1
- --------------------------------------------------------------------------------
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 JUNE 30, 2001
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 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 (I.R.S. Employer
incorporation or organization) 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 [ ]
At August 10, 2001, there were 164,430,645 shares of our $.01 par value
common stock outstanding.
- --------------------------------------------------------------------------------
2
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
INDEX TO FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2001
<Table>
<Caption>
PART I. FINANCIAL INFORMATION
PAGE
----
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets at December 31, 2000 and
June 30, 2001 (Unaudited) 3
Consolidated Statements of Operations for the Three Months and
Six Months Ended June 30, 2000 and 2001 (Unaudited) 4
Consolidated Statements of Cash Flows for the Six Months Ended
June 30, 2000 and 2001 (Unaudited) 5
Consolidated Statements of Comprehensive Income
for the Three Months and Six Months Ended 6
June 30, 2000 and 2001 (Unaudited)
Notes to Consolidated Financial Statements (Unaudited) 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 22
Item 3. Quantitative and Qualitative Disclosures About Market Risks 30
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 34
Item 2. Changes in Securities and Use of Proceeds 34
Item 3. Defaults Upon Senior Securities 34
Item 4. Submission of Matters to a Vote of Security Holders 34
Item 5. Other Information 34
Item 6. Exhibits and Reports on Form 8-K 35
</Table>
2
3
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<Table>
<Caption>
DECEMBER 31, JUNE 30,
ASSETS 2000 2001
----------- -----------
($ IN THOUSANDS)
CURRENT ASSETS:
Cash and cash equivalents.......................................................... $ -- $ --
Restricted cash.................................................................... 3,500 --
Accounts receivable:
Oil and gas sales................................................................ 50,109 31,431
Oil and gas marketing sales...................................................... 46,953 37,463
Joint interest and other, net of allowances of $1,085,000 and $1,083,000,
respectively................................................................... 15,998 25,908
Related parties.................................................................. 4,383 8,684
Deferred income tax asset.......................................................... 40,819 --
Short-term derivative instruments.................................................. -- 128,128
Inventory.......................................................................... 3,167 3,736
Other.............................................................................. 1,997 1,437
----------- -----------
Total Current Assets......................................................... 166,926 236,787
----------- -----------
PROPERTY AND EQUIPMENT:
Oil and gas properties, at cost based on full-cost accounting:
Evaluated oil and gas properties................................................. 2,590,512 3,212,049
Unevaluated properties........................................................... 25,685 66,022
Less: accumulated depreciation, depletion and amortization....................... (1,770,827) (1,848,594)
----------- -----------
845,370 1,429,477
Other property and equipment....................................................... 79,898 108,543
Less: accumulated depreciation and amortization.................................... (37,034) (39,248)
----------- -----------
Total Property and Equipment................................................. 888,234 1,498,772
----------- -----------
OTHER ASSETS:
Investment in Gothic Energy Corporation............................................ 126,434 --
Deferred income tax asset.......................................................... 229,823 158,376
Long-term derivative instruments................................................... -- 30,509
Long-term investments, other....................................................... 2,000 12,223
Other assets....................................................................... 27,009 16,767
----------- -----------
Total Other Assets........................................................... 385,266 217,875
----------- -----------
TOTAL ASSETS......................................................................... $ 1,440,426 $ 1,953,434
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable and current maturities of long-term debt............................. $ 836 $ 875
Accounts payable................................................................... 62,940 81,510
Accrued property acquisitions...................................................... 22,530 --
Accrued interest................................................................... 17,537 22,250
Other accrued liabilities.......................................................... 21,637 27,608
Revenues and royalties due others.................................................. 35,682 24,155
Income tax payable................................................................. 1,539 3,343
----------- -----------
Total Current Liabilities.................................................... 162,701 159,741
----------- -----------
LONG-TERM DEBT, NET.................................................................. 944,845 1,239,218
----------- -----------
REVENUES AND ROYALTIES DUE OTHERS.................................................... 7,798 10,519
----------- -----------
DEFERRED INCOME TAX LIABILITY........................................................ 11,850 15,189
----------- -----------
OTHER LIABILITIES.................................................................... -- 3,321
----------- -----------
CONTINGENCIES (NOTE 3)
STOCKHOLDERS' EQUITY:
Preferred Stock, $.01 par value, 10,000,000 shares authorized; 624,037 and 0
shares of 7% cumulative convertible stock issued and outstanding at December 31,
2000 and June 30, 2001, entitled in liquidation to $31.2 million and
$0.0 million, respectively....................................................... 31,202 --
Common Stock, par value of $.01, 350,000,000 shares authorized; 157,819,171 and
169,218,107 shares issued at December 31, 2000 and June 30, 2001, respectively... 1,578 1,692
Paid-in capital.................................................................... 963,584 1,047,963
Accumulated deficit................................................................ (659,286) (556,926)
Accumulated other comprehensive income (loss)...................................... (3,901) 52,699
Less: treasury stock, at cost; 4,788,747 and 4,792,529 common shares at
December 31, 2000 and June 30, 2001, respectively................................ (19,945) (19,982)
----------- -----------
Total Stockholders' Equity................................................... 313,232 525,446
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........................................... $ 1,440,426 $ 1,953,434
=========== ===========
</Table>
The accompanying notes are an integral part of these
consolidated financial statements.
3
4
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2000 2001 2000 2001
---------- ---------- ---------- ---------
($ IN THOUSANDS, EXCEPT PER SHARE DATA)
REVENUES:
Oil and gas sales................................................ $100,221 $175,225 $ 187,514 $ 396,444
Risk management income........................................... -- 62,455 -- 62,455
Oil and gas marketing sales...................................... 34,242 38,001 61,610 94,166
-------- --------- --------- ---------
Total Revenues............................................... 134,463 275,681 249,124 553,065
-------- --------- --------- ---------
OPERATING COSTS:
Production expenses.............................................. 12,581 18,842 25,126 36,630
Production taxes................................................. 5,717 9,991 10,933 24,286
General and administrative....................................... 3,188 2,873 6,220 6,874
Oil and gas marketing expenses................................... 33,122 36,913 59,666 91,391
Oil and gas depreciation, depletion and amortization............. 24,877 39,910 49,360 78,083
Depreciation and amortization of other assets.................... 1,836 1,837 3,702 3,790
-------- --------- --------- ---------
Total Operating Costs........................................ 81,321 110,366 155,007 241,054
-------- --------- --------- ---------
INCOME FROM OPERATIONS............................................ 53,142 165,315 94,117 312,011
-------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest and other income........................................ 1,667 683 2,859 1,252
Interest expense................................................. (21,813) (22,984) (42,677) (48,873)
Gothic standby credit facility costs............................. -- -- -- (3,392)
-------- --------- --------- ---------
Total Other Income (Expense)................................. (20,146) (22,301) (39,818) (51,013)
-------- --------- --------- ---------
INCOME BEFORE INCOME TAX AND EXTRAORDINARY ITEM................... 32,996 143,014 54,299 260,998
INCOME TAX EXPENSE................................................ 1,362 57,529 1,463 105,225
-------- --------- ------- ---------
NET INCOME BEFORE EXTRAORDINARY ITEM.............................. 31,634 85,485 52,836 155,773
EXTRAORDINARY ITEM:
Loss on early extinguishment of debt, net of applicable
income tax .................................................... -- (46,000) -- (46,000)
-------- --------- ------- ---------
NET INCOME........................................................ 31,634 39,485 52,836 109,773
Preferred stock dividends........................................ (2,907) (182) (6,949) (728)
Gain on repurchase of preferred stock............................ 1,481 -- 11,895 --
-------- --------- --------- ---------
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS....................... $ 30,208 $ 39,303 $ 57,782 $ 109,045
======== ========= ========= =========
EARNINGS PER COMMON SHARE -- BASIC:
Income before extraordinary item................................. $ 0.26 $ 0.52 $ 0.53 $ 0.97
Extraordinary item............................................... -- (0.28) -- (0.29)
-------- --------- --------- ---------
Net income....................................................... $ 0.26 $ 0.24 $ 0.53 $ 0.68
======== ========= ========= =========
EARNINGS PER COMMON SHARE -- ASSUMING DILUTION:
Income before extraordinary item................................. $ 0.22 $ 0.50 $ 0.36 $ 0.91
Extraordinary item............................................... -- (0.27) -- (0.27)
-------- --------- --------- ---------
Net income....................................................... $ 0.22 $ 0.23 $ 0.36 $ 0.64
======== ========= ========= =========
WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT
SHARES OUTSTANDING (IN THOUSANDS):
Basic............................................................ 116,466 162,588 108,196 160,161
======== ========= ========= =========
Assuming dilution................................................ 146,113 171,321 146,285 170,835
======== ========= ========= =========
</Table>
The accompanying notes are an integral part of these
consolidated financial statements.
4
5
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<Table>
<Caption>
SIX MONTHS ENDED
JUNE 30,
------------------------
2000 2001
--------- ---------
($ IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income .................................................... $ 52,836 $ 109,773
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation, depletion and amortization ..................... 51,258 80,088
Risk management income ....................................... -- (62,455)
Extraordinary loss on early extinguishment of debt ........... -- 46,000
Income taxes ................................................. 1,463 105,225
Write-off of credit facility cost ............................ -- 3,392
Amortization of loan costs ................................... 1,804 1,785
Amortization of bond discount ................................ 42 349
Accretion of Gothic note premium ............................. -- (750)
(Gain) loss on sale of fixed assets and other ................ (1) 29
Equity in losses (earnings) of equity investees .............. 131 260
Bad debt expense ............................................. 256 --
Other ........................................................ (36) 85
--------- ---------
Cash provided by operating activities before changes in
current assets and liabilities .......................... 107,753 283,781
Changes in current assets and liabilities .................... (23,883) 13,221
--------- ---------
Cash provided by operating activities ...................... 83,870 297,002
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Exploration and development of oil and gas properties ......... (78,947) (206,054)
Purchases of oil and gas properties ........................... (24,981) (75,446)
Sales of oil and gas properties ............................... 1,368 174
Sales of non-oil and gas assets ............................... 835 159
Additions to buildings and other fixed assets ................. (3,390) (8,834)
Additions to drilling rig equipment ........................... -- (11,930)
Long-term investments ......................................... (2,000) (591)
Investment in Gothic senior discount notes .................... (22,352) --
Additions to other assets ..................................... (967) (12,214)
Other ......................................................... (135) 480
--------- ---------
Cash used in investing activities .......................... (130,569) (314,256)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term borrowings ............................ 113,000 273,000
Payments on long-term borrowings .............................. (93,500) (138,000)
Cash received from issuance of senior notes ................... -- 786,664
Cash paid to purchase senior notes ............................ -- (830,382)
Cash paid for redemption premium on senior notes .............. -- (75,639)
Cash received from exercise of stock options .................. 764 2,782
Cash paid for preferred stock dividend ........................ -- (1,092)
Other ......................................................... -- (11)
--------- ---------
Cash provided by financing activities ...................... 20,264 17,322
--------- ---------
EFFECT OF CHANGES IN EXCHANGE RATE ON CASH ...................... (204) (68)
--------- ---------
NET DECREASE IN CASH AND CASH EQUIVALENTS ....................... (26,639) --
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD .................. 38,658 --
--------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD ........................ $ 12,019 $ --
========= =========
</Table>
The accompanying notes are an integral part of these
consolidated financial statements.
5
6
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ ------------------------
2000 2001 2000 2001
--------- --------- --------- ---------
($ IN THOUSANDS)
Net income ................................................. $ 31,634 $ 39,485 $ 52,836 $ 109,773
Other comprehensive income (loss), net of income tax:
Foreign currency translation adjustments ................. (2,475) 2,494 (2,953) (725)
Cumulative effect of accounting change for financial
derivatives ............................................ -- -- -- (53,580)
Change in derivative fair value .......................... -- 95,785 -- 137,923
Reclassification adjustments -- derivative settlements ... -- (45,344) -- (27,018)
--------- --------- --------- ---------
Other comprehensive income ................................. $ 29,159 $ 92,420 $ 49,883 $ 166,373
========= ========= ========= =========
</Table>
The accompanying notes are an integral part of these
consolidated financial statements.
6
7
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES
Principles of Consolidation -- The accompanying unaudited consolidated financial
statements of Chesapeake Energy Corporation and Subsidiaries have been prepared
in accordance with the instructions to Form 10-Q as prescribed by the Securities
and Exchange Commission. All material adjustments (consisting solely of normal
recurring adjustments) which, in the opinion of management, are necessary for a
fair presentation of the results for the interim periods have been reflected.
The results for the three and six months ended June 30, 2001 are not necessarily
indicative of the results to be expected for the full year. This Form 10-Q
relates to the three and six months ended June 30, 2000 (the "Prior Quarter" and
"Prior Period," respectively) and the three and six months ended June 30, 2001
(the "Current Quarter" and "Current Period," respectively).
Change in Accounting Method -- Effective January 1, 2001, we adopted Statement
of Financial Accounting Standards No. 133, Accounting for Derivative Instruments
and Hedging Activities. This statement establishes accounting and reporting
guidelines for our hedging activities. It requires that all derivative
instruments be recognized as assets or liabilities in the consolidated balance
sheet measured at fair value. The accounting for changes in the fair value of a
derivative instrument depends on the intended use of the derivative and the
resulting designation. For derivative instruments designated as cash flow hedges
which meet the effectiveness guidelines of SFAS 133, changes in fair value are
recognized in other comprehensive income until the hedged item is recognized in
earnings. Hedge effectiveness is measured at least quarterly based on the
relative changes in fair value between the derivative contract and the hedged
item over time. Any change in fair value resulting from ineffectiveness, as
defined by SFAS 133, is recognized immediately in earnings. The net gain
recognized in earnings during the Current Quarter representing the amount of the
hedges' ineffectiveness was $1.0 million. Changes in fair value of contracts
that do not meet SFAS 133 definition of a cash flow hedge are also recognized in
earnings.
Adoption of SFAS 133 at January 1, 2001 resulted in the recognition of $9.3
million of current derivative assets and $98.6 million in current derivative
liabilities. The cumulative effect of the accounting change decreased
accumulated other comprehensive income by $53.6 million, net of income tax, but
did not have an effect on our net income or earnings per share amounts.
All of our derivative instruments have been executed in connection with our gas
and crude oil hedging program. The realized derivative profit or loss is
included in oil and gas sales in the period for which the underlying production
was hedged.
If a derivative which qualified for cash flow hedge accounting is liquidated or
sold prior to maturity, the gain or loss at the time of termination remains in
accumulated other comprehensive income to be amortized into oil and gas sales
over the original term of the instrument. If a derivative which does not qualify
for cash flow hedge accounting is liquidated or sold prior to maturity, the gain
or loss at the time of termination will be amortized into oil and gas sales over
the original term of the instrument.
2. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Our results of operations and operating cash flows are impacted by changes in
market prices for oil and gas. To mitigate a portion of this exposure to adverse
market changes, we have entered into derivative instruments. All of our
derivative instruments have been entered into as hedges of oil and gas price
risk and not for speculative purposes.
We utilize derivative instruments to reduce exposure to unfavorable changes in
oil and gas prices which are subject to significant and often volatile
fluctuations. Our derivative instruments are currently comprised of swaps,
collars and cap-swaps. These instruments allow us to predict with greater
certainty the effective oil and gas prices to be received for our hedged
production.
7
8
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
o For swap instruments, we receive a fixed price for the respective
commodities and pay a floating market price, as defined in each instrument,
to the counterparty. The fixed-price payment and the floating-price payment
are netted, resulting in a net amount due to or from the counterparty.
o Collars 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, then we receive the fixed price and pay the market price. If the
market price is between the call and the put strike price, then no payments
are due from either party.
o For cap-swaps, we receive a fixed price for the respective commodities and
pay a floating market price. The fixed price received by Chesapeake
includes a premium in exchange for a "cap" on the counterparty's exposure.
Pursuant to SFAS 133, our cap-swaps do not qualify for designation as cash flow
hedges. Therefore, changes in the fair value of these instruments that occur
prior to their maturity are reported in the statement of operations as risk
management income (loss). Amounts recorded in risk management income (loss) do
not represent cash gains or losses. Rather, these amounts are temporary
valuation swings in contracts or portions of contracts that are not entitled to
receive hedge accounting treatment. All amounts initially recorded in this
caption are ultimately reversed within this same caption over the respective
contract terms.
The estimated fair values of our derivative instruments as of June 30, 2001 are
provided below. The associated carrying values of these instruments are equal to
the estimated fair values.
<Table>
<Caption>
JUNE 30,
2001
----------------
($ IN THOUSANDS)
Derivative assets:
Fixed-price gas swaps.................................... $ 75,874
Fixed-price gas cap-swaps................................ 60,986
Fixed-price gas collars.................................. 17,587
Fixed-price crude oil swaps.............................. 3,681
Fixed-price crude oil cap-swaps.......................... 509
---------
Total.................................................... $ 158,637
=========
</Table>
The fair value of our derivative instruments as of June 30, 2001 was estimated
based on market prices of gas and crude oil for the periods covered by the
instruments. The net differential between the prices in each instrument and
market prices for future periods, as adjusted for estimated basis, has been
applied to the volumes stipulated in each instrument to arrive at an estimated
future value. The fair value of derivative instruments which contain options
(such as collar structures) has been estimated based on remaining term,
volatility and other factors.
8
9
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
Risk management income in the statement of operations for the following period
is comprised of the following:
<Table>
<Caption>
SIX MONTHS ENDED
JUNE 30, 2001
----------------
($ IN THOUSANDS)
Risk Management Income:
Change in fair value of derivatives not qualifying for
hedge accounting .................................. $61,495
Ineffective portion of derivatives qualifying for hedge
accounting ........................................ 960
-------
$62,455
=======
</Table>
Although derivatives often fail to achieve 100% effectiveness, our derivative
instruments continue to be highly effective in achieving the risk management
objectives for which they were intended.
The change in fair market value of our derivative instruments since December 31,
2000 has resulted from a decrease in market prices for gas and crude oil. The
majority of this change in fair value was reflected in accumulated other
comprehensive income, net of deferred income tax effects. Derivative assets
reflected as current in the June 30, 2001 consolidated balance sheet represent
the estimated fair value of derivative instrument settlements scheduled to occur
over the subsequent twelve-month period based on market prices for oil and gas
as of the balance sheet date. The derivative settlement amounts are not due and
payable until the monthly period that the related underlying hedged transaction
occurs.
We expect to transfer approximately $49.0 million of the balance in accumulated
other comprehensive income, based upon the market prices at June 30, 2001, to
earnings during the next 12 months when the forecasted transactions actually
occur. All forecasted transactions currently being hedged are expected to occur
by December 2003.
In addition to commodity hedging transactions related to our oil and gas
production, our marketing subsidiary, Chesapeake Energy Marketing, Inc., enters
into various hedging transactions designed to hedge against physical purchase
and sale commitments it makes. Gains or losses on these transactions are
recorded as adjustments to oil and gas marketing sales in the consolidated
statements of operations and are not considered material by management.
3. CONTINGENCIES
West Panhandle Field Cessation Cases. One of our subsidiaries, Chesapeake
Panhandle Limited Partnership ("CP") (f/k/a MC Panhandle, Inc.), and two
subsidiaries of Kinder Morgan, Inc. have been defendants in 13 lawsuits filed
between June 1997 and January 1999 by royalty owners seeking the cancellation of
oil and gas leases in the West Panhandle Field in Texas. MC Panhandle, Inc.,
which we acquired in April 1998, has owned the leases since January 1, 1997. The
co-defendants are prior lessees. The plaintiffs in these cases have claimed the
leases terminated upon the cessation of production for various periods,
primarily during the 1960s. In addition, the plaintiffs have sought to recover
conversion damages, exemplary damages, attorneys' fees and interest. The
defendants have asserted that any cessation of production was excused and have
pled affirmative defenses of limitations, waiver, temporary estoppel, laches and
title by adverse possession. Four of the 13 cases have been tried, and there
have been appellate decisions in three of them. In January 2001, we settled the
claims of the principal plaintiffs in eight of ten cases tried or pending in the
District Court of Moore County, Texas, 69th Judicial District. The settlement
was not material to our financial condition or results of operations.
There are five related West Panhandle cessation cases which continue to be
pending, two in the District Court of Moore County, Texas, 69th Judicial
District, one in the District Court of Carson County, Texas, 100th Judicial
District, and two in the U.S. District Court, Northern District of Texas,
Amarillo Division. In one of the Moore County cases, CP and the other defendants
have appealed a January 2000 judgment notwithstanding verdict in favor
9
10
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
of plaintiffs. In addition to quieting title to the lease (including existing
gas wells and all attached equipment) in plaintiffs, the court awarded actual
damages against CP in the amount of $716,400 and exemplary damages in the amount
of $25,000. The court further awarded, jointly and severally from all
defendants, $160,000 in attorneys' fees and interest and court costs. On March
28, 2001, the Amarillo Court of Appeals reversed and rendered judgment in favor
of CP and the other defendants, finding that the subject leases had been revived
as a matter of law, making all other issues moot. The Court of Appeals has
denied the plaintiffs' motion for rehearing. In the other Moore County, Texas
case, in June 1999, the court granted plaintiffs' motion for summary judgment in
part, finding that the lease had terminated due to the cessation of production,
subject to the defendants' affirmative defenses. In February 2001, the court
granted plaintiffs' motion for summary judgment on defendants' affirmative
defenses but reversed its ruling that the lease had terminated as a matter of
law. In one of the U.S. District Court cases, after a trial in May 1999, the
jury found plaintiffs' claims were barred by the payment of shut-in royalties,
laches and revivor. Plaintiffs have moved for a new trial. There are motions
pending in the remaining two cases.
We have previously established an accrued liability we believe will be
sufficient to cover the estimated costs of litigation for each of the pending
cases. Because of the inconsistent verdicts reached by the juries in the four
cases tried to date and because the amount of damages sought is not specified in
all of the pending cases, the outcome of any future trials and the amount of
damages that might ultimately be awarded could differ from management's
estimates. CP and the other defendants are vigorously defending against the
plaintiffs' claims.
Chesapeake is currently involved in various other routine disputes incidental to
its business operations. While it is not possible to determine the ultimate
disposition of these matters, management, after consultation with legal counsel,
is of the opinion that the final resolution of all such currently pending or
threatened litigation is not likely to have a material adverse effect on the
consolidated financial position or results of operations of Chesapeake.
Due to the nature of the oil and gas business, Chesapeake and its subsidiaries
are exposed to possible environmental risks. Chesapeake has implemented various
policies and procedures to avoid environmental contamination and risks from
environmental contamination. Chesapeake is not aware of any potential material
environmental issues or claims.
4. NET INCOME PER SHARE
Statement of Financial Accounting Standards No. 128, Earnings Per Share,
requires presentation of "basic" and "diluted" earnings per share, as defined,
on the face of the statement of operations for all entities with complex capital
structures. SFAS 128 requires a reconciliation of the numerators and
denominators of the basic and diluted EPS computations.
10
11
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
A reconciliation for the quarters ended June 30, 2000 and 2001 is as follows (in
thousands, except per share data):
<Table>
<Caption>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ------
FOR THE QUARTER ENDED JUNE 30, 2000:
BASIC EPS
Income available to common stockholders.. $ 30,208 116,466 $ 0.26
=======
EFFECT OF DILUTIVE SECURITIES
Assumed conversion at the beginning of
the period of preferred stock
exchanged during the period:
Common shares assumed issued........... -- 10,595
Preferred stock dividends.............. 1,545 --
Gain on repurchase of preferred stock.. (1,481) --
Assumed conversion of 1,557,037 shares of
preferred stock at the beginning of the
period:
Common shares assumed issued........... -- 11,202
Preferred stock dividends.............. 1,362 --
Employee stock options................... -- 7,850
-------- --------
DILUTED EPS
Income available to common stockholders
and assumed conversions............... $ 31,634 146,113 $ 0.22
======== ======== =======
FOR THE QUARTER ENDED JUNE 30, 2001:
BASIC EPS
Income available to common stockholders.. $ 39,303 162,588 $ 0.24
=======
EFFECT OF DILUTIVE SECURITIES
Assumed conversion at the beginning of the
period of preferred shares exchanged
during the period:
Common shares issued................... -- 1,432
Preferred stock dividends.............. 182 --
Employee stock options................... -- 7,294
Warrants assumed in Gothic acquisition... -- 7
-------- --------
DILUTED EPS
Income available to common stockholders
and assumed conversions............... $ 39,485 171,321 $ 0.23
======== ======== =======
FOR THE SIX MONTHS ENDED JUNE 30, 2000:
BASIC EPS
Income available to common stockholders.. $ 57,782 108,196 $ 0.53
=======
EFFECT OF DILUTIVE SECURITIES
Assumed conversion at the beginning of the
period of preferred shares exchanged
during the period:
Common shares assumed issued........... -- 19,956
Preferred stock dividends.............. 4,224 --
Gain on redemption of preferred stock.. (11,895) --
Assumed conversion of 1,557,037 shares of
preferred stock at beginning
of period:
Common shares assumed issued........... -- 11,202
Preferred stock dividends.............. 2,725 --
Employee stock options................... -- 6,931
-------- --------
DILUTED EPS
Income available to common stockholders
and assumed conversions................ $ 52,836 146,285 $ 0.36
======== ======== =======
</Table>
11
12
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
<Table>
<Caption>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ------
FOR THE SIX MONTHS ENDED JUNE 30, 2001:
BASIC EPS
Income available to common stockholders.. $109,045 160,161 $ 0.68
=======
EFFECT OF DILUTIVE SECURITIES
Assumed conversion at the beginning of the
period of preferred shares exchanged
during the period:
Common shares assumed issued........... -- 2,952
Preferred stock dividends.............. 728 --
Employee stock options................... -- 7,715
Warrants assumed in Gothic acquisition... -- 7
-------- --------
DILUTED EPS
Income available to common stockholders
and assumed conversions................ $109,773 170,835 $ 0.64
======== ======== =======
</Table>
For the Prior Quarter, the Current Quarter, the Prior Period and the Current
Period, outstanding options to purchase 0.7 million, 0.3 million, 1.6 million
and 0.2 million shares of common stock at a weighted average exercise price of
$10.57, $15.98, $6.76 and $18.78, respectively, were antidilutive because the
exercise prices of the options were greater than the average market price of our
common stock. For the Current Quarter and Current Period, outstanding warrants
to purchase 1.1 million shares of common stock at a weighted average exercise
price of $12.46 were antidilutive because the exercise prices of the warrants
were greater than the average market price of our common stock.
5. SENIOR NOTES
On April 6, 2001, we issued $800 million principal amount of 8.125% senior notes
due 2011, which were subsequently exchanged on July 12, 2001 for substantially
identical notes registered under the Securities Act of 1933. During April 2001,
we used a portion of the offering proceeds to purchase $140.7 million principal
amount of our 9.625% senior notes and $3.0 million principal amount of the
11.125% senior secured notes of Gothic Production Corporation, a Chesapeake
subsidiary. On May 7, 2001, we redeemed all $120 million principal amount of our
9.125% senior notes, the remaining $359.3 million principal amount of our 9.625%
senior notes and the remaining $199.3 million principal amount of Gothic
Production Corporation's 11.125% senior secured notes. The purchase and
redemption of these notes included payment of aggregate make-whole and
redemption premiums of $75.6 million which was further adjusted by the write-off
of unamortized debt costs and debt issue premiums. These costs are reflected as
a $46.0 million, after tax, extraordinary loss in the Current Quarter.
On January 16, 2001, we acquired Gothic and its obligations under the 11.125%
senior secured notes. See note 6. At March 31, 2001, there was outstanding
$202.3 million principal amount of 11.125% senior secured notes due 2005 which
had been issued by Gothic Production Corporation and guaranteed by Gothic Energy
Corporation. The 11.125% senior secured notes were collateralized by a second
priority lien on substantially all of the gas and oil properties owned by Gothic
Production Corporation. The notes were redeemable at Gothic Production
Corporation's option on or after May 1, 2002 at the redemption prices set forth
in the indenture or prior to May 1, 2002 at the make-whole prices set forth in
the indenture. In April 2001, we purchased $3.0 million of these notes for total
consideration of $3.5 million, including $0.1 million in interest and $0.4
million in premium. On May 7, 2001, the remaining $199.3 million was redeemed
for total consideration of $222.5 million, including $0.4 million in interest
and $22.8 million in redemption premium.
On April 22, 1998, we issued $500 million principal amount of 9.625% senior
notes due 2005. The 9.625% senior notes were redeemable at our option at any
time on or after May 1, 2002 at the redemption prices set forth in the
12
13
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
indenture or at the make-whole prices, as set forth in the indenture, if
redeemed prior to May 1, 2002. In April 2001, we purchased $140.7 million of
these notes for total consideration of $160.2 million, including a $13.6 million
premium and interest of $5.9 million. On May 7, 2001, the remaining $359.3
million was redeemed for total consideration of $393.3 million, including $0.6
million of interest and $33.4 million of redemption premium.
On March 17, 1997, we issued $150 million principal amount of 7.875% senior
notes due 2004. The 7.875% senior notes are redeemable at our option at any time
prior to March 15, 2004 at the make-whole prices determined in accordance with
the indenture.
Also on March 17, 1997, we issued $150 million principal amount of 8.5% senior
notes due 2012. The 8.5% senior notes are redeemable at our option at any time
prior to March 15, 2004 at the make-whole prices determined in accordance with
the indenture and, on or after March 15, 2004, at the redemption prices set
forth in the indenture. During the quarter ended March 31, 2001, Chesapeake
purchased and subsequently retired $7.3 million of these notes for total
consideration of $7.4 million, including accrued interest of $0.2 million and
the write-off of $0.1 million of unamortized bond discount.
On April 9, 1996, we issued $120 million principal amount of 9.125% senior notes
due 2006. The 9.125% senior notes were redeemable at our option at any time
prior to April 15, 2001 at the make-whole prices determined in accordance with
the indenture and, on or after April 15, 2001, at the redemption prices set
forth in the indenture. On May 7, 2001, we redeemed these notes for total
consideration of $126.1 million, including $0.7 million in interest and $5.4
million of redemption premium.
Chesapeake is a holding company and owns no operating assets and has no
significant operations independent of its subsidiaries. Our obligations under
the 8.125% senior notes, the 7.875% senior notes and the 8.5% senior notes have
been fully and unconditionally guaranteed, on a joint and several basis, by each
of our "Restricted Subsidiaries" (as defined in the respective indentures
governing these notes) (collectively, the "guarantor subsidiaries"). Each
guarantor subsidiary is a direct or indirect wholly-owned subsidiary.
Set forth below are condensed consolidating financial statements of the
guarantor subsidiaries and our subsidiaries which are not guarantors of the
senior notes. Chesapeake Energy Marketing, Inc. was a non-guarantor subsidiary
for all periods presented. Carmen Acquisition Corp. was also a non-guarantor
subsidiary in the Current Period. Upon the acquisition of Gothic Energy
Corporation and Gothic Production Corporation on January 16, 2001, these
subsidiaries were non-guarantor subsidiaries. As of May 7, 2001, all of the
Gothic Production Corporation 11.125% senior secured notes were purchased or
redeemed and both subsidiaries became guarantor subsidiaries on May 14, 2001.
Based on these events, we have presented Gothic Energy Corporation and Gothic
Production Corporation as guarantor subsidiaries for the Current Period. All of
our other wholly-owned subsidiaries were guarantor subsidiaries during all
periods presented.
13
14
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
AS OF DECEMBER 31, 2000
($ IN THOUSANDS)
<Table>
<Caption>
NON-
GUARANTOR GUARANTOR
SUBSIDIARIES SUBSIDIARY PARENT ELIMINATIONS CONSOLIDATED
------------ ---------- ----------- ------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents.................... $ (19,868) $ 7,200 $ 12,668 $ -- $ --
Restricted cash.............................. 3,500 -- -- -- 3,500
Accounts receivable.......................... 91,903 46,903 -- (21,363) 117,443
Deferred income tax asset.................... -- -- 40,819 -- 40,819
Inventory.................................... 3,040 127 -- -- 3,167
Other........................................ 1,997 -- -- -- 1,997
----------- ---------- ----------- -------- -----------
Total Current Assets................... 80,572 54,230 53,487 (21,363) 166,926
----------- ---------- ----------- -------- -----------
PROPERTY AND EQUIPMENT:
Oil and gas properties....................... 2,590,512 -- -- -- 2,590,512
Unevaluated leasehold........................ 25,685 -- -- -- 25,685
Other property and equipment................. 30,670 23,246 25,982 -- 79,898
Less: accumulated depreciation, depletion and
amortization............................... (1,787,314) (18,153) (2,394) -- (1,807,861)
----------- ---------- ----------- -------- -----------
Net Property and Equipment............. 859,553 5,093 23,588 -- 888,234
----------- ---------- ----------- -------- -----------
OTHER ASSETS:
Investments in subsidiaries and
intercompany advances...................... -- -- (612,832) 612,832 --
Investment in Gothic Energy Corporation...... -- 9,732 116,702 -- 126,434
Deferred tax asset........................... -- -- 229,823 -- 229,823
Other assets................................. 9,890 418 89,516 (70,815) 29,009
----------- ---------- ----------- -------- -----------
Total Other Assets..................... 9,890 10,150 (176,791) 542,017 385,266
----------- ---------- ----------- -------- -----------
TOTAL ASSETS................................... $ 950,015 $ 69,473 $ (99,716) $520,654 $ 1,440,426
=========== ========== =========== ======== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Notes payable and current maturities of
long-term debt............................. $ 836 $ -- $ -- $ -- $ 836
Accounts payable and other................... 118,620 49,613 19,090 (25,458) 161,865
----------- ---------- ----------- -------- -----------
Total Current Liabilities.............. 119,456 49,613 19,090 (25,458) 162,701
----------- ---------- ----------- -------- -----------
LONG-TERM DEBT................................. 92,321 -- 919,244 (66,720) 944,845
----------- ---------- ----------- -------- -----------
REVENUES AND ROYALTIES DUE OTHERS.............. 7,798 -- -- -- 7,798
----------- ---------- ----------- -------- -----------
DEFERRED INCOME TAX LIABILITY.................. 11,850 -- -- -- 11,850
----------- ---------- ----------- -------- -----------
INTERCOMPANY PAYABLES.......................... 1,351,144 138 (1,351,282) -- --
----------- ---------- ----------- -------- -----------
STOCKHOLDERS' EQUITY (DEFICIT):
Common Stock................................. 26 1 1,569 (18) 1,578
Other........................................ (632,580) 19,721 311,663 612,850 311,654
----------- ---------- ----------- -------- -----------
(632,554) 19,722 313,232 612,832 313,232
----------- ---------- ----------- -------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
(DEFICIT)...................................... $ 950,015 $ 69,473 $ (99,716) $520,654 $ 1,440,426
=========== ========== =========== ======== ===========
</Table>
14
15
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET
AS OF JUNE 30, 2001
($ IN THOUSANDS)
<Table>
<Caption>
GUARANTOR NON-GUARANTOR
SUBSIDIARIES SUBSIDIARIES PARENT ELIMINATIONS CONSOLIDATED
------------ ------------- ----------- ------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents .................. $ (24,111) $ 2,175 $ 21,936 $ -- $ --
Accounts receivable ........................ 86,927 37,413 3,564 (24,418) 103,486
Deferred income tax asset .................. -- -- -- -- --
Short-term derivative instruments .......... 128,128 -- -- -- 128,128
Inventory .................................. 3,117 619 -- -- 3,736
Other ...................................... 1,420 7 10 -- 1,437
----------- ----------- ----------- ----------- -----------
Total Current Assets ............... 195,481 40,214 25,510 (24,418) 236,787
----------- ----------- ----------- ----------- -----------
PROPERTY AND EQUIPMENT:
Oil and gas properties ..................... 3,212,049 -- -- -- 3,212,049
Unevaluated leasehold ...................... 66,022 -- -- -- 66,022
Other property and equipment ............... 53,264 23,670 31,609 -- 108,543
Less: accumulated depreciation,
depletion and amortization .............. (1,866,674) (18,413) (2,755) -- (1,887,842)
----------- ----------- ----------- ----------- -----------
Net Property and Equipment ......... 1,464,661 5,257 28,854 -- 1,498,772
----------- ----------- ----------- ----------- -----------
OTHER ASSETS:
Investments in subsidiaries and
intercompany advances .................... -- -- (253,615) 253,615 --
Deferred income tax asset .................. (141,624) (1,858) 301,858 -- 158,376
Long-term derivative instruments ........... 30,509 -- -- -- 30,509
Long-term investments, other ............... -- 9,632 2,591 -- 12,223
Other assets ............................... 6,808 390 80,396 (70,827) 16,767
----------- ----------- ----------- ----------- -----------
Total Other Assets ................... (104,307) 8,164 131,230 182,788 217,875
----------- ----------- ----------- ----------- -----------
TOTAL ASSETS ................................. $ 1,555,835 $ 53,635 $ 185,594 $ 158,370 $ 1,953,434
=========== =========== =========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable and current
maturities of long-term debt ............ $ 875 $ -- $ -- $ -- $ 875
Accounts payable and other ................. 132,871 32,659 22,069 (28,733) 158,866
----------- ----------- ----------- ----------- -----------
Total Current Liabilities .......... 133,746 32,659 22,069 (28,733) 159,741
----------- ----------- ----------- ----------- -----------
LONG-TERM DEBT ............................... 226,874 -- 1,079,064 (66,720) 1,239,218
----------- ----------- ----------- ----------- -----------
REVENUES AND ROYALTIES DUE
OTHERS ..................................... 10,519 -- -- -- 10,519
----------- ----------- ----------- ----------- -----------
OTHER LIABILITIES ............................ 3,321 -- -- -- 3,321
----------- ----------- ----------- ----------- -----------
DEFERRED INCOME TAXES ........................ 15,189 -- -- -- 15,189
----------- ----------- ----------- ----------- -----------
INTERCOMPANY PAYABLES ........................ 1,442,469 (1,692) (1,440,985) 208 --
----------- ----------- ----------- ----------- -----------
STOCKHOLDERS' EQUITY:
Common Stock ............................... 1,566 1 1,683 (1,558) 1,692
Other ...................................... (277,849) 22,667 523,763 255,173 523,754
----------- ----------- ----------- ----------- -----------
(276,283) 22,668 525,446 253,615 525,446
----------- ----------- ----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.... $ 1,555,835 $ 53,635 $ 185,594 $ 158,370 $ 1,953,434
=========== =========== =========== =========== ===========
</Table>
15
16
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
($ IN THOUSANDS)
<Table>
<Caption>
GUARANTOR NON-GUARANTOR
SUBSIDIARIES SUBSIDIARIES PARENT ELIMINATIONS CONSOLIDATED
------------ ------------- --------- ------------ ------------
FOR THE THREE MONTHS ENDED JUNE 30, 2000:
REVENUES:
Oil and gas sales ........................... $ 100,221 $ -- $ -- $ -- $ 100,221
Oil and gas marketing sales ................. -- 79,973 -- (45,731) 34,242
--------- --------- --------- --------- ---------
Total Revenues ........................... 100,221 79,973 -- (45,731) 134,463
--------- --------- --------- --------- ---------
OPERATING COSTS:
Production expenses and taxes ............... 18,298 -- -- -- 18,298
General and administrative .................. 2,841 299 48 -- 3,188
Oil and gas marketing expenses .............. -- 78,853 -- (45,731) 33,122
Oil and gas depreciation, depletion
and amortization .......................... 24,876 1 -- -- 24,877
Other depreciation and amortization ......... 1,008 20 808 -- 1,836
--------- --------- --------- --------- ---------
Total Operating Costs .................... 47,023 79,173 856 (45,731) 81,321
--------- --------- --------- --------- ---------
INCOME FROM OPERATIONS ........................ 53,198 800 (856) -- 53,142
--------- --------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest and other income ................... 1,165 467 20,945 (20,910) 1,667
Interest expense ............................ (21,484) -- (21,239) 20,910 (21,813)
Equity in net earnings of subsidiaries ...... -- -- 32,784 (32,784) --
--------- --------- --------- --------- ---------
Total Other Income (Expense) ............. (20,319) 467 32,490 (32,784) (20,146)
--------- --------- --------- --------- ---------
INCOME BEFORE INCOME TAXES .................... 32,879 1,267 31,634 (32,784) 32,996
INCOME TAX EXPENSE ............................ 1,362 -- -- -- 1,362
--------- --------- --------- --------- ---------
NET INCOME .................................... $ 31,517 $ 1,267 $ 31,634 $ (32,784) $ 31,634
========= ========= ========= ========= =========
FOR THE THREE MONTHS ENDED JUNE 30, 2001:
REVENUES:
Oil and gas sales ........................... $ 175,225 $ -- $ -- $ -- $ 175,225
Risk management income ...................... 62,455 -- -- -- 62,455
Oil and gas marketing sales ................. -- 108,600 -- (70,599) 38,001
--------- --------- --------- --------- ---------
Total Revenues ........................... 237,680 108,600 -- (70,599) 275,681
--------- --------- --------- --------- ---------
OPERATING COSTS:
Production expenses and taxes ............... 28,833 -- -- -- 28,833
General and administrative .................. 2,550 259 64 -- 2,873
Oil and gas marketing expenses .............. -- 107,512 -- (70,599) 36,913
Oil and gas depreciation, depletion
and amortization .......................... 39,910 -- -- -- 39,910
Other depreciation and amortization ......... 1,287 20 530 -- 1,837
--------- --------- --------- --------- ---------
Total Operating Costs .................... 72,580 107,791 594 (70,599) 110,366
--------- --------- --------- --------- ---------
INCOME FROM OPERATIONS ........................ 165,100 809 (594) -- 165,315
--------- --------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest and other income ................... 697 (101) 23,808 (23,721) 683
Interest expense ............................ (24,201) -- (22,504) 23,721 (22,984)
Gothic standby credit facility costs ........ -- -- -- -- --
Equity in net earnings of subsidiaries ...... -- -- 76,888 (76,888) --
--------- --------- --------- --------- ---------
Total Other Income (Expense) ............. (23,504) (101) 78,192 (76,888) (22,301)
--------- --------- --------- --------- ---------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEMS ..................... 141,596 708 77,598 (76,888) 143,014
INCOME TAX EXPENSE ............................ 56,961 284 31,039 (30,755) 57,529
--------- --------- --------- --------- ---------
NET INCOME BEFORE
EXTRAORDINARY ITEMS ........................... 84,635 424 46,559 (46,133) 85,485
--------- --------- --------- --------- ---------
EXTRAORDINARY ITEMS:
Loss on early extinguishment of debt, net
of applicable income tax ................. (8,171) -- (37,829) -- (46,000)
--------- --------- --------- --------- ---------
NET INCOME .................................... $ 76,464 $ 424 $ 8,730 $ (46,133) $ 39,485
========= ========= ========= ========= =========
</Table>
16
17
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
($ IN THOUSANDS)
<Table>
<Caption>
GUARANTOR NON-GUARANTOR
SUBSIDIARIES SUBSIDIARIES PARENT ELIMINATIONS CONSOLIDATED
------------ ------------- --------- ------------ ------------
FOR THE SIX MONTHS ENDED JUNE 30, 2000:
REVENUES:
Oil and gas sales .......................... $ 187,167 $ 347 $ -- $ -- $ 187,514
Oil and gas marketing sales ................ -- 149,098 -- (87,488) 61,610
--------- --------- --------- --------- ---------
Total revenues .......................... 187,167 149,445 -- (87,488) 249,124
--------- --------- --------- --------- ---------
OPERATING COSTS:
Production expenses and taxes .............. 35,979 80 -- -- 36,059
General and administrative ................. 5,561 590 69 -- 6,220
Oil and gas marketing expenses ............. -- 147,154 -- (87,488) 59,666
Oil and gas depreciation, depletion
and amortization ......................... 49,259 101 -- -- 49,360
Other depreciation and amortization ........ 2,034 40 1,628 -- 3,702
--------- --------- --------- --------- ---------
Total operating costs ................... 92,833 147,965 1,697 (87,488) 155,007
--------- --------- --------- --------- ---------
INCOME (LOSS) FROM OPERATIONS ................ 94,334 1,480 (1,697) -- 94,117
--------- --------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest and other income .................. 1,963 803 41,912 (41,819) 2,859
Interest expense ........................... (42,439) (34) (42,023) 41,819 (42,677)
Equity in net earnings of subsidiaries ..... -- -- 54,644 (54,644) --
--------- --------- --------- --------- ---------
Total other income (expense) ............ (40,476) 769 54,533 (54,644) (39,818)
--------- --------- --------- --------- ---------
INCOME (LOSS) BEFORE INCOME TAXES ............ 53,858 2,249 52,836 (54,644) 54,299
INCOME TAX EXPENSE ........................... 1,463 -- -- -- 1,463
--------- --------- --------- --------- ---------
NET INCOME (LOSS) ............................ $ 52,395 $ 2,249 $ 52,836 $ (54,644) $ 52,836
========= ========= ========= ========= =========
FOR THE SIX MONTHS ENDED JUNE 30, 2001:
REVENUES:
Oil and gas sales .......................... $ 396,444 $ -- $ -- $ -- $ 396,444
Risk management income ..................... 62,455 -- -- -- 62,455
Oil and gas marketing sales ................ -- 242,513 -- (148,347) 94,166
--------- --------- --------- --------- ---------
Total revenues .......................... 458,899 242,513 -- (148,347) 553,065
--------- --------- --------- --------- ---------
OPERATING COSTS:
Production expenses and taxes .............. 60,916 -- -- -- 60,916
General and administrative ................. 6,093 609 172 -- 6,874
Oil and gas marketing expenses ............. -- 239,738 -- (148,347) 91,391
Oil and gas depreciation, depletion
and amortization ......................... 78,083 -- -- -- 78,083
Other depreciation and amortization ........ 2,349 40 1,401 -- 3,790
--------- --------- --------- --------- ---------
Total operating costs ................... 147,441 240,387 1,573 (148,347) 241,054
--------- --------- --------- --------- ---------
INCOME (LOSS) FROM OPERATIONS ................ 311,458 2,126 (1,573) -- 312,011
--------- --------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest and other income .................. 1,139 (26) 46,542 (46,403) 1,252
Interest expense ........................... (52,015) (1) (43,260) 46,403 (48,873)
Gothic standby credit facility costs ....... -- -- (3,392) -- (3,392)
Equity in net earnings of subsidiaries ..... -- -- 148,612 (148,612) --
--------- --------- --------- --------- ---------
Total other income (expense) ............ (50,876) (27) 148,502 (148,612) (51,013)
--------- --------- --------- --------- ---------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEMS .................... 260,582 2,099 146,929 (148,612) 260,998
INCOME TAX EXPENSE ........................... 105,058 840 58,772 (59,445) 105,225
--------- --------- --------- --------- ---------
NET INCOME BEFORE
EXTRAORDINARY ITEMS ........................ 155,524 1,259 88,157 (89,167) 155,773
--------- --------- --------- --------- ---------
EXTRAORDINARY ITEMS:
Loss on early extinguishment of debt,
net of applicable income tax ............ (8,171) -- (37,829) -- (46,000)
--------- --------- --------- --------- ---------
NET INCOME ................................... $ 147,353 $ 1,259 $ 50,328 $ (89,167) $ 109,773
========= ========= ========= ========= =========
</Table>
17
18
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
($ IN THOUSANDS)
<Table>
<Caption>
GUARANTOR NON-GUARANTOR
SUBSIDIARIES SUBSIDIARIES PARENT ELIMINATIONS CONSOLIDATED
------------ ------------- --------- ------------ ------------
FOR THE SIX MONTHS ENDED JUNE 30, 2000:
CASH FLOWS FROM OPERATING ACTIVITIES .......... $ 88,395 $ (4,753) $ 228 $ -- $ 83,870
--------- --------- --------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Oil and gas properties, net ................. (104,075) 1,515 -- -- (102,560)
Proceeds from sale of assets ................ 835 -- -- -- 835
Gothic senior note and other investments .... -- (22,352) (2,000) (24,352)
Additions to other property and equipment ... (1,501) (46) (1,843) -- (3,390)
Other additions ............................. (1,069) -- (33) -- (1,102)
--------- --------- --------- --------- ---------
(105,810) (20,883) (3,876) -- (130,569)
--------- --------- --------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES .......... 10,973 10,284 (993) -- 20,264
--------- --------- --------- --------- ---------
EFFECT OF CHANGES IN EXCHANGE RATE ON CASH .... (204) -- -- -- (204)
--------- --------- --------- --------- ---------
NET INCREASE (DECREASE) IN CASH ............... (6,646) (15,352) (4,641) -- (26,639)
CASH, BEGINNING OF PERIOD ..................... (7,156) 20,409 25,405 -- 38,658
--------- --------- --------- --------- ---------
CASH, END OF PERIOD ........................... $ (13,802) $ 5,057 $ 20,764 $ -- $ 12,019
========= ========= ========= ========= =========
FOR THE SIX MONTHS ENDED JUNE 30, 2001:
CASH FLOWS FROM OPERATING ACTIVITIES .......... $ 285,270 $ 6,746 $ 4,986 $ -- $ 297,002
--------- --------- --------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Oil and gas properties, net ................. (281,326) -- -- -- (281,326)
Proceeds from sale of assets ................ 159 -- -- -- 159
Additions to other property and equipment ... (14,712) (425) (5,627) -- (20,764)
Other additions ............................. (5,156) -- (7,169) -- (12,325)
--------- --------- --------- --------- ---------
(301,035) (425) (12,796) -- (314,256)
--------- --------- --------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES .......... 11,590 (11,346) 17,078 -- 17,322
--------- --------- --------- --------- ---------
EFFECT OF CHANGES IN EXCHANGE RATE ON CASH .... (68) -- -- -- (68)
--------- --------- --------- --------- ---------
NET INCREASE (DECREASE) IN CASH ............... (4,243) (5,025) 9,268 -- --
CASH, BEGINNING OF PERIOD ..................... (19,868) 7,200 12,668 -- --
--------- --------- --------- --------- ---------
CASH, END OF PERIOD ........................... $ (24,111) $ 2,175 $ 21,936 $ -- $ --
========= ========= ========= ========= =========
</Table>
18
19
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
($ IN THOUSANDS)
<Table>
<Caption>
GUARANTOR NON-GUARANTOR
SUBSIDIARIES SUBSIDIARIES PARENT ELIMINATIONS CONSOLIDATED
------------ ------------- --------- ------------ ------------
FOR THE THREE MONTHS ENDED JUNE 30, 2000:
Net income (loss) ................................. $ 31,517 $ 1,267 $ 31,634 $ (32,784) $ 31,634
Other comprehensive income, net of income tax:
Foreign currency translation .................... (2,475) -- -- -- (2,475)
--------- --------- --------- --------- ---------
Other comprehensive income (loss) ................. $ 29,042 $ 1,267 $ 31,634 $ (32,784) $ 29,159
========= ========= ========= ========= =========
FOR THE THREE MONTHS ENDED JUNE 30, 2001:
Net income (loss) ................................. $ 76,464 $ 424 $ 8,730 $ (46,133) $ 39,485
Other comprehensive income, net of income tax:
Foreign currency translation .................... 2,494 -- -- -- 2,494
Cumulative effect of accounting change for
financial derivatives ......................... -- -- -- -- --
Change in fair value of derivative instruments .. 95,785 -- -- -- 95,785
Fair value of derivatives reclassified to
earnings ...................................... (45,344) -- -- -- (45,344)
--------- --------- --------- --------- ---------
Other comprehensive income (loss) ................. $ 129,399 $ 424 $ 8,730 $ (46,133) $ 92,420
========= ========= ========= ========= =========
FOR THE SIX MONTHS ENDED JUNE 30, 2000:
Net income (loss) ................................. $ 52,395 $ 2,249 $ 52,836 $ (54,644) $ 52,836
Other comprehensive income, net of income tax:
Foreign currency translation ...................... (2,953) -- -- -- (2,953)
--------- --------- --------- --------- ---------
Other comprehensive income (loss) ................. $ 49,442 $ 2,249 $ 52,836 $ (54,644) $ 49,883
========= ========= ========= ========= =========
FOR THE SIX MONTHS ENDED JUNE 30, 2001:
Net income (loss) ................................. $ 147,353 $ 1,259 $ 50,328 $ (89,167) $ 109,773
Other comprehensive income, net of income tax:
Foreign currency translation .................... (725) -- -- -- (725)
Cumulative effect of accounting change for
financial derivatives ......................... (53,580) -- -- -- (53,580)
Change in fair value of derivative instruments .. 137,923 -- -- -- 137,923
Fair value of derivatives reclassified to
earnings ...................................... (27,018) -- -- -- (27,018)
--------- --------- --------- --------- ---------
Other comprehensive income (loss) ................. $ 203,953 $ 1,259 $ 50,328 $ (89,167) $ 166,373
========= ========= ========= ========= =========
</Table>
19
20
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
6. ACQUISITION OF GOTHIC ENERGY CORPORATION
We completed the acquisition of Gothic Energy Corporation on January 16, 2001 by
merging a wholly-owned subsidiary into Gothic. We issued a total of 4.0 million
shares of Chesapeake common stock in the merger. Gothic shareholders (other than
Chesapeake) received 0.1908 of a share of Chesapeake common stock (valued at
$7.00 per share, which was based on the value of Chesapeake common stock on the
day before the merger was announced) for each share of Gothic common stock. In
addition, outstanding warrants and options to purchase Gothic common stock were
converted to the right to purchase Chesapeake common stock (1.1 million shares
as of June 30, 2001 at a weighted average exercise price of $12.46 per share)
based on the merger exchange ratio. Prior to the merger, Chesapeake purchased
substantially all of Gothic's 14.125% senior secured discount notes for total
consideration valued at $80.8 million in cash and Chesapeake common stock. Prior
to the merger, we also purchased $31.6 million principal amount of 11.125%
senior secured notes due 2005 issued by Gothic's operating subsidiary and
guaranteed by Gothic. The consideration for this purchase consisted of cash and
Chesapeake common stock valued at $34.8 million. Subsequent to the acquisition,
we redeemed all remaining 14.125% senior secured discount notes for total
consideration of $243,000. In February 2001, we purchased $1.0 million principal
amount of Gothic senior secured notes tendered pursuant to a change-of-control
offer at a purchase price of 101%. During April and May 2001, we purchased or
redeemed the remaining $202.3 million principal amount of the 11.125% senior
secured notes for total consideration of $225.9 million, including premium of
$23.1 million and interest of $0.5 million. Subsequently, Gothic Energy
Corporation and Gothic Production Corporation became guarantor subsidiaries of
Chesapeake's senior notes.
The acquisition of Gothic was accounted for using the purchase method as of
January 1, 2001 because we had effective control as of that date, and the
results of operations of Gothic have been included since that date.
The following unaudited pro forma information has been prepared assuming Gothic
had been acquired as of January 1, 2000. The pro forma information is presented
for information purposes only and is not necessarily indicative of what would
have occurred if the acquisition had been made as of that date. In addition, the
pro forma information is not intended to be a projection of future results and
does not reflect any efficiencies that may result from the integration of
Gothic.
<Table>
<Caption>
Pro Forma Information (Unaudited)
(In thousands, except per share data)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2000 JUNE 30, 2000
------------------ ----------------
Revenues.............................................. $151,511 $ 280,987
Income before income taxes............................ $ 33,456 $ 53,581
Net income............................................ $ 31,703 $ 51,015
Earnings per common share -- basic..................... $ 0.23 $ 0.45
Earnings per common share -- assuming dilution......... $ 0.19 $ 0.31
</Table>
7. REVOLVING CREDIT FACILITY
On May 2, 2001, we received a temporary increase in our revolving credit
facility from $100 million to $150 million, pending amendments to our credit
facility. On June 11, 2001, our credit agreement was amended and restated, and
our revolving credit facility was increased to $225 million, maturing September
2003, with an initial committed borrowing base of $225 million. The borrowing
base is subject to periodic redeterminations. As of June 30, 2001, we had
borrowed $160 million under the facility and $1.4 million of the facility
secured various letters of credit. Borrowings under the facility are
collateralized by some of our producing oil and gas properties and bear
interest at either the reference rate of Union Bank of California, N.A. or
London Interbank Offered Rate (LIBOR), at our option, plus a margin that varies
according to total facility usage. The average interest rate on the outstanding
facility at June 30, 2001 was 6.5%. Unused portions of the facility accrue an
annual commitment fee of 0.50%. The credit facility contains various covenants
and restrive provisions, including financial condition covenants requiring
20
21
CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
us to maintain certain financial ratios at or above specified
levels. In addition, extensions of credit under the facility may not exceed the
lesser of the maximum amount of indebtedness permitted under the 8.125% senior
note indenture or 15% of adjusted consolidated net tangible assets.
8. SEGMENT INFORMATION
Chesapeake has two reportable segments under SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information, consisting of exploration and
production, and marketing. The reportable segment information can be derived
from note 5 as Chesapeake Energy Marketing, Inc., which is our marketing
segment, is the only material non-guarantor subsidiary for all income statement
periods presented.
9. SUBSEQUENT EVENTS
Seven Seas Petroleum Inc. Investment -- On July 24, 2001, we purchased $22.5
million principal amount of 12% senior secured notes due 2004 issued by Seven
Seas Petroleum Inc. and detachable seven-year warrants to purchase approximately
12.6 million shares of Seven Seas common stock at an exercise price of
approximately $1.78 per share. The shares issuable upon exercise of the warrants
will represent 20% of Seven Seas common stock after completion of a rights
offering and other transactions contemplated by Seven Seas. Seven Seas has
granted us registration rights with respect to the warrant shares. The chairman
and chief executive officer of Seven Seas has granted us an option that could
require him to purchase a portion of our notes and warrants if he has not
invested at least $10.0 million in Seven Seas notes after the proposed rights
offering. The 12% senior secured notes and $22.5 million of notes acquired by
other parties are secured by a pledge of substantially all of the assets owned
by Seven Seas, including all of the Seven Seas' subsidiaries which hold the
concessions to the company's oil and gas interests in Colombia.
10. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board issued SFAS Nos. 141 and
142. SFAS No. 141, Business Combinations, requires that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001.
SFAS No. 142, Goodwill and Other Intangible Assets, changes the accounting for
goodwill from an amortization method to an impairment-only approach and will be
effective January 2002. We believe that adoption of these new standards will not
have an effect on our results of operations or our financial position.
21
22
PART I. FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
ACQUISITION OF GOTHIC ENERGY CORPORATION
We completed the acquisition of Gothic Energy Corporation on January 16, 2001 by
merging a wholly-owned subsidiary into Gothic. We issued 4.0 million shares in
the merger along with additional warrants and options to purchase our common
stock in exchange for outstanding Gothic warrants and options. Prior to the
merger, Chesapeake purchased substantially all of Gothic's 14.125% senior
secured discount notes for total consideration of $80.8 million in cash and
Chesapeake common stock. We also purchased $31.6 million principal amount of
11.125% senior secured notes due 2005 issued by Gothic's operating subsidiary
for total consideration of $34.8 million in cash and Chesapeake common stock.
Subsequent to the acquisition, we redeemed all remaining 14.125% senior secured
discount notes for total consideration of $243,000. In February 2001, we
purchased $1.0 million principal amount of Gothic senior secured notes tendered
pursuant to a change-of-control offer at a purchase price of 101%. During April
and May 2001, we purchased or redeemed the remaining $202.3 million of 11.125%
senior secured notes for total consideration of $225.9 million. On May 14, 2001,
Gothic Energy Corporation and Gothic Production Corporation became guarantor
subsidiaries of Chesapeake's senior notes.
During 2000, we obtained a standby commitment for a $275 million credit
facility. The facility, if needed, would have replaced our existing revolving
credit facility and provided funds to repurchase any of Gothic Production
Corporation's 11.125% senior secured notes tendered pursuant to a
change-of-control offer required by the indenture. We did not use the standby
credit facility and the commitment terminated in February 2001. Chesapeake
incurred $3.4 million of costs for the standby facility which were recognized in
the quarter ended March 31, 2001.
RESULTS OF OPERATIONS -- Three Months Ended June 30, 2001 ("Current Quarter")
vs. June 30, 2000 ("Prior Quarter")
General. For the Current Quarter, we realized net income of $39.5 million, or
$0.23 per diluted common share. This compares to net income of $31.6 million, or
$0.22 per diluted common share, in the Prior Quarter. Net income included a
$62.5 million non-cash risk management gain recorded pursuant to SFAS 133, and a
$46.0 million extraordinary loss in connection with the early retirement of
debt.
Oil and Gas Sales. During the Current Quarter, oil and gas sales increased 75%
to $175.2 million from $100.2 million in the Prior Quarter. For the Current
Quarter, we produced 39.1 billion cubic feet equivalent, consisting of 0.7
million barrels of oil and 35.0 billion cubic feet of gas, compared to 0.8 mmbo
and 29.3 bcf, or 34.1 bcfe, in the Prior Quarter. The production increase is
primarily the result of the Gothic acquisition. Average oil prices realized were
$27.70 per barrel of oil in the Current Quarter compared to $24.46 per bo in the
Prior Quarter, an increase of 13%. Average gas prices realized were $4.46 per
thousand cubic feet in the Current Quarter compared to $2.76 per mcf in the
Prior Quarter, an increase of 62%.
For the Current Quarter, we realized an average price of $4.48 per thousand
cubic feet equivalent, compared to $2.94 per mcfe in the Prior Quarter. Our
hedging activities resulted in increased oil and gas revenues of $7.2 million,
or $0.18 per mcfe, in the Current Quarter, compared to decreases in oil and gas
revenues of $11.0 million, or $0.32 per mcfe, in the Prior Quarter.
22
23
The following table shows our production by region for the Prior Quarter and the
Current Quarter:
<Table>
<Caption>
FOR THE THREE MONTHS ENDED JUNE 30,
-----------------------------------------------------------
2000 2001
------------------------------ ---------------------------
OPERATING AREAS (mmcfe) PERCENT (mmcfe) PERCENT
------------------------------ ------------- -------------- ------------- ------------
Mid-Continent................. 19,215 56% 27,045 69%
Gulf Coast.................... 8,643 25 6,634 17
Canada........................ 3,579 11 3,111 8
Permian Basin................. 1,540 5 1,133 3
Other areas................... 1,108 3 1,214 3
------ ------ ------ -----
Total.................... 34,085 100% 39,137 100%
====== ====== ====== ======
</Table>
Gas production represented approximately 90% of our total production volume on
an equivalent basis in the Current Quarter, compared to 86% in the Prior
Quarter.
Risk Management Income. Amounts recorded in this caption represent non-cash
gains and losses created by temporary valuation swings in derivatives or
portions of derivatives which are not entitled to receive hedge accounting. All
amounts recorded in this caption are ultimately reversed in this caption over
the respective contract terms. Risk management income for the Current Quarter
was a net gain of $62.5 million, which included a $61.5 million gain
attributable to the change in fair value for certain derivative instruments
which did not meet the definition of cash flow hedges under SFAS 133 for the
Current Quarter and a gain of $1.0 million relating to hedge ineffectiveness.
Although derivatives often fail to achieve 100% effectiveness, our derivative
instruments continue to be highly effective in achieving the risk management
objectives for which they were intended.
Oil and Gas Marketing Sales. We realized $38.0 million in oil and gas marketing
sales for third parties in the Current Quarter, with corresponding oil and gas
marketing expenses of $36.9 million, for a margin of $1.1 million. This compares
to sales of $34.2 million, expenses of $33.1 million, and a margin of $1.1
million in the Prior Quarter. The increase in marketing sales and cost of sales
was due primarily to higher oil and gas prices in the Current Quarter as
compared to the Prior Quarter.
Production Expenses. Production expenses increased to $18.8 million in the
Current Quarter, a $6.2 million increase from the $12.6 million of production
expenses incurred in the Prior Quarter. On a unit of production basis,
production expenses were $0.48 and $0.37 per mcfe in the Current and Prior
Quarters, respectively. The increase in production expenses between periods is
due primarily to the additional costs associated with properties acquired since
the Prior Quarter, the increase in ad valorem taxes due to higher commodity
prices, and the overall increase in costs for goods and services that oil and
gas producers have experienced in 2001.
Production Taxes. Production taxes, which consist primarily of wellhead
severance taxes, were $10.0 million and $5.7 million in the Current and Prior
Quarters, respectively. On a per unit basis, production taxes were $0.26 per
mcfe in the Current Quarter compared to $0.17 per mcfe in the Prior Quarter. The
increase in the Current Quarter is due to higher oil and gas prices. In general,
production taxes are calculated using value-based formulas that produce higher
per unit costs when oil and gas prices increase.
Oil and Gas Depreciation, Depletion and Amortization. Depreciation, depletion
and amortization of oil and gas properties for the Current Quarter was $39.9
million, compared to $24.9 million in the Prior Quarter. The DD&A rate per mcfe,
which is a function of capitalized costs, future development costs and the
related underlying reserves in the periods presented, increased from $0.73 in
the Prior Quarter to $1.02 in the Current Quarter. This increase is a result of
the Gothic acquisition and escalating drilling and equipment costs in 2001.
Chesapeake's DD&A rate in the future will be a function of the results of future
acquisition, exploration, development and production results. Our rate is
expected to trend upward in 2001 based on projected higher drilling, completion
and acquisition costs throughout the oil and gas industry.
Depreciation and Amortization of Other Assets. Depreciation and amortization of
other assets was $1.8 million in the Current Quarter and in the Prior Quarter.
We anticipate D&A will continue at current levels during the remainder of 2001.
23
24
General and Administrative. General and administrative expenses, which are net
of capitalized internal costs, were $2.9 million in the Current Quarter compared
to $3.2 million in the Prior Quarter. We capitalized $2.1 million of internal
costs in the Current Quarter directly related to our oil and gas exploration and
development efforts, compared to $1.5 million in the Prior Quarter. We
anticipate that G&A costs during the remainder of 2001 will remain at
approximately the same level as the Current Period.
Interest and Other Income. Interest and other income for the Current Quarter was
$0.7 million compared to $1.7 million in the Prior Quarter. The decrease was
primarily the result of a reduction in interest and other miscellaneous income
and the recognition of a $0.3 million loss, which represents our share of RAM
Energy, Inc.'s net loss for the Current Quarter. We acquired 49.5% of the
outstanding common stock of RAM Energy, Inc. on March 30, 2001. In addition, we
have also made two recent investments in corporate notes. We acquired $12.1
million principal amount of RAM's 11.5% senior notes due 2008 on July 2, 2001,
and we acquired $22.5 million principal amount of 12% senior secured notes due
2004 issued by Seven Seas Petroleum Inc. on July 24, 2001. These investments,
which are described below under "Liquidity and Capital Resources," will cause
our future interest income to increase.
Interest Expense. Interest expense increased to $23.0 million in the Current
Quarter from $21.8 million in the Prior Quarter. The increase in the Current
Quarter was due to the interest on debt assumed as a result of the Gothic
acquisition partially offset by a decrease in interest expense resulting from
the refinancing of a significant portion of our senior notes in April 2001. In
addition to the interest expense reported, we capitalized $1.3 million of
interest during the Current Quarter compared to $0.6 million capitalized in the
Prior Quarter.
Income Taxes. During the Current Quarter, we recorded income tax expense of
$57.5 million on pre-tax income before extraordinary item of $143.0 million,
compared to income tax expense of $1.4 million on $33.0 million of pre-tax
income in the Prior Quarter. The Prior Quarter expense related to our Canadian
operations only. The Prior Quarter U.S. tax expense was offset by a
corresponding reduction in the valuation allowance which had been established
due to uncertainty surrounding our ability to utilize tax net operating loss
carryforwards prior to their expiration. Based upon various factors, management
determined that a valuation allowance was no longer required as of December 31,
2000 and as a result we recognized income tax expense in the Current Quarter.
Extraordinary Item. The $46.0 million extraordinary loss in the Current Quarter
includes the payment of aggregate make-whole and redemption premiums related to
debt repurchases and redemptions and the write-off of related unamortized debt
costs and unamortized debt issue premium in the Current Quarter.
RESULTS OF OPERATIONS -- Six Months Ended June 30, 2001 ("Current Period") vs.
June 30, 2000 ("Prior Period")
General. For the Current Period, Chesapeake realized net income of $109.8
million, or $0.64 per diluted common share. This compares to $52.8 million, or
$0.36 per diluted common share in the Prior Period. Net income included a $62.5
million non-cash risk management gain recorded pursuant to SFAS 133, and a $46.0
million extraordinary loss in connection with the early retirement of debt.
Oil and Gas Sales. During the Current Period, oil and gas sales increased to
$396.4 million from $187.5 million, an increase of $208.9 million, or 111%. For
the Current Period, we produced 1.4 mmbo and 71.1 bcf, compared to 1.7 mmbo and
58.1 bcf in the Prior Period. The production increase is primarily the result of
the Gothic acquisition. We have included Gothic's results of operations since
January 1, 2001 because we had effective control as of that date. Average oil
prices realized were $28.36 per barrel in the Current Period compared to $24.52
per barrel in the Prior Period, an increase of 16%. Average gas prices realized
were $5.03 per mcf in the Current Period compared to $2.53 per mcf in the Prior
Period, an increase of 99%.
For the Current Period, we realized an average price of $5.00 per mcfe, compared
to $2.76 per mcfe in the Prior Period. Our hedging activities resulted in a
decrease in oil and gas revenues of $23.3 million, or $0.29 per mcfe, in the
Current Period, compared to a decrease in oil and gas revenues of $13.2 million
in the Prior Period, or $0.19 per mcfe.
24
25
The following table shows our production by region for the Current Period and
the Prior Period:
<Table>
<Caption>
FOR THE SIX MONTHS ENDED JUNE 30,
-----------------------------------------------------------
2000 2001
----------------------------- ---------------------------
OPERATING AREAS (mmcfe) PERCENT (mmcfe) PERCENT
--------------------------------- ------------- ------------- ------------- ------------
Mid-Continent.................... 37,734 55% 54,030 68%
Gulf Coast....................... 18,808 28 14,926 19
Canada........................... 6,504 9 5,798 7
Permian.......................... 3,145 5 2,672 4
Other areas...................... 1,825 3 1,867 2
------ ------ ------ -----
Total....................... 68,016 100% 79,293 100%
====== ====== ====== ======
</Table>
Gas production represented approximately 90% of our total production volume on
an equivalent basis in the Current Period, compared to 85% in the Prior Period.
Risk Management Income. Amounts recorded in this caption represent non-cash
gains and losses created by temporary valuation swings in derivatives or
portions of derivatives which are not entitled to receive hedge accounting. All
amounts recorded in this caption are ultimately reversed in this caption over
the respective contract terms. Risk management income for the Current Period was
a net gain of $62.5 million, which included a $61.5 million gain attributable to
the change in fair value for certain derivative instruments which did not meet
the definition of cash flow hedges under SFAS 133 for the Current Period and a
gain of $1.0 million relating to hedge ineffectiveness. Although derivatives
often fail to achieve 100% effectiveness, our derivative instruments continue to
be highly effective in achieving the risk management objectives for which they
were intended.
Oil and Gas Marketing Sales. We realized $94.2 million in oil and gas marketing
sales to third parties in the Current Period, with corresponding oil and gas
marketing expenses of $91.4 million for a margin of $2.8 million. This compares
to sales of $61.6 million and expenses of $59.7 million in the Prior Period for
a margin of $1.9 million. The increase in marketing sales and cost of sales was
due primarily to higher oil and gas prices in the Current Period as compared to
the Prior Period.
Production Expenses. Production expenses increased to $36.6 million in the
Current Period, a $11.5 million increase from $25.1 million incurred in the
Prior Period. On a production unit basis, production expenses were $0.46 and
$0.37 per mcfe in the Current and Prior Periods, respectively. The increase in
production expenses between periods is due primarily to the additional costs
associated with properties acquired since the Prior Period, the increase in ad
valorem taxes due to higher commodity prices and the overall increase in costs
for goods and services that oil and gas producers have experienced in 2001.
Production Taxes. Production taxes, which consist primarily of wellhead
severance taxes, were $24.3 million and $10.9 million in the Current and Prior
Periods, respectively. On a per unit basis, production taxes were $0.31 per mcfe
in the Current Period compared to $0.16 per mcfe in the Prior Period. This
increase was the result of higher oil and gas prices. In general, production
taxes are calculated using value-based formulas that produce higher per unit
costs when oil and gas prices increase.
Oil and Gas Depreciation, Depletion and Amortization. DD&A for the Current
Period was $78.1 million, compared to $49.4 million in the Prior Period. This
increase was caused by increased production as well as an increase in the DD&A
rate per mcfe from $0.73 to $0.98 in the Prior and Current Periods,
respectively. This increase is a result of the Gothic acquisition and escalating
drilling and equipment costs in 2001. Chesapeake's DD&A rate in the future will
be a function of the results of future acquisition, exploration, development and
production results. Our rate is expected to trend upward in 2001 based on
projected higher drilling, completion and acquisition costs throughout the oil
and gas industry.
Depreciation and Amortization of Other Assets. D&A increased to $3.8 million in
the Current Period compared to $3.7 million in the Prior Period. We anticipate
D&A will continue at current levels during the remainder of 2001.
General and Administrative. G&A, which is net of capitalized internal payroll
and non-payroll expenses, was $6.9 million in the Current Period compared to
$6.2 million in the Prior Period. This increase is primarily due to an increase
in the number of employees and the general increase in overhead associated with
the growth of Chesapeake. We capitalized $3.9 million of internal costs in the
Current Period directly related to our oil and gas exploration and
25
26
development efforts, compared to $3.4 million in the Prior Period. The increase
in capitalized internal costs is primarily due to the addition of technical
employees and other related costs. We anticipate that G&A costs during the
remainder of 2001 will remain at approximately the same level as the Current
Period.
Interest and Other Income. Interest and other income for the Current Period was
$1.3 million compared to $2.9 million in the Prior Period. The decrease is
primarily the result of a reduction in interest and other miscellaneous income
and the recognition of a $0.3 million loss, which represents our share of RAM
Energy, Inc.'s losses for the Current Quarter. We acquired 49.5% of the
outstanding common stock of RAM Energy, Inc. on March 30, 2001. In addition, we
have also made two recent investments in corporate notes. We acquired $12.1
million principal amount of RAM's 11.5% senior notes due 2008 on July 2, 2001,
and we acquired $22.5 million principal amount of 12% senior secured notes due
2004 issued by Seven Seas Petroleum Inc. on July 24, 2001. These investments,
which are described below under "Liquidity and Capital Resources," will cause
our future interest income to increase.
Interest Expense. Interest expense increased to $48.9 million in the Current
Period from $42.7 million in the Prior Period. The increase in the Current
Period was due to the interest associated with the debt assumed as a result of
the Gothic acquisition in the Current Period partially offset by a decrease in
interest expense resulting from the refinancing of a significant portion of our
senior notes in April 2001. We capitalized $2.2 million of interest during the
Current Period compared to $1.3 million capitalized in the Prior Period.
Income Taxes. We recorded income tax expense of $105.2 million on pre-tax income
of $261.0 million for the Current Period, compared to $1.5 million on pre-tax
income of $54.3 million in the Prior Period. The Prior Period expense related to
our Canadian operations only. The Prior Period U.S. tax expense was offset by a
corresponding reduction in the valuation allowance which had been established
due to uncertainty surrounding our ability to utilize net tax operating loss
carryforwards prior to their expiration. Based upon various factors, management
determined that a valuation allowance was no longer required as of December 31,
2000 and as a result we recognized income tax expense in the Current Period.
Extraordinary Item. The $46.0 million extraordinary loss in the Current Period
includes the payment of aggregate make-whole and redemption premiums related to
debt repurchases and redemptions and the write-off of related unamortized debt
costs and unamortized debt issue premium in the Current Quarter.
RISK MANAGEMENT ACTIVITIES
See Item 3 -- "Quantitative and Qualitative Disclosures About Market Risks."
LIQUIDITY AND CAPITAL RESOURCES
Chesapeake had working capital of $77.0 million at June 30, 2001. On May 2,
2001, we received a temporary increase in our revolving credit facility from
$100 million to $150 million, pending amendments to our credit facility. On June
11, 2001, our credit agreement was amended and restated, and our revolving
credit facility was increased to $225 million, maturing September 2003, with an
initial committed borrowing base of $225 million. The borrowing base is subject
to periodic redeterminations. As of June 30, 2001, we had borrowed $160 million
under the facility and $1.4 million of the facility secured various letters of
credit. Borrowings under the facility are collateralized by some of our
producing oil and gas properties and bear interest at either the reference rate
of Union Bank of California, N.A., or London Interbank Offered Rate (LIBOR), at
our option, plus a margin that varies according to total facility usage. The
average interest rate on the outstanding facility at June 30, 2001 was 6.5%.
Unused portions of the facility accrue an annual commitment fee of 0.50%. The
credit facility contains various covenants and restrictive provisions including
financial condition covenants requiring us to maintain certain financial ratios
at or above specified levels. In addition, extensions of credit under the
facility may not exceed the lesser of the maximum amount of indebtedness
permitted under the 8.125% senior note indenture or 15% of adjusted consolidated
net tangible assets.
At June 30, 2001, our senior notes represented $1.1 billion of our long-term
debt. During the first quarter 2001, we purchased and subsequently retired $7.3
million of our 8.5% senior notes due 2012 for total consideration of $7.4
million, including accrued interest of $0.2 million and the write-off of $0.1
million of unamortized bond discount.
26
27
On April 6, 2001, we issued $800 million principal amount of 8.125% senior notes
due 2011, which were subsequently exchanged on July 12, 2001 for substantially
identical notes registered under the Securities Act of 1933. During April 2001,
we used a portion of the offering proceeds to purchase $140.7 million principal
amount of our 9.625% senior notes and $3.0 million principal amount of the
11.125% senior secured notes of Gothic Production Corporation, a Chesapeake
subsidiary. On May 7, 2001, we redeemed all $120 million principal amount of our
9.125% senior notes, the remaining $359.3 million principal amount of our 9.625%
senior notes and the remaining $199.3 million principal amount of Gothic
Production Corporation's 11.125% senior secured notes. The purchase and
redemption of these notes included payment of aggregate make-whole and
redemption premiums of $75.6 million which was further adjusted by the write-off
of unamortized debt costs and debt issue premiums. These costs are reflected as
a $46.0 million, after tax, extraordinary loss in the Current Period. The
refinancing lowered the interest rate and extended the maturity of approximately
74% of our senior notes.
Following the note redemptions, our senior notes consist of the following: $800
million principal amount of 8.125% senior notes due 2011, $150 million principal
amount of 7.875% senior notes due 2004 and $142.7 million principal amount of
8.5% senior notes due 2012. Debt ratings for the senior notes are B2 by Moody's
Investor Service, B+ by Standard & Poor's Ratings Services and BB- by Fitch,
IBCA, Duff and Phelps as of June 18, 2001. Debt ratings for our secured bank
credit facility is Ba3 by Moody's Investor Service, BB by Standard & Poor's
Ratings Services and BB+ by Fitch, IBCA, Duff and Phelps. There are no scheduled
principal payments required on any of the senior notes until March 2004, when
$150 million is due.
Our senior notes are unsecured senior obligations of Chesapeake and rank equally
with all of our other unsecured indebtedness. All of our wholly owned
subsidiaries except Chesapeake Energy Marketing, Inc. and Carmen Acquisition
Corp. guarantee the notes, including Gothic Energy Corporation and Gothic
Production Corporation as of May 14, 2001. The 7.875% senior notes and the 8.5%
senior notes are redeemable at our option at any time prior to March 15, 2004 at
the make-whole price determined in accordance with the redemption indentures,
and on and after March 15, 2004, we may redeem the 8.5% senior notes at the
redemption price set forth in the indenture. We may redeem all or some of the
8.125% senior notes at any time after April 1, 2006 and prior to such date
pursuant to make-whole provisions in the indenture. We must repurchase at least
50% of the 7.875% senior notes by August 31, 2003, in order to extend the credit
facility until June 2005 for an amount equal to the total revolving credit
facility commitment less the outstanding amount of the 7.875% notes plus $50
million.
The indenture for the 8.125% senior notes contains covenants limiting our
ability and our restricted subsidiaries' ability to incur additional
indebtedness; pay dividends on our capital stock or redeem, repurchase or retire
our capital stock or subordinated indebtedness; make investments and other
restricted payments; create restrictions on the payment of dividends or other
amounts to us from our restricted subsidiaries; incur liens; engage in
transactions with affiliates; sell assets; and consolidate, merge or transfer
assets. The debt incurrence covenant does not affect our ability to borrow under
or expand our secured credit facility. As of June 30, 2001, we estimate that
secured commercial bank indebtedness of approximately $1.3 billion could have
been incurred under the indenture. The indenture covenants do not apply to
Chesapeake Energy Marketing, Inc. and Carmen Acquisition Corp., both
unrestricted subsidiaries.
On May 1, 2001, we redeemed all of the outstanding shares of our 7% cumulative
convertible preferred stock at a redemption price of $52.45 per share, payable
in 5.7 shares of common stock and cash of $2.45. Prior to redemption, the
preferred stock was convertible into common stock at a conversion price of $6.95
per share. During the Current Quarter, 622,768 shares of preferred stock were
converted into 4,480,171 shares of common stock. On the redemption date, the
remaining 1,269 shares of preferred stock were redeemed for 7,239 shares of
common stock and cash in the amount of $3,115, including cash in lieu of
fractional shares. Whether the shares had been converted or were redeemed,
holders of preferred stock on April 3, 2001, the record date for the last
regular quarterly dividend on the preferred stock, received the cash dividend
paid on May 1, 2001.
We believe we have adequate resources, including cash on hand and budgeted cash
flow from operations, to fund our capital expenditure budget for exploration and
development activities during 2001, which are currently estimated to be
approximately $300-325 million. However, we are concerned that the industry's
finding costs and operating margins have been adversely impacted during the past
few months by much higher service costs and much lower gas
27
28
prices. As a result, we have elected to reduce our capital expenditure budget
during the next 12 to 18 months by $125 million and expect other exploration and
production companies to make capital expenditure reductions as well. We
anticipate that a decrease in capital expenditures across the industry will lead
to lower service costs and more attractive finding costs. Based on our current
cash flow assumptions, the potential sale of our Canadian assets and our capital
expenditure budget, we expect to have substantial cash flow available for debt
reduction and acquisition of oil and gas properties in the next 12 to 18 months.
On March 30, 2001, we issued 1.1 million shares of Chesapeake common stock in
exchange for 1.3 million shares of RAM Energy, Inc. common stock, representing
49.5% of its outstanding equity securities. Our shares were valued at $8.854
each, or $9.9 million in total. We agreed to adjust the consideration for our
acquisition of RAM shares by making a cash payment to the RAM shareholders equal
to the shortfall if they sell the Chesapeake shares they received at a price
that is less than $8.854 per share. We have registered the Chesapeake shares
for resale. We also received an option granted by one of the RAM shareholders to
purchase an additional 1.0% of RAM's outstanding equity securities. The option
is exercisable for a year beginning in February 2002 for an aggregate exercise
price of $202,000 in cash. In May 2001, we purchased options to purchase RAM's
11.5% senior notes due February 15, 2008 at an average of $792 per $1,000 face
amount of the notes. The option premiums were $0.6 million. On July 2, 2001 we
exercised the options and received $12.1 million of RAM's 11.5% senior notes for
a total purchase price of $10.7 million, which included accrued interest of $0.5
million. The notes we acquired represent approximately 11.7% of RAM's
outstanding 11.5% senior notes.
On July 24, 2001, we purchased $22.5 million principal amount of 12% senior
secured notes due 2004 issued by Seven Seas Petroleum Inc. and detachable
seven-year warrants to purchase approximately 12.6 million shares of Seven Seas
common stock at an exercise price of approximately $1.78 per share. The shares
issuable upon exercise of the warrants will represent 20% of Seven Seas common
stock after completion of a rights offering and other transactions contemplated
by Seven Seas. Seven Seas has granted us registration rights with respect to the
warrant shares. Seven Seas common stock is listed for trading on the American
Stock Exchange. The chairman and chief executive officer of Seven Seas has
granted us an option that could require him to purchase a portion of our notes
and warrants if he has not invested at least $10.0 million in Seven Seas notes
after the proposed rights offering The 12% senior secured notes and $22.5
million of notes acquired by other parties are secured by a pledge of
substantially all of the assets owned by Seven Seas, including all of the Seven
Seas' subsidiaries which hold the concessions to the company's oil and gas
interests in Colombia.
Chesapeake is currently planning to sell its Canadian assets, which are located
in the Helmet Field of northeastern British Columbia. The estimated reserves
related to these assets totaled approximately 177 bcfe at June 30, 2001, which
represent approximately 10% of our total reserves as of that date. The Canadian
assets produce approximately 12 bcfe a year. We have received several offers for
these properties and anticipate closing a sale late in the third quarter or
early in the fourth quarter of 2001. Chesapeake expects to report a gain from
the sale and intends to re-deploy the sales proceeds into debt reduction and/or
further investment in our core U.S. operating areas, where we receive higher gas
prices, possess greater operating efficiencies and achieve higher rates of
return.
Our cash provided by operating activities increased 254% to $297.0 million
during the Current Period compared to $83.9 million during the Prior Period. The
increase was due primarily to higher oil and gas prices realized during the
Current Period and the acquisition of Gothic Energy Corporation in January 2001.
Cash used in investing activities increased to $314.3 million during the Current
Period from $130.6 million in the Prior Period. During the Current Period we
expended approximately $177.1 million to initiate drilling on 117 (62.2 net)
wells and invested approximately $28.8 million in leasehold acquisitions. This
compares to $68.3 million to initiate drilling on 66 (35.6 net) wells and $10.6
million to purchase leasehold in the Prior Period. During the Current Period, we
had acquisitions of oil and gas properties of $53.1 million and divestitures of
oil and gas properties of $0.2 million. This compares to acquisitions of $25.0
million and divestitures of $1.4 million in the Prior Period. We also acquired
K. Stewart Petroleum Corporation for $22.4 million during the Current Period.
This acquisition included 20 bcfe of proved reserves and more than 100 bcfe of
probable and possible reserves. During the Current Period, we had additional
investments in rig equipment totaling $11.9 million and investments in building
and other fixed assets of $8.8 million.
28
29
There was $17.3 million of cash provided in financing activities in the Current
Period, compared to $20.3 million in the Prior Period. The activity in the
Current Period reflects the net increase in borrowings under our commercial bank
credit facility of $135 million. This is primarily offset by the $786.7 million
received from the issuance of the $800 million 8.125% senior notes in April
2001, the $906.0 million paid for the redemption of various senior secured notes
and the $2.8 million received from the exercise of stock options.
In June 2001, the Financial Accounting Standards Board issued SFAS Nos. 141 and
142. SFAS No. 141, Business Combinations, requires that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001.
SFAS No. 142, Goodwill and Other Intangible Assets, changes the accounting for
goodwill from an amortization method to an impairment-only approach and will be
effective January 2002. We believe that adoption of these new standards will not
have an effect on our results of operations or our financial position.
FORWARD-LOOKING STATEMENTS
This report includes "forward-looking statements" within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. Forward-looking statements give our current expectations or forecasts
of future events. These statements are based on our historical operating trends,
our estimate of proved reserves as of June 30, 2001 and our current derivative
contract position. They include statements regarding oil and gas reserve
estimates, planned capital expenditures, the drilling of oil and gas wells and
future acquisitions, expected oil and gas production, cash flow and anticipated
liquidity, business strategy and other plans and objectives for future
operations, expected future expenses and utilization of net operating loss
carryforwards. Statements concerning the fair values of derivative contracts and
their estimated contribution to our future results of operations are based upon
market information as of a specific date. These market prices are subject to
significant volatility.
Although we believe the expectations and forecasts reflected in these and other
forward-looking statements are reasonable, we can give no assurance they will
prove to have been correct. They can be affected by inaccurate assumptions or by
known or unknown risks and uncertainties. Factors that could cause actual
results to differ materially from expected results are described under "Risk
Factors" in our Form 10-K, as amended, for the year ended December 31, 2000, and
include:
o the volatility of oil and gas prices,
o our substantial indebtedness,
o our commodity price risk management activities,
o the cost and availability of drilling and production services,
o our ability to replace reserves,
o the availability of capital,
o uncertainties inherent in estimating quantities of oil and gas reserves,
projecting future rates of production and the timing of development
expenditures,
o uncertainties in evaluating oil and gas reserves of acquired properties and
associated potential liabilities,
o drilling and operating risks,
o our ability to generate future taxable income sufficient to utilize our
NOLs before expiration,
o future ownership changes which could result in additional limitations to
our NOLs,
o adverse effects of governmental and environmental regulation,
o losses possible from pending or future litigation,
o the strength and financial resources of our competitors, and
o the loss of officers or key employees.
We caution you not to place undue reliance on these forward-looking statements,
which speak only as of the date of this report, and we undertake no obligation
to update this information. We urge you to carefully review and consider the
disclosures made in this and our other reports filed with the Securities and
Exchange Commission that attempt to advise interested parties of the risks and
factors that may affect our business.
29
30
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
COMMODITY PRICE RISK
Chesapeake's results of operations are highly dependent upon the prices received
for oil and gas production.
RISK MANAGEMENT ACTIVITY
Our results of operations and operating cash flows are impacted by changes in
market prices for oil and gas. To mitigate a portion of this exposure to adverse
market changes, we have entered into derivative instruments. All of our
derivative instruments have been entered into as hedges of oil and gas price
risk and not for speculative purposes.
We utilize derivative instruments to reduce exposure to unfavorable changes in
oil and gas prices which are subject to significant and often volatile
fluctuations. Our derivative instruments are currently comprised of swaps,
collars and cap-swaps. These instruments allow us to predict with greater
certainty the effective oil and gas prices to be received for our hedged
production.
o For swap instruments, we receive a fixed price for the respective
commodities and pay a floating market price, as defined in each instrument,
to the counterparty. The fixed-price payment and the floating-price payment
are netted, resulting in a net amount due to or from the counterparty.
o Collars 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, then we receive the fixed price and pay the market price. If the
market price is between the call and the put strike price, then no payments
are due from either party.
o For cap-swaps, we receive a fixed price for the respective commodities and
pay a floating market price. The fixed price received by Chesapeake
includes a premium in exchange for a "cap" on the counterparty's exposure.
Pursuant to SFAS 133, our cap-swaps do not qualify for designation as cash flow
hedges. Therefore, changes in the fair value of these instruments that occur
prior to their maturity are reported in the statement of operations as risk
management income (loss). Amounts recorded in risk management income (loss) do
not represent cash gains or losses. Rather, these amounts are temporary
valuation swings in contracts or portions of contracts that are not entitled to
receive hedge accounting treatment. All amounts initially recorded in this
caption are ultimately reversed within this same caption over the respective
contract terms.
The estimated fair values of our derivative instruments as of June 30, 2001 are
provided below. The associated carrying values of these instruments are equal to
the estimated fair values.
<Table>
<Caption>
JUNE 30,
2001
----------------
($ IN THOUSANDS)
Derivative assets:
Fixed-price gas swaps.................................... $ 75,874
Fixed-price gas cap-swaps................................ 60,986
Fixed-price gas collars.................................. 17,587
Fixed-price crude oil swaps.............................. 3,681
Fixed-price crude oil cap-swaps.......................... 509
---------
Total.................................................... $ 158,637
=========
</Table>
The fair value of our derivative instruments as of June 30, 2001 was estimated
based on market prices of gas and crude oil for the periods covered by the
instruments. The net differential between the prices in each instrument and
market prices for future periods, as adjusted for estimated basis, has been
applied to the volumes stipulated in each instrument to arrive at an estimated
future value. The fair value of derivative instruments which contain options
(such as collar structures) has been estimated based on remaining term,
volatility and other factors.
30
31
Risk management income in the statement of operations for the following period
is comprised of the following:
<Table>
<Caption>
SIX MONTHS ENDED
JUNE 30, 2001
----------------
($ IN THOUSANDS)
Risk Management Income:
Change in fair value of derivatives not qualifying for
hedge accounting..................................... $ 61,495
Ineffective portion of derivatives qualifying for hedge
accounting........................................... 960
---------
$ 62,455
=========
</Table>
Although derivatives often fail to achieve 100% effectiveness, our derivative
instruments continue to be highly effective in achieving the risk management
objectives for which they were intended.
The change in fair market value of our derivative instruments since December 31,
2000 has resulted from a decrease in market prices for gas and crude oil. The
majority of this change in fair value was reflected in accumulated other
comprehensive income, net of deferred income tax effects. Derivative assets
reflected as current in the June 30, 2001 consolidated balance sheet represent
the estimated fair value of derivative instrument settlements scheduled to occur
over the subsequent twelve-month period based on market prices for oil and gas
as of the balance sheet date. The derivative settlement amounts are not due and
payable until the monthly period that the related underlying hedged transaction
occurs.
We expect to transfer approximately $49.0 million of the balance in accumulated
other comprehensive income, based upon the market prices at June 30, 2001, to
earnings during the next 12 months when the forecasted transactions actually
occur. All forecasted transactions currently being hedged are expected to occur
by December 2003.
As of June 30, 2001, we had the following derivative instruments designed to
hedge a portion of our domestic gas production for periods after June 2001:
<Table>
<Caption>
SWAPS CAP-SWAPS COLLARS
------------------------- -------------------------------------- ---------------------------------------
NYMEX NYMEX NYMEX
NYMEX NYMEX CAPPED DEFINED DEFINED
INDEX INDEX LOW LOW HIGH
STRIKE STRIKE STRIKE STRIKE STRIKE
VOLUME PRICE VOLUME PRICE PRICE VOLUME PRICE PRICE
(mmbtu) ($ per mmbtu) (mmbtu) ($ per mmbtu) ($ per mmbtu) (mmbtu) ($ per mmbtu) ($ per mmbtu)
---------- ------------- ---------- ------------ ------------- ---------- ------------- -------------
3rd Quarter 2001 26,680,000 4.68 5,520,000 5.85 4.68 7,360,000 4.25 6.26
4th Quarter 2001 12,880,000 4.75 11,020,000 5.94 4.62 5,520,000 4.00 6.08
Total 2001 39,560,000 4.71 16,540,000 5.91 4.64 12,880,000 4.14 6.19
1st Quarter 2002 7,200,000 4.36 18,900,000 5.32 4.09 1,800,000 4.00 5.75
2nd Quarter 2002 7,280,000 3.77 22,750,000 4.55 3.55 3,640,000 4.00 5.38
3rd Quarter 2002 7,360,000 3.84 23,000,000 4.57 3.57 3,680,000 4.00 5.38
4th Quarter 2002 7,360,000 3.99 18,120,000 4.49 3.49 2,460,000 4.00 5.56
Total 2002 29,200,000 3.99 82,770,000 4.72 3.67 11,580,000 4.00 5.47
1st Quarter 2003 6,890,000 4.04 5,400,000 4.01 3.01 -- -- --
2nd Quarter 2003 6,370,000 3.61 5,460,000 3.56 2.56 -- -- --
3rd Quarter 2003 6,440,000 3.71 5,520,000 3.65 2.65 -- -- --
4th Quarter 2003 6,440,000 3.87 5,520,000 3.84 2.84 -- -- --
Total 2003 26,140,000 3.82 21,900,000 3.77 2.77 -- -- --
</Table>
Subsequent to June 30, 2001, we settled the gas swaps for July and August 2001.
Gains of $13.0 million and $13.7 million will be recognized as price adjustments
in July and August 2001, respectively.
Subsequent to June 30, 2001, we settled the July and August 2001 gas cap-swaps.
Gains of $2.2 million and $2.2 million will be recognized as price adjustments
in July and August 2001, respectively.
31
32
Subsequent to June 30, 2001, we settled the gas collars for July and August
2001. Gains of $2.3 million and $2.6 million will be recognized as price
adjustments in July and August 2001, respectively.
As of June 30, 2001, we had the following open derivative instruments designed
to hedge a portion of our domestic crude oil production for periods after June
2001:
<Table>
<Caption>
SWAPS CAP-SWAPS
------------------------ -------------------------------------
NYMEX
NYMEX NYMEX CAPPED
INDEX INDEX LOW
STRIKE STRIKE STRIKE
VOLUME PRICE VOLUME PRICE PRICE
(mbbls) ($ per bbl) (mbbls) ($ per bbl) ($ per bbl)
------- ----------- ------- ----------- -----------
3rd Quarter 2001 490 29.65 -- -- --
4th Quarter 2001 490 29.56 -- -- --
Total 2001 980 29.61 -- -- --
1st Quarter 2002 -- -- 270 25.64 20.64
2nd Quarter 2002 -- -- 273 25.41 20.41
3rd Quarter 2002 -- -- 276 25.18 20.18
4th Quarter 2002 -- -- 276 24.98 19.98
Total 2002 -- -- 1,095 25.30 20.30
</Table>
Subsequent to June 30, 2001, we settled the crude oil swap for July 2001 for a
gain of $0.5 million which will be recognized as a price adjustment in July
2001.
Subsequent to June 30, 2001, we entered into the following derivative
instruments designed to hedge a portion of our domestic gas production for
periods after June 2001:
<Table>
<Caption>
SWAPS CAP-SWAPS
--------------------------- ----------------------------------------
NYMEX
NYMEX NYMEX CAPPED
INDEX INDEX LOW
STRIKE STRIKE STRIKE
VOLUME PRICE VOLUME PRICE PRICE
(mmbtu) ($ per mmbtu) (mmbtu) ($ per mmbtu) ($ per mmbtu)
---------- ------------- ---------- ------------- -------------
4th Quarter 2001 8,300,000 3.37 -- -- --
Total 2001 8,300,000 3.37 -- -- --
1st Quarter 2002 3,600,000 4.05 -- -- --
2nd Quarter 2002 1,820,000 3.69 -- -- --
3rd Quarter 2002 1,840,000 3.80 -- -- --
4th Quarter 2002 5,500,000 3.99 -- -- --
Total 2002 12,760,000 3.94 -- -- --
1st Quarter 2003 7,200,000 4.03 3,600,000 3.85 2.85
2nd Quarter 2003 7,280,000 3.63 3,640,000 3.49 2.49
3rd Quarter 2003 7,360,000 3.72 3,680,000 3.58 2.58
4th Quarter 2003 7,360,000 3.91 3,680,000 3.76 2.76
Total 2003 29,200,000 3.82 14,600,000 3.67 2.67
</Table>
Subsequent to June 30, 2001, we entered into the following derivative
instruments designed to hedge a portion of our domestic crude oil production for
periods after June 2001:
<Table>
<Caption>
SWAPS
---------------------------
NYMEX INDEX
VOLUME STRIKE PRICE
(mbbls) ($ per bbl)
------- -----------
1st Quarter 2002 180 25.71
2nd Quarter 2002 182 25.14
3rd Quarter 2002 62 25.00
Total 2002 424 25.36
</Table>
In addition to commodity hedging transactions related to our oil and gas
production, our marketing subsidiary, Chesapeake Energy Marketing, Inc., enters
into various hedging transactions designed to hedge against physical
32
33
purchase and sale commitments it makes. Gains or losses on these transactions
are recorded as adjustments to oil and gas marketing sales in the consolidated
statements of operations and are not considered material by management.
INTEREST RATE RISK
The table below presents principal cash flows and related weighted average
interest rates by expected maturity dates. The fair value of the long-term debt
has been estimated based on quoted market prices.
<Table>
<Caption>
JUNE 30, 2001
----------------------------------------------------------------------------
YEARS OF MATURITY
----------------------------------------------------------------------------
2001 2002 2003 2004 2005 THEREAFTER TOTAL FAIR VALUE
---- ---- ---- ---- ---- ---------- ----- ----------
($ IN MILLIONS)
LIABILITIES:
Long-term debt, including current
portion -- fixed rate............. $0.4 $ 0.6 $ -- $150.0 $ -- $942.7 $1,093.7 $1,080.5
Average interest rate............... 9.1% 9.1% -- 7.9% -- 8.2% 8.1% --
Long-term debt -- variable rate..... $ -- $ -- $160.0 $ -- $ -- $ -- $ 160.0 $ 160.0
Average interest rate............... -- -- 6.5% -- -- -- 6.5% --
</Table>
Changes in interest rates affect the amount of interest we earn on our cash,
cash equivalents and short-term investments and the interest rate we pay on
borrowings under our credit facility. We are not presently using any interest
rate derivative instruments to manage exposure to interest rate changes. All of
our other long-term indebtedness is fixed rate and therefore does not expose us
to the risk of earnings or cash flow loss due to changes in market interest
rates.
33
34
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to ordinary routine litigation incidental to our business. In
addition, Chesapeake is a defendant in other pending actions which are described
in Item 3 of our Annual Report on Form 10-K for the year ended December 31,
2000.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the second quarter of 2001, we issued 4,480,171 shares of our common
stock upon the conversion of 622,768 shares of our 7% convertible preferred
stock. The preferred stock was convertible into common stock at a conversion
price of $6.95 per share based on the market value of the common stock on the
date of conversion. On the redemption date for the preferred stock, May 1, 2001,
we issued 7,239 shares of common stock and paid cash in the amount of $3,115,
including cash in lieu of fractional shares, to redeem the remaining 1,269
shares of preferred stock outstanding. The redemption price was $52.45 per share
of preferred stock, payable in 5.7 shares of common stock and cash of $2.45. The
issuances of common stock upon conversion and redemption of preferred stock were
not registered under the Securities Act of 1933 in reliance on the exemption
from registration provided by Section 3(a)(9) of the Act. They were exchanges by
us with our existing security holders exclusively, and no commission or other
remuneration was paid or given for soliciting such exchanges.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES OR DIVIDEND ARREARAGES
- -- Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Four matters were submitted to a vote of the shareholders at Chesapeake's annual
meeting of shareholders held on June 8, 2001: the election of directors,
amendments to our certificate of incorporation to reduce the maximum number of
directors from 15 to nine and to increase the number of authorized shares of
common stock from 250 million to 350 million, and the adoption of a stock option
plan for employees and consultants. In the election of directors, Edgar F.
Heizer, Jr. received 140,635,223 votes for election, and 9,265,991 shares were
withheld from voting; Tom L. Ward received 140,676,801 votes for election, and
9,224,413 shares were withheld from voting; and Frederick B. Whittemore received
140,637,879 votes for election, and 9,263,335 shares were withheld from voting.
There were no broker non-votes. The other directors whose terms continued after
the meeting are Breene M. Kerr, Aubrey K. McClendon and Shannon T. Self. In the
amendment to our certificate of incorporation to reduce the maximum number of
directors, 147,324,523 votes were received for the amendment, 2,312,816 votes
were received against the amendment and 263,875 shares were withheld from voting
on this proposal. In the amendment to our certificate of incorporation to
increase the number of authorized shares of common stock, 141,065,675 votes were
received for the amendment, 8,488,634 votes were received against the amendment
and 346,905 shares were withheld from voting on this proposal. In the adoption
of Chesapeake's 2001 Stock Option Plan, 109,487,795 votes were received for
adoption of the plan, 39,935,520 votes were received against adoption of the
plan and 477,899 shares were withheld from voting on this proposal.
ITEM 5. OTHER INFORMATION
- -- Not applicable
34
35
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following exhibits are filed as a part of this report:
Exhibit No.
3.1 Registrant's Restated Certificate of Incorporation.
3.2 Registrant's Bylaws, as amended through August 10, 2001.
4.6 $225,000,000 Second Amended and Restated Credit
Agreement, dated as of June 11, 2001, among Chesapeake Energy Corporation,
Chesapeake Exploration Limited Partnership, as Borrower, Bear Stearns Corporate
Lending Inc., as Syndication Agent, Union Bank of California, N.A., as
Administrative Agent and Collateral Agent, BNP Paribas and Toronto Dominion
(Texas), Inc., as Co-Documentation Agents and other lenders party thereto.
10.1.8 Registrant's 2001 Stock Option Plan. Incorporated herein by
reference to Exhibit B to Registrant's definitive proxy statement for its 2001
annual meeting of shareholders filed April 30, 2001.
10.1.9 Registrant's 2001 Executive Officer Stock Option Plan.
10.1.10 Registrant's 2001 Nonqualified Stock Option Plan.
12 Computation of ratios of earnings to fixed charges.
(b) Reports on Form 8-K
During the quarter ended June 30, 2001, we filed the following
current reports on Form 8-K:
On April 2, 2001, we filed a current report on Form 8-K reporting under Item 5
that we had issued a press release on March 30, 2001 announcing the schedule for
releasing revised 2001 forecasts and providing information for accessing the
related conference call.
On April 2, 2001, we filed a current report on Form 8-K reporting under Item 5
that we had issued a press release on March 30, 2001 announcing the pricing of
our $800 million offering of 8-1/8% Senior Notes due 2011 and our planned
redemption of $823 million principal amount of senior notes.
On April 3, 2001, we filed a current report on Form 8-K reporting under Item 9
that we had issued a press release on April 2, 2001 announcing updated operating
assumptions, commodity hedging activities and projections for 2001 and 2002 and
the availability of the information on our web site.
On April 9, 2001, we filed a current report on Form 8-K reporting under Item 5
that we had issued a press release on April 6, 2001 announcing the closing of
our $800 million offering of 8-1/8% Senior Notes due 2011 and the redemption to
occur on May 7, 2001 of all of our $500 million principal amount of 9-5/8%
Senior Notes due 2005 and $120 million principal amount of 9-1/8% Senior Notes
due 2006 and the outstanding $202.5 million principal amount of 11-1/8% Senior
Secured Notes due 2005 of our subsidiary Gothic Production Corporation.
On April 16, 2001, we filed a current report on Form 8-K under Item 9 reporting
the posting on our web site of operating assumptions and projections for the
first two quarters of 2001 and full years 2001 and 2002.
On April 17, 2001, we filed a current report on Form 8-K reporting under Item 5
that we had issued a press release on April 16, 2001 announcing the schedule for
our first quarter 2001 earnings release, providing information for accessing the
related conference call and our presentation at an industry conference, and
reporting operating
35
36
assumptions, commodity hedging activities and projections for the first two
quarters of 2001 and full years 2001 and 2002.
On April 27, 2001, we filed a current report on Form 8-K reporting under Item 5
that we had issued a press release on April 26, 2001 announcing our financial
and operating results for the first quarter of 2001.
36
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CHESAPEAKE ENERGY CORPORATION
(Registrant)
By: /s/ Aubrey K. McClendon
---------------------------------
Aubrey K. McClendon
Chairman and Chief Executive Officer
August 14, 2001 By: /s/ Marcus C. Rowland
- ---------------------------- ---------------------------------
Date Marcus C. Rowland
Executive Vice President and
Chief Financial Officer
37
38
EXHIBIT INDEX
<Table>
<Caption>
Exhibit No.
- -----------
3.1 Registrant's Restated Certificate of Incorporation.
3.2 Registrant's Bylaws, as amended through August 10, 2001.
4.6 $225,000,000 Second Amended and Restated Credit Agreement, dated
as of June 11, 2001, among Chesapeake Energy Corporation,
Chesapeake Exploration Limited Partnership, as Borrower, Bear
Stearns Corporate Lending Inc., as Syndication Agent, Union Bank
of California, N.A., as Administrative Agent and Collateral
Agent, BNP Paribas and Toronto Dominion (Texas), Inc., as
Co-Documentation Agents and other lenders party thereto.
10.1.8 Registrant's 2001 Stock Option Plan. Incorporated herein by
reference to Exhibit B to Registrant's definitive proxy statement
for its 2001 annual meeting of shareholders filed April 30, 2001.
10.1.9 Registrant's 2001 Executive Officer Stock Option Plan.
10.1.10 Registrant's 2001 Nonqualified Stock Option Plan.
12 Computation of ratios of earnings to fixed charges.
</Table>