Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
Part II. Other Information
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
Exhibits
EX-2.1
chk-ex_21x20180930x10qutic.htm
EX-31.1
chk-ex_311x20180930x10q.htm
EX-31.2
chk-ex_312x20180930x10q.htm
EX-32.1
chk-ex_321x20180930x10q.htm
EX-32.2
chk-ex_322x20180930x10q.htm
Chesapeake Energy Earnings 2018-09-30
CHK 10Q Quarterly Report
Balance Sheet
Income Statement
Cash Flow
10-Q 1 chk-20180930_10q.htm 10-Q Document
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 September 30, 2018
[ ] 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 every Interactive Data File required to be submitted 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 such files). YES [X] NO [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company" and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Smaller Reporting Company [ ] Emerging Growth Company [ ]
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ]
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 October 25, 2018, there were 913,710,098 shares of our $0.01 par value common stock outstanding.
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2018
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1.
Basis of Presentation
Basis of Presentation
The accompanying condensed consolidated financial statements of Chesapeake were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the rules and regulations of the SEC. Pursuant to such rules and regulations, certain disclosures have been condensed or omitted.
This Form 10-Q relates to the three and nine months ended September 30, 2018 (the “Current Quarter” and the “Current Period”, respectively) and the three and nine months ended September 30, 2017 (the “Prior Quarter” and the “Prior Period”, respectively). Our annual report on Form 10-K for the year ended December 31, 2017 (“2017 Form 10-K”) should be read in conjunction with this Form 10-Q. The accompanying condensed consolidated financial statements reflect all normal recurring adjustments which, in the opinion of management, are necessary for a fair statement of our condensed consolidated financial statements and accompanying notes and include the accounts of our direct and indirect wholly owned subsidiaries and entities in which we have a controlling financial interest. Intercompany accounts and balances have been eliminated.
Recently Issued Accounting Standards
The Financial Accounting Standards Board (FASB) issued Revenue from Contracts with Customers (Topic 606) superseding virtually all existing revenue recognition guidance. We adopted this new standard in the first quarter of 2018 using the modified retrospective approach. We applied the new standard to all contracts that were not completed as of January 1, 2018 and reflected the aggregate effect of all modifications in determining and allocating the transaction price. See Note 10 for further details regarding our adoption of Topic 606.
In February 2018, the FASB issued Accounting Standards Update (ASU) 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The new standard allows for stranded tax effects resulting from tax reform legislation known as the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) previously recognized in accumulated other comprehensive income to be reclassified to retained earnings. For public business entities, the amendments are effective for annual periods, including interim periods within the annual periods, beginning after December 15, 2018. Early adoption is permitted in any interim or annual period, but we do not plan to early adopt. We are currently evaluating the impact of this standard on our consolidated financial statements and related disclosures.
In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815), which makes significant changes to the current hedge accounting guidance. The new standard eliminates the requirement to separately measure and report hedge ineffectiveness and generally requires the entire change in the fair value of a hedging instrument to be presented in the same income statement line as the hedged item. The new standard also eases certain documentation and assessment requirements and modifies the accounting for components excluded from the assessment of hedge effectiveness. The new standard update is effective for annual and interim periods beginning after December 15, 2018, including interim periods within those annual periods. Early adoption is permitted, but we do not plan to early adopt. We are currently evaluating the impact of this standard on our consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which updated lease accounting guidance requiring lessees to recognize most leases, including operating leases, on the balance sheet as a right-of-use asset and lease liability for leases with terms in excess of 12 months. In January 2018, the FASB issued ASU 2018-01 permitting an entity to elect an optional transition practical expedient to not evaluate land easements that existed or expired before the adoption of Topic 842 and were not previously accounted for as leases. In July 2018, the FASB issued ASU 2018-11 to provide an additional transition practical expedient by allowing entities to initially apply the new leases standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. We plan to elect both practical expedients. We plan to adopt the new standard on January 1, 2019 by recognizing a cumulative-effect adjustment to the opening balance of retained earnings. The standard will not apply to our leases of mineral rights. Using the revised framework, we have completed our assessment of lease categories that we believe will be affected by the new standard. We are continuing to assess the accounting treatment for these leases but do not expect the adoption to have significant impacts to our consolidated financial statements or related disclosures.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
2.
Earnings Per Share
Basic earnings per share (EPS) is calculated using the weighted average number of common shares outstanding during the period and includes the effect of any participating securities as appropriate. Participating securities consist of unvested restricted stock issued to our employees and non-employee directors that provide dividend rights.
Diluted EPS is calculated assuming the issuance of common shares for all potentially dilutive securities, provided the effect is not antidilutive. For all periods presented, our contingent convertible senior notes did not have a dilutive effect and, therefore, were excluded from the calculation of diluted EPS. See Note 3 for further discussion of our convertible senior notes and contingent convertible senior notes.
A reconciliation of basic EPS and diluted EPS is as follows:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
(in millions, except per share data)
Net income (loss) available to common stockholders
$
60
$
(41
)
$
288
$
506
Effect of dilutive securities
—
—
—
—
Diluted income (loss) available to common stockholders
$
60
$
(41
)
$
288
$
506
Weighted average common and common equivalent shares outstanding - basic
910
909
909
908
Effect of dilutive securities
1
—
—
—
Weighted average common and common equivalent shares outstanding - diluted
911
909
909
908
Net income per share attributable to Chesapeake:
Basic
$
0.07
$
(0.05
)
$
0.32
$
0.56
Diluted
$
0.07
$
(0.05
)
$
0.32
$
0.56
Shares of common stock for the following securities were excluded from the calculation of diluted EPS as the effect was antidilutive:
Common stock equivalent of our preferred stock outstanding
60
60
60
60
Common stock equivalent of our convertible senior notes outstanding
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
3.
Debt
Our long-term debt consisted of the following as of September 30, 2018 and December 31, 2017:
September 30, 2018
December 31, 2017
Principal
Amount
Carrying Amount
Principal Amount
Carrying Amount
($ in millions)
7.25% senior notes due 2018
$
44
$
44
$
44
$
44
Floating rate senior notes due 2019
380
380
380
380
6.625% senior notes due 2020
437
437
437
437
6.875% senior notes due 2020
227
227
227
227
6.125% senior notes due 2021
548
548
548
548
5.375% senior notes due 2021
267
267
267
267
4.875% senior notes due 2022
451
451
451
451
8.00% senior secured second lien notes due 2022(a)
1,416
1,823
1,416
1,895
5.75% senior notes due 2023
338
338
338
338
7.00% senior notes due 2024
850
850
—
—
8.00% senior notes due 2025
1,300
1,290
1,300
1,290
5.5% convertible senior notes due 2026(b)(c)
1,250
859
1,250
837
7.5% senior notes due 2026
400
400
—
—
8.00% senior notes due 2027
1,300
1,298
1,300
1,298
2.25% contingent convertible senior notes due 2038(b)
9
8
9
8
Term loan due 2021
—
—
1,233
1,233
Revolving credit facility
645
645
781
781
Debt issuance costs
—
(54
)
—
(63
)
Interest rate derivatives
—
1
—
2
Total debt, net
9,862
9,812
9,981
9,973
Less current maturities of long-term debt, net(d)
(433
)
(432
)
(53
)
(52
)
Total long-term debt, net
$
9,429
$
9,380
$
9,928
$
9,921
___________________________________________
(a)
On October 29, 2018, we delivered a notice of redemption to the trustee with respect to 100% of the aggregate principal amount of the outstanding senior secured second lien notes dues 2022.
(b)
We are required to account for the liability and equity components of our convertible debt instruments separately and to reflect interest expense through the first demand repurchase date, as applicable, at the interest rate of similar nonconvertible debt at the time of issuance. The applicable rates for our 2.25% Contingent Convertible Senior Notes due 2038 and our 5.5% Convertible Senior Notes due 2026 are 8.0% and 11.5%, respectively.
(c)
Prior to maturity under certain circumstances and at the holder’s option, the notes are convertible. During the Current Quarter, the price of our common stock was below the threshold level for conversion and, as a result, the holders do not have the option to convert their notes in the fourth quarter of 2018.
(d)
As of September 30, 2018, net current maturities of long-term debt includes our 7.25% Senior Notes due December 2018, our Floating Rate Senior Notes due April 2019, and due to the holders’ put option, our 2.25% Contingent Convertible Notes due December 2038.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
Debt Issuances and Retirements
In the Current Quarter, we issued at par $850 million of 7.00% Senior Notes due 2024 (“2024 notes”) and $400 million of 7.50% Senior Notes due 2026 (“2026 notes”) pursuant to a public offering for net proceeds of $1.230 billion. We used the net proceeds from the senior notes, together with cash on hand and borrowings under our revolving credit facility, to repay in full $1.233 billion of borrowings under our secured term loan due 2021 for $1.285 billion, which included a $52 million call premium. We recorded a loss of approximately $65 million associated with the repayment of the term loan, including the call premium and the write-off of $13 million of associated deferred charges.
We may redeem some or all of the 2024 notes at any time prior to April 1, 2021 and some or all of the 2026 notes at any time prior to October 1, 2021, in each case at a price equal to 100% of the principal amount of the notes to be redeemed plus a “make-whole” premium. At any time prior to April 1, 2021, with respect to the 2024 notes, and October 1, 2021, with respect to the 2026 notes, we also may redeem up to 35% of the aggregate principal amount of each series of notes with an amount of cash not greater than the net cash proceeds of certain equity offerings at a specified redemption price. In addition, we may redeem some or all of the 2024 notes at any time on or after April 1, 2021 and some or all of the 2026 notes at any time on or after October 1, 2021, in each case at the redemption prices in accordance with the terms of the notes and the indenture and supplemental indenture governing the notes. These senior notes are unsecured obligations of Chesapeake and rank equally in right of payment with all of our other existing and future senior unsecured indebtedness and rank senior in right of payment to all of our future subordinated indebtedness. Our obligations under the senior notes are jointly and severally, fully and unconditionally guaranteed by certain of our direct and indirect wholly owned subsidiaries.
In the Prior Period, we retired $1.609 billion principal amount of our outstanding senior notes, senior secured second lien notes and contingent convertible notes through purchases in the open market, tender offers or repayment upon maturity for $1.751 billion. For the open market repurchases and tender offers, we recorded an aggregate net loss of approximately $1 million in the Prior Quarter and an aggregate gain of approximately $183 million in the Prior Period including $260 million of premium associated with our 8.00% Senior Secured Second Lien Notes due 2022.
Revolving Credit Facility
On September 12, 2018, we amended and restated our credit agreement dated December 15, 2014. The amended and restated revolving credit facility matures in September 2023 and the aggregate initial commitment of the lenders and borrowing base under the facility is $3.0 billion. The revolving credit facility provides for an accordion feature, pursuant to which the aggregate commitments thereunder may be increased to up to $4.0 billion from time to time, subject to agreement of the participating lenders and certain other customary conditions. Borrowing base redeterminations will continue to occur semiannually and our next borrowing base redetermination is scheduled for the second quarter of 2019. As of September 30, 2018, we had outstanding borrowings of $645 million under the revolving credit facility and had used $182 million of the revolving credit facility for various letters of credit. We recorded a loss of $3 million associated with certain deferred charges related to the revolving credit facility prior to this amendment.
Borrowings under the revolving credit facility bear interest at an alternative base rate (ABR) or LIBOR, at our election, plus an applicable margin ranging from0.50%-2.00% per annum for ABR loans and 1.50%-3.00% per annum for LIBOR loans, depending on the percentage of the borrowing base then being utilized and whether our leverage ratio exceeds 4.00 to 1.
Our revolving credit facility is subject to various financial and other covenants. The terms of the revolving credit facility include covenants limiting, among other things, our ability to incur additional indebtedness, make investments or loans, incur liens, consummate mergers and similar fundamental changes, make restricted payments, make investments in unrestricted subsidiaries and enter into transactions with affiliates. Our revolving credit facility contains financial covenants that, after a transition period and the suspension of most of the covenants during the fourth quarter of 2018 as a result of the closing of the sale of certain of our Utica Shale properties pursuant to our purchase and sale agreement with EAP Ohio, LLC (“Encino”), requires the Company to maintain (i) a leverage ratio of not more than 5.50 to 1 through the fiscal quarter ending September 30, 2019, which threshold decreases over time to 4.00 to 1 for the fiscal quarter ending March 31, 2021 and each fiscal quarter thereafter, (ii) a secured leverage ratio of not more than 2.50 to 1 until the later of (x) the fiscal quarter ending March 31, 2021 or (y) the fiscal quarter in when the Company’s leverage ratio does not exceed 4.00 to 1 and (iii) a fixed charge coverage ratio of not less than 2.00 to 1 through the fiscal quarter ending December 31, 2019; not less than 2.25 to 1 through the fiscal quarter ending June 30, 2020; and not less than 2.50 to 1 for the fiscal quarter ended September 30, 2020 and thereafter. For the Current Quarter, we
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
were subject to the financial covenants applicable prior to the amended and restated revolving credit facility in addition to maintaining a leverage ratio of not more than 5.50 to 1.
As of September 30, 2018, we were in compliance with all applicable financial covenants under the credit agreement and we were able to borrow up to the full availability under the revolving credit facility.
Fair Value of Debt
We estimate the fair value of our senior notes based on the market value of our publicly traded debt as determined based on the yield of our senior notes (Level 1). The fair value of all other debt is based on a market approach using estimates provided by an independent investment financial data services firm (Level 2). Fair value is compared to the carrying value, excluding the impact of interest rate derivatives, in the table below:
September 30, 2018
December 31, 2017
Carrying
Amount
Estimated
Fair Value
Carrying
Amount
Estimated
Fair Value
($ in millions)
Short-term debt (Level 1)
$
432
$
433
$
52
$
53
Long-term debt (Level 1)
$
3,495
$
3,546
$
2,633
$
2,629
Long-term debt (Level 2)
$
5,884
$
6,010
$
7,286
$
7,301
4.
Contingencies and Commitments
There have been no material developments in previously reported legal or environmental contingencies or commitments other than the items discussed below. For a discussion of commitments and contingencies, see “Contingencies and Commitments,” Note 4 to the Consolidated Financial Statements in our 2017 Form 10-K.
Contingencies
Regulatory and Related Proceedings. We have previously disclosed receiving U.S. Postal Service and state subpoenas seeking information on our royalty payment practices. The U.S. Postal Service inquiry and all such outstanding state subpoenas have been resolved.
We have also previously disclosed defending lawsuits alleging various violations of the Sherman Antitrust Act and state antitrust laws. In 2016, putative class action lawsuits were filed in the U.S. District Court for the Western District of Oklahoma and in Oklahoma state courts, and an individual lawsuit was filed in the U.S. District Court of Kansas, in each case against us and other defendants. The lawsuits generally allege that, since 2007 and continuing through April 2013, the defendants conspired to rig bids and depress the market for the purchases of oil and natural gas leasehold interests and properties in the Anadarko Basin containing producing oil and natural gas wells. The lawsuits seek damages, attorney’s fees, costs and interest, as well as enjoinment from adopting practices or plans that would restrain competition in a similar manner as alleged in the lawsuits. On April 12, 2018, we reached a tentative settlement to resolve substantially all Oklahoma civil class action antitrust cases for an immaterial amount.
On July 28, 2017, OOGC America LLC (OOGC) filed a demand for arbitration with the American Arbitration Association against Chesapeake Exploration, L.L.C., our wholly owned subsidiary, in connection with OOGC’s purchase of certain oil and gas leases and other assets pursuant to a Purchase and Sale Agreement entered into on October 10, 2010. In connection with the sale, we also entered into a Development Agreement with OOGC, dated November 15, 2010 (the “Development Agreement”), which governs each of our rights and obligations with respect to the sale, including the transportation and marketing of oil and gas. OOGC’s breach of contract, breach of agency and fiduciary duties and other claims generally allege, among other things, that we subjected OOGC to excessive rates for gathering and other services provided for under the Development Agreement and interfered with OOGC’s right to audit the documents that supported those rates. OOGC seeks relief that may be material, including unspecified damages, attorneys’ fees, costs and expenses, disgorgement and various declaratory judgments. We intend to vigorously defend these claims.
On July 24, 2018, Healthcare of Ontario Pension Plan (HOOPP) filed a demand for arbitration with the American Arbitration Association regarding HOOPP’s purchase of our interest in Chaparral Energy, Inc. stock for $215 million on January 5, 2014. HOOPP claims that the Company engaged in material misrepresentations and fraud, and that we violated the Exchange Act and Oklahoma Uniform Securities Act. HOOPP seeks either rescission or $215 million in monetary damages, and in either case, interest, attorney’s fees, disgorgement and punitive damages. We intend to vigorously defend these claims.
Commitments
Gathering, Processing and Transportation Agreements
We have contractual commitments with midstream service companies and pipeline carriers for future gathering, processing and transportation of oil, natural gas and NGL to move certain of our production to market. Working interest owners and royalty interest owners, where appropriate, will be responsible for their proportionate share of these costs. Commitments related to gathering, processing and transportation agreements are not recorded as obligations in the accompanying consolidated balance sheets; however, they are reflected in our estimates of proved reserves.
The aggregate undiscounted commitments under our gathering, processing and transportation agreements, excluding any reimbursement from working interest and royalty interest owners, credits for third-party volumes or future costs under cost-of-service agreements, are presented below:
September 30, 2018
($ in millions)
2018
$
269
2019
1,048
2020
992
2021
900
2022
792
2023 – 2035
4,443
Total
$
8,444
In addition, we have entered into long-term agreements for certain natural gas gathering and related services within specified acreage dedication areas in exchange for cost-of-service based fees redetermined annually, or tiered fees based on volumes delivered relative to scheduled volumes. Future gathering fees may vary with the applicable agreement.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
5.
Other Liabilities
Other current liabilities as of September 30, 2018 and December 31, 2017 are detailed below:
September 30, 2018
December 31, 2017
($ in millions)
Revenues and royalties due others
$
535
$
612
Accrued drilling and production costs
313
216
Joint interest prepayments received
81
74
Accrued compensation and benefits
192
214
Other accrued taxes
123
43
Other
194
296
Total other current liabilities
$
1,438
$
1,455
Other long-term liabilities as of September 30, 2018 and December 31, 2017 are detailed below:
September 30, 2018
December 31, 2017
($ in millions)
CHK Utica ORRI conveyance obligation(a)
$
—
$
156
Unrecognized tax benefits
53
101
Other
107
97
Total other long-term liabilities
$
160
$
354
____________________________________________
(a)
In the Current Period, we repurchased previously conveyed overriding royalty interests (ORRI) from the CHK Utica, L.L.C. investors and extinguished our obligation to convey future ORRIs to the CHK Utica, L.L.C. investors for combined consideration of $199 million. The total CHK Utica ORRI conveyance obligation extinguished in the Current Period was $183 million, of which, $30 million was recorded in current liabilities and $153 million was recorded in long-term liabilities. The fair value of the consideration allocated to the extinguishment of liability, $122 million, was less than the carrying amount of the conveyance obligation and resulted in a gain of $61 million recognized in other income on our condensed consolidated statement of operations. The fair value of the consideration allocated to the purchase of ORRIs on proved producing properties was $77 million and recorded in proved oil and natural gas properties in our condensed consolidated balance sheet.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
6.
Income Taxes
We estimate our annual effective tax rate for continuing operations in recording our quarterly income tax provision (or benefit) for the various jurisdictions in which we operate. The tax effects of statutory rate changes, significant unusual or infrequent items, and certain changes in the assessment of the realizability of deferred tax assets are excluded from the determination of our estimated annual effective tax rate as such items are recognized as discrete items in the quarter in which they occur.
For the Current Quarter, our estimated annual effective tax rate remains nominal as a result of having a full valuation allowance against our net deferred tax asset. Taking into account our projected operating results for the subsequent 2018 quarter, we project remaining in a net deferred tax asset position as of December 31, 2018. Based on all available positive and negative evidence, including estimates of future taxable income, we believe it is more-likely-than-not that these deferred tax assets will not be realized. A significant piece of objectively verifiable negative evidence evaluated is the cumulative loss incurred over the rolling three-year period ending September 30, 2018. Such evidence limits our ability to consider various forms of subjective positive evidence, such as our projections for future growth and earnings. A valuation allowance was recorded against substantially all of our net deferred tax asset as of December 31, 2017 and against all of our net deferred tax asset as of September 30, 2018.
We are subject to U.S. federal income tax as well as income and capital taxes in various state jurisdictions in which we operate. We recorded a $1 million income tax expense in the Current Quarter and an $8 million income tax benefit in the Current Period. The $1 million expense in the Current Quarter was a result of discrete items related to additional state income tax expense for the settlement of a state income tax audit and the filing of amended state income tax returns. The $8 million benefit in the Current Period was a result of discrete items consisting of a $13 million reduction to the liability for state unrecognized tax benefits due to the expiration of applicable statutes of limitations which was partially offset by eliminating a deferred tax asset for alternative minimum tax carryforwards in the amount of $3 million and recording additional state income tax expense of $2 million relating primarily to the settlement of a state income tax audit and the filing of amended state income tax returns. A further reduction to the liability for state unrecognized tax benefits was also recorded against interest expense in the amount of $4 million.
On December 22, 2017, the President of the United States signed into law the Tax Act, which substantially revised numerous areas of U.S. federal income tax law, including reducing the tax rate for corporations from a maximum rate of 35% to a flat rate of 21% and eliminating the corporate alternative minimum tax (AMT). The various estimates included in determining our tax provision as of December 31, 2017 remain provisional through the nine months ended September 30, 2018 and may be adjusted through subsequent events such as the filing of the 2017 consolidated federal income tax return and the issuance of additional guidance such as new Treasury Regulations. Moreover, we are still in the process of evaluating the full impact of the Tax Act both at the federal and state level.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
7.
Share-Based Compensation
Our share-based compensation program consists of restricted stock, stock options, performance share units (PSUs) and cash restricted stock units (CRSUs) granted to employees and restricted stock granted to non-employee directors under our long term incentive plans. The restricted stock and stock options are equity-classified awards and the PSUs and CRSUs are liability-classified awards.
Equity-Classified Awards
Restricted Stock. We grant restricted stock units to employees and non-employee directors. A summary of the changes in unvested restricted stock during the Current Period is presented below:
Shares of
Unvested
Restricted Stock
Weighted Average
Grant Date
Fair Value Per Share
(in thousands)
Unvested restricted stock as of January 1, 2018
13,178
$
6.37
Granted
5,776
$
3.77
Vested
(5,782
)
$
7.67
Forfeited
(1,376
)
$
6.09
Unvested restricted stock as of September 30, 2018
11,796
$
4.49
The aggregate intrinsic value of restricted stock that vested during the Current Period was approximately $20 million based on the stock price at the time of vesting.
As of September 30, 2018, there was approximately $38 million of total unrecognized compensation expense related to unvested restricted stock. The expense is expected to be recognized over a weighted average period of approximately 2.12 years.
Stock Options. In the Current Period and the Prior Period, we granted members of management stock options that vest ratably over a three-year period. Each stock option award has an exercise price equal to the closing price of our common stock on the grant date. Outstanding options expire seven years to ten years from the date of grant.
We utilize the Black-Scholes option pricing model to measure the fair value of stock options. The expected life of an option is determined using the simplified method. Volatility assumptions are estimated based on the average historical volatility of Chesapeake stock over the expected life of an option. The risk-free interest rate is based on the U.S. Treasury rate in effect at the time of the grant over the expected life of the option. The dividend yield is based on an annual dividend yield, taking into account our dividend policy, over the expected life of the option. We used the following weighted average assumptions to estimate the grant date fair value of the stock options granted in the Current Period:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
The following table provides information related to stock option activity in the Current Period:
Number of
Shares
Underlying
Options
Weighted
Average
Exercise Price Per Share
Weighted
Average
Contract Life in Years
Aggregate
Intrinsic
Value(a)
(in thousands)
($ in millions)
Outstanding as of January 1, 2018
16,285
$
8.25
7.73
$
1
Granted
3,611
$
3.01
Exercised
—
$
—
$
—
Expired
(602
)
$
13.83
Forfeited
(1,067
)
$
5.45
Outstanding as of September 30, 2018
18,227
$
7.19
7.44
$
8
Exercisable as of September 30, 2018
8,250
$
10.73
6.05
$
2
___________________________________________
(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.
As of September 30, 2018, there was $16 million of total unrecognized compensation expense related to stock options. The expense is expected to be recognized over a weighted average period of approximately 1.74 years.
Restricted Stock and Stock Option Compensation. We recognized the following compensation costs related to restricted stock and stock options for the Current Quarter, the Prior Quarter, the Current Period and the Prior Period:
Three Months Ended September 30,
Nine Months Ended September 30,
2018
2017
2018
2017
($ in millions)
General and administrative expenses
$
6
$
9
$
21
$
20
Oil and natural gas properties
1
3
5
7
Oil, natural gas and NGL production expenses
1
2
4
7
Total restricted stock and stock option compensation
$
8
$
14
$
30
$
34
Liability-Classified Awards
Performance Share Units. We granted PSUs to senior management that vest ratably over a three-year performance period and are settled in cash. The ultimate amount earned is based on achievement of performance metrics established by the Compensation Committee of the Board of Directors. Compensation expense associated with PSU awards is recognized over the service period based on the graded-vesting method. The value of the PSU awards at the end of each reporting period is dependent upon our estimates of the underlying performance measures.
For PSUs granted in 2017 and 2016, performance metrics include a total shareholder return (TSR) component, which can range from 0% to 100% and an operational performance component based on finding and development costs, which can range from 0% to 100%, resulting in a maximum payout of 200%. The payout percentage for the 2016 and 2017 PSU awards is capped at 100% if our absolute TSR is less than zero. The PSUs are settled in cash on the third anniversary of the awards. We utilized a Monte Carlo simulation for the TSR performance measure and the following assumptions to determine the grant date fair value of the 2017 and 2016 PSU awards.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
Reporting Period Assumptions
Assumption
2017 Awards
2016 Awards
Volatility
51.65
%
41.46
%
Risk-free interest rate
2.65
%
2.19
%
Dividend yield for value of awards
—
%
—
%
As the above assumptions change, the PSU liabilities will be adjusted quarterly through the end of the performance period.
For PSUs granted in 2018, performance metrics include an operational performance component based on a ratio of cumulative earnings before interest expense, income taxes, and depreciation, depletion and amortization expense (EBITDA) to capital expenditures, for which payout can range from 0% to 200%. The vested PSUs are settled in cash on each of the three annual vesting dates. We used the closing price of our common stock on the grant date to determine the grant date fair value of the PSUs. The PSU liability will be adjusted quarterly, based on changes in our stock price and expected satisfaction of performance metrics, through the end of the performance period.
Cash Restricted Stock Units. In the Current Period, we granted CRSUs to employees that vest straight-line over a three-year period and are settled in cash on each of the three annual vesting dates. The ultimate amount earned is based on the closing price of our common stock on each of the vesting dates. We used the closing price of our common stock on the grant date to determine the grant date fair value of the CRSUs. The CRSU liability will be adjusted quarterly, based on changes in our stock price, through the end of the performance period. The CRSUs are subsequently adjusted, based on changes in our stock price through the end of each subsequent reporting period, through the end of each vesting period.
The following table presents a summary of our liability-classified awards:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
8.
Derivative and Hedging Activities
We use derivative instruments to reduce our exposure to fluctuations in future commodity prices and to protect our expected operating cash flow against significant market movements or volatility. All of our oil, natural gas and NGL 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. None of our open oil, natural gas and NGL derivative instruments were designated for hedge accounting as of September 30, 2018 or December 31, 2017.
Oil, Natural Gas and NGL Derivatives
As of September 30, 2018 and December 31, 2017, our oil, natural gas and NGL derivative instruments consisted of the following types of instruments:
•
Swaps: We receive a fixed price and pay a floating market price to the counterparty for the hedged commodity. In exchange for higher fixed prices on certain of our swap trades, we may sell call options and call swaptions.
•
Options: We sell, and occasionally buy, call options in exchange for a premium. At the time of settlement, if the market price exceeds the fixed price of the call option, we pay the counterparty the excess on sold call options and we receive 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.
•
Call Swaptions: We sell call swaptions to counterparties that allow the counterparty, on a specific date, to extend an existing fixed-price swap for a certain period of time.
•
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, we receive the fixed price and pay the market price. If the market price is between the put and the call strike prices, no payments are due from either party. Three-way collars include the sale by us of an additional put option in exchange for a more favorable strike price on the call option. This eliminates the counterparty’s downside exposure below the second put option strike price.
•
Basis Protection Swaps: These instruments are arrangements that guarantee a fixed price differential to NYMEX from a specified delivery point. We receive the fixed price differential and pay the floating market price differential to the counterparty for the hedged commodity.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
The estimated fair values of our oil, natural gas and NGL derivative instrument assets (liabilities) as of September 30, 2018 and December 31, 2017 are provided below:
September 30, 2018
December 31, 2017
Notional Volume
Fair Value
Notional Volume
Fair Value
($ in millions)
($ in millions)
Oil (mmbbl):
Fixed-price swaps
21
$
(294
)
21
$
(151
)
Three-way collars
—
(8
)
2
(10
)
Call swaptions
—
—
2
(13
)
Basis protection swaps
8
2
11
(9
)
Total oil
29
(300
)
36
(183
)
Natural gas (bcf):
Fixed-price swaps
400
(a)
(19
)
532
149
Three-way collars
88
3
—
—
Collars
66
—
47
11
Call options
60
—
110
(3
)
Basis protection swaps
44
(7
)
65
(7
)
Total natural gas
658
(23
)
754
150
NGL (mmgal):
Fixed-price swaps
57
(15
)
33
(2
)
Total estimated fair value
$
(338
)
$
(35
)
____________________________________________
a)
Includes 170 bcf related to trades executed in accordance with the purchase and sale agreement with Encino. These trades are reflected at fair market value as of September 30, 2018, with an offsetting receivable balance. The trades were novated to Encino upon closing of the purchase and sale agreement on October 29, 2018.
We have terminated certain commodity derivative contracts that were previously designated as cash flow hedges for which the original contract months are yet to occur. See further discussion below under Effect of Derivative Instruments – Accumulated Other Comprehensive Income (Loss).
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
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, 2018 and December 31, 2017 on a gross basis and after same-counterparty netting:
Balance Sheet Classification
Gross
Fair Value
Amounts Netted
in the
Consolidated
Balance Sheets
Net Fair Value
Presented in the
Consolidated
Balance Sheet
($ in millions)
As of September 30, 2018
Commodity Contracts:
Short-term derivative asset
$
14
$
(14
)
$
—
Long-term derivative asset
3
(3
)
—
Short-term derivative liability
(324
)
14
(310
)
Long-term derivative liability
(31
)
3
(28
)
Total derivatives
$
(338
)
$
—
$
(338
)
As of December 31, 2017
Commodity Contracts:
Short-term derivative asset
$
157
$
(130
)
$
27
Short-term derivative liability
(188
)
130
(58
)
Long-term derivative liability
(4
)
—
(4
)
Total derivatives
$
(35
)
$
—
$
(35
)
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:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
Effect of Derivative Instruments – Accumulated Other Comprehensive Income (Loss)
A reconciliation of the changes in accumulated other comprehensive income (loss) in our consolidated statements of stockholders’ equity related to our cash flow hedges is presented below:
Three Months Ended September 30,
2018
2017
Before Tax
After Tax
Before Tax
After Tax
($ in millions)
Balance, beginning of period
$
(97
)
$
(40
)
$
(132
)
(75
)
Losses reclassified to income
8
8
8
8
Balance, end of period
$
(89
)
$
(32
)
(124
)
(67
)
Nine Months Ended September 30,
2018
2017
Before Tax
After Tax
Before Tax
After Tax
($ in millions)
Balance, beginning of period
$
(114
)
$
(57
)
$
(153
)
$
(96
)
Net change in fair value
—
—
4
4
Losses reclassified to income
25
25
25
25
Balance, end of period
$
(89
)
$
(32
)
$
(124
)
$
(67
)
The accumulated other comprehensive loss as of September 30, 2018 represents the net deferred loss associated with commodity derivative contracts that were previously designated as cash flow hedges for which the original contract months are yet to occur. Remaining deferred gain or loss amounts will be recognized in earnings in the month for which the original contract months are to occur. As of September 30, 2018, we expect to transfer approximately $35 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 highly rated or deemed by us to have acceptable credit strength 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, 2018, our oil, natural gas and NGL derivative instruments were spread among 11 counterparties.
Hedging Arrangements
Certain of our hedging arrangements are with counterparties that are also lenders (or affiliates of lenders) under our revolving credit facility. The contracts entered into with these counterparties are secured by the same collateral that secures our revolving credit facility. In addition, we enter into bilateral hedging agreements with other counterparties. The counterparties’ and our obligations under 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. As of September 30, 2018, we posted $14 million in letters of credit as collateral for our commodity derivatives. No cash was posted as collateral for our commodity derivatives.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
Fair Value
The fair value of our derivatives is based on third-party pricing models which utilize inputs that are either readily available in the public market, such as oil, natural gas and NGL forward curves and discount rates, or can be corroborated from active markets or broker quotes. These values are compared to the values given by our counterparties for reasonableness. Since oil, natural gas and NGL swaps do not include optionality and therefore generally have no unobservable inputs, they are classified as Level 2. All other derivatives have some level of unobservable input, such as volatility curves, and are therefore classified as Level 3. Derivatives are also subject to the risk that either party to a contract will be unable to meet its obligations. We factor non-performance risk into the valuation of our derivatives using current published credit default swap rates. To date, this has not had a material impact on the values of our derivatives.
The following table provides information for financial assets (liabilities) measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)
A summary of the changes in the fair values of our financial assets (liabilities) classified as Level 3 during the Current Period and the Prior Period is presented below:
Commodity
Derivatives
($ in millions)
Balance, as of January 1, 2018
$
(15
)
Total gains (losses) (realized/unrealized):
Included in earnings(a)
(3
)
Total purchases, issuances, sales and settlements:
Settlements
13
Balance, as of September 30, 2018
$
(5
)
Balance, as of January 1, 2017
$
(10
)
Total gains (losses) (realized/unrealized):
Included in earnings(a)
1
Total purchases, issuances, sales and settlements: