1 - ------------------------------------------------------------------------------- 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, 1998 [ ] 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 July 31, 1998, there were 98,335,100 shares of the registrant's $.01 par value Common Stock outstanding. - -------------------------------------------------------------------------------
2 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES INDEX TO FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 1998 PART I. FINANCIAL INFORMATION <TABLE> <CAPTION> PAGE ---- <S> <C> Item 1. Consolidated Financial Statements: Consolidated Balance Sheets at June 30, 1998 (Unaudited) and December 31, 1997 3 Consolidated Statements of Operations for the Three and Six Months Ended June 30, 1998 and 1997 (Unaudited) 4 Consolidated Statements of Cash Flows for the Six Months Ended June 30, 1998 and 1997 (Unaudited) 5 Notes to Consolidated Financial Statements (Unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 PART II. OTHER INFORMATION Item 1. Legal Proceedings 25 Item 2. Changes in Securities and Use of Proceeds 25 Item 3. Defaults Upon Senior Securities 26 Item 4. Submission of Matters to a Vote of Security Holders 26 Item 5. Other Information 26 Item 6. Exhibits and Reports on Form 8-K 26 </TABLE> 2
3 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED) ASSETS <TABLE> <CAPTION> JUNE 30, DECEMBER 31, 1998 1997 ------------- ------------- (UNAUDITED) ($ IN THOUSANDS) <S> <C> <C> CURRENT ASSETS: Cash and cash equivalents ........................................ $ 59,690 $ 123,860 Short-term investments ........................................... 6,637 12,570 Accounts receivable: Oil and gas sales ............................................... 21,866 10,654 Oil and gas marketing sales ..................................... 26,122 20,493 Joint interest and other, net of allowance for doubtful accounts of $1,049,000 and $691,000............................ 32,898 38,781 Related parties ................................................. 6,707 4,246 Inventory ........................................................ 5,216 5,493 Other ............................................................ 2,378 1,624 ------------- ------------- Total current assets .......................................... 161,514 217,721 ------------- ------------- PROPERTY AND EQUIPMENT: Oil and gas properties, at cost based on full cost accounting: Evaluated oil and gas properties ................................ 2,002,236 1,095,363 Unevaluated properties .......................................... 99,229 125,155 Less: accumulated depreciation, depletion and ................... (1,143,521) (602,391) ------------- ------------- amortization 957,944 618,127 Other property and equipment ..................................... 77,309 67,633 Less: accumulated depreciation and amortization .................. (18,887) (6,573) ------------- ------------- Total property and equipment .................................. 1,016,366 679,187 ------------- ------------- OTHER ASSETS ....................................................... 82,293 55,876 ------------- ------------- TOTAL ASSETS .................................................. $ 1,260,173 $ 952,784 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable ................................................. $ 58,559 $ 81,775 Accrued liabilities and other .................................... 49,906 42,733 Revenues and royalties due others ................................ 21,615 28,972 ------------- ------------- Total current liabilities ..................................... 130,080 153,480 ------------- ------------- LONG-TERM DEBT, NET ................................................ 919,034 508,992 ------------- ------------- REVENUES AND ROYALTIES DUE OTHERS .................................. 11,345 10,106 ------------- ------------- STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value, 10,000,000 shares authorized; 4,600,000 and 0 shares of 7% cumulative convertible stock issued and outstanding at June 30, 1998 and December 31, 1997, respectively, entitled in liquidation to $230 million...... 230,000 -- Common stock, 250,000,000 shares authorized; $.01 par value; 100,903,950 and 74,298,061 shares issued and outstanding at June 30, 1998, and December 31, 1997, respectively ........... 1,009 743 Paid-in capital .................................................. 680,511 460,733 Accumulated deficit .............................................. (693,975) (181,270) Less: treasury stock, at cost; 4,282,000 and zero shares at June 30, 1998 and December 31, 1997, respectively ............ (17,831) -- ------------- ------------- Total stockholders' equity .................................... 199,714 280,206 ------------- ------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ......................... $ 1,260,173 $ 952,784 ============= ============= </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) (IN THOUSANDS, EXCEPT PER SHARE DATA) <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, -------------------------- -------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> REVENUES: Oil and gas sales ...................................... $ 75,639 $ 45,354 $ 125,880 $ 102,753 Oil and gas marketing sales ............................ 33,671 23,743 60,195 46,153 Interest and other ..................................... 2,571 5,430 2,795 8,707 ---------- ---------- ---------- ---------- Total revenues ..................................... 111,881 74,527 188,870 157,613 ---------- ---------- ---------- ---------- COSTS AND EXPENSES: Production expenses .................................... 14,673 4,019 22,567 7,177 Production taxes ....................................... 2,621 906 4,165 2,056 Oil and gas marketing expenses ......................... 33,705 23,845 59,966 45,592 Impairment of oil and gas properties ................... 216,000 236,000 466,000 236,000 Impairment of other assets ............................. 10,000 -- 10,000 -- Oil and gas depreciation, depletion and amortization ... 43,900 42,358 75,242 67,021 Depreciation and amortization of other assets .......... 1,922 1,073 3,302 1,946 General and administrative ............................. 5,134 2,582 9,514 5,063 Interest ............................................... 18,665 8,680 29,353 12,334 ---------- ---------- ---------- ---------- Total costs and expenses ........................... 346,620 319,463 680,109 377,189 ---------- ---------- ---------- ---------- LOSS BEFORE INCOME TAX AND EXTRAORDINARY ITEM ........... (234,739) (244,936) (491,239) (219,576) INCOME TAX BENEFIT ...................................... -- (27,153) -- (17,898) ---------- ---------- ---------- ---------- LOSS BEFORE EXTRAORDINARY ITEM .......................... (234,739) (217,783) (491,239) (201,678) EXTRAORDINARY ITEM: Loss on early extinguishment of debt ................... (13,334) -- (13,334) (177) ---------- ---------- ---------- ---------- NET LOSS ................................................ (248,073) (217,783) (504,573) (201,855) PREFERRED STOCK DIVIDENDS ............................... (4,025) -- (4,025) -- ---------- ---------- ---------- ---------- NET LOSS AVAILABLE TO COMMON SHAREHOLDERS ............... $ (252,098) $ (217,783) $ (508,598) $ (201,855) ========== ========== ========== ========== EARNINGS PER COMMON SHARE (BASIC AND ASSUMING DILUTION) Loss before extraordinary item ......................... $ (2.29) $ (3.12) $ (5.35) $ (2.87) Extraordinary item ..................................... (0.12) -- (0.15) -- ---------- ---------- ---------- ---------- Net loss ............................................... $ (2.41) $ (3.12) $ (5.50) $ (2.87) ========== ========== ========== ========== WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING Basic and assuming dilution ............................ 104,662 69,819 92,504 70,277 ========== ========== ========== ========== </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, -------------------------- 1998 1997 ---------- ---------- ($ IN THOUSANDS) <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ........................................................................ $ (504,573) $ (201,855) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation, depletion and amortization ....................................... 77,542 68,274 Impairment of oil and gas assets ............................................... 466,000 236,000 Impairment of other assets ..................................................... 10,000 -- Deferred taxes ................................................................. -- (14,195) Amortization of loan costs ..................................................... 1,002 693 Amortization of bond discount .................................................. 56 26 Gain on sale of fixed assets and other ......................................... (368) (1,071) Extraordinary loss before income tax benefit ................................... 13,334 (3,526) Equity in (earnings) losses of equity investees ................................ 285 (321) Bad debt expense ............................................................... 516 299 ---------- ---------- Cash provided by operating activities before changes in current assets and liabilities .......................................... 63,794 84,324 Changes in current assets and liabilities ...................................... (44,074) (42,136) ---------- ---------- Cash provided by operating activities ........................................ 19,720 42,188 ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Exploration, development and acquisition of oil and gas properties .............. (472,879) (281,709) Proceeds from sale of assets .................................................... 4,404 -- Long-term loans made to third parties ........................................... -- (18,000) Other investments ............................................................... -- (10,751) Repayment of long-term loan ..................................................... 2,000 -- Additions to other property and equipment ....................................... (5,183) (29,245) ---------- ---------- Cash used in investing activities ............................................ (471,658) (339,705) ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term borrowings .............................................. 658,750 292,626 Payments on long-term borrowings ................................................ (474,166) (12,750) Proceeds from issuance of preferred stock ....................................... 222,781 -- Purchase of treasury stock ...................................................... (17,831) -- Cash received from exercise of stock options .................................... 101 1,114 Other financing ................................................................. (1,867) (195) ---------- ---------- Cash provided by financing activities ........................................ 387,768 280,795 ---------- ---------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS .............................. (64,170) (16,722) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD .................................... 123,860 140,739 ---------- ---------- CASH AND CASH EQUIVALENTS, END OF PERIOD .......................................... $ 59,690 $ 124,017 ========== ========== </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 5
6 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) 1. ACCOUNTING PRINCIPLES The accompanying unaudited consolidated financial statements of Chesapeake Energy Corporation and subsidiaries (the "Company") 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, 1998 are not necessarily indicative of the results to be expected for the full fiscal year. The Company changed its fiscal year end from June 30 to December 31 for the period ended December 31, 1997. This Form 10-Q relates to the three and six months ended June 30, 1998 (the "Current Quarter" and "Current Period", respectively) and June 30, 1997 (the "Prior Quarter" and "Prior Period", respectively). 2. RECENT EVENTS On April 22, 1998, the Company issued $230 million (4.6 million shares) of its 7% Cumulative Convertible Preferred Stock, $50 per share liquidation preference, and $500 million of its 9.625% Series A Senior Notes due 2005. Net proceeds from these offerings were approximately $711 million. On April 27, 1998, Chesapeake acquired from Gothic Energy Corporation natural gas reserves in the Arkoma Basin of Oklahoma for $20 million, and purchased $39.5 million of Gothic 12% preferred stock (with liquidation value of $50 million) and ten-year warrants to purchase 15% of Gothic's currently outstanding common stock for $0.01 per share. As part of this transaction, for additional consideration of $10.5 million, Chesapeake entered into a five-year drilling and acquisitions participation agreement with Gothic. On April 27, 1998, Chesapeake acquired the British Columbia properties of Sunoma Acquisitions Ltd. for $33 million. On April 28, 1998, the Company acquired by merger the Mid-Continent operations of DLB Oil & Gas, Inc. for $17.5 million in cash, 5,000,000 shares of the Company's common stock, and the assumption of $90 million in outstanding debt and working capital obligations. On April 30, 1998, the Company acquired 100% of the stock of MC Panhandle Corp., a wholly-owned subsidiary of Occidental Petroleum Corporation, by paying approximately $95 million, net of working capital adjustments. Effective April 30, 1998, the Company purchased all of its $90 million aggregate principal amount 10.5% Senior Notes due 2002. The cost to acquire the 10.5% Senior Notes was approximately $99 million. The early retirement of these notes resulted in an extraordinary charge of approximately $13.3 million during the Current Quarter. 3. LEGAL PROCEEDINGS The Company and certain of its officers and directors are defendants in a consolidated class action suit alleging violations of the Securities Exchange Act of 1934. The plaintiffs assert that the defendants made material misrepresentations and failed to disclose material facts about the success of the Company's exploration efforts in the Louisiana Trend. As a result, the complaint alleges the price of the Company's common stock was artificially inflated from January 25, 1996 until June 27, 1997, when the Company issued a press release announcing disappointing drilling results in the Louisiana Trend and a full-cost ceiling writedown to be reflected in its June 30, 1997 financial statements. The plaintiffs further allege that certain of the named individual defendants sold common stock during the class period when they knew or should have known adverse nonpublic information. The plaintiffs seek a determination that the suit is a proper class action and damages in an unspecified amount, together with interest and costs of litigation, including attorneys' fees. The Company and the individual defendants believe 6
7 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) that these claims are without merit, and intend to defend against them vigorously. No estimate of loss or range of estimate of loss, if any, can be made at this time. A purported class action alleging violations of the Securities Act of 1933 and the Oklahoma Securities Act has been filed against the Company and others on behalf of investors who purchased common stock of Bayard Drilling Technologies, Inc. ("Bayard") in, or traceable to, its initial public offering in November 1997. Total proceeds of the offering were $254 million, of which the Company received net proceeds of $90 million as a selling shareholder. Plaintiffs allege that the Company, a major customer of Bayard's drilling services and the owner of 30.1% of Bayard's common stock outstanding prior to the offering, was a controlling person of Bayard. Plaintiffs assert that the Bayard prospectus contained material omissions and misstatements relating to (i) the Company's financial "problems" and their impact on Bayard's operating results, (ii) increased costs associated with Bayard's growth strategy, (iii) undisclosed pending related-party transactions between Bayard and third parties other than the Company, (iv) Bayard's planned use of offering proceeds and (v) Bayard's capital expenditures and liquidity. The alleged defective disclosures are claimed to have resulted in a decline in Bayard's share price following the public offering. Plaintiffs seek a determination that the suit is a proper class action and damages in an unspecified amount or rescission, together with interest and costs of litigation, including attorneys' fees. The Company believes that the claims are without merit and intends to defend against them vigorously. No estimate of loss or range of estimate of loss, if any, can be made at this time. In October 1996, Union Pacific Resources Company ("UPRC") sued the Company alleging infringement of a patent for a drillbit steering method. Other claims asserted by UPRC have been dismissed. UPRC's infringement claims against the Company are based on services provided to the Company by a third party vendor controlled by former UPRC employees. UPRC is seeking injunctive relief, damages of an unspecified amount, including actual and enhanced damages, interest, costs and attorneys' fees. The Company believes that it has meritorious defenses to UPRC's allegations and that the UPRC patent is invalid. The Company has filed a motion to construe UPRC's patent claims and other dispositive motions are pending. No estimate of loss or range of estimate of loss, if any, can be made at this time; however, in reports filed in the proceeding, experts for UPRC claim that damages could be as much as $18 million while Company experts state that the amount should not exceed $25,000, in each case based on a reasonable royalty. The Company 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 the Company. 4. IMPAIRMENT OF OIL AND GAS PROPERTIES AND OTHER ASSETS The Company incurred an impairment of oil and gas properties charge of $216 million in the Current Quarter. This writedown was caused primarily by the effects of accounting for the Current Quarter acquisitions using the purchase accounting method, as well as a significant decline in oil prices from March 31 to June 30. The Company also recorded a $10 million impairment in the Current Quarter related to certain of its gas processing and transportation assets located in Louisiana. 5. NET LOSS PER SHARE In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 128, Earnings Per Share ("SFAS 128"). SFAS 128 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 is effective for financial statements issued for periods ending after December 15, 1997 and requires restatement of all prior period earnings per share amounts. The Company has adopted SFAS 128 and has restated all prior periods presented. 7
8 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) SFAS 128 requires a reconciliation of the numerators and denominators of the basic and diluted EPS computations. For the Current Quarter, the Prior Quarter, the Current Period and the Prior Period, there was no difference between actual weighted average shares outstanding, which are used in computing basic EPS, and diluted weighted average shares outstanding, which are used in computing diluted EPS. Options to purchase 8.3 million and 7.9 million shares of common stock at a weighted average exercise price of $4.13 and $7.09 were outstanding at June 30, 1998 and 1997, respectively, but were not included in the computation of diluted EPS because the effect of these outstanding options would be antidilutive. 6. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENT In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999 (January 1, 2000 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designed as part of a hedge transaction and, if it is, the type of hedge transaction. For fair-value hedge transactions in which the Company is hedging changes in an asset's, liability's, or firm commitment's fair value, changes in the fair value of the derivative instrument will generally be offset in the income statement by changes in the hedged item's fair value. For cash-flow hedge transactions, in which the Company is hedging the variability of cash flows related to a variable-rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument will be reported in other comprehensive income. The gains and losses on the derivative instrument that are reported in other comprehensive income will be reclassified as earnings in the periods in which earnings are impacted by the variability of the cash flows of the hedged item. The ineffective portion of all hedges will be recognized in current-period earnings. The Company has not yet determined the impact that the adoption of FAS 133 will have on its earnings or its balance sheet. 7. ACQUISITION OF HUGOTON In March 1998, the Company acquired Hugoton Energy Corporation ("Hugoton") pursuant to a merger by issuing 25.8 million shares of the Company's common stock in exchange for 100% of Hugoton's common stock. The acquisition of Hugoton was accounted for using the purchase method as of March 1, 1998, and the results of operations of Hugoton have been included since that date. The following unaudited pro forma information has been prepared assuming Hugoton had been acquired as of the beginning of the periods presented. 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 those dates. In addition, the pro forma information is not intended to be a projection of future results and does not reflect the efficiencies expected to result from the integration of Hugoton. Pro Forma Information (Unaudited) (In thousands, except per share data) <TABLE> <CAPTION> Six Months Ended June 30, 1998 1997 ---------- --------- <S> <C> <C> Revenues................................................ $ 198,562 $ 198,946 Loss before extraordinary item.......................... $ (492,688) $(197,871) Net Loss................................................ $ (506,022) $(198,048) Loss before extraordinary item per common share......... $ (5.37) $ (2.82) Loss per common share................................... $ (5.51) $ (2.82) </TABLE> 8
9 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) The Company also acquired other businesses and oil and gas properties since December 1997. The results of operations of these businesses and properties were not material in relation to the Company's consolidated results of operations. 8. SENIOR NOTES 10.5% Notes The Company had outstanding at March 31, 1998, $90 million in aggregate principal amount of 10.5% Senior Notes due 2002. The 10.5% Notes were senior, unsecured obligations of the Company and were fully and unconditionally guaranteed, jointly and severally, by Guarantor Subsidiaries (as defined below). All outstanding 10.5% Notes were acquired by the Company effective April 30, 1998. See Note 2. 9.125% Notes The Company has outstanding $120 million in aggregate principal amount of 9.125% Senior Notes which mature April 15, 2006. The 9.125% Notes bear interest at an annual rate of 9.125%, payable semiannually on each April 15 and October 15. The 9.125% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. 7.875% Notes The Company has outstanding $150 million in aggregate principal amount of 7.875% Senior Notes which mature March 15, 2004. The 7.875% Notes bear interest at the rate of 7.875%, payable semiannually on each March 15 and September 15. The 7.875% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. 8.5% Notes The Company has outstanding $150 million in aggregate principal amount of 8.5% Senior Notes which mature March 15, 2012. The 8.5% Notes bear interest at the rate of 8.5%, payable semiannually on each March 15 and September 15. The 8.5% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. 9.625% Notes On April 22, 1998, the Company issued $500 million aggregate principal amount of 9.625% Senior Notes which mature May 1, 2005. The 9.625% Notes bear interest at an annual rate of 9.625%, payable semiannually on each May 1 and November 1. The 9.625% Notes are senior, unsecured obligations of the Company and are fully and unconditionally guaranteed, jointly and severally, by the Guarantor Subsidiaries. The Company is a holding company and owns no operating assets and has no significant operations independent of its subsidiaries. The Company's obligations under its Senior Notes have been fully and unconditionally guaranteed, on a joint and several basis, by each of the Company's "Restricted Subsidiaries" (as defined in the respective indentures governing the Senior Notes) (collectively, the "Guarantor Subsidiaries"). Each of the Guarantor Subsidiaries is a direct or indirect wholly-owned subsidiary of the Company. The Senior Note Indentures contain certain covenants, including covenants limiting the Company and the Guarantor Subsidiaries with respect to asset sales, restricted payments, the incurrence of additional indebtedness and the issuance of preferred stock, liens, sale and leaseback transactions, lines of business, dividend and other payment restrictions affecting Guarantor Subsidiaries, mergers or consolidations, and transactions with affiliates. The 9
10 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) Company is obligated to repurchase the 9.125% and 9.625% Senior Notes in the event of a change of control or certain asset sales. Set forth below are condensed consolidating financial statements of the Guarantor Subsidiaries, the Company's subsidiaries which are not guarantors of the Senior Notes (the "Non-Guarantor Subsidiaries") and the Company. Separate financial statements of each Guarantor Subsidiary have not been provided because management has determined that they are not material to investors. As of and for the three and six months ended June 30, 1998, the only Non-Guarantor Subsidiary was Chesapeake Energy Marketing, Inc. As of and for the three and six months ended June 30, 1997, the Non-Guarantor Subsidiaries were Chesapeake Energy Marketing, Inc. and Chesapeake Canada Corporation. For both periods, the remaining subsidiaries of the Company were Guarantor Subsidiaries. 10
11 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING BALANCE SHEET AS OF JUNE 30, 1998 ($ IN THOUSANDS) <TABLE> <CAPTION> ASSETS GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> CURRENT ASSETS: Cash and cash equivalents .................$ (11,054) $ 10,415 $ 60,329 $ -- $ 59,690 Short-term investments .................... -- -- 6,637 -- 6,637 Accounts receivable, net .................. 74,865 21,821 182 (9,275) 87,593 Inventory ................................. 5,125 91 -- -- 5,216 Other ..................................... 1,901 (23) 500 -- 2,378 ----------- ----------- ----------- ----------- ----------- Total Current Assets ................... 70,837 32,304 67,648 (9,275) 161,514 ----------- ----------- ----------- ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties .................... 2,002,236 -- -- -- 2,002,236 Unevaluated leasehold ..................... 99,229 -- -- -- 99,229 Other property and equipment .............. 59,984 426 16,899 -- 77,309 Less: accumulated depreciation, Depletion and amortization .............. (1,161,222) (20) (1,166) -- (1,162,408) ----------- ----------- ----------- ----------- ----------- Total Property and Equipment ........... 1,000,227 406 15,733 -- 1,016,366 ----------- ----------- ----------- ----------- ----------- INVESTMENTS IN SUBSIDIARIES AND INTERCOMPANY ADVANCES ..................... 479,538 -- 471,150 (950,688) -- OTHER ASSETS ................................ 39,538 593 42,162 -- 82,293 ----------- ----------- ----------- ----------- ----------- TOTAL ASSETS ...........................$ 1,590,140 $ 33,303 $ 596,693 $ (959,963) $ 1,260,173 =========== =========== =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Notes payable and current maturities of long-term debt .......................$ -- $ -- $ -- $ -- $ -- Accounts payable and other ................ 88,370 27,757 24,757 (10,804) 130,080 ----------- ----------- ----------- ----------- ----------- Total Current Liabilities .............. 88,370 27,757 24,757 (10,804) 130,080 ----------- ----------- ----------- ----------- ----------- LONG-TERM DEBT .............................. -- -- 919,034 -- 919,034 ----------- ----------- ----------- ----------- ----------- REVENUES PAYABLE ............................ 11,345 -- -- -- 11,345 ----------- ----------- ----------- ----------- ----------- INTERCOMPANY PAYABLES ....................... 1,321,703 (3,557) (1,319,675) 1,529 -- ----------- ----------- ----------- ----------- ----------- STOCKHOLDERS' EQUITY: Preferred Stock ........................... -- -- 230,000 -- 230,000 Common Stock .............................. 26 1 999 (17) 1,009 Other ..................................... 168,696 9,102 741,578 (950,671) (31,295) ----------- ----------- ----------- ----------- ----------- Total Stockholders' Equity ............. 168,722 9,103 972,577 (950,688) 199,714 ----------- ----------- ----------- ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .................$ 1,590,140 $ 33,303 $ 596,693 $ (959,963) $ 1,260,173 =========== =========== =========== =========== =========== </TABLE> 11
12 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 1997 ($ IN THOUSANDS) <TABLE> <CAPTION> ASSETS GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> CURRENT ASSETS: Cash and cash equivalents ................. $ (589) $ 13,999 $ 110,450 $ -- $ 123,860 Short-term investments .................... -- -- 12,570 -- 12,570 Accounts receivable, net .................. 57,476 22,882 1,524 (7,708) 74,174 Inventory ................................. 4,918 575 -- -- 5,493 Other ..................................... 1,613 1 10 -- 1,624 ----------- ----------- ----------- ----------- ----------- Total Current Assets ................... 63,418 37,457 124,554 (7,708) 217,721 ----------- ----------- ----------- ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties .................... 1,056,118 39,245 -- -- 1,095,363 Unevaluated leasehold ..................... 125,155 -- -- -- 125,155 Other property and equipment .............. 51,868 343 15,422 -- 67,633 Less: accumulated depreciation, Depletion and amortization .............. (593,359) (14,650) (955) -- (608,964) ----------- ----------- ----------- ----------- ----------- Total Property and Equipment ........... 639,782 24,938 14,467 -- 679,187 ----------- ----------- ----------- ----------- ----------- INVESTMENTS IN SUBSIDIARIES AND INTERCOMPANY ADVANCES ..................... 81,755 49,958 903,713 (1,035,426) -- ----------- ----------- ----------- ----------- ----------- OTHER ASSETS ................................ 10,189 6,918 38,769 -- 55,876 ----------- ----------- ----------- ----------- ----------- TOTAL ASSETS ........................... $ 795,144 $ 119,271 $ 1,081,503 $(1,043,134) $ 952,784 =========== =========== =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Notes payable and current maturities of long-term debt ....................... $ -- $ -- $ -- $ -- $ -- Accounts payable and other ................ 104,259 29,649 27,280 (7,708) 153,480 ----------- ----------- ----------- ----------- ----------- Total Current Liabilities .............. 104,259 29,649 27,280 (7,708) 153,480 ----------- ----------- ----------- ----------- ----------- LONG-TERM DEBT .............................. -- -- 508,992 -- 508,992 ----------- ----------- ----------- ----------- ----------- REVENUES PAYABLE ............................ 10,106 -- -- -- 10,106 ----------- ----------- ----------- ----------- ----------- INTERCOMPANY PAYABLES ....................... 853,958 2,959 -- (856,917) -- ----------- ----------- ----------- ----------- ----------- STOCKHOLDERS' EQUITY: Common Stock .............................. 10 3 733 (3) 743 Other ..................................... (173,189) 86,660 544,498 (178,506) 279,463 ----------- ----------- ----------- ----------- ----------- Total Stockholders' Equity ............. (173,179) 86,663 545,231 (178,509) 280,206 ----------- ----------- ----------- ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................. $ 795,144 $ 119,271 $ 1,081,503 $(1,043,134) $ 952,784 =========== =========== =========== =========== =========== </TABLE> 12
13 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> FOR THE THREE MONTHS ENDED JUNE 30, 1998 REVENUES: Oil and gas sales ........................ $ 74,592 $ -- $ -- $ 1,047 $ 75,639 Oil and gas marketing sales .............. 11,350 49,561 -- (27,240) 33,671 Interest and other ....................... 542 129 23,948 (22,048) 2,571 ----------- ----------- ----------- ----------- ----------- Total Revenues ........................ 86,484 49,690 23,948 (48,241) 111,881 ----------- ----------- ----------- ----------- ----------- COSTS AND EXPENSES: Production expenses and taxes ............ 17,294 -- -- -- 17,294 Oil and gas marketing expenses ........... 11,081 48,817 -- (26,193) 33,705 Impairment of oil and gas properties ..... 216,000 -- -- -- 216,000 Impairment of other assets ............... 10,000 -- -- -- 10,000 Oil and gas depreciation, depletion and amortization ....................... 43,900 -- -- -- 43,900 Other depreciation and amortization ...... 1,198 34 690 -- 1,922 General and administrative ............... 4,800 359 (25) -- 5,134 Interest ................................. 21,876 -- 18,837 (22,048) 18,665 ----------- ----------- ----------- ----------- ----------- Total Costs and Expenses .............. 326,149 49,210 19,502 (48,241) 346,620 ----------- ----------- ----------- ----------- ----------- INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEM ................... (239,665) 480 4,446 -- (234,739) INCOME TAX EXPENSE (BENEFIT) ............... -- -- -- -- -- ----------- ----------- ----------- ----------- ----------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ....................... (239,665) 480 4,446 -- (234,739) ----------- ----------- ----------- ----------- ----------- EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax ........... (2,164) -- (11,170) -- (13,334) ----------- ----------- ----------- ----------- ----------- NET INCOME (LOSS) ..................... $ (241,829) $ 480 $ (6,724) $ -- $ (248,073) =========== =========== =========== =========== =========== FOR THE THREE MONTHS ENDED JUNE 30, 1997 REVENUES: Oil and gas sales ........................ $ 48,572 $ (3,579) $ -- $ 361 $ 45,354 Gas marketing sales ...................... -- 41,767 -- (18,024) 23,743 Interest and other ....................... 434 (19) 44,543 (39,528) 5,430 ----------- ----------- ----------- ----------- ----------- Total revenues ........................ 49,006 38,169 44,543 (57,191) 74,527 ----------- ----------- ----------- ----------- ----------- COSTS AND EXPENSES: Production expenses and taxes ............ 5,336 (411) -- -- 4,925 Gas marketing expenses ................... -- 41,508 -- (17,663) 23,845 Impairment of oil and gas properties ..... 236,000 -- -- -- 236,000 Oil and gas depreciation ................. 43,651 (1,293) -- -- 42,358 Other depreciation and amortization ...... 601 (11) 483 -- 1,073 General and administrative ............... 2,013 191 378 -- 2,582 Interest ................................. 37,164 (217) 11,261 (39,528) 8,680 ----------- ----------- ----------- ----------- ----------- Total Costs and Expenses .............. 324,765 39,767 12,122 (57,191) 319,463 ----------- ----------- ----------- ----------- ----------- INCOME (LOSS) BEFORE INCOME TAX ............ (275,759) (1,598) 32,421 -- (244,936) INCOME TAX EXPENSE (BENEFIT) ............... (28,714) (1,408) 2,969 -- (27,153) ----------- ----------- ----------- ----------- ----------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM .................. (247,045) (190) 29,452 -- (217,783) EXTRAORDINARY ITEM: Loss on early extinguishmet of debt, net of applicable income tax ............... -- -- -- -- -- ----------- ----------- ----------- ----------- ----------- NET INCOME (LOSS) ..................... $ (247,045) $ (190) $ 29,452 $ -- $ (217,783) =========== =========== =========== =========== =========== </TABLE> 13
14 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> FOR THE SIX MONTHS ENDED JUNE 30, 1998 REVENUES: Oil and gas sales ....................... $ 124,207 $ -- $ -- $ 1,673 $ 125,880 Oil and gas marketing sales ............. 21,071 87,565 -- (48,441) 60,195 Interest and other ...................... 566 219 43,983 (41,973) 2,795 ---------- ---------- ---------- ---------- ---------- Total Revenues ....................... 145,844 87,784 43,983 (88,741) 188,870 ---------- ---------- ---------- ---------- ---------- COSTS AND EXPENSES: Production expenses and taxes ........... 26,732 -- -- -- 26,732 Oil and gas marketing expenses .......... 20,617 86,117 -- (46,768) 59,966 Impairment of oil and gas properties .... 466,000 -- -- -- 466,000 Impairment of other assets .............. 10,000 -- -- -- 10,000 Oil and gas depreciation, depletion and amortization ...................... 75,242 -- -- -- 75,242 Other depreciation and amortization ..... 2,061 54 1,187 -- 3,302 General and administrative .............. 8,874 633 7 -- 9,514 Interest ................................ 41,099 -- 30,227 (41,973) 29,353 ---------- ---------- ---------- ---------- ---------- Total Costs and Expenses ............. 650,625 86,804 31,421 (88,741) 680,109 ---------- ---------- ---------- ---------- ---------- INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEM .................. (504,781) 980 12,562 -- (491,239) INCOME TAX EXPENSE (BENEFIT) .............. -- -- -- -- -- ---------- ---------- ---------- ---------- ---------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ...................... (504,781) 980 12,562 -- (491,239) ---------- ---------- ---------- ---------- ---------- EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax .......... (2,164) -- (11,170) -- (13,334) ---------- ---------- ---------- ---------- ---------- NET INCOME (LOSS) .................... $ (506,945) $ 980 $ 1,392 $ -- $ (504,573) ========== ========== ========== ========== ========== FOR THE SIX MONTHS ENDED JUNE 30, 1997 REVENUES: Oil and gas sales ....................... $ 105,367 $ (3,579) $ -- $ 965 $ 102,753 Gas marketing sales ..................... -- 87,335 -- (41,182) 46,153 Interest and other ...................... 611 178 47,446 (39,528) 8,707 ---------- ---------- ---------- ---------- ---------- Total revenues ....................... 105,978 83,934 47,446 (79,745) 157,613 ---------- ---------- ---------- ---------- ---------- COSTS AND EXPENSES: Production expenses and taxes ........... 9,644 (411) -- -- 9,233 Gas marketing expenses .................. -- 85,809 -- (40,217) 45,592 Impairment of oil and gas properties .... 236,000 -- -- -- 236,000 Oil and gas depreciation ................ 68,314 (1,293) -- -- 67,021 Other depreciation and amortization ..... 1,109 9 828 -- 1,946 General and administrative .............. 3,770 426 867 -- 5,063 Interest ................................ 37,336 (217) 14,743 (39,528) 12,334 ---------- ---------- ---------- ---------- ---------- Total Costs and Expenses ............. 356,173 84,323 16,438 (79,745) 377,189 ---------- ---------- ---------- ---------- ---------- INCOME (LOSS) BEFORE INCOME TAX ........... (250,195) (389) 31,008 -- (219,576) INCOME TAX EXPENSE (BENEFIT) .............. (19,384) (967) 2,453 -- (17,898) ---------- ---------- ---------- ---------- ---------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ................. (230,811) 578 28,555 -- (201,678) EXTRAORDINARY ITEM: Loss on early extinguishmet of debt, net of applicable income tax .............. (179) -- 2 -- (177) ---------- ---------- ---------- ---------- ---------- NET INCOME (LOSS) .................... $ (230,990) $ 578 $ 28,557 $ -- $ (201,855) ========== ========== ========== ========== ========== </TABLE> 14
15 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> FOR THE SIX MONTHS ENDED JUNE 30, 1998 CASH FLOWS FROM OPERATING ACTIVITIES: $ (609) $ (476) $ 20,805 $ -- $ 19,720 ---------- ---------- ---------- ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Oil and gas properties ......................... (472,879) -- -- -- (472,879) Proceeds from sale of assets ................... 804 -- 3,600 -- 4,404 Repayment of long-term loans ................... 2,000 -- -- -- 2,000 Other additions ................................ (3,448) (258) (1,477) -- (5,183) ---------- ---------- ---------- ---------- ---------- (473,523) (258) 2,123 -- (471,658) ---------- ---------- ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings ....................... -- -- 658,750 -- 658,750 Payments on borrowings ......................... -- -- (474,166) -- (474,166) Cash received from issuance of preferred stock . -- -- 222,781 -- 222,781 Cash paid for purchase of treasury stock ....... -- -- (17,832) -- (17,832) Cash received from exercise of stock options ... -- -- 102 -- 102 Other financing ................................ (1,867) -- -- -- (1,867) Intercompany advances, net ..................... 465,229 (2,545) (462,684) -- -- ---------- ---------- ---------- ---------- ---------- 463,362 (2,545) (73,049) -- 387,768 ---------- ---------- ---------- ---------- ---------- Net increase (decrease) in cash ................ (10,770) (3,279) (50,121) -- (64,170) Cash, beginning of period ...................... (284) 13,694 110,450 -- 123,860 ---------- ---------- ---------- ---------- ---------- Cash, end of period ............................ $ (11,054) $ 10,415 $ 60,329 $ -- $ 59,690 ========== ========== ========== ========== ========== FOR THE SIX MONTHS ENDED JUNE 30, 1997 CASH FLOWS FROM OPERATING ACTIVITIES: .................................... $ 76,181 $ (5,366) $ (28,627) $ -- $ 42,188 ---------- ---------- ---------- ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Oil and gas properties ......................... (281,801) 92 -- -- (281,709) Loans to third parties ......................... -- -- (18,000) -- (18,000) Other investments .............................. (2,751) -- (8,000) -- (10,751) Other additions ................................ (22,133) (1,795) (5,317) -- (29,245) ---------- ---------- ---------- ---------- ---------- (306,685) (1,703) (31,317) -- (339,705) ---------- ---------- ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term borrowings ............. -- -- 292,626 -- 292,626 Payments on borrowings ......................... -- -- (12,750) -- (12,750) Cash received from exercise of stock options ... -- -- 1,114 -- 1,114 Other financing ................................ -- -- (195) -- (195) Intercompany advances, net ..................... 219,188 5,250 (224,438) -- -- ---------- ---------- ---------- ---------- ---------- 219,188 5,250 56,357 -- 280,795 ---------- ---------- ---------- ---------- ---------- Net increase (decrease) in cash and cash equivalents .................................. (11,316) (1,819) (3,587) -- (16,722) Cash, beginning of period ...................... 4,782 6,182 129,775 -- 140,739 ---------- ---------- ---------- ---------- ---------- Cash, end of period ............................ $ (6,534) $ 4,363 $ 126,188 $ -- $ 124,017 ========== ========== ========== ========== ========== </TABLE> 15
16 PART I. FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT EVENTS On July 7, 1998 the Company's Board of Directors authorized management to explore alternatives to enhance shareholder value, including a possible sale or merger of the Company, based upon the Board's opinion that the market is substantially undervaluing the Company's assets and exploration potential. Also on July 7, 1998 Chesapeake's Board of Directors unanimously adopted a shareholder rights plan designed to deter coercive takeover tactics and to prevent a change of control from occurring without all shareholders receiving a fair price. On April 22, 1998, the Company issued $230 million (4.6 million shares) of its 7% Cumulative Convertible Preferred Stock, $50 per share liquidation preference, and $500 million of its 9.625% Series A Senior Notes due 2005. Net proceeds from these offerings were approximately $711 million. On April 27, 1998, Chesapeake acquired from Gothic Energy Corporation natural gas reserves in the Arkoma Basin of Oklahoma for $20 million, and purchased $39.5 million of Gothic 12% preferred stock (with liquidation value of $50 million) and ten-year warrants to purchase 15% of Gothic's currently outstanding common stock for $0.01 per share. As part of this transaction, for additional consideration of $10.5 million, Chesapeake entered into a five-year drilling and acquisitions participation agreement with Gothic. On April 27, 1998, Chesapeake acquired the British Columbia properties of Sunoma Acquisitions Ltd. for $33 million. On April 28, 1998, the Company acquired by merger the Mid-Continent operations of DLB Oil & Gas, Inc. ("DLB") for $17.5 million in cash, 5,000,000 shares of the Company's common stock, and the assumption of $90 million in outstanding debt and working capital obligations. On April 30, 1998, the Company acquired 100% of the stock of MC Panhandle Corp., a wholly-owned subsidiary of Occidental Petroleum Corporation, by paying approximately $95 million, net of working capital adjustments. Effective April 30, 1998, the Company purchased all of its $90 million aggregate principal amount 10.5% Senior Notes due 2002. The cost to acquire the 10.5% Senior Notes was approximately $99 million. The early retirement of these notes resulted in an extraordinary charge of $13.3 million during the Current Quarter. 16
17 RESULTS OF OPERATIONS Three Months Ended June 30, 1998 vs. June 30, 1997 General. For the three months ended June 30, 1998 (the "Current Quarter"), the Company realized a net loss of $248.1 million, or a loss of $2.41 per common share. This compares to a net loss of $217.8 million, or a loss of $3.12 per common share, in the three months ended June 30, 1997 (the "Prior Quarter"). The loss in the Current Quarter was primarily caused by a $216.0 million asset writedown recorded under the full-cost method of accounting, a $10.0 million impairment related to certain of the Company's gas processing and transportation assets located in Louisiana, a $13.3 million extraordinary loss on the early extinguishment of debt, and an $8.7 million loss from recurring operations. The asset writedown was primarily caused by the acquisitions completed in April 1998 for consideration in excess of the present value (10% discount) of the future net revenues of the proved reserves acquired as of June 30, 1998, as well as the evaluation of certain leasehold, seismic and other exploration-related costs that were previously unevaluated, and by decreases in oil prices from March 31, 1998 to June 30, 1998. See " - Impairment of Oil and Gas Properties". The loss in the Prior Quarter was also caused by an asset writedown recorded under the full-cost method of accounting. The $236 million asset writedown in the Prior Quarter was primarily caused by poor exploration results in the Company's drilling program, particularly in the Austin Chalk portion of the Louisiana Trend, combined with decreased oil and gas prices, and higher drilling and equipping costs as of June 30, 1997. Oil and Gas Sales. During the Current Quarter, oil and gas sales increased significantly to $75.6 million from $45.4 million, an increase of $30.2 million, or 67%. This increase resulted from significantly higher oil and gas production volumes, which increased from 21.3 billion cubic feet equivalent of natural gas ("bcfe") in the Prior Quarter to 37.2 bcfe in the Current Quarter, an increase of 15.9 bcfe, or 75%. The higher production volumes were primarily the result of the Company's acquisitions completed during the first four months of 1998. For the Current Quarter, the Company produced 1.8 million barrels of oil ("mmbo") and 26.3 billion cubic feet of natural gas ("bcf"), compared to 0.9 mmbo and 16.2 bcf in the Prior Quarter. Average oil prices realized were $12.85 per barrel of oil in the Current Quarter compared to $19.10 per barrel in the Prior Quarter, a decrease of 33%. Average gas prices realized were $1.99 per thousand cubic feet ("mcf") in the Current Quarter compared to $1.80 per mcf in the Prior Quarter, an increase of 11%. For the Current Quarter, the Company realized an average price of $2.03 per thousand cubic feet equivalent of natural gas ("mcfe"), compared to $2.13 per mcfe in the Prior Quarter. The Company's hedging activities resulted in increased oil and gas revenues of $2.2 million, or $0.06 per mcfe, in the Current Quarter, compared to decreases in oil and gas revenues of $63 thousand in the Prior Quarter. The following table shows the Company's production by region for the Current Quarter and the Prior Quarter: <TABLE> <CAPTION> FOR THE THREE MONTHS ENDED JUNE 30, ------------------------------------------------------- 1998 1997 ------------------------- ------------------------ OPERATING AREAS MMCFE PERCENT MMCFE PERCENT --------------------- ----------- ---------- ---------- --------- <S> <C> <C> <C> <C> Mid-Continent .............. 18,773 50% 4,098 19% Gulf Coast ................. 13,199 35 15,621 73 Canada ..................... 2,414 6 -- -- Other areas ................ 2,845 9 1,567 8 ---------- ---------- ---------- ---------- Total ................. 37,231 100% 21,286 100% ========== ========== ========== ========== </TABLE> Natural gas production represented approximately 71% of the Company's total production volume on an equivalent basis in the Current Quarter, compared to 76% in the Prior Quarter. The Company anticipates natural gas will represent 70-75% of anticipated 1998 and 1999 production. As of June 30, 1998 natural gas represented approximately 84% of the Company's proved reserves of 1,260 bcfe. 17
18 Oil and Gas Marketing Sales. The Company realized $33.7 million in oil and gas marketing sales for third parties in the Current Quarter, with corresponding oil and gas marketing expenses of $33.7 million. This compares to sales of $23.7 million and expenses of $23.8 million in the Prior Quarter. Interest and Other. Interest and other revenues for the Current Quarter were $2.6 million compared to $5.4 million in the Prior Quarter. The decrease was primarily caused by the Company maintaining lower invested cash balances resulting in reduced interest income, partially offset by a gain of $0.6 million from the sale of the Company's interest in an oilfield service company, Peak USA Energy Services, Ltd., during the Current Quarter. Production Expenses and Taxes. Production expenses increased to $14.7 million in the Current Quarter, a $10.7 million increase from $4.0 million incurred in the Prior Quarter. On a production unit basis, production expenses were $0.39 and $0.19 per mcfe in the Current and Prior Quarters, respectively. The primary reason for the increase was production from properties acquired in late 1997 and 1998, which typically have higher unit-of-production expenses than the Company's historical production base. The Company anticipates production expenses will average $0.35 to $0.40 per mcfe for 1998. Production taxes, which consist primarily of wellhead severance taxes, were $2.6 million and $0.9 million in the Current and Prior Quarters, respectively. This increase was primarily the result of increased production. On a per unit basis, production taxes were $0.07 per mcfe in the Current Quarter compared to $0.04 per mcfe in the Prior Quarter, the result of higher tax rates associated with production from properties acquired in late 1997 and 1998 compared to the Company's historical production base. Impairment of Oil and Gas Properties. The Company utilizes the full-cost method to account for its investments in oil and gas properties. Under this method, all costs of acquisition, exploration and development of oil and gas reserves (including such costs as leasehold acquisition costs, geological and geophysical expenditures, certain capitalized internal costs, dry hole costs and tangible and intangible development costs) are capitalized as incurred. These oil and gas property costs, including the estimated future capital expenditures to develop proved undeveloped reserves, are depleted and charged to operations using the unit-of-production method based on the ratio of current production to proved oil and gas reserves as estimated by the Company's independent engineering consultants and Company engineers. Costs directly associated with the acquisition and evaluation of unproved properties are excluded from the amortization computation until it is determined whether or not proved reserves can be assigned to the property or whether impairment has occurred. To the extent that capitalized costs of oil and gas properties, net of accumulated depreciation, depletion and amortization and related deferred income taxes, exceed the discounted future net revenues (at 10%) of proved oil and gas properties, such excess costs are charged to operations. The Company incurred an impairment of oil and gas properties charge of $216 million in the Current Quarter, compared to an impairment charge of $236 million in the Prior Quarter. The writedown in the Current Quarter was caused by a combination of several factors, including the acquisitions completed by the Company in April 1998. The most significant factor was the completion of the acquisition of DLB, which was accounted for using the purchase method. The purchase price, which was established in February 1998 when the terms of the acquisition were amended (based upon a Chesapeake common stock price of $6 per share), was allocated primarily to DLB's evaluated oil and gas properties. Based upon reserve estimates as of June 30, 1998, the portion of the purchase price which was allocated to evaluated oil and gas properties exceeded the associated discounted future net revenues from DLB's estimated proves reserves by approximately $70 million. In total, approximately $116 million of the writedown was related to acquisitions completed during the Current Quarter. The evaluation of certain leasehold, seismic and other exploration-related costs that were previously unevaluated, together with decreases in oil prices at June 30, 1998, were the remaining contributing factors which led to the writedown in the Current Quarter. Future impairment charges, if any, will be dependent upon several factors, primarily oil and gas prices in effect at the date of determination. Impairment of Other Assets. In the Current Quarter, the Company incurred an impairment charge of $10 million related to certain of the Company's gas processing and transportation assets located in Louisiana. No such charge was recorded in the Prior Quarter. 18
19 Oil and Gas Depreciation, Depletion and Amortization. Depreciation, depletion and amortization of oil and gas properties ("DD&A") for the Current Quarter was $43.9 million, compared to $42.4 million in the Prior Quarter. This increase was caused by significantly increased production offset by a decrease in the DD&A rate per mcfe from $1.99 to $1.18 in the Prior and Current Quarters, respectively. The Company's DD&A rate is expected to decrease to approximately $0.90-$0.95 per mcfe for the remainder of 1998 as the result of the impairment charge, increased drilling in the Mid-Continent, and reduced drilling in Louisiana. Depreciation and Amortization of Other Assets. Depreciation and amortization of other assets ("D&A") increased to $1.9 million in the Current Quarter compared to $1.1 million in the Prior Quarter. This increase in D&A was caused by increased investments in depreciable buildings and equipment incurred in conjunction with the acquisitions and increased amortization of debt issuance costs as a result of the issuance of Senior Notes in April 1998. The Company anticipates D&A expense throughout the remainder of 1998 to remain at approximately the same level incurred in the Current Quarter. General and Administrative. General and administrative expenses ("G&A"), which are net of capitalized internal payroll and non-payroll expenses, were $5.1 million in the Current Quarter compared to $2.6 million in the Prior Quarter. This increase was primarily caused by increased employment levels associated with the Company's acquisitions. The Company capitalized $1.1 million of internal costs in the Current Quarter directly related to the Company's oil and gas exploration and development efforts, compared to $1.4 million in the Prior Quarter. The Company anticipates that G&A costs for the remainder of 1998 will not increase significantly. Interest. Interest and other expense increased to $18.7 million in the Current Quarter from $8.7 million in the Prior Quarter. This increase was a result of additional interest expense in the Current Quarter on the $500 million principal amount of Senior Notes issued on April 22, 1998. In addition to the interest expense reported, the Company capitalized $1.6 million of interest during the Current Quarter compared to $2.6 million capitalized in the Prior Quarter. The Company does not anticipate interest expense will increase significantly during the remainder of 1998. Provision for Income Taxes. The Company recorded no income tax expense for the Current Quarter, compared to an income tax benefit of $27.2 million in the Prior Quarter. At June 30, 1998, the Company had a net operating loss carryforward of approximately $500 million for regular federal income taxes which will expire in future years beginning in 2007. Management believes that it cannot be demonstrated at this time that it is more likely than not that the deferred income tax assets, comprised primarily of the net operating loss carryforward, will be realizable in future years, and therefore a valuation allowance of $280 million has been recorded. The Company does not expect to record any book income tax expense for the remainder of 1998 based on information available at this time. Six Months Ended June 30, 1998 vs. June 30, 1997 General. For the six months ended June 30, 1998 (the "Current Period"), the Company realized a net loss of $504.6 million, or a loss of $5.50 per common share. This compares to a net loss of $201.9 million, or a loss of $2.87 per common share, in the six months ended June 30, 1997 (the "Prior Period"). The loss in the Current Period was primarily caused by a $466 million asset writedown recorded under the full-cost method of accounting, a $10 million impairment related to certain of the Company's gas processing and transportation assets located in Louisiana, a $13.3 million extraordinary loss on the early extinguishment of debt, and a $15.2 million loss from recurring operations. The asset writedown was partially caused by the acquisitions completed during the Current Period for consideration in excess of the present value (10% discount) of the future net revenues of the proved reserves acquired as of June 30, 1998. See "- Impairment of Oil and Gas Properties". The loss in the Prior Period was also caused by an asset writedown recorded under the full-cost method of accounting. The $236 million asset writedown in the Prior Period was primarily caused by poor exploration results in the Company's drilling program, particularly in the Austin Chalk portion of the Louisiana Trend, combined with decreased oil and gas prices, and higher drilling and equipping costs as of June 30, 1997. Oil and Gas Sales. During the Current Period, oil and gas sales increased significantly to $125.9 million from $102.8 million, an increase of $23.1 million, or 22%. This increase resulted from significantly higher oil and gas 19
20 production volumes, which increased from 41.8 bcfe in the Prior Period to 60.2 bcfe in the Current Period, an increase of 18.4 bcfe, or 44%. The higher production volumes were primarily the result of the Company's acquisitions completed during the first four months of 1998. For the Current Period, the Company produced 3.0 mmbo and 42.2 bcf, compared to 1.7 mmbo and 31.9 bcf in the Prior Period. Average oil prices realized were $13.63 per barrel in the Current Period compared to $20.29 per barrel in the Prior Period, a decrease of 33%. Average gas prices realized were $2.01 per mcf in the Current Period compared to $2.17 per mcf in the Prior Period, a decrease of 7%. For the Current Period, the Company realized an average price of $2.09 per mcfe, compared to $2.46 per mcfe in the Prior Period. The Company's hedging activities resulted in increased oil and gas revenues of $4.0 million, or $0.07 per mcfe, in the Current Period, compared to decreases in oil and gas revenues of $289 thousand in the Prior Period. The following table shows the Company's production by region for the Current Period and the Prior Period: <TABLE> <CAPTION> FOR THE SIX MONTHS ENDED JUNE 30, -------------------------------------------------------- 1998 1997 ------------------------- ------------------------- OPERATING AREAS MMCFE PERCENT MMCFE PERCENT --------------------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Mid-Continent ................... 26,427 44% 8,340 20% Gulf Coast ...................... 24,868 41 30,640 73 Canada .......................... 3,144 5 -- -- Other areas ..................... 5,755 10 2,854 7 ---------- ---------- ---------- ---------- Total ...................... 60,194 100% 41,834 100% ========== ========== ========== ========== </TABLE> Natural gas production represented approximately 70% of the Company's total production volume on an equivalent basis in the Current Period, compared to 76% in the Prior Period. Oil and Gas Marketing Sales. The Company realized $60.2 million in oil and gas marketing sales for third parties in the Current Period, with corresponding oil and gas marketing expenses of $60.0 million. This compares to sales of $46.2 million and expenses of $45.6 million in the Prior Period. Interest and Other. Interest and other revenues for the Current Period were $2.8 million compared to $8.7 million in the Prior Period. The decrease was primarily caused by the Company maintaining lower invested cash balances resulting in reduced interest income, partially offset by a gain of $0.6 million from the sale of the Company's interest in an oilfield service company, Peak USA Energy Services, Ltd., during the Current Period. Production Expenses and Taxes. Production expenses increased to $22.6 million in the Current Period, a $15.4 million increase from $7.2 million incurred in the Prior Period. On a production unit basis, production expenses were $0.37 and $0.17 per mcfe in the Current and Prior Periods, respectively. The primary reason for the increase was production from properties acquired in late 1997 and 1998, which typically have higher unit-of-production expenses than the Company's historical production base. Production taxes, which consist primarily of wellhead severance taxes, were $4.2 million and $2.1 million in the Current and Prior Periods, respectively. This increase was primarily the result of increased production. On a per unit basis, production taxes were $0.07 per mcfe in the Current Period compared to $0.05 per mcfe in the Prior Period, the result of higher tax rates associated with production from properties acquired in late 1997 and 1998 compared to the Company's historical production base. Impairment of Oil and Gas Properties. The Company utilizes the full-cost method to account for its investments in oil and gas properties. Under this method, all costs of acquisition, exploration and development of oil and gas reserves (including such costs as leasehold acquisition costs, geological and geophysical expenditures, certain capitalized internal costs, dry hole costs and tangible and intangible development costs) are capitalized as incurred. These oil and gas property costs, including the estimated future capital expenditures to develop proved undeveloped reserves, are depleted and charged to operations using the unit-of-production method based on the ratio of current 20
21 production to proved oil and gas reserves as estimated by the Company's independent engineering consultants and Company engineers. Costs directly associated with the acquisition and evaluation of unproved properties are excluded from the amortization computation until it is determined whether or not proved reserves can be assigned to the property or whether impairment has occurred. To the extent that capitalized costs of oil and gas properties, net of accumulated depreciation, depletion and amortization and related deferred income taxes, exceed the discounted future net revenues of proved oil and gas properties, such excess costs are charged to operations. The Company incurred an impairment of oil and gas properties charge of $466 million in the Current Period, compared to an impairment charge of $236 million in the Prior Period. The writedown in the Current Period was caused by a combination of several factors, including the acquisitions completed by the Company during the Current Period, which were accounted for using the purchase method. The most significant factors were the acquisitions of Hugoton and DLB. Higher drilling and completion costs, the evaluation of certain leasehold, seismic and other exploration-related costs that were previously unevaluated, together with decreases in oil and gas prices from December 31, 1997 to June 30, 1998 were the remaining contributing factors which led to the writedown in the Current Period. The $236 million writedown incurred in the Prior Period was due primarily to significant expenditures for acreage acquisition and drilling costs followed by unfavorable exploration and production results in Louisiana, together with increases in drilling and equipment costs and declines in oil and gas prices as of June 30, 1997. Future impairment charges, if any, will be dependent upon several factors, primarily oil and gas prices in effect at the date of determination. Impairment of Other Assets. In the Current Period, the Company incurred an impairment charge of $10 million related to certain of the Company's gas processing and transportation assets located in Louisiana. No such charge was recorded in the Prior Period. Oil and Gas Depreciation, Depletion and Amortization. DD&A for the Current Period was $75.2 million, compared to $67.0 million in the Prior Period. This increase was caused by significantly increased production offset by a decrease in the DD&A rate per mcfe from $1.60 to $1.25 in the Prior and Current Periods, respectively. Depreciation and Amortization of Other Assets. D&A increased to $3.3 million in the Current Period compared to $1.9 million in the Prior Period. This increase in D&A was caused by increased investments in depreciable buildings and equipment incurred in conjunction with the acquisitions and increased amortization of debt issuance costs as a result of the issuance of Senior Notes in April 1998. General and Administrative. G&A, which is net of capitalized internal payroll and non-payroll expenses, were $9.5 million in the Current Period compared to $5.1 million in the Prior Period. This increase was primarily caused by increased employment levels associated with the Company's acquisitions. The Company capitalized $3.2 million of internal costs in the Current Period directly related to the Company's oil and gas exploration and development efforts, compared to $2.8 million in the Prior Period. Interest. Interest and other expense increased to $29.4 million in the Current Period from $12.3 million in the Prior Period. This increase was a result of additional interest expense in the Current Period on the $500 million principal amount of Senior Notes issued on April 22, 1998. In addition to the interest expense reported, the Company capitalized $3.8 million of interest during the Current Period compared to $5.3 million capitalized in the Prior Period. Provision for Income Taxes. The Company recorded no income tax expense for the Current Period, compared to an income tax benefit of $17.9 million in the Prior Period. RISK MANAGEMENT ACTIVITIES Periodically the Company utilizes hedging strategies to hedge the price of a portion of its future oil and gas production. These strategies include (1) swap arrangements that establish an index-related price above which the Company pays the counterparty and below which the Company is paid by the counterparty, (2) the purchase of index-related puts that provide for a "floor" price below which the counterparty pays the Company the amount by 21
22 which the price of the commodity is below the contracted floor, (3) the sale of index-related calls that provide for a "ceiling" price above which the Company pays the counterparty the amount by which the price of the commodity is above the contracted ceiling, and (4) basis protection swaps, which are arrangements that guarantee the price differential of oil or gas from a specified delivery point or points. The Company only enters into commodity hedging transactions related to the Company's oil and gas production volumes or physical purchase or sale commitments of its oil and gas marketing subsidiaries. Results from commodity hedging transactions are reflected in oil and gas sales to the extent related to the Company's oil and gas production. Gains or losses on crude oil and natural gas hedging transactions are recognized as price adjustments in the months of related production. See Note 6 of the Notes to Consolidated Financial Statements. As of June 30, 1998, the Company had the following natural gas swap arrangements for periods after June 1998: <TABLE> <CAPTION> MONTHLY NYMEX-INDEX VOLUME STRIKE PRICE MONTHS (MMBTU) (PER MMBTU) ---------------- -------------- ------------------ <S> <C> <C> July 1998.................. 6,510,000 $2.356 August 1998................ 6,510,000 $2.356 September 1998............. 6,300,000 $2.356 October 1998............... 4,960,000 $2.346 </TABLE> If the swap arrangements listed above had been settled on June 30, 1998, the Company would have received $0.1 million. The Company has closed transactions for natural gas previously hedged for the period April 1999 through November 1999 and locked in net proceeds of $3.2 million. If the open gas swap arrangements as of August 12, 1998 had been settled as of that date, the Company would have received $8.9 million. The Company has hedged a portion of its oil production from January 1999 through December 1999, which, if settled on June 30, 1998, would have resulted in a $0.6 million reduction of revenue. The Company has closed transactions for crude oil previously hedged for the period from September 1998 through February 1999 and has locked in net proceeds of $0.2 million. If the open oil swap arrangements as of August 12, 1998 had been settled as of that date, the Company would have paid $0.7 million. The Company also utilizes hedging strategies to manage fixed-interest rate exposure. Through the use of a swap arrangement, the Company believes that it can benefit from stable or falling interest rates and reduce its upfront interest expense. As of June 30, 1998, the Company's interest rate swap resulted in a $0.2 million reduction of interest expense for the period May 1998 through July 1998, which settled on August 3, 1998. LIQUIDITY AND CAPITAL RESOURCES In April 1998, the Company completed an offering of $230 million of 7% Cumulative Convertible Preferred Stock and $500 million principal amount of 9.625% Senior Notes due 2005. The net proceeds of these offerings were approximately $711 million, of which $170 million was used to retire all of the Company's commercial bank debt, approximately $99 million was used to retire all $90 million principal amount of the Company's 10.5% Senior Notes due 2002, $345 million was used to fund certain of the Company's acquisitions, with the balance of the net proceeds increasing the Company's working capital. As of June 30, 1998, the Company had working capital of approximately $31.4 million. The Company, as the result of significantly lower oil and gas prices and a change in the Company's strategy away from higher risk drilling and toward a more balanced acquisition and exploitation strategy, has continued to reduce its capital expenditure plans. The Company currently estimates that it will expend approximately $90 million for drilling, seismic and leasehold expenditures for the six months ended December 31, 1998. The capital expenditure budget is largely discretionary, and can be adjusted by the Company based on operating results or other factors. The Company believes it has sufficient capital resources from anticipated cash flow from operations and working capital to fund the reduced drilling program for 1998. 22
23 On May 20, 1998, the Company's Board of directors approved the expenditure of up to $25 million to purchase outstanding Company common stock. On July 14, 1998, the Board increased the authorized expenditure to $30 million. As of August 11, 1998 the Company had purchased approximately 7.8 million shares of common stock for an aggregate amount of $27.7 million pursuant to such authorization. The Company has received a commitment from its primary commercial bank to obtain a secured revolving bank loan. As a result of the reduced capital expenditure plan, reduced acquisition program, and the potential sale of assets or merger of the Company, the Company has evaluated the size of the bank facility required. It is anticipated that a $50 million facility will be completed by the end of August 1998 and will contain terms and conditions similar to the bank facilities the Company has had in the past, and also include collateral-based borrowing limitations. The primary purpose of the facility will be to provide standby liquidity for the Company. The Company is evaluating certain asset divestiture opportunities separately from the larger strategic alternative initiative. Certain non-core properties, primarily non-operated or small working interest oil-prone properties may be sold. The Company anticipates these sales could result in cash proceeds of up to $50 million over the next six months. The Company's cash provided by operating activities before changes in current assets and liabilities decreased 24% to $63.8 million during the Current Period compared to $84.3 million during the Prior Period. The decrease was due primarily to reduced operating income as a result of a decrease in average oil and gas prices between periods. Cash used in investing activities increased to $471.7 million during the Current Period from $339.7 million in the Prior Period. The Company completed several acquisitions requiring cash in the Current Period which totaled $345.0 million, compared to none in the Prior Period, offset by a significant decrease in drilling activity and leasehold acquisitions in the Current Period compared to the Prior Period. During the Current Period the Company expended approximately $112.0 million to initiate drilling on 91 gross (82.0 net) wells and invested approximately $8.4 million in leasehold acquisitions. This compares to $180.4 million to initiate drilling on 94 gross (59.9 net) wells and $95.0 million to purchase leasehold in the Prior Period. Cash provided by financing activities was $387.8 million in the Current Period, compared to $280.8 million in the Prior Period. During the Current Period, the Company retired $465 million in debt consisting of $85 million in debt assumed at the completion of the DLB acquisition, $120 million in debt assumed at the completion of the Hugoton acquisition, $90 million in Senior Notes, and $170 million in borrowings made under its commercial bank credit facilities. The Company issued $500 million in Senior Notes and $230 million in Preferred Stock. During the Prior Period, the Company issued $300 million in Senior Notes. The Company is subject to certain routine legal proceedings, none of which are expected to have a material adverse effect upon the Company's financial condition or operations. The Company is also a defendant in other non-routine lawsuits, which are described in Note 3 of the notes to the accompanying financial statements. Also see Part II, Item 1 of this report. An adverse outcome in one or more of such suits could have a material effect on the Company, although management is unable to quantify the Company's exposure to liability. No provision for litigation liability has been recorded in the Company's financial statements. FORWARD LOOKING STATEMENTS This Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. All statements other than statements of historical facts included in this Form 10-Q, including without limitation statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding planned capital expenditures, expected oil and gas production, the Company's financial position, business strategy and other plans and objectives for future operations, capital expenditures plans, and expected future expenses are forward looking statements. Although the Company believes that the expectations reflected in such forward-looking statement are reasonable, it can give no assurance that such expectations will prove to have been correct. Factors that could cause actual results to differ materially from those expected by the Company, including, without limitation, factors discussed under Risk Factors in the Company's Form 10-K for the 23
24 period ended December 31, 1997 are concentration of unevaluated leasehold in Louisiana, impairment of asset value, need to replace reserves, substantial capital requirements, substantial indebtedness, fluctuations in the prices of oil and gas, uncertainties inherent in estimating quantities of oil and gas reserves and projecting future rates of production and timing of development expenditures, competition, operating risks, acquisition and integration of operation risks, restrictions imposed by lenders, liquidity and capital requirements, the effects of governmental and environmental regulation, patent and securities litigation and adverse changes in the market for the Company's oil and gas production. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof, including, without limitation, changes in the Company's business strategy or planned capital expenditures, or to reflect the occurrence of unanticipated events. 24
25 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is subject to ordinary routine litigation incidental to its business. In addition, the Company is a defendant in two purported class actions alleging violations of federal and Oklahoma state securities laws. Also the Company is defending a patent infringement claim in another pending action. These matters are described in Item 3 of the Company's Transition Report on Form 10-K for the six-month period ended December 31, 1997, as updated by its Quarterly Report for the three months ended March 31, 1998. Subsequent developments are as follows: On May 20, 1998, the U.S. District Court for the Northern District of Texas, Forth Worth Division entered two orders in Union Pacific Resources Company v. Chesapeake Energy Corporation, et al. granting the Company summary judgment on several issues. The court ruled as a matter of law that UPRC's tort claims for misappropriation of trade secrets and tortious interference with business relations are barred by the statute of limitations. Further, the court found that UPRC's claim for inducement to infringe its patent for a drillbit steering method is barred as to any wells drilled by the Company prior to August 14, 1995. The only issues remaining in the case involve the validity, potential infringement and value, if any, of UPRC's patent. On July 30, 1998, plaintiffs in Yuan, et al. v. Bayard Drilling Technologies, Inc., et al. filed an Amended Class Action Complaint in the U.S. District Court for the Western District of Oklahoma alleging violations of the Securities Act of 1933 (the "Securities Act") and the Oklahoma Securities Act by the Company and others purportedly on behalf of investors who purchased common stock of Bayard Drilling Technologies, Inc. in, or traceable to its initial public offering in November 1997. Total proceeds of the offering were $254 million, of which the Company received net proceeds of $90 million as a selling shareholder. Plaintiffs allege that the Company, a major customer of Bayard's drilling services and the owner of 30.1% of Bayard's common stock outstanding prior to the offering, was controlling person of Bayard. Plaintiffs assert that the Bayard prospectus contained material omissions and misstatements relating to (i) the Company's financial "problems" and their impact on Bayard's operating results, (ii) increased costs associated with Bayard's growth strategy, (iii) undisclosed pending related-party transactions between Bayard and third parties other than the Company, (iv) Bayard's planned use of offering proceeds and (v) Bayard's capital expenditures and liquidity. The alleged defective disclosures are claimed to have resulted in a decline in Bayard's share price following the public offering. Plaintiffs seek a determination that the suit is a proper class action and damages in an unspecified amount or rescission, together with interest and costs of litigation, including attorneys' fees. No estimate of loss or range of estimate of loss, if any, can be made at this time. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On April 22, 1998, the Company sold 4,600,000 shares (the "Shares") of 7% Cumulative Convertible Preferred Stock having a liquidation preference of $50 per share in a private placement to Donaldson, Lufkin & Jenrette Securities Corporation, Morgan Stanley & Co. Incorporated, Bear, Stearns & Co. Inc., Lehman Brothers Inc. and J.P. Morgan Securities Inc. (the "Initial Purchasers") pursuant to the exemption from registration provided by Section 4 (2) of the Securities Act. The Initial Purchasers resold the shares to qualified institutional buyers, as defined in, and in reliance on the exemption from registration provided by, Rule 144A under the Securities Act. The aggregate offering price for the Shares was $230 million, and aggregate discounts and commissions were $6.9 million. Each of the Shares is convertible at the holders' option, exercisable at any time unless previously redeemed, into shares of Company common stock at a conversion price of $6.95 per Share (equivalent to a conversion rate of approximately 7.1942 shares of common stock for each Share), subject to adjustment pursuant to antidilution provisions. The Shares are redeemable, in whole or in part, at the Company's option at any time on or after May 1, 2001, initially at a price of $52.45 per share and thereafter at prices declining to $50 per share on or after May 1, 2008, plus in each case all accrued and unpaid dividends to the redemption date, which redemption price may be paid in 25
26 cash, by delivery of shares of Company common stock or through a combination thereof. Upon any Change of Control (as defined in the Certificate of Designation for the Shares), each holder of Shares will, in the event that the Market Value (as defined) at such time is less than the Conversion Price, have a one-time option to convert such holder's Shares into common stock at an adjusted Conversion Price equal to the greater of (x) the Market Value for the period ending on the Change of Control date and (y) 66 2/3% of the Market Value for the period ended April 16, 1998. In lieu of issuing shares of common stock for Shares surrendered for conversion upon a Change of Control, the Company may, at its option, make a cash payment equal to the Market Value of the common stock otherwise issuable determined for the period ending on the Change of Control date. On July 7, 1998, the Company's Board of Directors declared a dividend distribution of one preferred stock purchase right (a "right") for each outstanding share of common stock, par value $0.01 per share, of the Company. The distribution was paid on July 27, 1998 to the stockholders of record on that date. Each right entitles the registered holder thereof to purchase from the Company one one-thousandths of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share, of the Company at a price of $25.00, subject to adjustment. ITEM 3. DEFAULTS UPON SENIOR SECURITIES - - Not applicable ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company's annual meeting of shareholders was held on June 12, 1998. In the election of directors, Tom L. Ward received 78,929,789 votes for election, and 1,042,840 shares were withheld from voting. E.F. Heizer, Jr. received 78,924,095 votes for election, and 1,048,534 shares were withheld from voting. Frederick B. Whittemore received 78,928,222 shares for election, and 1,044,407 shares were withheld from voting. ITEM 5. OTHER INFORMATION Discretionary Voting of Proxies at Annual Meeting. The Company will exercise discretionary authority to vote proxies at the Company's next annual meeting of shareholders on any shareholder proposal for which the shareholder has not requested inclusion in the Company's proxy statement unless the shareholder notifies the Company of the proposal and the shareholder's intention to present the proposal from the floor of the meeting not later than April 19, 1999. 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 Certificate of Incorporation. Incorporated herein by reference to Exhibit 3.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 4.1.1 Second [Third] Supplemental Indenture, dated April 22, 1998, to Indenture dated as of March 15, 1997 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, and United States Trust Company of New York, as Trustee, with respect to 7-7/8% Senior Notes due 2004. Incorporated herein by reference to Exhibit 4.1.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 4.2.1 Second [Third] Supplemental Indenture, dated April 22, 1998, to Indenture dated as of March 15, 1997 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, and United States Trust Company of New York, as Trustee, with respect to 8-1/2% Senior Notes due 2012. Incorporated herein by reference to Exhibit 4.2.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 4.4.1 Third Supplemental Indenture, dated April 22, 1998, to Indenture dated as of April 1, 1996 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, and United States Trust Company of New York, as Trustee, with respect to 9-1/8% Senior 26
27 Notes due 2006. Incorporated herein by reference to Exhibit 4.4.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 10.4.1 Amended and Restated Loan Agreement dated July 13, 1998 between Chesapeake Energy Marketing, Inc. and Aubrey K. McClendon. 10.4.2 Amended and Restated Loan Agreement dated July 13, 1998 between Chesapeake Energy Marketing, Inc. and Tom L. Ward. 10.5 Rights Agreement dated July 15, 1998 between the Registrant and UMB Bank, N.A., as Rights Agent. Incorporated herein by reference to Exhibit 1 to Registrant's registration statement on Form 8-A filed July 16, 1998. 27 Financial Data Schedule (b) Reports on Form 8-K During the quarter ended June 30, 1998, the Company filed the following Current Reports on Form 8-K dated: On April 17, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing agreements to acquire British Columbia properties; $450 million senior notes and $150 million perpetual convertible preferred stock offering; and transaction with Gothic Energy Corporation. On April 17, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing tender offer to purchase all of the Company's $90 million 10-1/2% Senior Notes due 2002. On April 17, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the price information on tender for outstanding Senior Notes. On April 22, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the completion of $500 million Senior Notes and $200 million Preferred Stock offerings. On May 20, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the acceptance of tendered 10-1/2% Senior Notes for payment. On May 21, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the Company's stock repurchase program. On May 22, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing rulings in UPRC patent litigation. On May 22, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the first quarter 1998 results. On May 26, 1998, the Company filed a current report on Form 8-K/A amending the Company's Form 8-K dated March 10, 1998 and filed on March 26, 1998. The Form 8-K/A included pro forma combined financial data of Hugoton Energy Corporation. 27
28 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) August 14, 1998 /s/ Aubrey K. McClendon - ------------------------------ --------------------------------------- Date Aubrey K. McClendon Chairman and Chief Executive Officer August 14, 1998 /s/ Marcus C. Rowland - ------------------------------ --------------------------------------- Date Marcus C. Rowland Executive Vice President and Chief Financial Officer 28
29 Index to Exhibits <TABLE> <CAPTION> Exhibit No. Description Page - ----------- ------------ ---- <S> <C> <C> 3.1 Registrant's Certificate of Incorporation. Incorporated herein by reference to Exhibit 3.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 4.1.1 Second [Third] Supplemental Indenture, dated April 22, 1998, to Indenture dated as of March 15, 1997 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, and United States Trust Company of New York, as Trustee, with respect to 7-7/8% Senior Notes due 2004. Incorporated herein by reference to Exhibit 4.1.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 4.2.1 Second [Third] Supplemental Indenture, dated April 22, 1998, to Indenture dated as of March 15, 1997 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, and United States Trust Company of New York, as Trustee, with respect to 8-1/2% Senior Notes due 2012. Incorporated herein by reference to Exhibit 4.2.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 4.4.1 Third Supplemental Indenture, dated April 22, 1998, to Indenture dated as of April 1, 1996 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, and United States Trust Company of New York, as Trustee, with respect to 9-1/8% Senior Notes due 2006. Incorporated herein by reference to Exhibit 4.4.1 to Registrant's registration statement on Form S-3 (No. 333-57235). 10.4.1 Amended and Restated Loan Agreement dated July 13, 1998 between Chesapeake Energy Marketing, Inc. and Aubrey K. McClendon. 10.4.2 Amended and Restated Loan Agreement dated July 13, 1998 between Chesapeake Energy Marketing, Inc. and Tom L. Ward. 10.5 Rights Agreement dated July 15, 1998 between the Registrant and UMB Bank, N.A., as Rights Agent. Incorporated herein by reference to Exhibit 1 to Registrant's registration statement on Form 8-A filed July 16, 1998. 27 Financial Data Schedule </TABLE> 29