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Financial Instruments, Fair Value Measurement, Credit Risk and Foreign Exchange Risk

12 Months Ended

Dec. 31, 2019

Financial Instruments, Fair Value Measurement, Credit Risk and Foreign Exchange Risk

Financial Instruments

At December 31, 2019, the Company’s financial instruments recognized in the balance sheet consist of cash and cash equivalents, restricted cash and cash equivalents, accounts receivable, investment, derivatives, accounts payable and accrued liabilities, long-term debt, current and long-term equity compensation reward liability and other long-term liabilities.

Fair Value Measurement

The fair value of investment, derivatives and PSU liabilities are being remeasured at the estimated fair value at the end of each reporting period.

The fair value of the Company's investment in PetroTal was estimated to be $94.7 million as at December 31, 2019 based on the closing stock price of PetroTal of $0.38 or $0.50 CAD per share as at December 31, 2019 ( December 31, 2018 - $0.17 or $0.24 CAD per share).

The fair value of commodity price and foreign currency derivatives is estimated based on various factors, including quoted market prices in active markets and quotes from third parties. The Company also performs an internal valuation to ensure the reasonableness of third party quotes. In consideration of counterparty credit risk, the Company assessed the possibility of whether the counterparty to the derivative would default by failing to make any contractually required payments. Additionally, the Company considers that it is of substantial credit quality and has the financial resources and willingness to meet its potential repayment obligations associated with the derivative transactions.

The fair value of the PSU liability was estimated based on option pricing model using the inputs, such as quoted market prices in an active market, and PSU performance factor.

The fair value of investments, derivatives, PSU and DSU liabilities at December 31, 2019, and December 31, 2018 were as follows:



	As at December 31,
(Thousands of U.S. Dollars)	2019		2018
Investment - current and long-term assets	$	94,741	$	41,435
	$	94,741	$	41,435

Derivative liability	$	775	$	1,017
PSU and DSU liability	7,859		17,683
	$	8,634	$	18,700

The following table presents gains or losses on financial instruments recognized in the accompanying consolidated statements of operations:



(Thousands of U.S. Dollars)	Year Ended December 31,
	2019			2018			2017
Commodity price derivative loss	$	3,642		$	13,972		$	17,327
Foreign currency derivative loss (gain)	27			(890		)	(1,287		)
Investment gain	(49,884		)	(786		)	(111		)
	$	(46,215	)	$	12,296		$	15,929

These gains or losses are presented as financial instruments gains or losses in the consolidated statements of operations and cash flows.

GAAP establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy consists of three broad levels. Level 1 inputs consist of quoted prices (unadjusted) in active markets for identical assets and liabilities and have the highest priority. Level 2 and 3 inputs are based on significant other observable inputs and significant unobservable inputs, respectively, and have lower priorities. The Company uses appropriate valuation techniques based on the available inputs to measure the fair values of assets and liabilities.

Financial instruments not recorded at fair value at December 31, 2019 include the Senior Notes and the Revolving Credit Facility (Note 6). At December 31, 2019, the carrying amounts of the 6.25% Senior Notes and 7.75% Senior Notes were $290.7 million and $289.9 million, respectively, which represents the aggregate principal amount less unamortized debt issuance costs, and the fair values were $272.8 million and $279.1 million. The fair value of the Revolving Credit Facility approximates its carrying value. The fair value of the Senior Notes is determined based on quoted market prices considered Level 1 inputs. The fair value of the Revolving Credit Facility is estimated based on the amount the Company would have to pay a third party to assume the debt, including the credit spread for the difference between the issue rate and the period end market rate. The credit spread is the Company's default or repayment risk. The credit spread (premium or discount) is determined by comparing the debt to new issuances (secured or unsecured) and secondary trades of similar size and credit statistics for both public and private debt. The fair value of the Revolving Credit Facility was estimated using level 2 inputs.

The fair value of long-term restricted cash and cash equivalents and the revolving credit facility approximated their carrying value because interest rates are variable and reflective of market rates. The fair values of other financial instruments approximate their carrying amounts due to the short-term maturity of these instruments.

At December 31, 2019, the fair value of current portion of the investment and DSU liability was determined using Level 1 inputs and the fair value of derivatives and PSUs was determined using Level 2 inputs. The fair value of the long-term portion of the investment restricted by escrow conditions was previously determined using Level 3 inputs. The table below presents a roll-forward of the long-term portion of the investment:



	Year Ended December 31,
(Thousands of U.S. Dollars)	2019			2018
Opening balance	$	8,711		$	19,147
Transfer from long-term (Level 3) to current (Level 1)	(11,881		)	(10,522		)
Unrealized gain on valuation	2,604			846
Unrealized gain (loss) on foreign exchange	566			(760		)
Closing balance	$	—		$	8,711

The Company’s non-recurring fair value measurements include asset retirement obligations. The fair value of an asset retirement obligation is measured by reference to the expected future cash outflows required to satisfy the retirement obligation discounted at the Company’s credit-adjusted risk-free interest rate. The significant level 3 inputs used to calculate such liabilities include estimates of costs to be incurred, the Company’s credit-adjusted risk-free interest rate, inflation rates and estimated dates of abandonment. Accretion expense is recognized over time as the discounted liabilities are accreted to their expected settlement value, while the asset retirement cost is amortized over the estimated productive life of the related assets.

Commodity Price Risk

The Company may at time utilize commodity price derivatives to manage the variability in cash flows associated with the forecasted sale of its oil production, reduce commodity price risk and provide a base level of cash flow in order to assure it can execute at least a portion of its capital spending. As at December 31, 2019, the Company had outstanding commodity price derivative positions as follows:



Period and type of instrument	Volume, bopd	Reference	Purchased Put ($/bbl, Weighted Average)	Sold Call ($/bbl, Weighted Average)	Premium ($/bbl, Weighted Average)
Collars: January 1, to June 30, 2020	6,000	ICE Brent	55.00	69.05	n/a

Foreign Exchange Risk

The Company is exposed to foreign exchange risk in relation to its Colombian operations predominantly in operating costs, general and administrative costs and transportation costs. To mitigate exposure to fluctuations in foreign exchange, the Company may enter into foreign exchange derivatives. As at December 31, 2019 and subsequent to, the Company had outstanding foreign currency derivative positions as follows:



Period and type of instrument	Amount Hedged (Millions COP)	U.S. Dollar Equivalent of Amount Hedged (Thousands of U.S. Dollars)⁽¹⁾	Reference	Floor Price (COP, Weighted Average)	Cap Price (COP, Weighted Average)
Collars: January 1, to December 31, 2020	134,500	40,994	COP	3,305	3,423

⁽¹⁾At December 31, 2019 foreign exchange rate.

Unrealized foreign exchange gains and losses primarily result from fluctuation of the U.S. dollar to the Colombian peso due to Gran Tierra’s current and deferred tax liabilities, which are monetary liabilities mainly denominated in the local currency of the Colombian operations. As a result, foreign exchange gains and losses must be calculated on conversion to the U.S. dollar functional currency. A strengthening in the Colombian peso against the U.S. dollar results in foreign exchange gain, estimated at approximately

$6,000 for each one peso decrease in the exchange rate of the Colombian peso to one U.S. dollar. This effect was calculated based on the Company's December 31, 2019, deferred tax balances.

For the year ended December 31, 2019, 100% (December 31, 2018 - 100%, December 31, 2017 - 98%) of the Company's oil and natural gas sales were generated in Colombia. In Colombia, the Company receives 100% of its revenues in U.S. dollars and the majority of its capital expenditures are in U.S. dollars or are based on U.S. dollar prices.

Credit Risk

Credit risk arises from the potential that the Company may incur a loss if counterparty to a financial instrument fails to meet its obligation in accordance with agreed terms. The Company’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, restricted cash and accounts receivable. The carrying value of cash and cash equivalents, restricted cash and accounts receivable reflects management’s assessment of credit risk.

At December 31, 2019, cash and cash equivalents and restricted cash included balances in bank accounts, term deposits and certificates of deposit, placed with financial institutions with investment grade credit ratings.

Most of the Company’s accounts receivable relate to uncollateralized sales to customers in the oil and natural gas industry and are exposed to typical industry credit risks. The concentration of revenues in a single industry affects the Company’s overall exposure to credit risk because customers may be similarly affected by changes in economic and other conditions. The Company manages this credit risk by entering into sales contracts with only credit worthy entities and reviewing its exposure to individual entities on a regular basis. For the year ended December 31, 2019, the Company had three customers which were over 10% of sales.

To reduce the concentration of exposure to any individual counterparty, the Company utilizes a group of investment-grade rated financial institutions, for its derivative transactions. The Company monitors counterparty creditworthiness on an ongoing basis; however, it cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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