Derivative and Hedging Activities

Chesapeake uses derivative instruments to secure attractive pricing and margins on its share of expected production, to reduce its exposure to fluctuations in future commodity prices and to protect its expected operating cash flow against significant market movements or volatility. Chesapeake also uses derivative instruments to mitigate a portion of its exposure to foreign currency exchange rate fluctuations. All of our commodity 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.

Oil, Natural Gas and NGL Derivatives

As of September 30, 2016 and December 31, 2015, our oil, natural gas and NGL 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. In exchange for higher fixed prices on certain of our swap trades, we granted options that allow the counterparty to double the notional amount.

•

Options: Chesapeake sells, and occasionally buys, call options in exchange for a premium. At the time of settlement, if the market price exceeds the fixed price of the call option, Chesapeake pays the counterparty the excess on sold call options and Chesapeake receives the excess on bought call options. If the market price settles below the fixed price of the call option, no payment is due from either party.


•	Collars: These instruments contain a fixed floor price (put) and ceiling price (call). If the market price exceeds the call strike price or falls below the put strike price, Chesapeake receives the fixed price and pays the market price. If the market price is between the put and the call strike prices, no payments are due from either party.


•	Basis Protection Swaps: These instruments are arrangements that guarantee a fixed price differential to NYMEX from a specified delivery point. Chesapeake receives the fixed price differential and pays the floating market price differential to the counterparty for the hedged commodity.

The estimated fair values of our oil, natural gas and NGL derivative instrument assets (liabilities) as of September 30, 2016 and December 31, 2015 are provided below.



	September 30, 2016				December 31, 2015
	Volume	Fair Value			Volume	Fair Value
		($ in millions)				($ in millions)
Oil (mmbbl):
Fixed-price swaps	21.8	$	(49	)	13.5	$	144
Call options	8.7	(2		)	19.2	(7		)
Total oil	30.5	(51		)	32.7	137

Natural gas (tbtu):
Fixed-price swaps	640	(43		)	500	229
Collars	38	1			—	—
Call options	160	(26		)	295	(99		)
Basis protection swaps	44	1			57	—
Total natural gas	882	(67		)	852	130

NGL (mmgal):
Fixed-price swaps	36	(3		)	—	—

Total estimated fair value		$	(121	)		$	267

We have terminated certain commodity derivative contracts that were previously designated as cash flow hedges for which the hedged production is still expected to occur. See further discussion below under Effect of Derivative Instruments – Accumulated Other Comprehensive Income (Loss).

Interest Rate Derivatives

As of September 30, 2016 and December 31, 2015, there were no interest rate derivatives outstanding.

We have terminated fair value hedges related to certain of our 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 four years, we will recognize $6 million in net gains related to these transactions.

Foreign Currency Derivatives

We are party to cross currency swaps to mitigate our exposure to foreign currency exchange rate fluctuations. In the Current Quarter, in connection with our tender offers, we retired €36 million in aggregate principal amount of our 6.25% Euro-denominated Senior Notes due 2017, and we simultaneously unwound the cross currency swaps for the same principal amount at a cost of $8 million. Under the terms of the remaining cross currency swaps, on each semi-annual interest payment date, the counterparties pay us €8 million and we pay the counterparties $13 million, which yields an annual dollar-equivalent interest rate of 7.491%. Upon maturity of the notes, the counterparties will pay us €266 million and we will pay the counterparties $355 million. The terms of the cross currency swaps were based on the dollar/euro exchange rate on the issuance date of $1.3325 to €1.00. The swaps are designated as cash flow hedges and, because they are entirely effective in having eliminated any potential variability in our expected cash flows related to changes in foreign exchange rates, changes in their fair value do not impact earnings. The fair values of the cross currency swaps are recorded on the condensed consolidated balance sheets as liabilities of $56 million and $52 million as of September 30, 2016 and December 31, 2015, respectively. The euro-denominated debt in long-term debt has been adjusted to $299 million as of September 30, 2016, using an exchange rate of $1.1235 to €1.00.

Supply Contract Derivatives

From time to time and in the normal course of business, our marketing subsidiary enters into supply contracts under which we commit to deliver a predetermined quantity of natural gas to certain counterparties in an attempt to earn attractive margins. Under certain contracts, we receive a sales price that is based on the price of a product other than natural gas, thereby creating an embedded derivative requiring bifurcation. In one of these supply contracts, we were committed to supply a minimum of 90 bbtu per day of natural gas through March 2025. In the Current Quarter, we sold the long-term natural gas supply contract to a third party for cash proceeds of $146 million, which is included in marketing, gathering and compression revenues as a realized gain. We reversed the cumulative unrealized gains, resulting in an unrealized loss of $280 million in the Current Quarter and $297 million in the Current Period, respectively.

Effect of Derivative Instruments – Condensed Consolidated Balance Sheets

The following table presents the fair value and location of each classification of derivative instrument included in the condensed consolidated balance sheets as of September 30, 2016 and December 31, 2015 on a gross basis and after same-counterparty netting:



Balance Sheet Classification	Gross Fair Value			Amounts Netted in Condensed Consolidated Balance Sheet			Net Fair Value Presented in Condensed Consolidated Balance Sheet
	($ in millions)
As of September 30, 2016
Commodity Contracts:
Short-term derivative asset	$	31		$	(31	)	$	—
Short-term derivative liability	(135		)	31			(104		)
Long-term derivative asset	1			(1		)	—
Long-term derivative liability	(18		)	1			(17		)
Total commodity contracts	(121		)	—			(121		)
Foreign Currency Contracts:^(a)
Short-term derivative liability	(56		)	—			(56		)
Total foreign currency contracts	(56		)	—			(56		)
Total derivatives	$	(177	)	$	—		$	(177	)

As of December 31, 2015
Commodity Contracts:
Short-term derivative asset	$	381		$	(66	)	$	315
Short-term derivative liability	(106		)	66			(40		)
Long-term derivative liability	(8		)	—			(8		)
Total commodity contracts	267			—			267
Foreign Currency Contracts:^(a)
Long-term derivative liability	(52		)	—			(52		)
Total foreign currency contracts	(52		)	—			(52		)
Supply Contracts:
Short-term derivative asset	51			—			51
Long-term derivative asset	246			—			246
Total supply contracts	297			—			297
Total derivatives	$	512		$	—		$	512

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(a)	Designated as cash flow hedging instruments.

As of September 30, 2016 and December 31, 2015, we did not have any cash collateral balances for these derivatives.

Effect of Derivative Instruments – Condensed Consolidated Statements of Operations

The components of oil, natural gas and NGL revenues for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period are presented below.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
	($ in millions)
Oil, natural gas and NGL revenues	$	1,048		$	1,136		$	2,744		$	3,782
Gains (losses) on undesignated oil, natural gas and NGL derivatives	136			234			(110		)	369
Losses on terminated cash flow hedges	(7		)	(7		)	(24		)	(29		)
Total oil, natural gas and NGL revenues	$	1,177		$	1,363		$	2,610		$	4,122

The components of marketing, gathering and compression revenues for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period are presented below.



	Three Months Ended September 30,					Nine Months Ended September 30,
	2016			2015		2016			2015
	($ in millions)
Marketing, gathering and compression revenues	$	1,379		$	1,943	$	3,538		$	5,703
Gains (losses) on undesignated supply contract derivatives	(280		)	70		(297		)	290
Total marketing, gathering and compression revenues	$	1,099		$	2,013	$	3,241		$	5,993

The components of interest expense for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period are presented below.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
	($ in millions)
Interest expense on senior notes	$	114		$	171		$	336		$	513
Amortization of loan discount, issuance costs and other	9			14			27			37
Interest expense on revolving credit facility	10			2			27			8
Gains on terminated fair value hedges	(1		)	—			(2		)	(2		)
Gains on undesignated interest rate derivatives	—			—			—			(10		)
Capitalized interest	(59		)	(99		)	(191		)	(336		)
Total interest expense	$	73		$	88		$	197		$	210

Effect of Derivative Instruments – Accumulated Other Comprehensive Income (Loss)

A reconciliation of the changes in accumulated other comprehensive income (loss) in our condensed consolidated statements of stockholders’ equity related to our cash flow hedges is presented below.



	Three Months Ended September 30,
	2016						2015
	Before Tax			After Tax			Before Tax			After Tax
	($ in millions)
Balance, beginning of period	$	(163	)	$	(104	)	$	(211	)	$	(131	)
Net change in fair value	(4		)	(4		)	12			7
Losses reclassified to income	7			7			7			5
Balance, end of period	$	(160	)	$	(101	)	$	(192	)	$	(119	)

	Nine Months Ended September 30,
	2016						2015
	Before Tax			After Tax			Before Tax			After Tax
	($ in millions)
Balance, beginning of period	$	(160	)	$	(99	)	$	(231	)	$	(143	)
Net change in fair value	(23		)	(23		)	10			6
Losses reclassified to income	23			21			29			18
Balance, end of period	$	(160	)	$	(101	)	$	(192	)	$	(119	)

Approximately $92 million of the $101 million of accumulated other comprehensive loss as of September 30, 2016 represents the net deferred loss associated with commodity derivative contracts that were previously designated as cash flow hedges for which the hedged production is still expected to occur. Deferred gain or loss amounts will be recognized in earnings in the month in which the originally forecasted hedged production occurs. As of September 30, 2016, we expect to transfer approximately $22 million of net loss included in accumulated other comprehensive income to net income (loss) during the next 12 months. The remaining amounts will be transferred by December 31, 2022.

Credit Risk Considerations

Our derivative instruments expose us to our counterparties’ credit risk. To mitigate this risk, we enter into derivative contracts only with counterparties that are rated investment grade and deemed by management to be competent and competitive market makers, and we attempt to limit our exposure to non-performance by any single counterparty. As of September 30, 2016, our oil, natural gas and NGL and foreign currency derivative instruments were spread among 13 counterparties.

Hedging Arrangements

In 2015, we began entering into bilateral hedging agreements. The counterparties’ and our obligations under certain of the bilateral hedging agreements must be secured by cash or letters of credit to the extent that any mark-to-market amounts owed to us or by us exceed defined thresholds. In 2016, certain of our counterparties that are also lenders under our revolving credit facility entered into derivative contracts to be secured by the same collateral that secures the revolving credit facility. This will allow us to reduce any letters of credit posted as security with those counterparties.

Fair Value

The fair value of our derivatives is based on third-party pricing models which utilize inputs that are either readily available in the public market, such as oil, natural gas and NGL forward curves and discount rates, or can be corroborated from active markets or broker quotes. These values are compared to the values given by our counterparties for reasonableness. Since oil, natural gas, NGL, interest rate and cross currency swaps do not include optionality and therefore generally 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. Derivatives are also subject to the risk that either party to a contract will be unable to meet its 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.

The following table provides information for financial assets (liabilities) measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015:



	Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Total Fair Value
			($ in millions)
As of September 30, 2016
Derivative Assets (Liabilities):
Commodity assets	$	—	$	32		$	—		$	32
Commodity liabilities	—		(123		)	(30		)	(153		)
Foreign currency liabilities	—		(56		)	—			(56		)
Total derivatives	$	—	$	(147	)	$	(30	)	$	(177	)

As of December 31, 2015
Derivative Assets (Liabilities):
Commodity assets	$	—	$	372		$	9		$	381
Commodity liabilities	—		(14		)	(100		)	(114		)
Foreign currency liabilities	—		(52		)	—			(52		)
Supply contract assets	—		—			297			297
Total derivatives	$	—	$	306		$	206		$	512

A summary of the changes in the fair values of Chesapeake’s financial assets (liabilities) classified as Level 3 during the Current Period and the Prior Period is presented below.



	Commodity Derivatives			Supply Contracts
	($ in millions)
Beginning balance as of December 31, 2015	$	(91	)	$	297
Total gains (losses) (realized/unrealized):
Included in earnings^(a)	12			(118		)
Total purchases, issuances, sales and settlements:
Settlements	49			(33		)
Sales	—			(146		)
Ending balance as of September 30, 2016	$	(30	)	$	—

Beginning balance as of December 31, 2014	$	(54	)	$	1
Total gains (losses) (realized/unrealized):
Included in earnings^(a)	99			281
Total purchases, issuances, sales and settlements:
Settlements	(122		)	9
Ending balance as of September 30, 2015	$	(77	)	$	291

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(a)	Oil, Natural Gas and NGL Sales					Marketing, Gathering and Compression Revenue
	Oil, Natural Gas and NGL Sales					Marketing, Gathering and Compression Revenue
	2016			2015		2016			2015
	($ in millions)
Total gains (losses) included in earnings for the period	$	12		$	99	$	(118	)	$	281
Change in unrealized gains (losses) related to assets still held at reporting date	$	(1	)	$	72	$	—		$	281

Qualitative and Quantitative Disclosures about Unobservable Inputs for Level 3 Fair Value Measurements

The significant unobservable inputs for Level 3 derivative contracts include unpublished forward prices of natural gas, market volatility and credit risk of counterparties. Changes in these inputs impact the fair value measurement of our derivative contracts. For example, an increase or decrease in the forward prices and volatility of oil and natural gas prices decreases or increases the fair value of oil and natural gas derivatives, and adverse changes to our counterparties’ creditworthiness decreases the fair value of our derivatives. The following table presents quantitative information about Level 3 inputs used in the fair value measurement of our commodity derivative contracts at fair value as of September 30, 2016:



Instrument Type	Unobservable Input	Range	Weighted Average	Fair Value September 30, 2016
				($ in millions)
Oil trades^(a)	Oil price volatility curves	21.09% – 31.73%	29.04%	$	(2	)
Natural gas trades^(a)	Natural gas price volatility curves	21.20% – 59.56%	25.31%	$	(28	)

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(a)	Fair value is based on an estimate derived from option models.