• expanding the natural gas distribution and transmission business through expansion into new geographic areas in our current service territories;

• expanding the propane distribution business in existing and new markets through leveraging our community gas system services and our bulk delivery capabilities;

• utilizing the Company's expertise across our various businesses to improve overall performance;

• enhancing marketing channels to attract new customers;

• providing reliable and responsive customer service to retain existing customers;

• maintaining a capital structure that enables the Company to access capital as needed; and

• maintaining a consistent and competitive dividend for shareholders.

The following discussions and those later in the document on operating income and segment results include use of the term "gross margin." Gross margin is determined by deducting the cost of sales from operating revenue. Cost of sales includes the purchased cost of natural gas and propane and the cost of labor spent on direct revenue-producing activities. Gross margin should not be considered an alternative to operating income or net income, which are determined in accordance with GAAP. Chesapeake believes that gross margin, although a non-GAAP measure, is useful and meaningful to investors as a basis for making investment decisions. It provides investors with information that demonstrates the profitability achieved by the Company under its allowed rates for regulated operations and under its competitive pricing structure for non-regulated segments. Chesapeake's management uses gross margin in measuring its business units' performance and has historically analyzed and reported gross margin information publicly. Other companies may calculate gross margin in a different manner.

Management's Discussion and Analysis
Chesapeake had a successful 2008, in spite of the state of the global economic and financial markets. For the year, net income increased by three percent as the Company earned $13.6 million in net income, or $1.98 per share (diluted), compared to net income of $13.2 million, or $1.94 per share (diluted), earned in 2007. We were able to achieve this growth despite taking a charge of $1.2 million in other operating expenses for costs related to an unconsummated acquisition. Absent this charge, the Company estimates that, compared to 2007, net income would have increased to $14.3 million, or $2.08 per share (diluted). The higher period-over-period net income was attributable primarily to our natural gas segment. Our natural gas transmission and distribution operations continued to invest capital in current growth initiatives that favorably positioned us for future growth as well. These operations invested $25.6 million in property, plant, and equipment during 2008, primarily to expand our transmission and distribution systems. These expansions were undertaken pursuant to additional long-term firm transportation service contracts for our transmission operation and continued customer growth for the distribution operations. Collectively, these growth initiatives contributed $2.8 million to gross margin in 2008.
As a result of market conditions in the housing industry, the Company continued to see a slowdown in the number of new houses being constructed. Despite this slowdown, the average number of residential customers served by our natural gas distribution operations increased by four percent. While this growth percentage is lower than that experienced in recent years, it is still significantly above the national average.
PESCO experienced a record year as gross margin increased by 91 percent over 2007. This increase was achieved through enhanced sales contract terms, margins on spot sales of approximately $600,000 and a 26-percent growth in its customer base. A 26-percent increase in its customer base contributed to a 41-percent increase in volumes sold in 2008.
The successful completion of rate proceedings for the Company's natural gas transmission and Delmarva distribution operations added $387,000 to gross margin in 2008. In addition, these rate proceedings provided for lower depreciation allowances and lower asset removal cost allowances, which contributed to the period-over-period decrease in depreciation expense and asset removal costs of $2.3 million in 2008.
Propane price volatility during 2008 affected our wholesale marketing operation positively and our propane distribution operation negatively. Xeron capitalized on the price volatility, seizing opportunities to sell at prices above cost and to manage effectively the larger spreads between the market (spot) prices and forward propane prices experienced in 2008, which contributed to the operation's 38-percent year-over-year growth in gross margin.
In contrast, the volatility of wholesale propane prices had a negative impact on our propane distribution operations. Wholesale propane prices rose dramatically during the spring months of 2008, when they are traditionally falling. In efforts to protect the Company from the impact that additional price increases would have on our Pro-Cap (propane price-cap) Plan that we offer to customers, the propane distribution operation entered into a swap agreement. By December 31, 2008, the market price of propane had plummeted well below the unit price in the swap agreement. As a result, the Company marked the agreement relating to the January 2009 and February 2009 gallons to market, which increased cost of sales by $939,000 for 2008 and resulted in the Company adjusting the valuation of its propane inventory to current market prices in accordance with Accounting Research Bulletin No. 43. Both of these adjustments reduced gross margin during 2008 by a total of $2.3 million compared to 2007. The Company subsequently terminated the swap agreement in January 2009. Adverse economic conditions severely affected the advanced information services segment. BravePoint experienced lower consulting revenues as customers began to conserve their information technology spending, resulting in a nine percent decline in billable hours in 2008 compared to 2007.
In response to the instability and volatility of the financial markets, we increased the amounts of our committed short-term borrowing capacity from $15.0 million to $55.0 million, while maintaining total short-term line-of-credit capacity of $100.0 million. In addition, on October 31, 2008, the Company executed a $30.0 million long-term debt placement of 5.93 percent Unsecured Senior Notes, maturing on October 31, 2023. Page 30 Chesapeake Utilities Corporation 2008 Form 10-K

Operating Income
The year-over-year increase in operating income for 2008, driven by the strong
performance of our natural gas business segment, was partially offset by lower
operating income from the propane and advanced information services business
segments.

                                                                             Percentage
     (In thousands)                    2008         2007        Change         Change
     Natural gas                     $ 25,846     $ 22,485     $  3,361               15 %
     Propane                            1,586        4,498       (2,912 )            -65 %
     Advanced information services        695          836         (141 )            -17 %
     Other & eliminations                 352          295           57               19 %

     Total operating income          $ 28,479     $ 28,114     $    365                1 %

The Company's financial performance is discussed in greater detail below in "Results of Operations."
Critical Accounting Policies
Chesapeake prepares its financial statements in accordance with GAAP. Application of these accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingencies during the reporting period. Chesapeake bases its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Since most of Chesapeake's businesses are regulated and the accounting methods used by these businesses must comply with the requirements of the regulatory bodies, the choices available are limited by these regulatory requirements. In the normal course of business, estimated amounts are subsequently adjusted to actual results that may differ from estimates. Management believes that the following policies require significant estimates or other judgments of matters that are inherently uncertain. These policies and their application have been discussed with Chesapeake's Audit Committee.
Regulatory Assets and Liabilities
As a result of the ratemaking process, Chesapeake records certain assets and liabilities in accordance with Statement of Financial Accounting Standards ("SFAS") No. 71, "Accounting for the Effects of Certain Types of Regulation;" consequently, the accounting principles applied by our regulated utilities differ in certain respects from those applied by the unregulated businesses. Costs are deferred when there is a probable expectation that they will be recovered in future revenues as a result of the regulatory process. As more fully described in Note A to the Consolidated Financial Statements, Chesapeake had recorded regulatory assets of $3.6 million and regulatory liabilities of $24.7 million, at December 31, 2008. If the Company were required to terminate application of SFAS No. 71, it would be required to recognize all such deferred amounts as a charge or a credit to earnings, net of applicable income taxes. Such an adjustment could have a material effect on the Company's results of operations.
Valuation of Environmental Assets and Liabilities As more fully described in Note N, "Environmental Commitments and Contingencies," in the Notes to the Consolidated Financial Statements, Chesapeake has completed its responsibilities related to one environmental site and is currently participating in the investigation, assessment or remediation of three other former manufactured gas plant sites. Amounts have been recorded as environmental liabilities and associated environmental regulatory assets based on estimates of future costs provided by independent consultants. There is uncertainty in these amounts, because the United States Environmental Protection Agency ("EPA") or other applicable state environmental authority may not have selected the final remediation methods. In addition, there is uncertainty with regard to amounts that may be recovered from other potentially responsible parties.

Management's Discussion and Analysis
Since the Company's management believes that recovery of these expenditures, including any litigation costs, is probable through the regulatory process, the Company has recorded, in accordance with SFAS No. 71, a regulatory asset and corresponding regulatory liability. At December 31, 2008, Chesapeake had recorded an environmental regulatory asset of $779,000 and a liability of $511,000 for environmental costs.
Derivatives
Chesapeake may use derivative instruments to manage the price risk of its natural gas and propane purchasing activities. The Company continually monitors the use of these instruments to ensure compliance with its risk management policies and accounts for them in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," by recording their fair value as assets and liabilities. If the derivative contracts meet the "normal purchase and normal sale" scope exception of SFAS No. 133, the related activities and services are accounted for on an accrual basis of accounting.
The following is a review of Chesapeake's use of derivative instruments at December 31, 2008 and 2007:
• The natural gas distribution and marketing operations, during 2008 and 2007, entered into physical contracts for the purchase and sale of natural gas, which qualified for the "normal purchases and normal sales" scope exception under SFAS No. 133 in that they provided for the purchase or sale of natural gas to be delivered in quantities expected to be used or sold by the Company over a reasonable period of time in the normal course of business. Accordingly, they were not subject to the accounting requirements of SFAS No. 133.

• During 2008 and 2007, Chesapeake's propane distribution operations entered into physical contracts to buy propane supplies, which qualified for the "normal purchases and normal sales" scope exception under SFAS No. 133 in that they provided for the purchase or sale of propane to be delivered in quantities expected to be used or sold by the Company over a reasonable period of time in the normal course of business. Accordingly, the related liabilities incurred and assets acquired under these contracts were recorded when title to the underlying commodity passed.

• During 2008, but not during 2007, the propane distribution operation entered into a swap agreement to protect the Company from the impact of price increases on the Pro-Cap (propane price-cap) Plan that we offer to customers. The Company considered this agreement to be an economic hedge that did not qualify for hedge accounting as described in SFAS No. 133. At the end of the period, the market price of propane dropped below the unit price in the swap agreement. As a result of the price drop, the Company marked the agreement relating to the January 2009 and February 2009 gallons to market, which increased cost of sales in 2008 by approximately $939,000. In January 2009, the Company terminated this swap agreement.

• Chesapeake's propane wholesale marketing operation enters into forward and futures contracts that are considered derivatives under SFAS No. 133. In accordance with SFAS No. 133, open positions are marked to market using prices at the end of each reporting period and unrealized gains or losses are recorded in the Consolidated Statement of Income as revenue or expense. The contracts mature within one year and are almost exclusively for propane commodities, with delivery points at Mt. Belvieu, Texas; Conway, Kansas; and Hattiesburg, Mississippi. Management estimates the market valuation based on references to exchange-traded futures prices, historical differentials and actual trading activity at the end of the reporting period. Commodity price volatility may have a significant impact on the gain or loss in any given period. At December 31, 2008, these contracts had net unrealized gains of $1.4 million that were recorded in the financial statements. At December 31, 2007, these contracts had net unrealized gains of $179,000 that were recorded in the financial statements.

Operating Revenues
Revenues for the natural gas distribution operations of the Company are based on rates approved by the PSCs of the jurisdictions in which we operate. The natural gas transmission operation's revenues are based on rates approved by the FERC. Customers' base rates may not be changed without formal approval by these commissions. The PSCs, however, have granted the Company's regulated natural gas distribution operations the ability to negotiate rates, based on approved methodologies, with customers that have competitive alternatives. In addition, the natural gas transmission operation can negotiate rates above or below the FERC-approved tariff rates.
Page 32 Chesapeake Utilities Corporation 2008 Form 10-K

For regulated deliveries of natural gas, Chesapeake reads meters and bills customers on monthly cycles that do not coincide with the accounting periods used for financial reporting purposes. Chesapeake accrues unbilled revenues for gas that has been delivered, but not yet billed, at the end of an accounting period to the extent that they do not coincide. In connection with this accrual, Chesapeake must estimate the amount of gas that has not been accounted for on its delivery system and must estimate the amount of the unbilled revenue by jurisdiction and customer class. A similar computation is made to accrue unbilled revenues for propane customers with meters, such as community gas system customers.
The propane wholesale marketing operation records trading activity for open contracts on a net mark-to-market basis in the Company's income statement. The propane distribution, advanced information services and other segments record revenue in the period the products are delivered and/or services are rendered. Chesapeake's natural gas distribution operations in Delaware and Maryland each have a purchased gas cost recovery mechanism. This mechanism provides the Company with a method of adjusting the billing rates with its customers for changes in the cost of purchased gas included in base rates. The difference between the current cost of gas purchased and the cost of gas recovered in billed rates is deferred and accounted for as either unrecovered purchased gas costs or amounts payable to customers. Generally, these deferred amounts are recovered or refunded within one year.
The Company charges flexible rates to its natural gas distribution industrial interruptible customers to compete with alternative types of fuel. Based on pricing, these customers can choose natural gas or alternative fuels. Neither the Company nor the interruptible customer is contractually obligated to deliver or receive natural gas.
Allowance for Doubtful Accounts
An allowance for doubtful accounts is recorded against amounts due to reduce the net receivable balance to the amount we reasonably expect to collect based upon our collections experiences, the condition of the overall economy and our assessment of our customers' inability or reluctance to pay. If circumstances change, however, our estimate of the recoverability of accounts receivable may also change. Circumstances which could affect our estimates include, but are not limited to, customer credit issues, the level of natural gas prices and general economic conditions. Accounts are written off once they are deemed to be uncollectible.
Pension and other Postretirement Benefits Pension and other postretirement plan costs and liabilities are determined on an actuarial basis and are affected by numerous assumptions and estimates including the market value of plan assets, estimates of the expected return on plan assets, assumed discount rates, the level of contributions made to the plans, current demographic and actuarial mortality data. The assumed discount rate and the expected return on plan assets are the assumptions that generally have the most significant impact on the Company's pension costs and liabilities. The assumed discount rate, the assumed health care cost trend rate and the assumed rates of retirement generally have the most significant impact on our postretirement plan costs and liabilities. Additional information is presented in Note L, "Employee Benefit Plans," in the Notes to the Consolidated Financial Statements, including plan asset investment allocation, estimated future benefit payments, general descriptions of the plans, significant assumptions, the impact of certain changes in assumptions, and significant changes in estimates. The total pension and other postretirement benefit costs included in operating income were $537,000, $370,000 and $387,000 in 2008, 2007 and 2006, respectively. The company expects to record higher pension and postretirement benefit costs in the range of $400,000 to $600,000 for 2009. The increased costs for 2009 represents the significant market decline in the values of the defined pension plan assets when compared to prior years. Actuarial assumptions affecting 2009 include an expected long-term rate of return on plan assets of 6.0 percent, consistent with the prior year, and discount rates of 5.25 percent for each of the plans, compared with 5.5 percent for the plans a year earlier. The discount rates for each plan were determined by the Company considering high quality corporate bond rates based on Moody's Aa bond index, changes in those rates from the prior year, and other pertinent factors, such as the expected life of the plan and the lump-sum-payment option.

Management's Discussion and Analysis
Results of Operations

Net Income & Diluted Earnings Per Share Summary

                                                                  Increase                                     Increase
For the Years Ended December 31,       2008          2007        (decrease)         2007          2006        (decrease)
Net Income (Loss)*
Continuing operations                $ 13,607      $ 13,218      $       389      $ 13,218      $ 10,748      $     2,470
Discontinued operations                     -           (20 )             20           (20 )        (241 )            221

Total Net Income                     $ 13,607      $ 13,198      $       410      $ 13,198      $ 10,507      $     2,691

Diluted Earnings (Loss) Per Share
Continuing operations                $   1.98      $   1.94      $      0.04      $   1.94      $   1.76      $      0.18
Discontinued operations                     -             -                -             -         (0.04 )           0.04

Total Earnings Per Share             $   1.98      $   1.94      $      0.04      $   1.94      $   1.72      $      0.22

* Dollars in thousands.

The Company's net income from continuing operations increased by $389,000 in 2008 compared to 2007. Net income from continuing operations was $13.6 million, or $1.98 per share (diluted), for 2008, compared to net income from continuing operations of $13.2 million, or $1.94 per share (diluted) in 2007. Our 2008 results include a charge of $1.2 million to other operating expenses for costs relating to an unconsummated acquisition. The Company initiated discussions in the third quarter of 2007 with a potential acquisition target. These discussions continued through the first part of the second quarter of 2008, at which time, we determined that we would not be able to complete the acquisition. In the course of these negotiations, the Company incurred certain accounting, legal and other professional fees and expenses, which were expensed in the second quarter of 2008 in accordance with SFAS No. 141, "Business Combinations." Absent the charge for the unconsummated acquisition, the Company estimates that period-over-period net income would have increased by $1.1 million in 2008 to $14.3 million, or $2.08 per share (diluted).
The Company's net income from continuing operations increased by $2.5 million in 2007 compared to 2006. Net income from continuing operations was $13.2 million, or $1.94 per share (diluted), for 2007, compared to net income from continuing operations of $10.8 million, or $1.76 per share (diluted) in 2006. During 2007, Chesapeake decided to close its distributed energy services company, OnSight, which consistently experienced operating losses since 2004. The results of operations for OnSight have been reclassified to discontinued operations and shown net of tax for all periods presented. The discontinued operations experienced a net loss of $20,000 for 2007, compared to a net loss of $241,000, or $0.04 per share (diluted) for 2006. The Company did not have any discontinued operations in 2008.
Page 34 Chesapeake Utilities Corporation 2008 Form 10-K

Operating Income Summary (in thousands)

Increase Increase For the Years Ended December 31, 2008 2007 (decrease) 2007 2006 (decrease) Business Segment:
Natural gas $ 25,846 $ 22,485 $ 3,361 $ 22,485 $ 19,733 $ 2,752 Propane 1,586 4,498 (2,912 ) 4,498 2,534 1,964 Advanced information services 695 836 (141 ) 836 767 69 Other & eliminations 352 295 57 295 298 (3 )

Operating Income $ 28,479 $ 28,114 $ 365 $ 28,114 $ 23,332 $ 4,782

Other Income 103 291 (188 ) 291 189 102 Interest Charges 6,158 6,590 (432 ) 6,590 5,774 816 Income Taxes 8,817 8,597 220 8,597 6,999 1,598

Net Income from Continuing Operations $ 13,607 $ 13,218 $ 389 $ 13,218 $ 10,748 $ 2,470

2008 Compared to 2007
Operating income in 2008 increased by approximately $365,000, or one percent, compared to 2007. The financial, operational and other highlights or factors affecting the period-over-period change in operating income included the following:
• For the Company's natural gas marketing operation, enhanced sales contract terms, margins on spot sales of approximately $600,000 and a 26 percent growth in its customer base produced a period-over-period increase of $1.5 million, or 91 percent, in gross margin.

• New long-term, transportation capacity contracts implemented by ESNG in November 2007 provided for 8,300 Dts of additional firm transportation . . .