5. DERIVATIVE AND FINANCIAL INSTRUMENTS

To reduce the impact of fluctuations in oil and natural gas prices on our revenues, we periodically enter into derivative contracts with respect to a portion of our projected oil and natural gas production through various transactions that fix or modify the future prices to be realized. These hedging activities are intended to support oil and natural gas prices at targeted levels and to manage exposure to oil and natural gas price fluctuations. It is never our intention to enter into derivative contracts for speculative trading purposes.

Under ASC Topic 815, “Derivatives and Hedging,” all derivative instruments are recorded on the condensed consolidated balance sheets at fair value as either short-term or long-term assets or liabilities based on their anticipated settlement date. We will net derivative assets and liabilities for counterparties where we have a legal right of offset. Changes in the derivatives’ fair values are recognized currently in earnings unless specific hedge accounting criteria are met. We have not elected to designate any of our current derivative contracts as hedges; however, changes in the fair value of all of our derivative instruments are recognized in earnings and included in natural gas sales and oil sales in the condensed consolidated statements of operations.

As of September 30, 2017, we had the following derivative contracts in place for the periods indicated, all of which are accounted for as mark-to-market activities:

Fixed Price Basis Swaps–West Texas Intermediate (WTI)


	March 31,			June 30,			September 30,			December 31,			Total
	Volume	Average		Volume	Average		Volume	Average		Volume	Average		Volume	Average
	(Bbls)	Price		(Bbls)	Price		(Bbls)	Price		(Bbls)	Price		(Bbls)	Price
2017	—	$	—	—	$	—	—	$	—	64,568	$	59.83	64,568	$	59.83
2018	70,600	$	59.63	66,432	$	59.71	62,840	$	59.78	59,704	$	59.84	259,576	$	59.74
2019	62,528	$	60.41	59,552	$	60.44	57,024	$	60.48	54,824	$	60.52	233,928	$	60.46
2020	52,776	$	53.50	50,960	$	53.50	49,224	$	53.50	47,624	$	53.50	200,584	$	53.50
													758,656

Fixed Price Swaps—NYMEX (Henry Hub)


	March 31,			June 30,			September 30,			December 31,			Total
	Volume	Average		Volume	Average		Volume	Average		Volume	Average		Volume	Average
	(MMBtu)	Price		(MMBtu)	Price		(MMBtu)	Price		(MMBtu)	Price		(MMBtu)	Price
2017	—	$	—	—	$	—	—	$	—	124,160	$	3.79	124,160	$	3.79
2018	132,088	$	3.00	126,600	$	3.00	121,600	$	3.00	117,040	$	3.00	497,328	$	3.00
2019	119,832	$	2.85	115,784	$	2.85	112,032	$	2.85	108,552	$	2.85	456,200	$	2.85
2020	105,104	$	2.85	102,008	$	2.85	99,136	$	2.85	96,200	$	2.85	402,448	$	2.85
													1,480,136

The following table sets forth a reconciliation of the changes in fair value of the Partnership’s commodity derivatives for the nine months ended September 30, 2017 and the year ended December 31, 2016 (in thousands):


	September 30,		December 31,
	2017		2016
Beginning fair value of commodity derivatives	$	6,436	$	31,018
Net gains (losses) on crude oil derivatives		7,087		(8,355)
Net gains (losses) on natural gas derivatives		497		1,116
Net settlements on derivative contracts:
Crude oil		(6,133)		(13,622)
Natural gas		(2,624)		(6,919)
Net premiums on derivative contracts		—		3,198
Ending fair value of commodity derivatives	$	5,263	$	6,436

The effect of derivative instruments on our condensed consolidated statements of operations was as follows (in thousands):



		Amount of Gain (Loss) in Income
	Location of Gain (Loss)	Three Months Ended September 30,				Nine Months Ended September 30,
Derivative Type	in Income	2017		2016		2017		2016
Commodity – Oil Hedges	Oil sales	$	(1,456)	$	(1,032)	$	7,087	$	(4,600)
Commodity – Gas Hedges	Natural gas sales		(228)		2,104		497		1,936
		$	(1,684)	$	1,072	$	7,584	$	(2,664)

Derivative instruments expose us to counterparty credit risk. Our commodity derivative instruments are currently contracted with four counterparties. We generally execute commodity derivative instruments under master agreements which allow us, in the event of default, to elect early termination of all contracts with the defaulting counterparty. If we choose to elect early termination, all asset and liability positions with the defaulting counterparty would be net cash settled at the time of election. We include a measure of counterparty credit risk in our estimates of the fair values of derivative instruments. In August 2017, we repositioned certain of our crude oil and natural gas hedges in anticipation of the sale of the Texas Production Assets and, in the process, received $3.6 million in net cash from the counterparties on those hedges. As of September 30, 2017, and December 31, 2016, the impact of non-performance credit risk on the valuation of our derivative instruments was not significant.

Embedded Derivative

The Partnership entered into a contract for the sale of preferred units in October 2015 which contained provisions that were required to be bifurcated from the contract and valued as a derivative. The embedded derivative was valued through the use of a Monte Carlo model which utilized observable inputs, the Partnership’s unit prices at various timelines, as well as unobservable inputs related to the weighted probabilities of certain redemption scenarios. In November 2016, we completed a public offering and private placement of common units. As a result of these equity issuances, the Class B conversion rate was determined and the provisions that were required to bifurcate were removed. At that time, the fair value of the derivative was transferred to mezzanine equity.

The following table sets forth a reconciliation of the changes in fair value of the Partnership’s embedded derivative for the year ended December 31, 2016 (in thousands):


	December 31,
	2016
Beginning fair value of embedded derivative	$	(193,077)
Gain on embedded derivative		47,794
Transfer to mezzanine equity		145,283
Ending fair value of embedded derivative	$	—