1 =============================================================================== UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 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 October 30, 1998, there were 96,710,450 shares of the registrant's $.01 par value Common Stock outstanding. ===============================================================================
2 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1998 <TABLE> <CAPTION> PAGE ---- <S> <C> <C> PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements: Consolidated Balance Sheets at September 30, 1998 (Unaudited) and December 31, 1997 3 Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 1998 and 1997 (Unaudited) 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 1998 and 1997 (Unaudited) 5 Notes to Consolidated Financial Statements (Unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Item 3. Quantitative and Qualitative Disclosure About Market Risks 24 PART II. OTHER INFORMATION Item 1. Legal Proceedings 25 Item 2. Changes in Securities and Use of Proceeds 25 Item 3. Defaults Upon Senior Securities 25 Item 4. Submission of Matters to a Vote of Security Holders 25 Item 5. Other Information 25 Item 6. Exhibits and Reports on Form 8-K 25 </TABLE> 2
3 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ (UNAUDITED) ($ IN THOUSANDS) <S> <C> <C> ASSETS CURRENT ASSETS: Cash and cash equivalents ............................................... $ 20,749 $ 123,860 Restricted cash ......................................................... 4,200 -- Short-term investments .................................................. -- 12,570 Accounts receivable: Oil and gas sales ...................................................... 11,524 10,654 Oil and gas marketing sales ............................................ 23,120 20,493 Joint interest and other, net of allowance for doubtful accounts of $1,209,000 and $691,000............................................ 30,183 38,781 Related parties ........................................................ 16,568 4,246 Inventory ............................................................... 6,327 5,493 Other ................................................................... 4,618 1,624 ----------- ----------- Total current assets ................................................. 117,289 217,721 ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties, at cost based on full-cost accounting: Evaluated oil and gas properties ....................................... 2,054,907 1,095,363 Unevaluated properties ................................................. 92,083 125,155 Less: accumulated depreciation, depletion and amortization.............. (1,176,946) (602,391) ----------- ----------- 970,044 618,127 Other property and equipment ............................................ 78,974 67,633 Less: accumulated depreciation and amortization ......................... (20,537) (6,573) ----------- ----------- Total property and equipment ......................................... 1,028,481 679,187 ----------- ----------- OTHER ASSETS .............................................................. 81,504 55,876 ----------- ----------- TOTAL ASSETS ......................................................... $ 1,227,274 $ 952,784 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable ........................................................ $ 43,150 $ 81,775 Accrued liabilities and other ........................................... 55,505 42,733 Revenues and royalties due others ....................................... 20,645 28,972 ----------- ----------- Total current liabilities ............................................ 119,300 153,480 ----------- ----------- LONG-TERM DEBT, NET ....................................................... 919,055 508,992 ----------- ----------- REVENUES AND ROYALTIES DUE OTHERS ......................................... 12,524 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 September 30, 1998 and December 31, 1997, respectively, entitled in liquidation to $230 million............. 230,000 -- Common stock, $.01 par value, 250,000,000 shares authorized; 96,702,650 and 74,298,061 shares issued and outstanding at.............. 967 743 September 30, 1998 and December 31, 1997, respectively Paid-in capital ......................................................... 677,453 460,733 Accumulated deficit ..................................................... (702,063) (181,270) Less: treasury stock, at cost; 8,503,300 and 0 shares at September 30, 1998 and December 31, 1997, respectively............... (29,962) -- ----------- ----------- Total stockholders' equity ........................................... 176,395 280,206 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................................ $ 1,227,274 $ 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) <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------- -------------------------- 1998 1997 1998 1997 --------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) <S> <C> <C> <C> <C> REVENUES: Oil and gas sales ......................................... $ 70,082 $ 45,667 $ 195,962 $ 148,420 Oil and gas marketing sales ............................... 36,256 26,865 96,451 73,018 Interest and other ........................................ 778 5,878 3,573 14,585 --------- --------- --------- --------- Total revenues ........................................ 107,116 78,410 295,986 236,023 --------- --------- --------- --------- COSTS AND EXPENSES: Production expenses ....................................... 14,208 3,894 36,775 11,071 Production taxes .......................................... 1,976 1,286 6,141 3,342 Oil and gas marketing expenses ............................ 34,720 26,690 94,686 72,282 Impairment of oil and gas properties ...................... -- -- 466,000 236,000 Impairment of other assets ................................ -- -- 10,000 -- Oil and gas depreciation, depletion and amortization ...... 34,069 28,550 109,311 95,571 Depreciation and amortization of other assets ............. 2,518 1,142 5,820 3,088 General and administrative ................................ 5,197 2,760 14,711 7,823 Interest .................................................. 18,577 8,575 47,930 20,909 --------- --------- --------- --------- Total costs and expenses .............................. 111,265 72,897 791,374 450,086 --------- --------- --------- --------- INCOME (LOSS) BEFORE INCOME TAX AND EXTRAORDINARY ITEM ..... (4,149) 5,513 (495,388) (214,063) INCOME TAX BENEFIT ......................................... -- -- -- (17,898) --------- --------- --------- --------- INCOME (LOSS) BEFORE EXTRAORDINARY ITEM .................... (4,149) 5,513 (495,388) (196,165) EXTRAORDINARY ITEM: Loss on early extinguishment of debt ...................... -- -- (13,334) (177) --------- --------- --------- --------- NET INCOME (LOSS) .......................................... (4,149) 5,513 (508,722) (196,342) PREFERRED STOCK DIVIDENDS .................................. (4,026) -- (8,051) -- --------- --------- --------- --------- NET INCOME (LOSS) AVAILABLE TO COMMON SHAREHOLDERS ......... $ (8,175) $ 5,513 $(516,773) $(196,342) ========= ========= ========= ========= EARNINGS PER COMMON SHARE (BASIC AND ASSUMING DILUTION) Income (loss) before extraordinary item ................... $ (0.08) $ 0.08 $ (5.34) $ (2.79) Extraordinary item ........................................ -- -- (0.14) -- --------- --------- --------- --------- Net income (loss) ......................................... $ (0.08) $ 0.08 $ (5.48) $ (2.79) ========= ========= ========= ========= WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING Basic ..................................................... 98,046 70,376 94,355 70,376 ========= ========= ========= ========= Assuming dilution ......................................... 98,046 72,699 94,355 70,376 ========= ========= ========= ========= </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> NINE MONTHS ENDED SEPTEMBER 30, --------------------------- 1998 1997 --------- --------- ($ IN THOUSANDS) <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ................................................................ $(508,722) $(196,342) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation, depletion and amortization ............................... 113,449 97,571 Impairment of oil and gas assets ....................................... 466,000 236,000 Impairment of other assets ............................................. 10,000 -- Deferred taxes ......................................................... -- (17,898) Amortization of loan costs ............................................. 1,682 1,088 Amortization of bond discount .......................................... 77 46 Gain on sale of fixed assets and other ................................. (142) (3,766) Extraordinary loss ..................................................... 13,334 177 Equity in (earnings) losses of equity investees ........................ 487 (181) Bad debt expense ....................................................... 516 324 --------- --------- Cash provided by operating activities before changes in current assets and liabilities .................................. 96,681 117,019 Changes in current assets and liabilities .............................. (43,358) (32,207) --------- --------- Cash provided by operating activities ................................ 53,323 84,812 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Exploration, development and acquisition of oil and gas properties ...... (478,394) (380,804) Investment in preferred stock of Gothic Energy Corporation .............. (39,500) -- Proceeds from sale of assets ............................................ 6,714 1,190 Additions to other property and equipment ............................... (9,771) (40,605) Long-term loans made to third parties ................................... -- (20,000) Repayment of long-term loan ............................................. 2,000 -- Other investments ....................................................... -- (13,751) --------- --------- Cash used in investing activities .................................... (518,951) (453,970) --------- --------- 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 ............................... 222,760 -- Purchase of treasury stock .............................................. (29,962) -- Dividends paid on common stock .......................................... (5,592) (1,405) Dividends paid on preferred stock ....................................... (4,025) -- Cash received from exercise of stock options ............................ 131 1,340 Other financing ......................................................... -- (210) --------- --------- Cash provided by financing activities ................................ 367,896 279,601 --------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH ................................... (5,379) -- --------- --------- NET DECREASE IN CASH AND CASH EQUIVALENTS ................................. (103,111) (89,557) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ............................ 123,860 140,739 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD .................................. $ 20,749 $ 51,182 ========= ========= </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 SEPTEMBER 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 nine months ended September 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 nine months ended September 30, 1998 (the "Current Quarter" and "Current Period", respectively) and September 30, 1997 (the "Prior Quarter" and "Prior Period", respectively). 2. RECENT EVENTS On July 7, 1998 the Company's Board of Directors authorized management to explore strategic alternatives to enhance shareholder value, including a possible sale or merger of the Company, based upon the Board's opinion that the market was 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. Pursuant to the decision to explore various alternatives, the Company engaged Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") to advise the Company. The Company and DLJ are presently evaluating various alternatives, including the potential sale or merger of the Company, sale of certain assets, or alternative financial strategies. This process is underway and is expected to be concluded within the next few months. On November 2, 1998 the Company announced it had entered into an agreement to tender its 19.9% stake in Pan East Petroleum Corp. ("Pan East") to Poco Petroleums Ltd. and agreed to a property exchange with Pan East. Subject to the successful completion by Poco of its tender offer, the Company anticipates receiving approximately $26 million in cash and increasing its net reserves by four bcfe. As of September 30, 1998, the Company's net investment in the common stock of Pan East of $21.3 million has been accounted for using the equity method and is included in Other Assets in the accompanying Consolidated Balance Sheets. 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 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 6
7 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) 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. 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. SFAS 128 requires a reconciliation of the numerators and denominators of the basic and diluted EPS computations. For the Current 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 10.6 million and 8.5 million shares of common stock at a weighted average exercise price of $3.88 and $5.48 were outstanding at September 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. A reconciliation for the Prior Quarter is as follows: 7
8 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) <TABLE> <CAPTION> Net Income Shares Outstanding (Numerator) (Denominator) Per-Share (in 000's) (in 000's) Amount ----------- ------------------ --------- <S> <C> <C> <C> For the quarter ended September 30, 1997: Basic EPS Income available to common stockholders ............ $5,513 70,376 $0.08 ===== Effect of Dilutive Securities Employee stock options ............................. -- 2,323 ------ ------ Diluted EPS Income available to common stockholders and assumed conversions .......................... $5,513 72,699 $0.08 ====== ====== ===== </TABLE> 5. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENT In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 "Disclosures about Segments of an Enterprise and Related Information". This Statement establishes standards for the way that public enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. The Statement is effective for annual financial statements for periods beginning after December 15, 1997 and for interim financial statements issued subsequent to adoption in the annual financial statements. The Company expects that the adoption of this standard will not impact its results of operation or financial position, but may require additional disclosures. 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 the fair value of an asset, liability, or firm commitment, 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 results of operations or its financial position. 6. 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 8
9 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) 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) <TABLE> <CAPTION> Nine Months Ended September 30, 1998 1997 ----------- ---------- (In thousands, except per share data) <S> <C> <C> Revenues................................................ $ 305,678 $ 294,462 Loss before extraordinary item.......................... $ (496,837) $ (192,285) Net Loss................................................ $ (510,171) $ (192,462) Loss before extraordinary item per common share......... $ (4.96) $ (2.00) Net loss per common share............................... $ (5.10) $ (2.00) </TABLE> The Company acquired other businesses and oil and gas properties in the Current Period. The results of operations of these businesses and properties were not material in relation to the Company's consolidated results of operations. 7. SENIOR NOTES 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 (as defined below). 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 9
10 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) 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 Company is obligated to repurchase the 9.125% and 9.625% 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 nine months ended September 30, 1998, the only Non-Guarantor Subsidiary was Chesapeake Energy Marketing, Inc. As of and for the three and nine months ended September 30, 1997, the Non-Guarantor Subsidiaries were Chesapeake Energy Marketing, Inc. and Chesapeake Canada Corporation. For the 1997 and 1998 periods, the remaining subsidiaries of the Company were Guarantor Subsidiaries. 10
11 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING BALANCE SHEET AS OF SEPTEMBER 30, 1998 ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ------------ ------------- -------- ------------ ------------ <S> <C> <C> <C> <C> <C> ASSETS CURRENT ASSETS: Cash and cash equivalents ............ $ (4,882) $ 2,981 $ 26,850 $ -- $ 24,949 Short-term investments ............... -- -- -- -- -- Accounts receivable, net ............. 56,930 32,746 276 (8,557) 81,395 Inventory ............................ 6,189 138 -- -- 6,327 Other ................................ 4,059 43 516 -- 4,618 ----------- ----------- ----------- ----------- ----------- Total Current Assets .............. 62,296 35,908 27,642 (8,557) 117,289 ----------- ----------- ----------- ----------- ----------- PROPERTY AND EQUIPMENT: Oil and gas properties ............... 2,054,907 -- -- -- 2,054,907 Unevaluated leasehold ................ 92,083 -- -- -- 92,083 Other property and equipment ......... 59,484 2,572 16,918 -- 78,974 Less: accumulated depreciation, depletion and amortization ......... (1,196,120) (85) (1,278) -- (1,197,483) ----------- ----------- ----------- ----------- ----------- Total Property and Equipment ...... 1,010,354 2,487 15,640 -- 1,028,481 ----------- ----------- ----------- ----------- ----------- INVESTMENTS IN SUBSIDIARIES AND INTERCOMPANY ADVANCES ................ 474,616 -- 471,151 (945,767) -- OTHER ASSETS ........................... 39,500 580 41,424 -- 81,504 ----------- ----------- ----------- ----------- ----------- TOTAL ASSETS ...................... $ 1,586,766 $ 38,975 $ 555,857 $ (954,324) $ 1,227,274 =========== =========== =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Notes payable and current maturities of long-term debt .................. $ -- $ -- $ -- $ -- $ -- Accounts payable and other ........... 82,006 14,910 31,240 (8,856) 119,300 ----------- ----------- ----------- ----------- ----------- Total Current Liabilities ......... 82,006 14,910 31,240 (8,856) 119,300 ----------- ----------- ----------- ----------- ----------- LONG-TERM DEBT ......................... -- -- 919,055 -- 919,055 ----------- ----------- ----------- ----------- ----------- REVENUES PAYABLE ....................... 12,524 -- -- -- 12,524 ----------- ----------- ----------- ----------- ----------- INTERCOMPANY PAYABLES .................. 1,346,717 10,524 (1,357,540) 299 -- ----------- ----------- ----------- ----------- ----------- STOCKHOLDERS' EQUITY: Preferred Stock ...................... -- -- 230,000 -- 230,000 Common Stock ......................... 27 1 956 (17) 967 Other ................................ 145,492 13,540 732,146 (945,750) (54,572) ----------- ----------- ----------- ----------- ----------- Total Stockholders' Equity ........ 145,519 13,541 963,102 (945,767) 176,395 ----------- ----------- ----------- ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ............ $ 1,586,766 $ 38,975 $ 555,857 $ (954,324) $ 1,227,274 =========== =========== =========== =========== =========== </TABLE> 11
12 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 1997 ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ------------ ------------- -------- ------------ ------------ <S> <C> <C> <C> <C> <C> ASSETS 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 SEPTEMBER 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 SEPTEMBER 30, 1998 REVENUES: Oil and gas sales ........................... $ 69,780 $ (187) $ -- $ 489 $ 70,082 Oil and gas marketing sales ................. 973 64,769 -- (29,486) 36,256 Interest and other .......................... 966 405 28,024 (28,617) 778 --------- --------- --------- --------- --------- Total Revenues ........................... 71,719 64,987 28,024 (57,614) 107,116 --------- --------- --------- --------- --------- COSTS AND EXPENSES: Production expenses and taxes ............... 16,184 -- -- -- 16,184 Oil and gas marketing expenses .............. 1,040 62,677 -- (28,997) 34,720 Impairment of oil and gas properties ........ -- -- -- -- -- Impairment of other assets .................. -- -- -- -- -- Oil and gas depreciation, depletion and amortization .......................... 34,069 -- -- -- 34,069 Other depreciation and amortization ......... 1,637 88 793 -- 2,518 General and administrative .................. 4,514 636 47 -- 5,197 Interest .................................... 26,605 4 20,585 (28,617) 18,577 --------- --------- --------- --------- --------- Total Costs and Expenses ................. 84,049 63,405 21,425 (57,614) 111,265 --------- --------- --------- --------- --------- INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEM ...................... (12,330) 1,582 6,599 -- (4,149) INCOME TAX EXPENSE (BENEFIT) .................. -- -- -- -- -- --------- --------- --------- --------- --------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM .......................... (12,330) 1,582 6,599 -- (4,149) --------- --------- --------- --------- --------- EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax .............. -- -- -- -- -- --------- --------- --------- --------- --------- NET INCOME (LOSS) ........................ $ (12,330) $ 1,582 $ 6,599 $ -- $ (4,149) ========= ========= ========= ========= ========= FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1997 REVENUES: Oil and gas sales ........................... $ 45,049 $ -- $ -- $ 618 $ 45,667 Gas marketing sales ......................... -- 44,326 -- (17,461) 26,865 Interest and other .......................... 135 487 20,118 (14,862) 5,878 --------- --------- --------- --------- --------- Total Revenues ........................... 45,184 44,813 20,118 (31,705) 78,410 --------- --------- --------- --------- --------- COSTS AND EXPENSES: Production expenses and taxes ............... 5,180 -- -- -- 5,180 Gas marketing expenses ...................... -- 43,533 -- (16,843) 26,690 Impairment of oil and gas properties ........ -- -- -- -- -- Oil and gas depreciation, depletion and Amortization .............................. 28,550 -- -- -- 28,550 Other depreciation and amortization ......... 628 21 493 -- 1,142 General and administrative .................. 2,578 265 (83) -- 2,760 Interest .................................... 12,246 33 11,158 (14,862) 8,575 --------- --------- --------- --------- --------- Total Costs and Expenses ................. 49,182 43,852 11,568 (31,705) 72,897 --------- --------- --------- --------- --------- INCOME (LOSS) BEFORE INCOME TAX ............... (3,998) 961 8,550 -- 5,513 INCOME TAX EXPENSE (BENEFIT) .................. -- -- -- -- -- --------- --------- --------- --------- --------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ..................... (3,998) 961 8,550 -- 5,513 EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax .................. -- -- -- -- -- --------- --------- --------- --------- --------- NET INCOME (LOSS) ........................ $ (3,998) $ 961 $ 8,550 $ -- $ 5,513 ========= ========= ========= ========= ========= </TABLE> 13
14 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 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 NINE MONTHS ENDED SEPTEMBER 30, 1998 REVENUES: Oil and gas sales ........................... $ 193,800 $ -- $ -- $ 2,162 $ 195,962 Oil and gas marketing sales ................. 973 173,405 -- (77,927) 96,451 Interest and other .......................... 1,471 685 72,007 (70,590) 3,573 --------- --------- --------- --------- --------- Total Revenues ........................... 196,244 174,090 72,007 (146,355) 295,986 --------- --------- --------- --------- --------- COSTS AND EXPENSES: Production expenses and taxes ............... 42,916 -- -- -- 42,916 Oil and gas marketing expenses .............. 1,040 169,411 -- (75,765) 94,686 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 .......................... 109,311 -- -- -- 109,311 Other depreciation and amortization ......... 3,698 142 1,980 -- 5,820 General and administrative .................. 13,122 1,535 54 -- 14,711 Interest .................................... 67,704 4 50,812 (70,590) 47,930 --------- --------- --------- --------- --------- Total Costs and Expenses ................. 713,791 171,092 52,846 (146,355) 791,374 --------- --------- --------- --------- --------- INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEM ...................... (517,547) 2,998 19,161 -- (495,388) INCOME TAX EXPENSE (BENEFIT) .................. -- -- -- -- -- --------- --------- --------- --------- --------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM .......................... (517,547) 2,998 19,161 -- (495,388) --------- --------- --------- --------- --------- EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax .............. (2,164) -- (11,170) -- (13,334) --------- --------- --------- --------- --------- NET INCOME (LOSS) ........................ $(519,711) $ 2,998 $ 7,991 $ -- $(508,722) ========= ========= ========= ========= ========= FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 REVENUES: Oil and gas sales ........................... $ 150,416 $ (3,579) $ -- $ 1,583 $ 148,420 Gas marketing sales ......................... -- 131,661 -- (58,643) 73,018 Interest and other .......................... 746 665 67,564 (54,390) 14,585 --------- --------- --------- --------- --------- Total Revenues ........................... 151,162 128,747 67,564 (111,450) 236,023 --------- --------- --------- --------- --------- COSTS AND EXPENSES: Production expenses and taxes ............... 14,824 (411) -- -- 14,413 Gas marketing expenses ...................... -- 129,342 -- (57,060) 72,282 Impairment of oil and gas properties ........ 236,000 -- -- -- 236,000 Oil and gas depreciation, depletion and amortization .......................... 96,864 (1,293) -- -- 95,571 Other depreciation and amortization ......... 1,737 30 1,321 -- 3,088 General and administrative .................. 6,348 691 784 -- 7,823 Interest .................................... 49,582 (184) 25,901 (54,390) 20,909 --------- --------- --------- --------- --------- Total Costs and Expenses ................. 405,355 128,175 28,006 (111,450) 450,086 --------- --------- --------- --------- --------- INCOME (LOSS) BEFORE INCOME TAX ............... (254,193) 572 39,558 -- (214,063) INCOME TAX EXPENSE (BENEFIT) .................. (19,384) (967) 2,453 -- (17,898) --------- --------- --------- --------- --------- NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ..................... (234,809) 1,539 37,105 -- (196,165) EXTRAORDINARY ITEM: Loss on early extinguishment of debt, net of applicable income tax .................. (179) -- 2 -- (177) --------- --------- --------- --------- --------- NET INCOME (LOSS) ........................ $(234,988) $ 1,539 $ 37,107 $ -- $(196,342) ========= ========= ========= ========= ========= </TABLE> 14
15 CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (UNAUDITED) CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS ($ IN THOUSANDS) <TABLE> <CAPTION> GUARANTOR NON-GUARANTOR COMPANY SUBSIDIARIES SUBSIDIARIES (PARENT) ELIMINATIONS CONSOLIDATED ------------ ------------- ------- ------------ ------------ <S> <C> <C> <C> <C> <C> FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 CASH FLOWS FROM OPERATING ACTIVITIES: .......................................... $ 32,384 $ (21,068) $ 42,007 $ -- $ 53,323 --------- --------- --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Oil and gas properties ............................... (478,394) -- -- -- (478,394) Proceeds from sale of assets ......................... 3,114 -- 3,600 -- 6,714 Investment in preferred stock of Gothic .............. (39,500) -- -- -- (39,500) Repayment of long-term loan .......................... 2,000 -- -- -- 2,000 Other additions ...................................... (6,161) (1,343) (2,267) -- (9,771) --------- --------- --------- --------- --------- (518,941) (1,343) 1,333 -- (518,951) --------- --------- --------- --------- --------- 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 ....... -- -- 222,760 -- 222,760 Cash paid for purchase of treasury stock ............. -- -- (29,962) -- (29,962) Cash received from exercise of stock options ......... -- -- 131 -- 131 Cash dividends paid on common and preferred stock .................................... -- -- (9,617) -- (9,617) Intercompany advances, net ........................... 465,229 (2,545) (462,684) -- -- --------- --------- --------- --------- --------- 465,229 (2,545) (94,788) -- 367,896 --------- --------- --------- --------- --------- Effect of exchange rate changes on cash .............. (5,379) -- -- -- (5,379) --------- --------- --------- --------- --------- Net increase (decrease) in cash ...................... (26,707) (24,956) (51,448) -- (103,111) Cash, beginning of period ............................ (284) 13,694 110,450 -- 123,860 --------- --------- --------- --------- --------- Cash, end of period .................................. $ (26,991) $ (11,262) $ 59,002 $ -- $ 20,749 ========= ========= ========= ========= ========= FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 CASH FLOWS FROM OPERATING ACTIVITIES: .................. $ 76,828 $ 742 $ 7,242 $ -- $ 84,812 --------- --------- --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Oil and gas properties ............................... (380,868) 64 -- -- (380,804) Proceeds from sale of assets ......................... 1,190 -- -- -- 1,190 Loans to third parties ............................... (2,000) -- (18,000) -- (20,000) Other investments .................................... -- -- (13,751) -- (13,751) Other additions ...................................... (34,723) (240) (5,642) -- (40,605) --------- --------- --------- --------- --------- (416,401) (176) (37,393) -- (453,970) --------- --------- --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term borrowings ................... -- -- 292,626 -- 292,626 Payments on borrowings ............................... (67,655) 1,710 53,195 -- (12,750) Cash received from exercise of stock options.......... -- -- 1,340 -- 1,340 Cash dividends paid on common stock .................. -- -- (1,405) -- (1,405) Other financing ...................................... -- (15) (195) -- (210) Intercompany advances, net ........................... 396,018 (1,709) (394,309) -- -- --------- --------- --------- --------- --------- 328,363 (14) (48,748) -- 279,601 --------- --------- --------- --------- --------- Net increase (decrease) in cash and cash Equivalents ........................................ (11,210) 552 (78,899) -- (89,557) Cash, beginning of period ............................ 4,865 6,099 129,775 -- 140,739 --------- --------- --------- --------- --------- Cash, end of period .................................. $ (6,345) $ 6,651 $ 50,876 $ -- $ 51,182 ========= ========= ========= ========= ========= </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 strategic 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. Pursuant to the decision to explore various alternatives, the Company engaged Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") to advise the Company. The Company and DLJ are presently evaluating various alternatives, including the potential sale or merger of the Company, sale of certain assets, or alternative financial strategies. This process is underway and is expected to be concluded within the next few months. On November 2, 1998 the Company announced it entered into an agreement to tender its 19.9% stake in Pan East Petroleum Corp. ("Pan East") to Poco Petroleums Ltd. and agreed to a property exchange with Pan East. Subject to the successful completion by Poco of its tender offer, the Company anticipates receiving approximately $26 million in cash and increasing its net reserves by four billion cubic feet equivalent of natural gas. As of September 30, 1998, the Company's net investment in the common stock of Pan East of $21.3 million has been accounted for using the equity method and is included in Other Assets in the accompanying Consolidated Balance Sheets. RESULTS OF OPERATIONS Three Months Ended September 30, 1998 vs. September 30, 1997 General. For the three months ended September 30, 1998 (the "Current Quarter"), the Company realized a net loss of $4.1 million, or a loss of $0.08 per common share after deducting preferred dividends of $4.0 million. This compares to net income of $5.5 million, or income of $0.08 per common share, for the three months ended September 30, 1997 (the "Prior Quarter"). During the Current Quarter and Prior Quarter, the Company did not record any impairment of its oil and gas properties. Any future impairment is subject to a number of factors, some of which are beyond the control of the Company, including oil and natural gas prices. Lower oil or gas prices could have a material adverse effect on the Company's operations and financial condition and may result in future write-downs of the Company's oil and gas properties due to full-cost ceiling test limitations. As of September 30, 1998, the Company estimates that the present value (SEC-PV10%) of its proved reserves, based on prices at that time of $15.43 per bbl (NYMEX) and $2.32 per mcf (NYMEX), adjusted for usual well-head quality and location (basis) variances, was $929 million. The Company estimates that, as of September 30, 1998, for every $0.10 per thousand cubic feet ("mcf") reduction in natural gas prices and $1.00 per barrel of oil ("bbl") reduction in oil prices, the present value of the Company's proved oil and gas reserves would be reduced by approximately $55 million and $22 million, respectively. Oil and Gas Sales. During the Current Quarter, oil and gas sales increased significantly to $70.1 million from $45.7 million, an increase of $24.4 million, or 53%. This increase resulted from significantly higher oil and gas production volumes, which increased from 19.2 bcfe in the Prior Quarter to 36.3 bcfe in the Current Quarter, an increase of 17.1 bcfe, or 89%. 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 1.6 million barrels of oil ("mmbo") and 26.8 billion cubic feet of natural gas ("bcf"), compared to 0.9 mmbo and 13.9 bcf in the Prior Quarter. Average oil prices realized were $12.41 per barrel of oil in the Current Quarter compared 16
17 to $18.48 per barrel in the Prior Quarter, a decrease of 33%. Average gas prices realized were $1.88 per mcf in the Current Quarter compared to $2.12 per mcf in the Prior Quarter, a decrease of 11%. For the Current Quarter, the Company realized an average price of $1.93 per thousand cubic feet equivalent of natural gas ("mcfe"), compared to $2.38 per mcfe in the Prior Quarter. The Company's hedging activities resulted in increased oil and gas revenues of $6.5 million, or $0.18 per mcfe, in the Current Quarter, compared to increases in oil and gas revenues of $0.4 million 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 SEPTEMBER 30, ---------------------------------------------------------- 1998 1997 ----------------------------- -------------------------- OPERATING AREAS MMCFE PERCENT MMCFE PERCENT - --------------------- ------------- ------------- ------------- ------------ <S> <C> <C> <C> <C> Mid-Continent ................ 17,969 50% 4,277 22% Gulf Coast ................... 13,099 36 13,793 72 Canada ....................... 2,533 7 -- -- Other areas .................. 2,667 7 1,091 6 ------ ------ ------ ------ Total ................... 36,268 100% 19,161 100% ====== ====== ====== ====== </TABLE> Natural gas production represented approximately 74% of the Company's total production volume on an equivalent basis in the Current Quarter, compared to 73% in the Prior Quarter. The Company anticipates natural gas will represent 70-80% of anticipated 1998 and 1999 production. Oil and Gas Marketing Sales. The Company realized $36.3 million in oil and gas marketing sales for third parties in the Current Quarter, with corresponding oil and gas marketing expenses of $34.7 million, for a gross profit margin of $1.6 million. This compares to sales of $26.9 million and expenses of $26.7 million, resulting in a gross profit margin of $0.2 million in the Prior Quarter. Interest and Other. Interest and other revenues for the Current Quarter were $0.8 million compared to $5.9 million in the Prior Quarter. The decrease was primarily caused by the Company maintaining lower invested cash balances resulting in reduced interest income during the Current Quarter. Production Expenses and Taxes. Production expenses increased to $14.2 million in the Current Quarter, a $10.3 million increase from $3.9 million incurred in the Prior Quarter. This significant increase was due to higher production attributable to acquisitions and higher unit-of-production expense. On a production unit basis, production expenses were $0.39 and $0.20 per mcfe in the Current and Prior Quarters, respectively. Properties acquired in late 1997 and 1998 typically have higher unit-of-production expenses than the Company's historical production base. The Company anticipates production expenses will average $0.40 per mcfe for 1998. Production taxes, which consist primarily of wellhead severance taxes, were $2.0 million and $1.3 million in the Current and Prior Quarters, respectively. This increase was the result of increased production, offset by certain accounting reclassifications. On a per unit basis, production taxes were $0.05 per mcfe in the Current Quarter compared to $0.07 per mcfe in the Prior Quarter. The Company anticipates incurring production taxes at the rate of $0.07 per mcfe for the remainder of 1998 and 1999. Oil and Gas Depreciation, Depletion and Amortization. Depreciation, depletion and amortization of oil and gas properties ("DD&A") for the Current Quarter was $34.1 million, compared to $28.6 million in the Prior Quarter. This increase was caused by significantly increased production, partially offset by a decrease in the DD&A rate per mcfe from $1.49 to $0.94 in the Prior and Current Quarters, respectively. The Company's DD&A rate is expected to be approximately $0.95-$1.00 per mcfe for the remainder of 1998. Depreciation and Amortization of Other Assets. Depreciation and amortization of other assets ("D&A") increased to $2.5 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 17
18 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 $5.2 million in the Current Quarter compared to $2.8 million in the Prior Quarter. This increase was primarily caused by increased employment levels resulting from the Company's acquisitions. The Company capitalized $0.8 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 and expects G&A costs to trend somewhat lower in 1999. Interest. Interest expense increased to $18.6 million in the Current Quarter from $8.6 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 $2.0 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 or the Prior Quarter. At September 30, 1998, the Company had a net operating loss carryforward of approximately $525 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 has been recorded equaling the net deferred tax asset. The Company does not expect to record any book income tax expense or benefit for the remainder of 1998. Nine Months Ended September 30, 1998 vs. September 30, 1997 General. For the nine months ended September 30, 1998 (the "Current Period"), the Company realized a net loss of $508.7 million, or a loss of $5.48 per common share after deducting preferred dividends of $8.1 million. This compares to a net loss of $196.3 million, or a loss of $2.79 per common share, in the nine months ended September 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 $19.4 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 acquired proved reserves as of March 31, 1998 or June 30, 1998. See "- Impairment of Oil and Gas Properties". The loss in the Prior Period was caused by a $236 million asset write-down recorded under the full-cost method of accounting. The 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. Oil and Gas Sales. During the Current Period, oil and gas sales increased significantly to $196.0 million from $148.4 million, an increase of $47.6 million, or 32%. This increase resulted from significantly higher oil and gas production volumes, which increased from 61.0 bcfe in the Prior Period to 96.5 bcfe in the Current Period, an increase of 35.5 bcfe, or 58%. 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 4.6 mmbo and 69.0 bcf, compared to 2.5 mmbo and 45.9 bcf in the Prior Period. Average oil prices realized were $13.21 per barrel in the Current Period compared to $19.66 per barrel in the Prior Period, a decrease of 33%. Average gas prices realized were $1.96 per mcf in the Current Period compared to $2.15 per mcf in the Prior Period, a decrease of 9%. For the Current Period, the Company realized an average price of $2.03 per mcfe, compared to $2.43 per mcfe in the Prior Period. The Company's hedging activities resulted in increased oil and gas revenues of $10.5 million, or 18
19 $0.11 per mcfe, in the Current Period, compared to increases in oil and gas revenues of $0.1 million 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 NINE MONTHS ENDED SEPTEMBER 30, ----------------------------------------------------------- 1998 1997 ----------------------------- --------------------------- OPERATING AREAS MMCFE PERCENT MMCFE PERCENT - --------------------- ------------- ------------- ------------- ------------ <S> <C> <C> <C> <C> Mid-Continent ................ 44,809 46% 12,568 21% Gulf Coast ................... 39,519 41 45,136 74 Canada ....................... 5,677 6 -- -- Other areas .................. 6,457 7 3,291 5 ------ ------ ------ ------ Total ................... 96,462 100% 60,995 100% ====== ====== ====== ====== </TABLE> Natural gas production represented approximately 72% of the Company's total production volume on an equivalent basis in the Current Period, compared to 75% in the Prior Period. Oil and Gas Marketing Sales. The Company realized $96.4 million in oil and gas marketing sales for third parties in the Current Period, with corresponding oil and gas marketing expenses of $94.7 million, resulting in a gross profit margin of $1.7 million. This compares to sales of $73.0 million and expenses of $72.3 million with a gross profit margin of $0.7 million in the Prior Period. Interest and Other. Interest and other revenues for the Current Period were $3.6 million compared to $14.6 million in the Prior Period. The decrease was primarily caused by the Company maintaining lower invested cash balances resulting in reduced interest income during the Current Period. Production Expenses and Taxes. Production expenses increased to $36.8 million in the Current Period, a $25.7 million increase from $11.1 million incurred in the Prior Period, due to the significantly higher production levels and higher per unit costs. On a production unit basis, production expenses were $0.38 and $0.18 per mcfe in the Current and Prior Periods, respectively. The primary reason for the increase per mcfe 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 $6.1 million and $3.3 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 $0.06 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 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 ($250 million recorded during the quarter ended March 31, 1998, and $216 million recorded during the quarter ended June 19
20 30, 1998), 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 of these acquisitions were Hugoton Energy Corporation and DLB Oil & Gas, Inc. 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 lower 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 and the results of the Company's exploration activities. Impairment of Other Assets. In the Current Period, the Company incurred an impairment charge of $10 million as of June 30, 1998 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 $109.3 million, compared to $95.6 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 $1.57 to $1.13 in the Prior and Current Periods, respectively. Depreciation and Amortization of Other Assets. D&A increased to $5.8 million in the Current Period compared to $3.1 million in the Prior Period. This increase in D&A was caused by increased investments in depreciable buildings and equipment incurred in conjunction with 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, was $14.7 million in the Current Period compared to $7.8 million in the Prior Period. This increase was primarily caused by increased employment levels associated with the Company's acquisitions. The Company capitalized $4.0 million of internal costs in the Current Period directly related to the Company's oil and gas exploration and development efforts, compared to $4.2 million in the Prior Period. Interest. Interest expense increased to $47.9 million in the Current Period from $20.9 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 $5.8 million of interest during the Current Period compared to $7.9 million capitalized in the Prior Period. Provision for Income Taxes. The Company recorded no income tax expense for the Current Period, and recorded a $17.9 million tax benefit in the Prior Period. Loss on Early Extinguishment of Debt. During the Current Period and Prior Period, the Company recorded a loss on early extinguishment of debt of $13.3 million and $0.2 million, respectively. The loss in the Current Period was due primarily to the early retirement of the Company's 10.5% Senior Notes due 2002. The cost to acquire the $90 million aggregate principal amount 10.5% Senior Notes of $99 million, together with the write-off of associated debt issue costs, resulted in an extraordinary charge of $13.3 million during the Current Period. The Company did not record any such charges in the Current Quarter or Prior Quarter. 20
21 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 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. As of September 30, 1998, the Company had the following natural gas swap arrangement for periods after September 1998: <TABLE> <CAPTION> MONTHLY NYMEX-INDEX VOLUME STRIKE PRICE MONTHS (MMBTU) (PER MMBTU) ------ ------- ------------ <S> <C> <C> October 1998............... 4,960,000 $ 2.346 </TABLE> The swap arrangement listed above was closed but not settled as of September 30, 1998, resulting in net proceeds to the Company of $1.1 million in October 1998. 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. Subsequent to September 30, 1998, the Company sold December 1998 natural gas call options with a strike price of $2.60 on volume of 3.1 bcf for $0.1325 per mmbtu, and sold January 1999 natural gas call options with a strike price of $2.70 on volume of 3.1 bcf for $0.2225 per mmbtu. As of October 15, 1998, the Company closed transactions for oil previously hedged from January 1999 through December 1999, resulting in a $0.9 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 $0.4 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 September 30, 1998, the Company's interest rate swap resulted in a $0.2 million reduction of interest expense for the period August 1998 through October 1998, which settled on November 2, 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 September 30, 1998, the Company had a working capital deficit of approximately $2.0 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 $50 million for drilling, seismic and leasehold expenditures for the three months ended December 31, 1998 and is currently 21
22 budgeting $195 million in expenditures for 1999. 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, planned asset sales and unused commercial bank facilities to fund the reduced drilling program for the remainder of 1998. As part of its capital resources plan, the Company has undertaken to sell various non-core assets. The Company expects to realize between $75 and $100 million of cash from these asset sales within the six months beginning October 1, 1998, inclusive of the $26 million transaction announced on November 2, 1998 between Poco Petroleums Ltd. and the Company involving Pan East common stock and oil and gas reserves in the Helmet area of British Columbia. Other completed asset sales combined with offers currently in hand total approximately $25 million. These asset sales are independent of the Company's strategic alternatives evaluation process. The Company has a $50 million secured revolving bank facility with its primary commercial bank. As a result of its reduced capital expenditure plan, reduced acquisition program, and the planned sale of assets, the Company believes this size of bank facility is appropriate for the foreseeable future, although significantly larger secured facilities could be established within the limits of the Company's senior note indentures. The facility contains terms and conditions similar to the bank facilities the Company has had in the past, including collateral-based borrowing limitations. The primary purpose of the facility is to provide standby liquidity for the Company. The Company had no borrowings outstanding under this facility at September 30, 1998. 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 25, 1998 the Company had purchased approximately 8.5 million shares of common stock for an aggregate amount of $30.0 million pursuant to such authorization. The Company's senior note indentures contain restrictions on the Company's ability to make Restricted Payments (as defined), including the payment of preferred stock dividends unless certain tests are met. The Company anticipates that, based on expected production, pricing, and expenses for the twelve months ending December 31, 1998, it may not be able to meet the requirements to incur additional unsecured indebtedness, and consequently would not be able to pay cash dividends on its 7% Cumulative Convertible Preferred Stock as of February 1, 1999. Subsequent payments will be subject to the same restrictions and are dependent upon variables that are beyond the Company's ability to predict, chiefly the future level of oil and gas prices. This restriction does not affect the Company's ability to borrow under or expand its secured commercial bank facility. If the Company fails to pay dividends for six quarterly periods, the holders of preferred stock would be entitled to elect two additional members to the Board. The Company's cash provided by operating activities before changes in current assets and liabilities decreased 17% to $96.7 million during the Current Period compared to $117.0 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 $518.9 million during the Current Period from $453.9 million in the Prior Period. The Company completed several acquisitions requiring cash in the Current Period which totaled $345 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 $143.8 million to initiate drilling on 166 gross (91.5 net) wells and invested approximately $11.1 million in leasehold acquisitions. This compares to $254.4 million to initiate drilling on 140 gross (78.2 net) wells and $113.1 million to purchase leasehold in the Prior Period. Cash provided by financing activities was $367.9 million in the Current Period, compared to $279.6 million in the Prior Period. During the Current Period, the Company retired $465 million of debt consisting of $85 million of debt assumed at the completion of the DLB acquisition, $120 million of debt assumed at the completion of the Hugoton acquisition, $90 million of senior notes, and $170 million of 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. 22
23 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 for these non-routine lawsuits in the Company's financial statements. YEAR 2000 Project. The Company has placed a high priority on proactively resolving computer or imbedded chip problems related to the "Year 2000" which may have adverse material effects on its continuing operations or cash flow. This problem would be caused by the inability of a component (software, hardware or equipment with embedded microprocessors) to correctly process date data in and between the 20th and 21st centuries and therefore fail to properly perform its intended functions, and/or to exchange correct date data with other components. This problem would most typically be caused by erroneous date calculations, which results from using two digits to signify a year (century implied), handling leap years incorrectly or the use of "special" values that can be confused with legitimate calendar dates. The scope of the Year 2000 project includes conducting an inventory of the Company's software, hardware and "embedded systems" equipment, assessing potential for failure and the associated risk, prioritizing the need for remediation, repairing or replacing significant noncompliant items, and testing. In addition, the Company will take a similar approach to mitigating risks associated with the Year 2000 readiness of material business partners (vendors, suppliers, customers, etc.). The project will also identify contingency plans to cope with unexpected events resulting from Year 2000 issues. Beginning in mid 1997, the Company began an assessment of its core financial and operational software systems. Three critical systems were identified with date sensitivities: oil and gas financial accounting, production accounting and land/lease administration. A Year 2000 compliant release of the oil and gas financial accounting package in use at the Company is available and has been scheduled for implementation during the first calendar quarter of 1999. The production accounting system in use at the Company is also scheduled for upgrade to a Year 2000 compliant version early in 1999. Both of these upgrades have been scheduled to maintain currency with the respective vendors' support and to take advantage of additional features and performance enhancements. A project has been underway since early 1997 to implement a completely revamped version of the land/lease administration package in use at the Company to provide significantly increased functionality and reliability. The terms of this development arrangement stipulated Year 2000 compliance and is being monitored. Assessment continues for lower priority software systems. In addition, the Year 2000 compliant AS/400, on which the accounting package resides, was upgraded to provide additional capacity in late 1997. Operating system upgrades will be implemented in the near future for the Windows NT based servers to complete their remediation. Other activities either already underway or scheduled to start during the balance of 1998 include testing of desktop PC's, assessment of material business partners, and inventory of embedded systems in field locations. The following table summarizes the current overall status of the project with anticipated completion dates: <TABLE> <CAPTION> ------------------------------------------------------------------------------------- Phase ------------------------------------------------------------------------------------- Component Inventory Assessment/Prioritization Remediation/Contingency ---------------------- ----------------------- ------------------------------ ---------------------------- <S> <C> <C> <C> Software November 30, 1998 December 31, 1998 June 30, 1999 Hardware December 31, 1998 January 31, 1999 March 31, 1999 Business Partners December 31, 1998 March 31, 1999 June 30, 1999 Embedded Systems March 31, 1999 April 30, 1999 June 30, 1999 (Non-IT Systems) </TABLE> 23
24 In addition to the above, during the second quarter of 1999 the Company will develop an overall contingency plan to assure continued operations which will include precautionary measures. Cost. To date, the Company has incurred only minor consulting costs for Year 2000 project planning and scope definition. All software packages requiring an upgrade which have been identified will be upgraded within normal maintenance procedures and will not require additional out of pocket expense. In all cases these upgrades had been previously scheduled to maintain desired vendor support and no upgrade project schedule has been accelerated to achieve Year 2000 compliance. An accurate cost cannot be determined prior to conclusion of the Assessment/Prioritization phase, but it is expected total project expenditures including the use of outside consultants should not exceed $1 million. This does not include any costs which may be assessed by joint venture partners on properties not operated by the Company. Risks/Contingency. The failure to remediate critical systems (software, hardware or embedded systems), or the failure of a material business partner to resolve critical Year 2000 issues could have serious adverse impact on the ability of the Company to continue operations and meet obligations. At the current time, it is believed that any interruption in operation will be minor and short-lived and will pose no safety or environmental risks. However, until all assessment phases have been completed it is impossible to accurately identify the risks, quantify potential impacts or establish a contingency plan. The Company has not yet clearly identified the most likely worst case scenario if the Company and its material business partners do not achieve Year 2000 compliance on a timely basis. The Company currently intends to complete its contingency planning by June 30, 1999. 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 oil and gas reserve estimates, 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, expected future expenses, and Year 2000 compliance efforts are forwardlooking statements. Although the Company believes that the expectations reflected in such forward-looking statements 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 period ended December 31, 1997, are concentration of unevaluated leasehold in Louisiana, impairment of asset value, need to replace reserves, substantial capital requirements, ability to supplement capital resources with asset sales, substantial indebtedness, fluctuations in the prices of oil and gas, uncertainties inherent in estimating quantities of oil and gas reserves, projecting future rates of production and the 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, adverse changes in the market for the Company's oil and gas production and the Company's ability to successfully address Year 2000 issues. 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. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS - - Not applicable 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 and its officers and directors are defendants 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 Reports on Form 10-Q for the first and second quarters of 1998. On September 11, 1998, the Company and the other named defendants filed a motion to dismiss in Yuan, et al. v. Bayard Drilling Technologies, Inc., et al. pending in the U.S. District Court for the Western District of Oklahoma. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Effective as of September 11, 1998, the Rights Agreement between the Company and UMB Bank, N.A., as rights agent, was amended to add as an "Exempt Person" the pledgee of shares beneficially owned by certain other Exempt Persons as of the date of the amendment, to the extent that such pledgee exercises its rights under the pledge other than the exercise of any voting power or the acquisition of ownership. ITEM 3. DEFAULTS UPON SENIOR SECURITIES - - Not applicable ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - Not applicable ITEM 5. OTHER INFORMATION In July 1998, the Company made a $5 million secured loan to each of Aubrey K. McClendon and Tom L. Ward, the Company's Chairman and Chief Executive Officer and President, respectively. Each loan is payable on or before December 31, 1998 with interest accruing at an annual rate of 9 1/8%, payable quarterly. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following exhibits are filed as a part of this report: Exhibit No. 4.1.1 Fourth Supplemental Indenture, dated July 1, 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. 4.2.1 Fourth Supplemental Indenture, dated July 1, 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. 4.3.1 Fourth Supplemental Indenture, dated July 1, 1998, to Indenture dated as of April 1, 1996 among the Registrant, as issuer, its subsidiaries signatory thereto, as Subsidiary Guarantors, 25
26 and United States Trust Company of New York, as Trustee, with respect to 9-1/8% Senior Notes due 2006. 4.4.1 First Supplemental Indenture, dated July 1, 1998, to Indenture dated as of April 1, 1998 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 9-5/8% Senior Notes due 2005. 10.2.1 Amended and Restated Employment Agreement dated July 1, 1998 between Aubrey K. McClendon and Chesapeake Energy Corporation. 10.2.2 Amended and Restated Employment Agreement dated July 1, 1998 between Tom L. Ward and Chesapeake Energy Corporation. 10.3 Amendment No. 1 dated September 11, 1998 to Rights Agreement dated July 15, 1998 between the Registrant and UMB Bank, N.A., as Rights Agent. 12 Schedule of Ratios 27 Financial Data Schedule (b) Reports on Form 8-K During the quarter ended September 30, 1998, the Company filed the following Current Reports on Form 8-K: On July 2, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the declaration of quarterly cash dividends on the Company's common stock and preferred stock. On July 6, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing that Thomas L. Winton has been named Senior Vice President Information Technology. On July 9, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing that the Board of Directors authorized management to explore strategic alternatives to enhance shareholder value, involving possible sale or merger of the Company. On July 16, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing that the Board of Directors adopted a shareholder rights plan on July 7, 1998. On July 31, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing it had hired Donaldson Lufkin & Jenrette to act as financial advisor in evaluating the Company's various strategic alternatives. On August 7, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release reporting 1998 second quarter results. On September 29, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing the declaration of a quarterly cash dividend on the Company's preferred stock and the suspension of cash dividends on its common stock. 26
27 On October 7, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release announcing a significant Tuscaloosa discovery. On October 23, 1998, the Company filed a current report on Form 8-K reporting under Item 5 that the Company issued a press release providing a status report on drilling activity. On November 9, 1998, the Company filed a current report on Form 8-K announcing that it agreed to tender its 19.9% stake in Pan East Petroleum Corp. to Poco Petroleums Ltd. and agreed to a property exchange with Pan East. 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) November 16, 1998 /s/ Aubrey K. McClendon - -------------------------- ------------------------------------- Date Aubrey K. McClendon Chairman and Chief Executive Officer November 16, 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> 4.1.1 Fourth Supplemental Indenture, dated July 1, 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. 4.2.1 Fourth Supplemental Indenture, dated July 1, 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. 4.3.1 Fourth Supplemental Indenture, dated July 1, 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. 4.4.1 First Supplemental Indenture, dated July 1, 1998, to Indenture dated as of April 1, 1998 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 9-5/8% Senior Notes due 2005. 10.2.1 Amended and Restated Employment Agreement dated July 1, 1998 between Aubrey K. McClendon and Chesapeake Energy Corporation. 10.2.2 Amended and Restated Employment Agreement dated July 1, 1998 between Tom L. Ward and Chesapeake Energy Corporation. 10.3 Amendment No. 1 dated September 11, 1998 to Rights Agreement dated July 15, 1998 between the Registrant and UMB Bank, N.A., as Rights Agent. 12 Schedule of Ratios 27 Financial Data Schedule </TABLE>