Fair Value Measurements

9 Months Ended

Sep. 30, 2012

Fair Value Disclosures [Abstract]

Fair Value Measurements

Note 11 - Fair Value Measurements

The Company follows fair value measurement authoritative accounting guidance for all assets and liabilities measured at fair value. That authoritative accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. Market or observable inputs are the preferred sources of values, followed by assumptions based on hypothetical transactions in the absence of market inputs. The fair value hierarchy for grouping these assets and liabilities is based on the significance level of the following inputs:

• Level 1 – quoted prices in active markets for identical assets or liabilities

• Level 2 – quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations whose inputs are observable or whose significant value drivers are observable

• Level 3 – significant inputs to the valuation model are unobservable

The following is a listing of the Company’s assets and liabilities that are measured at fair value and where they are classified within the fair value hierarchy as of September 30, 2012:

	Level 1		Level 2		Level 3
	(in thousands)
Assets:
Derivatives (1)	$	—	$	64,248	$	—
Proved oil and gas properties (2)	$	—	$	—	$	2,057
Unproved oil and gas properties (2)	$	—	$	—	$	9,225
Liabilities:
Derivatives (1)	$	—	$	28,154	$	—
Net Profits Plan (1)	$	—	$	—	$	90,389

⁽¹⁾ This represents a financial asset or liability that is measured at fair value on a recurring basis.

⁽²⁾ This represents a non-financial asset or liability that is measured at fair value on a nonrecurring basis.

The following is a listing of the Company’s assets and liabilities that are measured at fair value and where they were classified within the fair value hierarchy as of December 31, 2011:

	Level 1		Level 2		Level 3
	(in thousands)
Assets:
Derivatives (1)	$	—	$	86,875	$	—
Proved oil and gas properties (2)	$	—	$	—	$	139,992
Unproved oil and gas properties (2)	$	—	$	—	$	15,809
Liabilities:
Derivatives (1)	$	—	$	55,681	$	—
Net Profits Plan (1)	$	—	$	—	$	107,731

⁽¹⁾ This represents a financial asset or liability that is measured at fair value on a recurring basis.

⁽²⁾ This represents a non-financial asset or liability that is measured at fair value on a nonrecurring basis.

Both financial and non-financial assets and liabilities are categorized within the above fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. The following is a description of the valuation methodologies used by the Company as well as the general classification of such instruments pursuant to the above fair value hierarchy.

Derivatives

The Company uses Level 2 inputs to measure the fair value of oil, gas, and NGL commodity derivatives. Fair values are based upon interpolated data. The Company derives internal valuation estimates taking into consideration the counterparties’ credit ratings, the Company’s credit rating, and the time value of money. These valuations are then compared to the respective counterparties’ mark-to-market statements. The considered factors result in an estimated exit-price that management believes provides a reasonable and consistent methodology for valuing derivative instruments. The derivative instruments utilized by the Company are not considered by management to be complex, structured, or illiquid. The oil, gas, and NGL commodity derivative markets are highly active.

Generally, market quotes assume that all counterparties have near zero, or low, default rates and have equal credit quality. However, an adjustment may be necessary to reflect the credit quality of a specific counterparty to determine the fair value of the instrument. The Company monitors the credit ratings of its counterparties and may ask counterparties to post collateral if their ratings deteriorate. In some instances the Company will attempt to novate the trade to a more stable counterparty.

Valuation adjustments are necessary to reflect the effect of the Company’s credit quality on the fair value of any liability position with a counterparty. This adjustment takes into account any credit enhancements, such as collateral margin that the Company may have posted with a counterparty, as well as any letters of credit between the parties. The methodology to determine this adjustment is consistent with how the Company evaluates counterparty credit risk, taking into account the Company’s credit rating, current credit facility margins, and any change in such margins since the last measurement date. All of the Company’s derivative counterparties are members of the Company’s credit facility bank syndicate.

The methods described above may result in a fair value estimate that may not be indicative of net realizable value or may not be reflective of future fair values and cash flows. While the Company believes that the valuation methods utilized are appropriate and consistent with accounting authoritative guidance and with other marketplace participants, the Company recognizes that third parties may use different methodologies or assumptions to determine the fair value of certain financial instruments that could result in a different estimate of fair value at the reporting date.

Refer to Note 10 - Derivative Financial Instruments for more information regarding the Company’s derivative instruments.

Net Profits Plan

The Net Profits Plan is a standalone liability for which there is no available market price, principal market, or market participants. The inputs available for this instrument are unobservable and are therefore classified as Level 3 inputs. The Company employs the income approach, which converts expected future cash flow amounts to a single present value amount. This technique uses the estimate of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk to calculate the fair value. There is a direct correlation between realized oil, gas, and NGL commodity prices driving net cash flows and the Net Profits Plan liability. Generally, higher commodity prices result in a larger Net Profits Plan liability and lower commodity prices result in a smaller Net Profits Plan liability.

The Company records the estimated fair value of the long-term liability for estimated future payments under the Net Profits Plan based on the discounted value of estimated future payments associated with each individual pool. The calculation of this liability is a significant management estimate. For those pools currently in payout, a discount rate of 12 percent is used to calculate this liability. A discount rate of 15 percent is used to calculate the liability for pools that have not reached payout. These rates are intended to represent the best estimate of the present value of expected future payments under the Net Profits Plan.

The Company’s estimate of its liability is highly dependent on commodity prices, cost assumptions, discount rates, and the overall market conditions, which are continually evaluated to consider the current market environment. The Net Profits Plan liability is determined using price assumptions of fiveone-year strip prices with the fifth year’s pricing then carried out indefinitely. The average price is adjusted for realized price differentials and to include the effects of the forecasted production covered by derivatives contracts in the relevant periods. The non-cash expense associated with this significant management estimate is highly volatile from period to period due to fluctuations that occur in the crude oil, gas, and NGL commodity markets.

If the commodity prices used in the calculation changed by five percent, the liability recorded at September 30, 2012, would differ by approximately $8 million. A one percent increase or decrease in the discount rate would result in a change of approximately $4 million. Actual cash payments to be made to participants in future periods are dependent on realized actual production, realized commodity prices, and costs associated with the properties in each individual pool of the Net Profits Plan. Consequently, actual cash payments are inherently different from the amounts estimated.

No published market quotes exist on which to base the Company’s estimate of fair value of its Net Profits Plan liability. As such, the recorded fair value is based entirely on management estimates that are described within this footnote. While some inputs to the Company’s calculation of fair value on the Net Profits Plan’s future payments are from published sources, others, such as the discount rate and the expected future cash flows, are derived from the Company’s own calculations and estimates.

The following table reflects the activity for the Company's Net Profits Plan liability measured at fair value using Level 3 inputs:

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
	(in thousands)
Beginning balance	$	89,591		$	133,419		$	107,731		$	135,850
Net increase (decrease) in liability (1)	5,558			(20,194		)	(1,753		)	(2,001		)
Net settlements (1)(2)(3)	(4,760		)	(4,736		)	(15,589		)	(25,360		)
Transfers in (out) of Level 3	—			—			—			—
Ending balance	$	90,389		$	108,489		$	90,389		$	108,489

_____________________ ___ __

⁽¹⁾  Net changes in the Company's Net Profits Plan liability are shown in the Change in Net Profits Plan liability line item of the accompanying statements of operations.

⁽²⁾  Settlements represent cash payments made or accrued under the Net Profits Plan. The Company accrued or made cash payments under the Net Profits Plan relating to divestiture proceeds of $274,000 for the three months ended September 30, 2012, and $2.0 million and $6.3 million for the nine months ended September 30, 2012, and 2011, respectively. There were no cash payments made or accrued relating to divestiture proceeds for the three months ended September 30, 2011.

⁽³⁾  During the first quarter of 2011, the Company elected to settle several Net Profits Plan pools associated with the acquisition of Nance Petroleum Corporation in 1999, through an aggregate $2.6 million cash payment. As a result, the Company reduced its Net Profits Plan liability by that amount. There was no impact on the accompanying statements of operations for the three-month or nine-month periods ended September 30, 2012, or 2011, related to these settlements. 

Long-term Debt

The 2019 Notes and 2021 Notes are valued using Level 1 inputs based on quoted secondary market trading prices. The estimated fair value of the 2019 Notes and the 2021 Notes as of September 30, 2012, was approximately $371 million and $370 million, respectively, and as of December 31, 2011, was approximately $359 million and $360 million, respectively.

The 2023 Notes are valued using Level 2 inputs based on bond valuation prices obtained from a third party source. The price is generated by qualitative algorithms that use direct market observations, such as recent sales, bid and ask prices from brokers, dealers, buy side firms, and other market inputs. The estimated fair value of these notes was approximately $422 million as of September 30, 2012. In accordance with the registration rights agreement discussed in Note 5 - Long-Term Debt, the Company exchanged its outstanding 2023 Notes for registered notes under the Securities Act on October 30, 2012. In future periods, the Company expects to value the notes using Level 1 inputs.

The estimated fair value of the 3.50% Senior Convertible Notes was approximately $394 million as of December 31, 2011. The estimated fair value of the embedded contingent interest derivative was immaterial as of December 31, 2011. The 3.50% Senior Convertible Notes were valued using Level 1 inputs, based on quoted secondary market trading prices. The 3.50% Senior Convertible Notes were settled during the second quarter of 2012. Please refer to Note 5 - Long-Term Debt for additional discussion.

There was no long-term debt measured at fair value on the accompanying balance sheets as of September 30, 2012, or December 31, 2011; all long-term debt is presented at historical value.

Proved Oil and Gas Properties

Proved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication that the carrying costs may not be recoverable. The Company uses Level 3 inputs and the income valuation technique, which converts future amounts to a single present value amount, to measure the fair value of proved properties through an application of discount rates and price forecasts selected by the Company’s management. The calculation of the discount rate is based on the best information available and was estimated to be 12 percent as of September 30, 2012, and December 31, 2011. Management believes that the discount rate is representative of current market conditions and takes into account estimates of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk. The prices for oil and gas are forecasted based on New York Mercantile Exchange (“NYMEX”) strip pricing, adjusted for basis differentials, for the first five years. The prices for NGLs are forecasted using Oil Price Information System Mont Belvieu (“OPIS”) pricing, adjusted for basis differentials, for as long as the market is actively trading, after which a flat terminal price is used for each commodity stream. Future operating costs are also adjusted as deemed appropriate for these estimates.

As a result of asset write-downs, proved oil and gas properties measured at fair value within the accompanying balance sheets were $2.1 million at September 30, 2012, and $140.0 million at December 31, 2011.

Unproved Oil and Gas Properties

Unproved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication that the carrying costs may not be recoverable. The Company uses a market approach, which takes into account the following significant assumptions: future development plans, risk weighted potential resource recovery, and estimated reserve values to measure the fair value of unproved properties.

As a result of asset write-downs, unproved oil and gas properties measured at fair value within the accompanying balance sheets were $9.2 million at September 30, 2012, and $15.8 million at December 31, 2011.

Materials Inventory

Materials inventory is valued at the lower of cost or market. The Company uses Level 2 inputs to measure the fair value of materials inventory, which is primarily comprised of tubular goods. The Company uses third party market quotes and compares the quotes to the book value of the materials inventory. If the book value exceeds the quoted market price, the Company reduces the book value to the market price. The considered factors result in an estimated exit price that management believes provides a reasonable and consistent methodology for valuing materials inventory. There were no materials inventories measured at fair value in the accompanying balance sheets at September 30, 2012, or December 31, 2011.

Asset Retirement Obligations

The income valuation technique is utilized by the Company to determine the fair value of the asset retirement obligation liability at the point of inception by applying a credit-adjusted risk-free rate, which takes into account the Company’s credit risk, the time value of money, and the current economic state, to the undiscounted expected abandonment cash flows. Given the unobservable nature of the inputs, the initial measurement of the asset retirement obligation liability is deemed to use Level 3 inputs. There were no asset retirement obligations measured at fair value in the accompanying balance sheets at September 30, 2012, or December 31, 2011.