This excerpt taken from the CHK 8-K filed Jul 9, 2008.
Ownership Risk Analysis
In order for a production payment to be considered a volumetric production payment, as opposed to a production loan (dollar-denominated production payment) or a prepaid commodity sale, the purchaser must assume the risks typically associated with ownership. Below we discuss the principal owner risks: price risk and production/reserve risk.
Price Risk. The buyers assumed all, or substantially all, price risk associated with the VPP share of production, as the price is completely index based (i.e., variable). Even though Chesapeake transferred to the buyers derivatives that will serve to mitigate price risk, the buyers have sole control over the derivatives and bear the counterparty credit risk associated with the derivative positions. Chesapeake provided no guarantee or commitment as to pricing.
Production and Reserve Risk. The buyers assumed significant reserve risk. In the event the leasehold interests covering the VPP have insufficient reserves to satisfy the scheduled quantities of production to be delivered under the VPP, there is no recourse to Chesapeake. Chesapeake has no obligation to deliver hydrocarbons from any other property or lease or from Chesapeakes retained interest in the subject leases.
The conveyance of the production payment contains a makeup mechanism to prevent either party from profiting on differences in the timing of actual delivery of the VPP share of hydrocarbons compared to the scheduled delivery of the VPP share of hydrocarbons. If there is a shortfall in scheduled deliveries, the quantity to be made up is adjusted to take into account any differences in the market price of the applicable hydrocarbons between the month in which the shortfall occurred and the month in which the shortfall is made up, and interest on the value of the deferred share of production is imposed. The shortfall quantity, as adjusted, is delivered in kind as soon as sufficient production is available from the properties. If market prices are higher in the month in which a makeup occurs compared to the month in which the production was scheduled to be delivered, the quantity of VPP hydrocarbons to be delivered will be reduced. If market prices are lower in the month in which the makeup occurs compared to the month in which the production was scheduled to be delivered, the quantity of VPP hydrocarbons will
Securities and Exchange Commission
June 13, 2008
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be increased. Accordingly, the buyers are in no better or worse position in terms of pricing risk than they would have been had the VPP share of production actually been delivered on the scheduled date.
While the makeup provision could cause the volumes ultimately delivered to the buyers to differ from the originally scheduled volumes, Chesapeake believes this does not substantively change the overall attributes of the VPP. The value and interest components of any short-term disruption in the scheduled deliveries of the VPP owners share of production would have a negligible effect on the overall VPP arrangement in relative terms. Conversely, a long-term disruption in the delivery of the scheduled volumes, although likely to have a more than negligible effect on the VPP arrangement through the value and interest components of the makeup provision, would indicate a cumulative inability of the reserves to keep pace with the scheduled volumes. The buyers have assumed the risk of inadequate reserves as the production payment is without recourse to other reserves or to Chesapeake.