Fair value measurements

The Company accounts for its oil and natural gas commodity and interest rate derivatives at fair value. The fair value of the derivatives are determined utilizing pricing models for similar instruments. The models use a variety of techniques to arrive at fair value, including quotes and pricing analysis. Inputs to the pricing models include publicly available prices and forward curves generated from a compilation of data gathered from third parties.

The Company has categorized its assets and liabilities measured at fair value, based on the priority of inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).

Assets and liabilities recorded at fair value on the consolidated balance sheets are categorized based on inputs to the valuation techniques as follows:



Level 1—	Assets and liabilities recorded at fair value for which values are based on unadjusted quoted prices for identical assets or liabilities in an active market that management has the ability to access. Active markets are considered to be those in which transactions for the assets or liabilities occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2—	Assets and liabilities recorded at fair value for which values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the assets or liabilities. Substantially all of these inputs are observable in the marketplace throughout the full term of the price risk management instrument and can be derived from observable data or supported by observable levels at which transactions are executed in the marketplace.

Level 3—	Assets and liabilities recorded at fair value for which values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Unobservable inputs are not corroborated by market data. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability.

When the inputs used to measure fair value fall within different levels of the hierarchy in a liquid environment, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company conducts a review of fair value hierarchy classifications on an annual basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets or liabilities. Transfers between fair value hierarchy levels are recognized and reported in the period in which the transfer occurred. No transfers between fair value hierarchy levels occurred during the years ended December 31, 2013 or 2012.

1. Fair value measurement on a recurring basis

The following presents the Company's fair value hierarchy for assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 and 2012.



(in thousands)	Level 1		Level 2		Level 3			Total fair value
As of December 31, 2013:
Commodity derivatives	$	—	$	94,741	$	—		$	94,741
Deferred premiums	—		—		(12,684		)	(12,684		)
Total	$	—	$	94,741	$	(12,684	)	$	82,057



(in thousands)	Level 1		Level 2			Level 3			Total fair value
As of December 31, 2012:
Commodity derivatives	$	—	$	27,103		$	—		$	27,103
Deferred premiums	—		—			(24,709		)	(24,709		)
Interest rate derivatives	—		(277		)	—			(277		)
Total	$	—	$	26,826		$	(24,709	)	$	2,117

These items are included in "Derivatives" on the consolidated balance sheets. Significant Level 2 assumptions associated with the calculation of discounted cash flows used in the "mark-to-market" analysis of commodity derivatives include the NYMEX natural gas and crude oil prices, appropriate risk adjusted discount rates and other relevant data. Significant Level 2 assumptions associated with the calculation of discounted cash flows used in the "mark-to-market" analysis of interest rate swaps include the interest rate curves, appropriate risk adjusted discount rates and other relevant data.

The Company’s deferred premiums associated with its commodity derivative contracts are categorized as Level 3, as the Company utilizes a net present value calculation to determine the valuation. They are considered to be measured on a recurring basis as the derivative contracts they derive from are measured on a recurring basis. As commodity derivative contracts containing deferred premiums are entered into, the Company discounts the associated deferred premium to its net present value at the contract trade date, using the Senior Secured Credit Facility rate at the trade date (historical input rates range from 2.00% to 3.56%) and then records the change in net present value to interest expense over the period from trade until the final settlement date at the end of the contract. After this initial valuation, the net present value of each deferred premium is not adjusted; therefore, significant increases (decreases) in the Senior Secured Credit Facility rate would result in a significantly lower (higher) fair value measurement for each new deal containing a deferred premium entered into; however, the valuation for the deals already recorded would remain unaffected. While the Company believes the sources utilized to arrive at the fair value estimates are reliable, different sources or methods could have yielded different fair value estimates; therefore, on a quarterly basis, the valuation is compared to counterparty valuations and third-party valuation of the deferred premiums for reasonableness.

The following table presents actual cash payments required for deferred premium contracts in place as of December 31, 2013, and for the calendar years following:



(in thousands)
2014	$	7,419
2015	5,166
2016	358
Total	$	12,943

A summary of the changes in assets classified as Level 3 measurements for the periods presented are as follows:



(in thousands)	For the year ended December 31, 2013
Balance of Level 3 at beginning of period	$	(24,709	)
Change in net present value of deferred premiums for derivatives	(462		)
Settlements⁽¹⁾	12,487
Balance of Level 3 at end of period	$	(12,684	)



(in thousands)	For the year ended December 31, 2012
Balance of Level 3 at beginning of period	$	(18,868	)
Change in net present value of deferred premiums for derivatives	(668		)
Total purchases and settlements:
Purchases	(11,291		)
Settlements	6,118
Balance of Level 3 at end of period	$	(24,709	)



	For the year ended December 31, 2011
(in thousands)	Derivative option contracts			Deferred premiums
Balance of Level 3 at beginning of period	$	20,026		$	(12,495	)
Gains (losses) included in earnings	5,323			—
Change in net present value of deferred premiums for derivatives	—			(471		)
Total purchases and settlements:
Purchases	—			(5,988		)
Settlements	—			86
Transfers out of Level 3⁽²⁾⁽³⁾	(25,349		)	—
Balance of Level 3 at end of period	$	—		$	(18,868	)

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(1)	The settlement amounts for the year ended December 31, 2013 include $2.2 million in deferred premiums which were settled net with the early terminated contracts from which they derive.

(2)

The Company transferred the commodity derivative option contracts out of Level 3 during the year ended December 31, 2011 due to the Company's ability to utilize transparent forward price curves and volatilities published and available through independent third party vendors. As a result, the Company transferred positions from Level 3 to Level 2 as the significant inputs used to calculate the fair value are all observable.


(3)	The Company's policy is to recognize transfers in and transfers out as of the actual date of the event or change in circumstances that caused the transfer.

2. Fair value measurement on a nonrecurring basis

The Company accounts for the impairment of long-lived assets (see Note B.20), if any, at fair value on a nonrecurring basis in accordance with GAAP. For purposes of fair value measurement, it was determined that the impairment of long-lived assets are classified as Level 3 based on the use of internally developed cash flow models. No impairments of long-lived assets were recorded in the years ended December 31, 2013, 2012 or 2011. See Note B.20 for discussion of the Company's impairment of materials and supplies in the year ended December 31, 2011.

The accounting policies for impairment of oil and natural gas properties are discussed in Note B.20. Significant inputs included in the calculation of discounted cash flows used in the impairment analysis include the Company's estimate of operating and development costs, anticipated production of proved reserves and other relevant data.