives

     660        94   

Net increase in outstanding payments in excess of cash balance

     119        45   

Other

     (28     (26
                

Cash provided by (used in) financing activities

     (2,197     40   
                

Net increase in cash and cash equivalents

     747        209   

Cash and cash equivalents, beginning of period

     102        307   
                

Cash and cash equivalents, end of period

   $ 849      $ 516   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)

(Unaudited)

 

         Three Months Ended    
March 31,
 
     2011      2010  

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION OF CASH PAYMENTS FOR:

     

Interest, net of capitalized interest

   $ 41       $ 89   

Income taxes, net of refunds received

   $       $ (8

SUPPLEMENTAL SCHEDULE OF SIGNIFICANT NON-CASH INVESTING AND FINANCING ACTIVITIES:

As of March 31, 2011 and 2010, dividends payable on our common and preferred stock were $90 million and $53 million, respectively.

For the three months ended March 31, 2011 and 2010, natural gas and oil properties were adjusted by $22 million and $1 million, respectively, as a result of an increase in accrued costs.

For the three months ended March 31, 2011 and 2010, other property and equipment were adjusted by $5 million and $1 million, respectively, as a result of an increase in accrued costs.

As of March 31, 2011 and 2010, we had recorded $202 million and $183 million, respectively, as a result of various accrued liabilities related to the purchase of proved and unproved properties and other assets.

During the three months ended March 31, 2010, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $11 million in aggregate principal amount for an aggregate of 298,500 shares of our common stock in privately negotiated exchanges.

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Unaudited)

 

         Three Months Ended    
March 31,
 
     2011     2010  
     ($ in millions)  

PREFERRED STOCK:

    

Balance, beginning and end of period

   $ 3,065      $ 466   
                

COMMON STOCK:

    

Balance, beginning of period

     7        6   

Exchange of convertible notes for 0 and 298,500 shares of common stock

              

Stock-based compensation

            1   
                

Balance, end of period

     7        7   
                

PAID-IN CAPITAL:

    

Balance, beginning of period

     12,194        12,146   

Stock-based compensation

     50        57   

Repurchase of 2.25% contingent convertible notes

     (21       

Exchange of convertible notes for 0 and 298,500 shares of common stock

            9   

Exercise of stock options

     1        1   

Dividends on common stock

     (48     (47

Dividends on preferred stock

     (15     (6
                

Balance, end of period

     12,161        12,160   
                

RETAINED EARNINGS (DEFICIT):

    

Balance, beginning of period

     190        (1,261

Net income (loss)

     (162     738   

Cumulative effect of accounting change, net of income taxes of $89 million

            (142

Dividends on preferred stock

     (28       
                

Balance, end of period

            (665
                

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):

    

Balance, beginning of period

     (168     102   

Hedging activity

     (47     166   

Investment activity

     3        (3
                

Balance, end of period

     (212     265   
                

TREASURY STOCK – COMMON:

    

Balance, beginning of period

     (24     (15

Purchase of 93,318 and 70,177 shares for company benefit plans

     (2     (2

Release of 2,310 and 4,162 shares for company benefit plans

              
                

Balance, end of period

     (26     (17
                

NONCONTROLLING INTEREST:

    

Balance, beginning of period

            897   

Deconsolidation of investment in Chesapeake Midstream Partners

            (897
                

Balance, end of period

              
                

TOTAL STOCKHOLDERS’ EQUITY

   $ 14,995      $ 12,216   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

         Three Months Ended    
March 31,
 
     2011     2010  
     ($ in millions)  

Net income (loss)

   $ (162   $ 738   

Other comprehensive income (loss), net of income tax:

    

Change in fair value of derivative instruments, net of income taxes of $3 million and $152 million

     5        249   

Reclassification of gain on settled contracts, net of income taxes of ($28) million and ($53) million

     (46     (87

Ineffective portion of derivatives qualifying for cash flow hedge accounting, net of income taxes of ($4) million and $2 million

     (6     4   

Unrealized gain (loss) on marketable securities, net of income taxes of $2 million and ($2) million

     3        (3
                

Comprehensive income (loss)

   $ (206   $ 901   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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Table of Contents

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.

Basis of Presentation and Summary of Significant Accounting Policies

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements of Chesapeake Energy Corporation (“Chesapeake” or the “company”) and its subsidiaries have been prepared in accordance with the instructions to Form 10-Q as prescribed by the Securities and Exchange Commission (SEC). Chesapeake’s annual report on Form 10-K for the year ended December 31, 2010 (2010 Form 10-K) includes certain definitions and a summary of significant accounting policies and should be read in conjunction with this Form 10-Q. All material adjustments (consisting solely of normal recurring adjustments) which, in the opinion of management, are necessary for a fair statement of the results for the interim periods have been reflected. The accompanying condensed consolidated financial statements of Chesapeake include the accounts of our direct and indirect wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. The results for the three months ended March 31, 2011 are not necessarily indicative of the results to be expected for the full year. This Form 10-Q relates to the three months ended March 31, 2011 (the “Current Quarter”) and the three months ended March 31, 2010 (the “Prior Quarter”).

Cumulative Effect of Accounting Change

Effective January 1, 2010, in accordance with new authoritative guidance for variable interest entities, we ceased consolidating our 50/50 midstream joint venture with Global Infrastructure Partners within our financial statements and began to account for the joint venture under the equity method (see Note 9). Adoption of this new guidance resulted in an after-tax cumulative effect charge to retained earnings of $142 million, which is reflected in our condensed consolidated statement of equity for the Prior Quarter. This charge reflects the difference between the carrying value of our initial investment in the joint venture, which was recorded at carryover basis as an entity under common control, and the fair value of our equity in the joint venture as of the formation date.

Critical Accounting Policies

We consider accounting policies related to hedging, natural gas and oil properties and income taxes to be critical policies. These policies are summarized in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2010 Form 10-K.

 

2.

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 March 31, 2011 and December 31, 2010, our natural gas and oil derivative instruments consisted 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.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

   

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 a certain pre-determined knockout price.

 

   

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.

The estimated fair values of our natural gas and oil derivative instruments as of March 31, 2011 and December 31, 2010 are provided below. The associated carrying values of these instruments are equal to the estimated fair values.

 

     March 31, 2011     December 31, 2010  
             Volume                     Fair Value                     Volume                     Fair Value          
           ($ in millions)           ($ in millions)  

Natural gas (bbtu):

        

Fixed-price swaps

     911,041      $ 587        1,035,134      $ 1,307   

Call options

     1,477,742        (922     1,477,742        (701

Put options

     (42,220     (44     (51,220     (59

Basis protection swaps

     252,360        (57     173,691        (55
                                

Total natural gas

     2,598,923        (436     2,635,347        492   
                                

Oil (mbbl):

        

Fixed-price swaps

     14,092        (50     4,385        (31

Call options

     72,126        (1,758     64,226        (1,129

Fixed-price knockout swaps

     1,557        (2     1,827        19   
                                

Total oil

     87,775        (1,810     70,438        (1,141
                                

Total estimated fair value

     $ (2,246     $ (649
                    

Pursuant to accounting guidance for derivatives, certain derivatives qualify for designation as cash flow hedges. Following this guidance, changes in the fair value of derivative instruments designated as cash flow hedges, to the extent they are effective in offsetting cash flows attributable to the hedged risk, are recorded in accumulated other comprehensive income until the hedged item is recognized in earnings as the physical transactions being hedged occur. Any change in fair value resulting from ineffectiveness is currently recognized in natural gas and oil sales. Changes in the fair value of non-qualifying derivatives that occur prior to their maturity (i.e., temporary fluctuations in value) are reported currently in the condensed consolidated statements of operations within natural gas and oil sales.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The components of natural gas and oil sales for the Current Quarter and the Prior Quarter are presented below.

 

     Three Months Ended
March 31,
 
     2011     2010  
     ($ in millions)  

Natural gas and oil sales

   $     1,188      $     1,184   

Gains (losses) on natural gas and oil derivatives

     (704     720   

Gains (losses) on ineffectiveness of cash flow hedges

     10        (6
                

Total natural gas and oil sales

   $ 494      $ 1,898   
                

Based upon the market prices at March 31, 2011, we expect to transfer approximately $1 million (net of income taxes) of loss included in accumulated other comprehensive income to net income (loss) during the next 12 months in the related month of production. All transactions hedged as of March 31, 2011 are expected to mature by December 31, 2022.

We have a multi-counterparty secured hedging facility with 12 counterparties that have committed to provide approximately 5.6 tcfe of hedging capacity and an aggregate mark-to-market capacity of $15.0 billion under the terms of the facility. In February 2011, we amended the agreement for the hedge facility primarily to allow us to protect our natural gas liquids production from price volatility and to allow for greater flexibility when hedging our anticipated production. As of March 31, 2011, we had hedged a total of 2.9 tcfe of our future production under the facility. The multi-counterparty facility allows us to enter into cash-settled natural gas, oil and natural gas liquids price and basis hedges with the counterparties. Our obligations under the multi-counterparty facility are secured by proved reserves, the value of which must cover the fair value of the transactions outstanding under the facility by at least 1.65 times, and guarantees by certain subsidiaries that also guarantee our corporate revolving bank credit facility and indentures. The counterparties’ obligations under the facility must be secured by cash or short-term U.S. Treasury instruments to the extent that any mark-to-market amounts they owe to Chesapeake exceed defined thresholds. The maximum volume-based hedging capacity under the facility is governed by the expected production of the pledged reserve collateral, and volume-based hedging limits are applied separately to price and basis hedges. In addition, there are volume-based sub-limits for natural gas, oil and natural gas liquids hedges. Chesapeake has significant flexibility with regard to releases and/or substitutions of pledged reserves, provided that certain collateral coverage and other requirements are met. The facility does not have a maturity date. Counterparties to the agreement have the right to cease entering into hedges with the company on a prospective basis as long as obligations associated with any existing transactions in the facility continue to be satisfied in accordance with the terms of the agreement.

Interest Rate Derivatives

To mitigate our exposure to volatility in interest rates related to our senior notes and bank credit facilities, we enter into interest rate derivatives. As of March 31, 2011 and December 31, 2010, our interest rate derivative instruments consisted of the following types of instruments:

 

   

Swaps: Chesapeake enters into fixed-to-floating interest rate swaps (we receive a fixed interest rate and pay a floating market rate) to mitigate our exposure to changes in the fair value of our senior notes. We enter into floating-to-fixed interest rate swaps (we receive a floating market rate and pay a fixed interest rate) to manage our interest rate exposure related to our bank credit facilities borrowings.

 

   

Call options: Occasionally we sell call options for a premium when we think it is more likely that the option will expire unexercised. The option allows the counterparty to terminate a pre-determined open swap on a specific date.

 

   

Swaptions: Occasionally we sell an option to a counterparty for a premium which allows the counterparty to enter into a pre-determined swap with us on a specific date.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The notional amount of debt hedged and the estimated fair value of our interest rate derivatives outstanding as of March 31, 2011 and December 31, 2010 are provided below.

 

     March 31, 2011     December 31, 2010  
     Notional
Amount
     Fair
Value
    Notional
Amount
     Fair
Value
 
     ($ in millions)  

Interest rate:

          

Swaps

   $     2,400       $     (79   $     1,900       $     (54

Call options

     250                250         (2

Swaptions

     100                500         (13
                                  

Total

   $ 2,750       $ (79   $ 2,650       $ (69
                                  

For interest rate derivative instruments designated as fair value hedges, the fair values of the hedges are recorded on the condensed consolidated balance sheets as assets or liabilities, with corresponding offsetting adjustments to the debt’s carrying value. Our qualifying interest rate swaps are considered 100% effective and therefore no ineffectiveness was recorded for the periods presented above. Changes in the fair value of non-qualifying interest rate derivatives that occur prior to their maturity (i.e., temporary fluctuations in value) are currently reported in the condensed consolidated statements of operations within interest expense.

Gains or losses from interest rate derivative transactions are reflected as adjustments to interest expense in the condensed consolidated statements of operations. The components of interest expense for the Current Quarter and the Prior Quarter are presented below.

 

     Three Months Ended
March 31,
 
     2011     2010  
     ($ in millions)  

Interest expense on senior notes

   $ 177      $ 192   

Interest expense on credit facilities

     21        12   

Capitalized interest

         (205         (161

(Gains) losses on interest rate derivatives

     (1     (30

Amortization of loan discount and other

     15        12   
                

Total interest expense

   $ 7      $ 25   
                

We have terminated certain fair value hedges related to senior notes. Gains and losses related to these terminated hedges will be amortized as an adjustment to interest expense over the remaining term of the related senior notes. Over the next ten years, we will recognize $35 million in gains related to such transactions.

Foreign Currency Derivatives

On December 6, 2006, we issued 600 million of 6.25% Euro-denominated Senior Notes due 2017. Concurrent with the issuance of the euro-denominated senior notes, we entered into a cross currency swap to mitigate our exposure to fluctuations in the euro relative to the dollar over the term of the notes. Under the terms of the cross currency swap, on each semi-annual interest payment date, the counterparties pay Chesapeake 19 million and Chesapeake pays the counterparties $30 million, which yields an annual dollar-equivalent interest rate of 7.491%. Upon maturity of the notes, the counterparties will pay Chesapeake 600 million and Chesapeake will pay the counterparties $800 million. The terms of the cross currency swap were based on the dollar/euro exchange rate on the issuance date of $1.3325 to 1.00. Through the cross currency swap, we have eliminated any potential variability in Chesapeake’s expected cash flows related to changes in foreign exchange rates and therefore the swap qualifies as a cash flow hedge. The fair value of the cross currency swap is recorded on the condensed consolidated balance

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

sheet as a liability of $7 million at March 31, 2011. The euro-denominated debt in long-term debt has been adjusted to $851 million at March 31, 2011 using an exchange rate of $1.4183 to 1.00.

Additional Disclosures Regarding Derivative Instruments and Hedging Activities

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 arrangements with the same counterparty in the accompanying condensed consolidated balance sheets. Derivative instruments reflected as current in the condensed consolidated balance sheets represent the estimated fair value of derivatives scheduled to settle over the next twelve months based on market prices/rates as of the respective balance sheet dates. The derivative settlement amounts are not due until the month in which the related underlying hedged transaction occurs. Cash settlements of our derivative instruments are generally classified as operating cash flows unless the derivative contains a significant financing element at contract inception, in which case these cash settlements are classified as financing cash flows in the accompanying condensed consolidated statements of cash flows.

The following table presents the fair value and location of each classification of derivative instrument as disclosed in the condensed consolidated balance sheets as of March 31, 2011 and December 31, 2010, on a gross basis without regard to same-counterparty netting:

 

          Fair Value  
    

Balance Sheet Location

   March 31,
2011
    December 31,
2010
 
          ($ in millions)  

Asset Derivatives:

       

Derivatives designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments    $ 243      $ 307   

Commodity contracts

   Long-term derivative instruments      21        12   
                   

Total

        264        319   
                   

Derivatives not designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments      295        921   

Commodity contracts

   Long-term derivative instruments      219        229   
                   

Total

        514        1,150   
                   

Liability Derivatives:

       

Derivatives designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments      (83     (59

Commodity contracts

   Long-term derivative instruments      (56       

Interest rate contracts

   Long-term derivative instruments      (31     (25

Foreign currency contracts

   Long-term derivative instruments      (7     (43
                   

Total

        (177     (127
                   

Derivatives not designated as hedging instruments:

       

Commodity contracts

   Short-term derivative instruments      (407     (222

Commodity contracts

   Long-term derivative instruments      (2,478     (1,837

Interest rate contracts

   Short-term derivative instruments             (15

Interest rate contracts

   Long-term derivative instruments      (48     (29
                   

Total

        (2,933         (2,103
                   

Total derivative instruments

      $     (2,332   $ (761
                   

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

A consolidated summary of the effect of derivative instruments on the condensed consolidated statements of operations for the Current Quarter and the Prior Quarter is provided below, separating fair value, cash flow and non-qualifying derivatives.

The following table presents the gain (loss) recognized in the statement of operations related to instruments designated as fair value derivatives as well as the corresponding hedged items:

 

     Three Months Ended
March  31,
 

Fair Value Derivatives

  

Location of Gain (Loss)

   2011     2010  
          ($ in millions)  

Interest rate contracts

   Interest expense    $ 6      $ 8   
                   

Senior notes hedged

   Interest expense    $     (13   $     (10
                   

The following table presents the pre-tax gain (loss) recognized in, and reclassified from, accumulated other comprehensive income (AOCI) related to instruments designated as cash flow derivatives:

 

          Three Months Ended
March 31,
 

Cash Flow Derivatives

  

Location of Gain (Loss)

   2011     2010  
          ($ in millions)  

Gain (Loss) Recognized in AOCI
(Effective Portion)

       

Commodity contracts

   AOCI    $ 16      $     405   

Foreign currency contracts

   AOCI          (18     2   
                   
      $ (2   $ 407   
                   

Gain (Loss) Reclassified from AOCI into Income (Effective Portion)

       

Commodity contracts

   Natural gas and oil sales    $ 74      $ 140   
                   

Gain (Loss) Recognized in Income

       

Commodity contracts

       

Ineffective Portion

   Natural gas and oil sales    $ 10      $ (6

Amount initially excluded from effectiveness testing

   Natural gas and oil sales      22        36   
                   
      $ 32      $ 30   
                   

The following table presents the gain (loss) recognized in the statement of operations related to instruments not qualifying as cash flow or fair value derivatives:

 

          Three Months Ended
March 31,
 

Non-Qualifying Derivatives

  

Location of Gain (Loss)

   2011     2010  
          ($ in millions)  

Commodity contracts

   Natural gas and oil sales    $ (800   $ 544   

Interest rate contracts

   Interest expense      (5     22   
                   
  

Total

   $     (805   $     566   
                   

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Credit Risk

Derivative instruments that enable us to hedge a portion of our exposure to natural gas and oil prices and interest rate volatility expose us to credit risk from our counterparties. To mitigate this risk, we enter into derivative contracts only with investment-grade rated counterparties deemed by management to be competent and competitive market makers, and we attempt to limit our exposure to non-performance by any single counterparty. On March 31, 2011, our commodity and interest rate derivative instruments were spread among 13 counterparties. Additionally, our multi-counterparty secured hedging facility described above includes 12 of our counterparties which are required to secure their natural gas and oil hedging obligations in excess of defined thresholds. We use this facility for all of our commodity hedging.

 

3.

Contingencies and Commitments

Litigation

On February 25, 2009, a putative class action was filed in the U.S. District Court for the Southern District of New York against the company and certain of its officers and directors along with certain underwriters of the company’s July 2008 common stock offering. Following the appointment of a lead plaintiff and counsel, the plaintiff filed an amended complaint on September 11, 2009 alleging that the registration statement for the offering contained material misstatements and omissions and seeking damages under Sections 11, 12 and 15 of the Securities Act of 1933 of an unspecified amount and rescission. The action was transferred to the U.S. District Court for the Western District of Oklahoma on October 13, 2009. The defendants’ motion to dismiss was denied on September 2, 2010. A derivative action was also filed in the District Court of Oklahoma County, Oklahoma on March 10, 2009 against the company’s directors and certain of its officers alleging breaches of fiduciary duties relating to the disclosure matters alleged in the securities case. The derivative action is stayed pursuant to stipulation. We are currently unable to assess the probability of loss or estimate a range of potential loss associated with the securities class action case, which is at an early stage.

Chesapeake is also involved in various other lawsuits and disputes incidental to its business operations, including commercial disputes, personal injury claims, claims for underpayment of royalties, property damage claims and contract actions. With regard to the latter, various mineral or leasehold owners have filed lawsuits against us seeking specific performance to require us to acquire their natural gas and oil interests and pay acreage bonus payments, damages based on breach of contract and/or, in certain cases, punitive damages based on alleged fraud. The company has successfully defended a number of these cases in various courts, has settled others and believes that it has substantial defenses to the claims made in those pending at the trial court and on appeal.

The company records an associated liability when a loss is probable and the amount is reasonably estimable. Although the outcome of litigation cannot be predicted with certainty, management is of the opinion that no pending or threatened lawsuit or dispute incidental to its business operations is likely to have a material adverse effect on the company’s consolidated financial position, results of operations or cash flows. The final resolution of such matters could exceed amounts accrued, however, and actual results could differ materially from management’s estimates.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Environmental Risk

Due to the nature of the natural gas and oil business, Chesapeake and its subsidiaries are exposed to possible environmental risks. Chesapeake has implemented various policies and procedures to reduce and mitigate such environmental risks. Chesapeake conducts periodic reviews, on a company-wide basis, to identify changes in our environmental risk profile. These reviews evaluate whether there is a contingent liability, its amount, and the likelihood that the liability will be incurred. The amount of any potential liability is determined by considering, among other matters, incremental direct costs of any likely remediation and the proportionate cost of employees who are expected to devote a significant amount of time directly to any possible remediation effort. We manage our exposure to environmental liabilities on properties to be acquired by identifying existing problems and assessing the potential liability. Depending on the extent of an identified environmental problem, Chesapeake may exclude a property from the acquisition, require the seller to remediate the property to our satisfaction, or agree to assume liability for the remediation of the property. Chesapeake has historically not experienced any significant environmental liability and is not aware of any potential material environmental issues or claims at March 31, 2011. There are, however, pending against us enforcement actions related to alleged methane migration in Pennsylvania and compliance with Clean Water Act permitting requirements in West Virginia, as well as an investigation by the Pennsylvania Department of Environmental Protection of a recent well control incident. While these actions may result in monetary sanctions, we do not expect that they will have a material adverse effect on our operations.

Rig Leases

In a series of transactions since 2006, our drilling subsidiaries have sold 89 drilling rigs and related equipment for $754 million and entered into a master lease agreement under which we agreed to lease the rigs from the buyer for initial terms of seven to ten years. The lease obligations are guaranteed by Chesapeake and certain of its subsidiaries. These transactions were recorded as sales and operating leasebacks and any related gain or loss is amortized to service operations expense over the lease term. Under the leases, we can exercise an early purchase option or we can purchase the rigs at the expiration of the lease for the fair market value at the time. In addition, in most cases we have the option to renew the lease for negotiated new terms at the expiration of the lease. Commitments related to rig lease payments are not recorded in the accompanying condensed consolidated balance sheets. As of March 31, 2011, the minimum aggregate undiscounted future rig lease payments were approximately $468 million.

Compressor Leases

Through various transactions since 2007, our compression subsidiary has sold 2,234 compressors, a significant portion of its compressor fleet, for $517 million and entered into a master lease agreement. The term of the agreement varies by buyer ranging from four to ten years. The lease obligations are guaranteed by Chesapeake and certain of its subsidiaries. These transactions were recorded as sales and operating leasebacks and any related gain or loss is amortized to marketing, gathering and compression expenses over the lease term. Under the leases, we can exercise an early purchase option or we can purchase the compressors at expiration of the lease for the fair market value at the time. In addition, in most cases we have the option to renew the lease for negotiated new terms at the expiration of the lease. Commitments related to compressor lease payments are not recorded in the accompanying condensed consolidated balance sheets. As of March 31, 2011, the minimum aggregate undiscounted future compressor lease payments were approximately $415 million.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Transportation Contracts

Chesapeake has various “firm” pipeline transportation service agreements with expiration dates ranging from 2011 to 2099. These commitments are not recorded in the accompanying condensed consolidated balance sheets. Under the terms of these contracts, we are obligated to pay demand charges as set forth in the transporter’s Federal Energy Regulatory Commission (FERC) gas tariff. In exchange, the company receives rights to flow natural gas production through pipelines located in highly competitive markets. The aggregate undiscounted amounts of such required demand payments are presented below:

 

     March 31,
2011
 
     ($ in millions)  

2011

   $ 265   

2012

     487   

2013

     549   

2014

     576   

2015

     568   

After 2015

     3,780   
        

Total

   $ 6,225   
        

Drilling Contracts

Currently, Chesapeake has contracts with various drilling contractors to lease approximately 50 rigs with terms of four months to three years. These commitments are not recorded in the accompanying condensed consolidated balance sheets. As of March 31, 2011, the aggregate undiscounted minimum future drilling rig commitment was approximately $182 million.

Natural Gas and Oil Purchase Obligations

Our marketing segment regularly commits to purchase natural gas from other owners in our properties and such commitments typically are short-term in nature. We have also committed to purchase any natural gas and oil associated with certain volumetric production payment transactions. The purchase commitments are based on market prices at the time of production, and the purchased natural gas and oil is resold.

Minimum Volume Commitments

We are a party to two natural gas gathering agreements with a subsidiary of Chesapeake Midstream Partners, L.P. (see Note 9), pursuant to which we have committed to deliver specified minimum volumes of natural gas. Annually and at the end of the term, Chesapeake will be invoiced for any shortfalls in such volume deliveries at the rate specified in the agreement. Volume commitments remaining under the agreement relating to our Barnett Shale natural gas production as of March 31, 2011 were as follows:

 

             Bcf          

2011

     248   

2012

     325   

2013

     338   

2014

     351   

2015

     365   

After 2015(a)

     1,321   
        

Total

     2,948   
        

 

(a)

Final commitment period is for the six months ending June 30, 2019.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Volume commitments remaining under the agreement relating to our Haynesville Shale natural gas production as of March 31, 2011 were as follows:

 

             Bcf          

2011

     60   

2012

     118   

2013

     135   
        

Total

     313   
        

Net Acreage Maintenance Commitments

Under the terms of our joint venture agreements with our partners (Statoil, Total and CNOOC), we are required to extend, renew or replace certain expiring joint leasehold, at our cost, to ensure that the net acreage is maintained in certain designated areas for certain designated time periods.

Other Commitments

As of March 31, 2011, we had made commitments to acquire additional proved and unproved properties in various transactions during the next twelve months for approximately $400 million.

 

4.

Net Income Per Share

Accounting guidance for earnings per share (EPS) requires presentation of “basic” and “diluted” earnings per share on the face of the statements of operations for all entities with complex capital structures as well as a reconciliation of the numerator and denominator of the basic and diluted EPS computations.

For the Current Quarter, the following securities and associated adjustments to net income, consisting of dividends on our cumulative convertible preferred stock, unvested restricted stock grants and outstanding stock options were not included in the calculation of diluted EPS, as the effect was antidilutive.

 

     Net Income
Adjustments
     Shares  
     ($ in millions)      (in millions)  

Three Months Ended March 31, 2011:

     

Common stock equivalent of our preferred stock outstanding:

     

5.75% cumulative convertible preferred stock

         $ 22               56   

5.75% cumulative convertible preferred stock (series A)

         $ 16               39   

5.00% cumulative convertible preferred stock (series 2005B)

         $ 3               5   

4.50% cumulative convertible preferred stock

         $ 3               6   

Unvested restricted stock

         $ —               8   

Outstanding stock options

         $ —               1   

For the Prior Quarter, all outstanding securities that were convertible into common stock were included in the calculation of diluted EPS.

As a result of the net loss to common stockholders for the Current Quarter, both basic weighted average shares outstanding, which are used in computing basic EPS, and diluted weighted average shares outstanding, which are used in computing diluted EPS, were 634 million shares. The basic and diluted loss per common share was $0.32.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

A reconciliation of basic EPS and diluted EPS for the Prior Quarter is as follows:

 

     Income
(Numerator)
     Weighted
Average
Shares
(Denominator)
     Per
Share
Amount
 
     (in millions, except per share data)  

Three Months Ended March 31, 2010:

        

Basic EPS

   $ 732         630       $ 1.17   
                          

Effect of Dilutive Securities:

        

Assumed conversion as of the beginning of the period of preferred shares outstanding during the period:

        

Common shares assumed issued for 5.00% cumulative convertible preferred stock (series 2005B)

     3         5      

Common shares assumed issued for 4.50% cumulative convertible preferred stock

     3         6      

Unvested restricted stock

             5      

Outstanding stock options

             1      
                    

Diluted EPS

   $ 738         647       $ 1.14   
                          

 

5.

Stockholders’ Equity, Restricted Stock and Stock Options

Common Stock

The following is a summary of the changes in our common shares outstanding for the three months ended March 31, 2011 and 2010:

 

     2011      2010  
     (in thousands)  

Shares outstanding at January 1

     655,251         648,549   

Restricted stock issuances (net of forfeitures)

     3,587         2,842   

Stock option exercises

     182         133   

Convertible note exchanges

             299   
                 

Shares outstanding at March 31

           659,020               651,823   
                 

In the Prior Quarter, we privately exchanged approximately $11 million in aggregate principal amount of our 2.25% Contingent Convertible Senior Notes due 2038 for an aggregate of 298,500 shares of our common stock valued at approximately $9 million. The difference between the allocated debt value of the notes that were exchanged and the fair value of the common stock issued resulted in a $2 million loss (including a nominal amount of deferred charges associated with the exchanges).

Preferred Stock

The following reflects our preferred shares outstanding for the three months ended March 31, 2011 and 2010:

 

     5.75%      5.75% (A)      4.50%      5.00%
(2005B)
     5.00%
(2005)
 
     (in thousands)  

Shares outstanding at January 1, 2011 and March 31, 2011

           1,500               1,100               2,559               2,096               —   
                                            

Shares outstanding at January 1, 2010 and March 31, 2010

                     2,559         2,096         5   
                                            

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Dividends

Dividends declared on our common stock and preferred stock are reflected as adjustments to retained earnings to the extent a surplus of retained earnings will exist after giving effect to the dividends. To the extent retained earnings are insufficient to fund the distributions, such payments constitute a return of contributed capital rather than earnings and are accounted for as a reduction to paid-in capital.

Dividends on our outstanding preferred stock are payable quarterly in cash, common stock or a combination thereof.

Stock-Based Compensation

Chesapeake’s stock-based compensation programs consist of restricted stock and stock options issued to employees and non-employee directors. We recognize in our financial statements the cost of employee services received in exchange for awards of equity instruments based on the fair value at the date of the grant. To the extent compensation cost relates to employees directly involved in natural gas and oil acquisition, exploration and development activities, such amounts are capitalized to natural gas and oil properties. Amounts not capitalized to natural gas and oil properties are recognized as general and administrative expenses, production expenses, marketing, gathering and compression expenses or service operations expense. We recorded the following stock-based compensation during the Current Quarter and the Prior Quarter:

 

         Three Months Ended    
March 31,
 
     2011      2010  
     ($ in millions)  

Natural gas and oil properties

   $ 31       $ 37   

General and administrative expenses

     23         22   

Production expenses

     9         10   

Marketing, gathering and compression expenses

     5         4   

Service operations expense

     3         2   
                 

Total

   $ 71       $ 75   
                 

Restricted Stock. Chesapeake began issuing shares of restricted common stock to employees in January 2004 and to non-employee directors in July 2005. The fair value of the awards issued is determined based on the fair market value of the shares on the date of grant. This value is amortized over the vesting period, which is generally four or five years from the date of grant for employees and three years for non-employee directors.

A summary of the changes in unvested shares of restricted stock for the three months ended March 31, 2011 is presented below:

 

     Number of
Unvested
Restricted
Shares
    Weighted Average
Grant-Date
Fair Value
     (in thousands)      

Unvested shares as of January 1, 2011

     21,375      $  28.68

Granted

     4,792      $  26.76

Vested

     (2,891   $  27.45

Forfeited

     (170   $  27.41
          

Unvested shares as of March 31, 2011

     23,106      $  28.45
          

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The aggregate intrinsic value of restricted stock vested during the Current Quarter was approximately $76 million based on the stock price at the time of vesting.

As of March 31, 2011, there was $416 million of total unrecognized compensation cost related to unvested restricted stock. The cost is expected to be recognized over a weighted average period of approximately two years.

The vesting of certain restricted stock grants could result in state and federal income tax benefits related to the difference between the market price of the common stock at the date of vesting and the date of grant. During both the Current Quarter and the Prior Quarter, we recognized a reduction in tax benefits related to restricted stock of $1 million, which was recorded as an adjustment to additional paid-in capital and deferred income taxes with respect to such benefits.

Stock Options. We granted stock options prior to 2006 under several stock compensation plans. Outstanding options expire ten years from the date of grant and vested over a four-year period. All of our outstanding stock options are fully vested and exercisable.

The following table provides information related to stock option activity for the three months ended March 31, 2011:

 

     Number of
Shares
Underlying
Options
    Weighted
Average
Exercise
Price

Per Share
     Weighted
Average
Contract
Life in
Years
   Aggregate
Intrinsic
Value(a)
 
     (in thousands)                 ($ in millions)  

Outstanding at January 1, 2011

     1,808        $ 8.90         2.03        $ 31       

Exercised

     (185     $ 7.02           

Forfeited/canceled

            $ —           
                

Outstanding and exercisable at March 31, 2011

     1,623        $ 9.12         1.88        $ 40       
                

 

(a)

The intrinsic value of a stock option is the amount by which the current market value or the market value upon exercise of the underlying stock exceeds the exercise price of the option.

There is no remaining unrecognized compensation cost related to unvested stock options.

During both the Current Quarter and the Prior Quarter, we recognized excess tax benefits related to stock options of $1 million, which were recorded as adjustments to additional paid-in capital and deferred income taxes with respect to such benefits.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

6.

Debt

Our long-term debt consisted of the following at March 31, 2011 and December 31, 2010:

 

     March 31,
2011
    December 31,
2010
 
     ($ in millions)  

7.625% senior notes due 2013

   $ 500      $ 500   

9.5% senior notes due 2015

     1,425        1,425   

6.25% euro-denominated senior notes due 2017(a)

     851        796   

6.5% senior notes due 2017

     1,100        1,100   

6.875% senior notes due 2018

     600        600   

7.25% senior notes due 2018

     800        800   

6.625% senior notes due 2020

     1,400        1,400   

6.875% senior notes due 2020

     500        500   

6.125% senior notes due 2021

     1,000          

2.75% contingent convertible senior notes due 2035(b)

     451        451   

2.5% contingent convertible senior notes due 2037(b)

     1,378        1,378   

2.25% contingent convertible senior notes due 2038(b)

     612        752   

Corporate revolving bank credit facility

            3,612   

Midstream revolving bank credit facility

            94   

Discount on senior notes(c)

     (707     (777

Interest rate derivatives(d)

     5        9   
                

Total long-term debt

   $             9,915      $         12,640   
                

 

(a)

The principal amount shown is based on the exchange rate of $1.4183 to 1.00 and $1.3269 to 1.00 as of March 31, 2011 and December 31, 2010, respectively. See Note 2 for information on our related foreign currency derivatives.

 

(b)

The holders of our contingent convertible senior notes may require us to repurchase, in cash, all or a portion of their notes at 100% of the principal amount of the notes on any of four dates that are five, ten, fifteen and twenty years before the maturity date. The notes are convertible, at the holder’s option, prior to maturity under certain circumstances into cash and, if applicable, shares of our common stock using a net share settlement process. One such triggering circumstance is when the price of our common stock exceeds a threshold amount during a specified period in a fiscal quarter. Convertibility based on common stock price is measured quarter by quarter. In the first quarter of 2011, the price of our common stock was below the threshold level for each series of the contingent convertible senior notes during the specified period and, as a result, the holders do not have the option to convert their notes into cash and common stock in the second quarter of 2011 under this provision. The notes are also convertible, at the holder’s option, during specified five-day periods if the trading price of the notes is below certain levels determined by reference to the trading price of our common stock. In general, upon conversion of a contingent convertible senior note, the holder will receive cash equal to the principal amount of the note and common stock for the note’s conversion value in excess of such principal amount. We will pay contingent interest on the convertible senior notes after they have been outstanding at least ten years, under certain conditions. We may redeem the convertible senior notes once they have been outstanding for ten years at a redemption price of 100% of the principal amount of the notes, payable in cash. The optional repurchase dates, the common stock price conversion threshold amounts and the ending date of the first six-month period in which contingent interest may be payable for the contingent convertible senior notes are as follows:

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Contingent

Convertible

Senior Notes

  

Repurchase Dates

   Common Stock
Price Conversion
Thresholds
     Contingent Interest
First Payable
(if applicable)

2.75% due 2035

   November 15, 2015, 2020, 2025, 2030          $ 48.62             May 14, 2016

2.5% due 2037

   May 15, 2017, 2022, 2027, 2032          $ 64.26             November 14, 2017

2.25% due 2038

   December 15, 2018, 2023, 2028, 2033          $ 107.36             June 14, 2019

 

(c)

Included in this discount is $645 million at March 31, 2011 and $711 million at December 31, 2010 associated with the equity component of our contingent convertible senior notes. This discount is based on an effective yield method.

 

(d)

See Note 2 for further discussion related to these instruments.

Senior Notes

Our senior notes are unsecured senior obligations of Chesapeake and rank equally in right of payment with all of our other existing and future senior indebtedness and rank senior in right of payment to all of our future subordinated indebtedness. Chesapeake is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. Our senior note obligations are guaranteed by certain of our wholly owned subsidiaries, excluding Chesapeake Midstream Development, L.P. (CMD) and its subsidiaries. See Note 11 for condensed consolidating financial information regarding our guarantor and non-guarantor subsidiaries. We may redeem the senior notes, other than the contingent convertible senior notes, at any time at specified make-whole or redemption prices. Our senior notes are governed by indentures containing covenants that limit our ability and our subsidiaries’ ability to incur certain secured indebtedness; enter into sale/leaseback transactions; and consolidate, merge or transfer assets.

We are required to account for the liability and equity components of our convertible debt instruments separately and to reflect interest expense at the interest rate of similar nonconvertible debt at the time of issuance. These rates for our 2.75% Contingent Convertible Senior Notes due 2035, our 2.5% Contingent Convertible Senior Notes due 2037 and our 2.25% Contingent Convertible Senior Notes due 2038 are 6.86%, 8.0% and 8.0%, respectively.

During the Current Quarter, we issued $1.0 billion of 6.125% Senior Notes due 2021 in a registered public offering. We used the net proceeds of $977 million from the offering to repay indebtedness outstanding under our corporate revolving bank credit facility.

During the Current Quarter, we repurchased $140 million in aggregate principal amount of our 2.25% Contingent Convertible Senior Notes due 2038 for approximately $129 million, including accrued interest. Associated with these repurchases, we recognized a loss of $2 million in the Current Quarter.

During the Prior Quarter, holders of our 2.25% Contingent Convertible Senior Notes due 2038 exchanged approximately $11 million in aggregate principal amount for an aggregate of 298,500 shares of our common stock in privately negotiated exchanges. Associated with these exchanges, we recognized a loss of $2 million in the Prior Quarter.

No scheduled principal payments are required under our senior notes until 2013 when $500 million is due.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Bank Credit Facilities

We utilize two revolving bank credit facilities, described below, as sources of liquidity.

 

     Corporate
Credit Facility(a)
     Midstream
Credit Facility(b)
     ($ in millions)

Facility structure

   Senior secured revolving      Senior secured revolving

Maturity date

   December 2015      July 2015

Borrowing capacity

   $      4,000      $      300

Amount outstanding as of March 31, 2011

   $            —      $        —

Letters of credit outstanding as of March 31, 2011

   $           13      $        —

 

(a)

Borrower is Chesapeake Exploration, L.L.C.

 

(b)

Borrower is Chesapeake Midstream Operating, L.L.C., a wholly owned subsidiary of Chesapeake Midstream Development, L.P.

Our credit facilities do not contain material adverse change or adequate assurance covenants. Although the applicable interest rates under our corporate credit facility fluctuate slightly based on our long-term senior unsecured credit ratings, neither of our credit facilities contains provisions which would trigger an acceleration of amounts due under the facilities or a requirement to post additional collateral in the event of a downgrade of our credit ratings.

Corporate Credit Facility

Our $4.0 billion syndicated revolving bank credit facility is used for general corporate purposes. Borrowings under the facility are secured by natural gas and oil proved reserves and bear interest at our option at either (i) the greater of the reference rate of Union Bank, N.A. or the federal funds effective rate plus 0.50%, both of which are subject to a margin that varies from 0.50% to 1.25% per annum according to our senior unsecured long-term debt ratings, or (ii) the Eurodollar rate, which is based on the London Interbank Offered Rate (LIBOR), plus a margin that varies from 1.50% to 2.25% per annum according to our senior unsecured long-term debt ratings. The collateral value and borrowing base are determined periodically. The unused portion of the facility is subject to a commitment fee of 0.50% per annum. Interest is payable quarterly or, if LIBOR applies, it may be payable at more frequent intervals.

The credit facility agreement contains various covenants and restrictive provisions which limit our ability to incur additional indebtedness, make investments or loans and create liens and require us to maintain an indebtedness to total capitalization ratio and an indebtedness to EBITDA ratio, in each case as defined in the agreement. We were in compliance with all covenants under the agreement at March 31, 2011. If we should fail to perform our obligations under these and other covenants, the revolving credit commitment could be terminated and any outstanding borrowings under the facility could be declared immediately due and payable. Such acceleration, if involving a principal amount of $50 million or more, would constitute an event of default under our senior note indentures, which could in turn result in the acceleration of a significant portion of our senior note indebtedness. The credit facility agreement also has cross default provisions that apply to other indebtedness of Chesapeake and its restricted subsidiaries with an outstanding principal amount in excess of $125 million.

The facility is fully and unconditionally guaranteed, on a joint and several basis, by Chesapeake and certain of our wholly owned subsidiaries.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Midstream Credit Facility

Our $300 million midstream syndicated revolving bank credit facility is used to fund capital expenditures to build natural gas gathering and other systems for our drilling program and for general corporate purposes associated with our midstream operations. Borrowings under the midstream credit facility are secured by all of the assets of the wholly owned subsidiaries (the restricted subsidiaries) of CMD, itself a wholly owned subsidiary of Chesapeake, and bear interest at our option at either (i) the greater of the reference rate of Wells Fargo Bank, National Association, the federal funds effective rate plus 0.50%, and the one-month LIBOR plus 1.00%, all of which are subject to a margin that varies from 1.75% to 2.25% per annum according to the most recent leverage ratio described below or (ii) the Eurodollar rate, which is based on the LIBOR plus a margin that varies from 2.75% to 3.25% per annum according to the most recent leverage ratio. The unused portion of the facility is subject to a commitment fee of 0.50% per annum. Interest is payable quarterly or, if LIBOR applies, it may be payable at more frequent intervals.

The midstream credit facility agreement contains various covenants and restrictive provisions which limit the ability of CMD and its restricted subsidiaries to incur additional indebtedness, make investments or loans and create liens. The agreement requires maintenance of a leverage ratio based on the ratio of indebtedness to EBITDA and an interest coverage ratio based on the ratio of EBITDA to interest expense, in each case as defined in the agreement. The leverage ratio increases during any three-quarter period, beginning in the quarter in which CMD makes a material disposition of assets to our master limited partnership midstream affiliate, Chesapeake Midstream Partners, L.P. As of December 21, 2010, the leverage ratio increased for a three-fiscal-quarter period beginning October 1, 2010 due to the sale of the Springridge gathering system, as it was classified as a material disposition of assets. We were in compliance with all covenants under the agreement at March 31, 2011. If CMD or its restricted subsidiaries should fail to perform their obligations under these and other covenants, the revolving credit commitment could be terminated and any outstanding borrowings under the facility could be declared immediately due and payable. The midstream credit facility agreement also has cross default provisions that apply to other indebtedness CMD and its restricted subsidiaries may have from time to time with an outstanding principal amount in excess of $15 million.

Other Financings

In 2009, we financed 113 real estate surface assets in the Barnett Shale area for approximately $145 million and entered into a 40-year master lease agreement under which we agreed to lease the sites for approximately $15 million to $27 million annually. This lease transaction was recorded as a financing lease and the cash received was recorded with an offsetting long-term liability on the condensed consolidated balance sheet. Chesapeake exercised its option to repurchase two of the assets in 2010. As of March 31, 2011, 111 assets were leased and the minimum aggregate undiscounted future lease payments were approximately $824 million. This obligation is recorded in other long-term liabilities on our condensed consolidated balance sheets.

In 2009, we financed our regional Barnett Shale headquarters building in Fort Worth, Texas for net proceeds of approximately $54 million with a five-year term loan which has a floating rate of prime plus 275 basis points. At our option, we may prepay in full without penalty beginning in year four. This obligation is recorded in other long-term liabilities on our condensed consolidated balance sheets.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

7.

Segment Information

In accordance with accounting guidance for disclosures about segments of an enterprise and related information, we have two reportable operating segments. Our exploration and production operating segment and natural gas and oil marketing, gathering and compression operating segment are managed separately because of the nature of their products and services. The exploration and production operating segment is responsible for finding and producing natural gas and oil. The marketing, gathering and compression operating segment is responsible for marketing, gathering and compression of natural gas and oil primarily from Chesapeake-operated wells. We also have drilling rig and trucking operations which are responsible for providing drilling rigs primarily used on Chesapeake-operated wells and trucking services utilized in the transportation of drilling rigs on both Chesapeake-operated wells and wells operated by third parties. Our drilling rig and trucking service operations are included in “Other Operations” in the table below.

Management evaluates the performance of our segments based upon income (loss) before income taxes. Revenues from the sale of natural gas and oil related to Chesapeake’s ownership interests by the marketing, gathering and compression operating segment are reflected as exploration and production revenues. Such amounts totaled $1.204 billion and $1.061 billion for the Current Quarter and the Prior Quarter, respectively. The following table presents selected financial information for Chesapeake’s operating segments.

 

     Exploration
and
Production
    Marketing,
Gathering
and
Compression
    Other
Operations
    Intercompany
Eliminations
    Consolidated
Total
 
                 ($ in millions)              

Three Months Ended March 31, 2011:

          

Revenues

   $ 494      $ 2,221      $ 248      $ (1,351   $ 1,612   

Intersegment revenues

            (1,204     (147     1,351          
                                        

Total revenues

   $ 494      $ 1,017      $ 101      $      $ 1,612   
                                        

Income (loss) before income taxes

   $ (297   $ 87      $ 22      $ (78   $ (266
                                        

Three Months Ended March 31, 2010:

          

Revenues

   $ 1,898      $ 1,905      $ 170      $ (1,175   $ 2,798   

Intersegment revenues

            (1,061     (114     1,175          
                                        

Total revenues

   $ 1,898      $ 844      $ 56      $      $ 2,798   
                                        

Income (loss) before income taxes

   $ 1,177      $ 87      $ 1      $ (65   $ 1,200   
                                        

As of March 31 2011:

          

Total assets

   $ 31,223      $ 3,400      $ 899      $ (722   $ 34,800   

As of December 31, 2010:

          

Total assets

   $ 33,560      $ 3,458      $ 854      $ (693   $ 37,179   

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

8.

Divestitures

Fayetteville Shale Asset Sale

On March 31, 2011, we sold all of our Fayetteville Shale assets in Central Arkansas to BHP Billiton Petroleum, a wholly owned subsidiary of BHP Billiton Limited (NYSE: BHP; ASX: BHP), for net proceeds of approximately $4.65 billion in cash. The sold properties consisted of approximately 487,000 net acres of leasehold, current net production of approximately 415 million cubic feet of natural gas equivalent per day and midstream assets consisting of approximately 420 miles of pipeline. As part of the transaction, Chesapeake has agreed to provide technical and business services for up to one year for BHP Billiton’s Fayetteville properties for an agreed-upon fee.

Joint Ventures

As of March 31, 2011, we had entered into six significant joint ventures pursuant to which we sold a portion of our leasehold in six different plays and received cash and commitments for future drilling and completion cost sharing. These transactions have allowed us to recover much or all of our initial leasehold investments in the plays, reduce our ongoing capital costs, reduce future DD&A expense and reduce future risks. The transactions are detailed below.

On February 11, 2011, we entered into a joint venture with CNOOC International Limited, a wholly owned subsidiary of CNOOC Limited (CNOOC), to develop our leasehold overlaying the Niobrara Shale, Codell and other formations in the Powder River and DJ Basins in northeast Colorado and southeast Wyoming. Under the terms of the joint venture, CNOOC acquired a 33.3% undivided interest in approximately 800,000 net acres of our Powder River and DJ Basins leasehold. We received $570 million in cash at closing, and CNOOC agreed to fund 66.7% of our share of drilling and completion costs in the Powder River and DJ Basins until an additional $697 million has been paid, which we expect to occur by year-end 2014. CNOOC also has the right to a 33.3% participation in any additional leasehold we acquire in the Powder River and DJ Basins at cost plus a fee.

On November 15, 2010, we entered into a joint venture with CNOOC International Limited to develop our Eagle Ford and Pearsall Shales leasehold in South Texas. Under the terms of the joint venture, CNOOC acquired a 33.3% undivided interest in approximately 600,000 net acres of our Eagle Ford and Pearsall Shales leasehold along with 18.2 bcfe of estimated proved reserves. We received $1.12 billion in cash at closing, and CNOOC agreed to fund 75% of our share of drilling and completion costs in the Eagle Ford and Pearsall Shales until an additional $1.08 billion has been paid, which we expect to occur by year-end 2012. In addition, CNOOC has the right to a 33.3% participation in any additional leasehold we acquire in the Eagle Ford and Pearsall Shales at cost plus a fee.

On January 25, 2010, we entered into a joint venture with Total E&P USA, Inc., a wholly owned subsidiary of Total S.A. (Total), to develop our Barnett Shale leasehold in north-central Texas. Under the terms of the joint venture, Total acquired a 25% undivided interest in approximately 270,000 net acres of our Barnett Shale leasehold along with 840 bcfe of estimated proved reserves. We received approximately $800 million in cash at closing (plus $78 million of drilling and completion carries due from the effective date of the transaction to the closing date), and Total agreed to fund 60% of our share of future drilling and completion costs in the Barnett Shale until $1.45 billion has been paid, which we expect to occur by year-end 2013. In addition, Total has the right to a 25% participation in any additional leasehold we acquire in the Barnett Shale at cost plus a fee.

On November 25, 2008, we entered into a joint venture with Statoil to develop our Marcellus Shale leasehold in Appalachia. Under the terms of the joint venture, Statoil acquired a 32.5% undivided interest in approximately 1.8 million net acres of our Marcellus Shale leasehold along with 2.5 bcfe of estimated proved reserves. We received $1.25 billion in cash at closing, and Statoil agreed to fund 75% of our share of drilling and completion costs in the Marcellus Shale until an additional $2.125 billion has been paid, which we expect to occur by year-end 2012. In addition, Statoil has the right to a 32.5% participation in any additional leasehold we acquire in the Marcellus Shale at cost plus a fee.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

On September 5, 2008, we entered into a joint venture with BP America Production Company, a wholly owned subsidiary of BP plc (BP), to develop our Fayetteville Shale leasehold in Arkansas. Under the terms of the joint venture, BP acquired a 25% undivided interest in approximately 540,000 net acres of our Fayetteville Shale leasehold along with 161.8 bcfe of estimated proved reserves. We received $1.1 billion in cash at closing, and BP paid an additional $800 million by funding 100% of Chesapeake’s 75% share of drilling and completion costs during 2008 and 2009. BP had the right to a 25% participation in any additional leasehold we acquired in the Fayetteville Shale at cost plus a fee until we sold all of our Fayetteville Shale assets on March 31, 2011 to BHP Billiton Petroleum.

On July 1, 2008, we entered into a joint venture with Plains Exploration & Production Company (PXP) to develop our Haynesville and Bossier Shale leasehold in Northwest Louisiana and East Texas. Under the terms of the joint venture, PXP acquired a 20% undivided interest in approximately 550,000 net acres of our Haynesville and Bossier Shale leasehold along with 22.9 bcfe of estimated proved reserves. We received $1.65 billion in cash at closing, and PXP agreed to fund 50% of our share of drilling and completion costs in the Haynesville and Bossier Shale over a multi-year period, up to an additional $1.65 billion. In August 2009, Chesapeake and PXP amended their agreement to accelerate the payment of PXP’s remaining drilling and completion cost carries as of September 30, 2009, in exchange for an approximate 12% reduction in the total amount of carry obligations due to Chesapeake. As a result, on September 29, 2009, Chesapeake received $1.1 billion in cash from PXP, and beginning in the 2009 fourth quarter Chesapeake and PXP each began paying their proportionate working interest costs on drilling. In addition, PXP has the right to a 20% participation in any additional leasehold we acquire in the Haynesville and Bossier Shales at cost plus a fee.

During the Current Quarter and the Prior Quarter, our drilling and completion costs included the benefit of approximately $527 million and $281 million, respectively, in drilling and completion carries associated with our joint venture agreements with CNOOC, Total and Statoil as follows:

 

Primary

Play

  

Joint Venture

Partner

  

Joint Venture

Agreement

Date

           Three Months Ended         
March 31,
 
             2011              2010      
               ($ in millions)  

Niobrara

   CNOOC    February 2011    $ 24       $   

Eagle Ford

   CNOOC    November 2010      122           

Barnett

   Total    January 2010      137         189   

Marcellus

   Statoil    November 2008      244         92   
                       
         $         527       $         281   
                       

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

During the Current Quarter and the Prior Quarter, as part of our joint venture agreements with CNOOC, Total, Statoil and Plains Exploration & Production Company, we sold interests in additional leasehold in the Eagle Ford, Barnett, Marcellus and Haynesville shale plays for approximately $224 million and $245 million, respectively.

For accounting purposes, cash proceeds from these joint venture transactions were reflected as a reduction of natural gas and oil properties with no gain or loss recognized.

Volumetric Production Payments

From time to time, we choose to monetize certain of our producing assets in our more mature producing regions through the sale of volumetric production payments. We retain drilling rights on the properties below currently producing intervals and outside of producing well bores. We also retain all production beyond the specified volumes sold in the transaction.

We have completed the following volumetric production payment (VPP) transactions since 2007:

 

Date of VPP

  

Region

   Proceeds        Proved Reserves  
(at time of sale)
   $ / mcfe          Original    
Term
 
          ($ in millions)     

(bcfe)

          (years)  

September 2010

   Barnett Shale        $ 1,150              390    $ 2.93           5   

June 2010

   Permian Basin      335                38    $ 8.73         10   

February 2010

  

East Texas

and the

Texas Gulf Coast

     180                46    $ 3.95         10   

August 2009

   South Texas      370                68    $ 5.46         7.5   

December 2008

  

Anadarko and

Arkoma Basins

     412                98    $ 4.19           8   

August 2008

   Anadarko Basin      600                93    $ 6.38         11   

May 2008

  

Texas, Oklahoma

and Kansas

     622                94    $ 6.53         11   

December 2007

  

Kentucky and

West Virginia

     1,100              208    $ 5.29         15   
                      
          $ 4,769           1,035    $ 4.61      
                      

For accounting purposes, cash proceeds from these transactions were reflected as a reduction of natural gas and oil properties with no gain or loss recognized, and our proved reserves were reduced accordingly.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

9.

Investments

At March 31, 2011 and December 31, 2010, we had the following investments:

 

                Carrying Value  
     Approximate
% Owned
   

Accounting
Method

   March 31,
2011
     December 31,
2010
 
                ($ in millions)  

Chesapeake Midstream Partners, L.P.

     42%      Equity    $ 695       $ 695   

Frac Tech Holdings, LLC

     26%      Equity      341         311   

Chaparral Energy, Inc.

     20%      Equity      130         133   

Gastar Exploration Ltd.

     11%      Cost      33         29   

Other

     —         Cost/Equity      29         40   
                      
        $             1,228       $             1,208   
                      

Chesapeake Midstream Partners, L.P. On September 30, 2009, we formed a joint venture with Global Infrastructure Partners (GIP), a New York-based private equity fund, to own and operate natural gas midstream assets. As part of the transaction, Chesapeake contributed certain natural gas gathering and processing assets to, and GIP purchased a 50% interest in, a new joint venture entity. The assets we contributed to the joint venture were substantially all of our midstream assets in the Barnett Shale and also the majority of our non-shale midstream assets in the Arkoma, Anadarko, Delaware and Permian Basins.

On August 3, 2010, Chesapeake Midstream Partners, L.P. (NYSE: CHKM) completed an initial public offering of 24,437,500 common units (including 3,187,500 common units issued pursuant to the exercise of the underwriters’ over-allotment option on August 3, 2010) representing limited partner interests and received gross offering proceeds of approximately $513 million at an initial offering price of $21.00 per unit less approximately $38 million for underwriting discounts and commissions, structuring fees and offering expenses. Common units owned by public security holders represent 17.7% of all outstanding limited partner interests, and Chesapeake and GIP hold 42.3% and 40.0%, respectively, of all outstanding limited partner interests. The limited partners, collectively, have a 98.0% interest in CHKM and the general partner, which is owned and controlled 50/50 by Chesapeake and GIP, has a 2.0% interest in CHKM.

During the Current Quarter, we recorded positive equity method adjustments of $17 million for our share of CHKM’s income and recorded accretion adjustments of $3 million for our share of equity in excess of cost. In addition, in the Current Quarter, we received a cash distribution of $20 million from CHKM. The carrying value of our investment in CHKM is less than our underlying equity in net assets by approximately $234 million as of March 31, 2011. This difference is being accreted over 20 years.

Frac Tech Holdings, LLC. Frac Tech Holdings, LLC, a private company based in Fort Worth, Texas, provides hydraulic fracturing and other services to oil and gas companies. In the Current Quarter, we recorded positive equity method adjustments of $38 million for our share of Frac Tech’s income and recorded depreciation adjustments of $8 million for our cost in excess of equity. The carrying value of our investment in Frac Tech is in excess of our underlying equity in net assets by approximately $200 million as of March 31, 2011. This excess amount is attributed to certain intangibles associated with the specialty services provided by Frac Tech and is being amortized over the estimated life of the intangibles.

Chaparral Energy, Inc. Chaparral Energy, Inc., based in Oklahoma City, Oklahoma, is a private independent oil and natural gas company engaged in the production, acquisition and exploitation of oil and natural gas properties. In the Current Quarter, we recorded negative equity method adjustments of $2 million for our share of Chaparral’s net loss and depreciation adjustments of $1 million for our cost in excess of equity. The carrying value of our investment in Chaparral is in excess of our underlying equity in net assets by approximately $58 million as of March 31, 2011. This excess is attributed to the natural gas and oil reserves held by Chaparral and is being amortized over the estimated life of these reserves based on a unit of production rate. We recently announced our intention to monetize our 20% interest in Chaparral Energy, Inc.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Monetization of this investment is subject to changes in market conditions and other factors, and we may not complete the transaction in the expected time frame or at all.

Gastar Exploration Ltd. Gastar Exploration Ltd. (NYSE Amex: GST), based in Houston, Texas, is an independent energy company engaged in the exploration, development and production of natural gas and oil in the U.S. During the Current Quarter, the common stock price of Gastar increased from $4.30 per share to $4.86 per share. Our investment in Gastar had a historical cost basis of $89 million as of March 31, 2011.

 

10.

Fair Value Measurements

Certain financial instruments are reported at fair value on the condensed consolidated balance sheets. Under fair value measurement accounting guidance, fair value is defined as the amount that would be received from the sale of an asset or paid for the transfer of a liability in an orderly transaction between market participants, i.e., an exit price. To estimate an exit price, a three-level hierarchy is used. The fair value hierarchy prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or a liability, into three levels. Level 1 inputs are unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 2 inputs are inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the financial asset or liability and have the lowest priority. Chesapeake uses a market valuation approach based on available inputs and the following methods and assumptions to measure the fair values of its assets and liabilities, which may or may not be observable in the market.

Cash Equivalents. The fair value of cash equivalents is based on quoted market prices.

Investments. The fair value of Chesapeake’s investment in Gastar Exploration Ltd. common stock is based on a quoted market price.

Other Long-Term Assets and Liabilities. The fair value of other long-term assets and liabilities, consisting of obligations under our deferred compensation plan, is based on quoted market prices.

Derivatives. The fair values of our commodity derivatives, interest rate swaps and foreign currency swaps are based on third-party pricing models which utilize inputs that are either readily available in the public market, such as natural gas and oil forward curves and discount rates, or can be corroborated from active markets or broker quotes. These values are then compared to the values given by our counterparties for reasonableness. Since commodity, interest rate and foreign currency swaps do not include optionality and therefore have no unobservable inputs, they are classified as Level 2. All other derivatives have some level of unobservable input, such as volatility curves, and are therefore classified as Level 3. For interest rate options and swaptions, we use the fair value estimates provided by our respective counterparties, which are classified as Level 3 inputs. These values are reviewed internally for reasonableness using future interest rate curves and time to maturity. Derivatives are also subject to the risk that counterparties will be unable to meet their obligations. We factor non-performance risk into the valuation of our derivatives using current published credit default swap rates. To date this has not had a material impact on the values of our derivatives.

Debt. The fair value of certain of our long-term debt is based on the face amount of that debt along with the value of related qualifying interest rate swaps, which are reported at Level 2.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The following table provides fair value measurement information for financial assets (liabilities) measured at fair value on a recurring basis as of March 31, 2011:

 

     Quoted
Prices in
Active
Markets
(Level 1)
    Significant
Other
Observable
Inputs
(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
    Total Fair Value  
     ($ in millions)  

Financial Assets (Liabilities):

        

Cash equivalents

   $ 849      $      $      $ 849   

Investments

     33                      33   

Other long-term assets

     56                      56   

Long-term debt

            (1,421       (1,421

Other long-term liabilities

     (56                   (56

Derivatives:

        

Commodity assets

            677        101        778   

Commodity liabilities

            (140     (2,884     (3,024

Interest rate liabilities

            (79            (79

Foreign currency liabilities

            (7            (7
                                

Total derivatives

            451        (2,783     (2,332
                                

Total

   $                   882      $               (970   $             (2,783   $               (2,871
                                

The following table provides fair value measurement information for financial assets (liabilities) measured at fair value on a recurring basis as of December 31, 2010:

 

     Quoted
Prices in
Active
Markets
(Level 1)
    Significant
Other
Observable
Inputs
(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
    Total Fair Value  
     ($ in millions)  

Financial Assets (Liabilities):

        

Cash equivalents

   $                   102      $      $      $ 102   

Investments

     29                      29   

Other long-term assets

     52                      52   

Long-term debt

                   (1,371     (1,371

Other long-term liabilities

     (52                   (52

Derivatives:

        

Commodity assets

            1,364        105        1,469   

Commodity liabilities

            (59     (2,059     (2,118

Interest rate liabilities

                   (69     (69

Foreign currency liabilities

                   (43     (43
                                

Total derivatives

            1,305        (2,066     (761
                                

Total

   $ 131      $               1,305      $             (3,437   $               (2,001
                                

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

A summary of the changes in Chesapeake’s assets (liabilities) classified as Level 3 measurements during the Current Quarter and the Prior Quarter is presented below:

 

     Derivatives        
     Commodity     Interest
Rate
    Foreign
Currency
    Debt  
     ($ in millions)  

Beginning Balance as of January 1, 2011

   $ (1,954   $ (69   $ (43   $ (1,371

Total gains (losses):

        

Included in earnings (realized)(a)

     6                        

Included in earnings or change in net assets (unrealized)(a)

     (879     16                 

Included in other comprehensive income (loss)

                            

Total purchases, issuances, sales and settlements:

        

Settlements

     44        (1              

Transfers in and out of Level 3(c)

            54        43        1,371   
                                

Ending Balance as of March 31, 2011

   $ (2,783   $      $      $   
                                

Beginning Balance as of January 1, 2010

   $ (666   $ (132   $ 43      $ (1,398

Total gains (losses):

        

Included in earnings (realized)(a)

     103        (2              

Included in earnings or change in net assets (unrealized)(a)

     (18     35        (48     40   

Included in other comprehensive income (loss)

     6               2          

Total purchases, issuances, sales and settlements:

        

Purchases

     53                        

Issuances

                          (450 )(b) 

Sales

     (78     (1              

Settlements

     (60     3               550 (b) 

Transfers in and out of Level 3

                            
                                

Ending Balance as of March 31, 2010

   $         (660   $             (97   $               (3   $         (1,258
                                

 

(a)

Amounts related to commodity derivatives are included in natural gas and oil sales, and amounts related to interest rate and foreign currency derivatives and debt are included in interest expense.

 

(b)

Amount represents a(n) (increase)/decrease in debt recorded at fair value as a result of new or terminated interest rate swaps.

 

(c)

The values related to interest rate and foreign currency swaps were transferred from Level 3 to Level 2 as a result of our ability to use data readily available in the public market to corroborate our estimated fair values.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Fair Value of Other Financial Instruments

The following disclosure of the estimated fair value of financial instruments is made in accordance with accounting guidance for financial instruments. We have determined the estimated fair values by using available market information and valuation methodologies. Considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts.

The carrying values of financial instruments comprising current assets and current liabilities approximate fair values due to the short-term maturities of these instruments. We estimate the fair value of our long-term debt and our convertible preferred stock primarily using quoted market prices. Fair value is compared to the carrying value, excluding the impact of interest rate derivatives, in the table below.

 

     March 31, 2011      December 31, 2010  
     Carrying
    Amount    
     Estimated
    Fair Value    
         Carrying    
Amount
     Estimated
    Fair Value    
 
     ($ in millions)  

Long-term debt

   $         9,910       $         11,608       $         12,631       $         13,272   

Convertible preferred stock

   $ 3,065       $ 3,072       $ 3,065       $ 3,019   

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

11.

Condensed Consolidating Financial Information

Chesapeake Energy Corporation is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. Our obligations under our outstanding senior notes and contingent convertible senior notes listed in Note 6 are fully and unconditionally guaranteed, jointly and severally, by certain of our wholly owned subsidiaries on a senior unsecured basis. Our midstream subsidiary, CMD, is not a guarantor and is subject to covenants in the midstream revolving bank credit facility referred to in Note 6 that restrict it from paying dividends or distributions or making loans to Chesapeake.

Set forth below are condensed consolidating financial statements for Chesapeake Energy Corporation (parent) on a stand-alone, unconsolidated basis, and its combined guarantor and combined non-guarantor subsidiaries as of March 31, 2011 and December 31, 2010 and for the three months ended March 31, 2011 and 2010. The financial information may not necessarily be indicative of results of operations, cash flows or financial position had the subsidiaries operated as independent entities.

CONDENSED CONSOLIDATING BALANCE SHEET

AS OF MARCH 31, 2011

($ in millions)

 

         Parent         Guarantor
Subsidiaries
     Non-
Guarantor
 Subsidiaries 
     Eliminations     Consolidated  

CURRENT ASSETS:

            

Cash and cash equivalents

   $      $ 785       $ 64       $      $ 849   

Other

     8        2,569         144         (26     2,695   
                                          

Total Current Assets

     8        3,354         208         (26     3,544   
                                          

PROPERTY AND EQUIPMENT:

            

Natural gas and oil properties, at cost based on full-cost accounting, net

            25,191         4                25,195   

Other property and equipment, net

            3,334         1,180                4,514   
                                          

Total Property and Equipment, Net

            28,525         1,184                29,709   
                                          

Other assets

     189        656         702                1,547   

Investments in subsidiaries and intercompany advances

     1,157        276                 (1,433       
                                          

TOTAL ASSETS

   $ 1,354      $ 32,811       $ 2,094       $ (1,459   $ 34,800   
                                          

CURRENT LIABILITIES:

            

Current liabilities

   $ 228      $ 4,249       $ 218       $ (26   $ 4,669   

Intercompany payable (receivable) from parent

     (24,317     22,756         1,446         115          
                                          

Total Current Liabilities

     (24,089     27,005         1,664         89        4,669   
                                          

LONG-TERM LIABILITIES:

            

Long-term debt, net

     9,915                               9,915   

Deferred income tax liabilities

     466        1,620         144         (115     2,115   

Other liabilities

     67        3,029         10                3,106   
                                          

Total Long-Term Liabilities

     10,448        4,649         154         (115     15,136   
                                          

STOCKHOLDERS’ EQUITY:

            
                                          

Total Stockholders’ Equity

     14,995        1,157         276         (1,433     14,995   
                                          

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,354      $ 32,811       $ 2,094       $ (1,459   $ 34,800   
                                          

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING BALANCE SHEET

AS OF DECEMBER 31, 2010

($ in millions)

 

         Parent         Guarantor
Subsidiaries
     Non-
Guarantor
 Subsidiaries 
     Eliminations     Consolidated  

CURRENT ASSETS:

            

Cash and cash equivalents

   $      $ 2       $ 100       $      $ 102   

Other

     7        3,065         123         (31     3,164   
                                          

Total Current Assets

     7        3,067         223         (31     3,266   
                                          

PROPERTY AND EQUIPMENT:

            

Natural gas and oil properties, at cost based on full-cost accounting, net

            27,822         4                27,826   

Other property and equipment, net

            3,246         1,306                4,552   
                                          

Total Property and Equipment, Net

            31,068         1,310                32,378   
                                          

Other assets

     166        669         700                1,535   

Investments in subsidiaries and intercompany advances

     1,217        269                 (1,486       
                                          

TOTAL ASSETS

   $ 1,390      $ 35,073       $ 2,233       $ (1,517   $ 37,179   
                                          

CURRENT LIABILITIES:

            

Current liabilities

   $ 302      $ 4,082       $ 137       $ (31   $ 4,490   

Intercompany payable (receivable) from parent

     (23,664     21,955         1,596         113          
                                          

Total Current Liabilities

     (23,362     26,037         1,733         82        4,490   
                                          

LONG-TERM LIABILITIES:

            

Long-term debt, net

     8,934        3,612         94                12,640   

Deferred income tax liabilities

     482        1,885         130         (113     2,384   

Other liabilities

     72        2,322         7                2,401   
                                          

Total Long-Term Liabilities

     9,488        7,819         231         (113     17,425   
                                          

STOCKHOLDERS’ EQUITY:

            
                                          

Total Stockholders’ Equity

     15,264        1,217         269         (1,486     15,264   
                                          

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,390      $ 35,073       $ 2,233       $ (1,517   $ 37,179   
                                          

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2011

($ in millions)

 

     Parent     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Natural gas and oil sales

   $      $ 494      $      $      $ 494   

Marketing, gathering and compression sales

            991        55        (29     1,017   

Service operations revenue

            101                      101   
                                        

Total Revenues

            1,586        55        (29     1,612   
                                        

OPERATING COSTS:

          

Production expenses

            238                      238   

Production taxes

            45                      45   

General and administrative expenses

            121        9               130   

Marketing, gathering and compression expenses

            968        39        (22     985   

Service operations expense

            77                      77   

Natural gas and oil depreciation, depletion and amortization

            358                      358   

Depreciation and amortization of other assets

            56        12               68   

(Gains) losses on sales of other property and equipment

            2        (7            (5
                                        

Total Operating Costs

            1,865        53        (22     1,896   
                                        

INCOME (LOSS) FROM OPERATIONS

            (279     2        (7     (284
                                        

OTHER INCOME (EXPENSE):

          

Interest expense

     (183     (1            177        (7

Earnings from equity investees

            6        19               25   

Losses on redemptions or exchanges of debt

     (2                          (2

Other income

               177        1        1        (177     2   

Equity in net earnings of subsidiary

     (157     9               148          
                                        

Total Other Income (Expense)

     (165     15        20        148        18   
                                        

INCOME (LOSS) BEFORE INCOME TAXES

     (165     (264     22        141        (266

INCOME TAX EXPENSE (BENEFIT)

     (3     (107     9        (3     (104
                                        

NET INCOME (LOSS)

   $ (162   $ (157   $ 13      $ 144      $ (162
                                        

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2010

($ in millions)

 

     Parent     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

REVENUES:

          

Natural gas and oil sales

   $      $ 1,898      $      $      $ 1,898   

Marketing, gathering and compression sales

            813        48        (17     844   

Service operations revenue

            56                      56   
                                        

Total Revenues

            2,767        48        (17     2,798   
                                        

OPERATING COSTS:

          

Production expenses

            207                      207   

Production taxes

            48                      48   

General and administrative expenses

            104        5               109   

Marketing, gathering and compression expenses

            793        22               815   

Service operations expense

            49                      49   

Natural gas and oil depreciation, depletion and amortization

            308                      308   

Depreciation and amortization of other assets

            40        10               50   

(Gains) losses on sales of other property and equipment

                                   
                                        

Total Operating Costs

            1,549        37               1,586   
                                        

INCOME (LOSS) FROM OPERATIONS

            1,218        11        (17     1,212   
                                        

OTHER INCOME (EXPENSE):

          

Interest expense

     (159     (57     (1     192        (25

Earnings (losses) from equity investees

            (8     21               13   

Losses on redemptions or exchanges of debt

     (2                          (2

Other income

     192        2               (192     2   

Equity in net earnings of subsidiary

               719        9               (728       
                                        

Total Other Income (Expense)

     750        (54     20        (728     (12
                                        

INCOME (LOSS) BEFORE INCOME TAXES

     750        1,164        31        (745     1,200   

INCOME TAX EXPENSE (BENEFIT)

     12        445        12        (7     462   
                                        

NET INCOME (LOSS)

   $ 738      $ 719      $ 19      $ (738   $ 738   
                                        

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

THREE MONTHS ENDED MARCH 31, 2011

($ in millions)

 

     Parent     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

CASH FLOWS FROM OPERATING ACTIVITIES

   $      $ 905      $ 61      $ (225   $ 741   
                                        

CASH FLOWS FROM INVESTING ACTIVITIES:

          

Additions to natural gas and oil properties

            (2,973                   (2,973

Proceeds from divestitures of proved and unproved properties

            5,182                      5,182   

Additions to other property and equipment

            (180     (251            (431

Other investing activities

            (8     373        60        425   
                                        

Cash provided by (used in) investing activities

            2,021        122        60        2,203   
                                        

CASH FLOWS FROM FINANCING ACTIVITIES:

          

Proceeds from credit facilities borrowings

            3,202        415               3,617   

Payments on credit facilities borrowings

            (6,814     (509            (7,323

Proceeds from issuance of senior notes, net of offering costs

               977                             977   

Cash paid to redeem debt

     (128                          (128

Other financing activities

     (120     760        (145     165        660   

Intercompany advances, net

     (729     709        20                 
                                        

Cash provided by (used in) financing activities

            (2,143     (219     165        (2,197
                                        

Net increase (decrease) in cash and cash equivalents

            783        (36            747   

Cash and cash equivalents, beginning of period

            2        100               102   
                                        

Cash and cash equivalents, end of period

   $      $ 785      $ 64      $      $ 849   
                                        

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

THREE MONTHS ENDED MARCH 31, 2010

($ in millions)

 

     Parent     Guarantor
Subsidiaries
    Non-
Guarantor
Subsidiaries
    Eliminations      Consolidated  

CASH FLOWS FROM OPERATING ACTIVITIES

   $      $ 1,123      $ 60      $       $ 1,183   
                                         

CASH FLOWS FROM INVESTING ACTIVITIES:

           

Additions to natural gas and oil properties

            (2,050                    (2,050

Proceeds from divestitures of proved and unproved properties

            1,224                       1,224   

Additions to other property and equipment

            (123     (156             (279

Other investing activities

            39        52                91   
                                         

Cash provided by (used in) investing activities

            (910     (104             (1,014
                                         

CASH FLOWS FROM FINANCING ACTIVITIES:

           

Proceeds from credit facilities borrowings

            2,817        107                2,924   

Payments on credit facilities borrowings

            (2,874     (70             (2,944

Other financing activities

     (78     136        2                60   

Intercompany advances, net

     78        (69     (9               
                                         

Cash provided by (used in) financing activities

            10        30                40   
                                         

Net increase (decrease) in cash and cash equivalents

            223        (14             209   

Cash and cash equivalents, beginning of period

            293        14                307   
                                         

Cash and cash equivalents, end of period

   $                 —      $ 516      $      $       $ 516   
                                         

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

12.

Recently Issued and Proposed Accounting Standards

The Financial Accounting Standards Board (FASB) recently issued guidance requiring additional disclosures for the reconciliation of purchases, sales, issuance and settlements of financial instruments valued with a Level 3 method effective beginning on January 1, 2011. We adopted this guidance in the Current Quarter. Adoption had no impact on our financial position or results of operations. See Note 10 for discussion regarding fair value measurements.

 

13.

Subsequent Events

On April 14, 2011, we entered into an agreement and plan of merger to acquire, and have commenced a cash tender offer to purchase, all of the outstanding shares of Bronco Drilling Company, Inc. (NASDAQ: BRNC) for $11.00 a share. The cash tender offer will expire on May 23, 2011, unless extended. If the offer is successful, Chesapeake, through an indirect wholly owned subsidiary, will acquire any remaining Bronco shares in a later merger for $11.00 per share in cash. We anticipate that we will need approximately $315 million to purchase Bronco shares acquired in the tender offer, to pay the merger consideration for remaining Bronco shares not acquired in the cash tender offer, including shares issuable under an outstanding stock purchase warrant, and to pay related fees and expenses. The acquisition includes 22 high-quality drilling rigs, primarily operating in the Williston and Anadarko Basins, and has support from Bronco’s two largest shareholders, who collectively own 32% of Bronco’s stock.

On May 2 and 3, 2011, we completed and settled tender offers to purchase the following senior notes and contingent convertible senior notes in order to reduce the amount of our outstanding indebtedness. We funded the purchase of the notes with a portion of the net proceeds we received from the sale of our Fayetteville Shale assets.

 

     Amount
      Tendered     
 
     ($ in millions)  

7.625% senior notes due 2013

   $ 36   

6.25% euro-denominated senior notes due 2017(a)

     363   

6.875% senior notes due 2018

     126   

7.25% senior notes due 2018

     131   

6.625% senior notes due 2020

     100   

2.75% contingent convertible senior notes due 2035

     55   

2.5% contingent convertible senior notes due 2037

     210   

2.25% contingent convertible senior notes due 2038

     266   
        
   $ 1,287   
        

 

(a)

We purchased 256 million of our euro-denominated senior notes which had a value of $363 million as of March 31, 2011, based on the exchange rate of $1.4183 to 1.00. Simultaneously with our purchase of the euro-denominated senior notes, we unwound foreign currency swaps for the same principal amount as the notes.

Also, we have offered to purchase $138 million of our 9.5% Senior Notes due 2015 and $439 million of our 6.5% Senior Notes due 2017 pursuant to tender offers which will expire on May 13, 2011.

Associated with the completed and pending tender offers described above, we expect to record a loss of approximately $185 million in the second quarter of 2011.

 

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Through a recently disclosed recapitalization of Frac Tech Holdings, LLC, on May 6, 2011, we received a cash distribution of approximately $200 million and now own 30% of the equity of a newly formed holding company of Frac Tech, Frac Tech International, LLC, up from our approximately 26% ownership prior to the recapitalization. In connection with the recapitalization, we have entered into a Master Frac Services Agreement that obligates us to use certain Frac Tech services through 2014, which services will be provided on market terms and at market rates.

 

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ITEM 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

The following table sets forth certain information regarding the production volumes, natural gas and oil sales, average sales prices received, other operating income and expenses for the three months ended March 31, 2011 (the “Current Quarter”) and the three months ended March 31, 2010 (the “Prior Quarter”):

 

         Three Months Ended    
March 31,
 
     2011     2010  

Net Production:

    

Natural gas (bcf)

     243.3        209.6   

Oil (mmbbl)(a)

     6.0        3.9   

Natural gas equivalent (bcfe)(b)

     279.6        232.8   

Natural Gas and Oil Sales ($ in millions):

    

Natural gas sales

   $ 788      $ 942   

Natural gas derivatives – realized gains (losses)

     505        379   

Natural gas derivatives – unrealized gains (losses)

     (549     415   
                

Total natural gas sales

     744        1,736   
                

Oil sales(a)

     400        242   

Oil derivatives – realized gains (losses)

     (17     20   

Oil derivatives – unrealized gains (losses)

     (633     (100
                

Total oil sales

     (250     162   
                

Total natural gas and oil sales

   $ 494      $ 1,898   
                

Average Sales Price (excluding all gains (losses) on derivatives):

    

Natural gas ($ per mcf)

   $ 3.24      $ 4.50   

Oil ($ per bbl)(a)

   $ 66.08      $ 62.59   

Natural gas equivalent ($ per mcfe)

   $ 4.25      $ 5.09   

Average Sales Price (excluding unrealized gains (losses) on derivatives):

    

Natural gas ($ per mcf)

   $ 5.31      $ 6.31   

Oil ($ per bbl)(a)

   $ 63.20      $ 67.70   

Natural gas equivalent ($ per mcfe)

   $ 5.99      $ 6.80   

Other Operating Income(c ) ($ in millions):

    

Marketing, gathering and compression net margin

   $ 32      $ 29   

Service operations net margin

   $ 24      $ 7   

Other Operating Income(c) ($ per mcfe):

    

Marketing, gathering and compression net margin

   $ 0.11      $ 0.12   

Service operations net margin

   $ 0.09      $ 0.03   

Expenses ($ per mcfe):

    

Production expenses

   $ 0.85      $ 0.89   

Production taxes

   $ 0.16      $ 0.21   

General and administrative expenses

   $ 0.46      $ 0.47   

Natural gas and oil depreciation, depletion and amortization

   $ 1.28      $ 1.32   

Depreciation and amortization of other assets

   $ 0.24      $</