Derivative Instruments

3 Months Ended

Mar. 31, 2014

Derivative Instruments

5. Derivative Instruments

Forward Purchase and Exchange-Traded Futures Contracts

The Company’s activities generally expose it to a variety of market risks, including the effects of changes in commodity prices such as corn. These financial exposures are monitored and have been managed by the Company through derivative instruments, including forward purchase contracts and exchange traded futures contracts, as an integral part of its overall risk management program. The Company’s risk management program focuses on the unpredictability of financial and commodities markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results.

The Company has generally followed a policy of using exchange-traded futures contracts as a means of managing its exposure to fluctuations in operating margins based on changes in commodity prices.  The Company did not have any exchange-traded futures contracts as of March 31, 2014.  During the three months ended March 31, 2013, exchange-traded futures contracts were valued at fair value and changes in fair value are recorded in cost of goods sold in the consolidated statements of operations.  

Forward purchase contracts are recorded at fair value unless a company elects to use the “normal purchases and normal sales scope exception” guidance of GAAP. To qualify for the normal purchases and normal sales scope exception, a contract must be appropriately designated and must provide for the purchase or sale of physical commodities in quantities that are expected to be used or sold over a reasonable period of time in the normal course of operations. The Company did not have forward purchase contracts during the three months ended March 31, 2014.  During the three months ended March 31, 2013, the Company did not elect the normal purchase and normal sales scope exception to its forward purchase contracts. Accordingly, changes in the fair value of these contracts have been recorded in cost of goods sold in the consolidated statements of operations.

The foregoing derivatives do not include any credit risk related contingent features, the Company has not entered into these derivative financial instruments for trading or speculative purposes, and it has not designated any of its derivatives as hedges for financial accounting purposes. At March 31, 2014 and December 31, 2013, the Company did not have any exchange-traded futures contracts or forward purchase contracts and, as such, did not hold any cash in margin deposit accounts.

The following table summarizes the realized and unrealized gain / (loss) of the Company’s derivative instruments (in thousands).

	Three Months Ended March 31,					From Inception to
Realized Gain / (Losses)	2014		2013			March 31, 2014
Exchange-traded futures contracts	$	-	$	249		$	(235	)
Unrealized Gain / (Losses)
Exchange-traded futures contracts		-		(276	)		648
Forward purchase contracts		-		20			(43	)

Convertible Notes

In July 2012, the Company issued 7.5% convertible senior notes due 2022 (the “Convertible Notes”) which contain the following embedded derivatives: (i) rights to convert into shares of the Company’s common stock, including upon a Fundamental Change (as defined in the indenture governing the Convertible Notes (the “Indenture”)); and (ii) a Coupon Make-Whole Payment (as defined in the Indenture) in the event of a conversion by the holders of the Convertible Notes prior to July 1, 2017. Embedded derivatives are separated from the host contract, the Convertible Notes, and carried at fair value when: (a) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract; and (b) a separate, stand-alone instrument with the same terms would qualify as a derivative instrument. The Company has concluded that the embedded derivatives within the Convertible Notes meet these criteria and, as such, must be valued separate and apart from the Convertible Notes and recorded at fair value each reporting period.

The Company combines these embedded derivatives and values them together as one unit of accounting. At each reporting period, the Company records these embedded derivatives at fair value which is included as a component of the Convertible Notes on the consolidated balance sheets.

The Company used a binomial lattice model in order to estimate the fair value of these embedded derivatives in the Convertible Notes. A binomial lattice model generates two probable outcomes—one up and another down—arising at each point in time, starting from the date of valuation until the maturity date. A lattice was initially used to determine if the Convertible Notes would be converted, called or held at each decision point. Within the lattice model, the following assumptions are made: (i) the Convertible Notes will be converted early if the conversion value is greater than the holding value; or (ii) the Convertible Notes will be called if the holding value is greater than both (a) the Redemption Price (as defined in the Indenture) and (b) the conversion value plus the Coupon Make-Whole Payment at the time. If the Convertible Notes are called, then the holders will maximize their value by finding the optimal decision between (1) redeeming at the Redemption Price and (2) converting the Convertible Notes.

Using this lattice, the Company valued these embedded derivatives using a “with-and-without method,” where the value of the Convertible Notes including the embedded derivatives, is defined as the “with”, and the value of the Convertible Notes excluding the embedded derivatives, is defined as the “without”. This method estimates the value of the embedded derivatives by looking at the difference in the values between the Convertible Notes with the embedded derivatives and the value of the Convertible Notes without the embedded derivatives. The lattice model requires the following inputs: (i) price of Gevo common stock; (ii) Conversion Rate (as defined in the Indenture); (iii) Conversion Price (as defined in the Indenture); (iv) maturity date; (v) risk-free interest rate; (vi) estimated stock volatility; and (vii) estimated credit spread for the Company.

The following table sets forth the inputs to the lattice model that were used to value the embedded derivatives.

	March 31,			December 31,
	2014			2013
Stock price	$	1.17		$	1.43
Conversion Rate		175.6697			175.6697
Conversion Price	$	5.69		$	5.69
Maturity date	July 1, 2022			July 1, 2022
Risk-free interest rate		2.5	%		2.8	%
Estimated stock volatility		78	%		65	%
Estimated credit spread		20	%		33	%

The following table sets forth the value of the Convertible Notes with and without the embedded derivative, and the fair value of the embedded derivative (in thousands).

	March 31,		December 31,
	2014		2013
Fair value of Convertible Notes:
With the embedded derivatives	$	20,310	$	15,925
Without the embedded derivatives		18,104		12,455
Estimated fair value of the embedded derivatives	$	2,206	$	3,470

Changes in certain inputs into the lattice model can have a significant impact on changes in the estimated fair value of the embedded derivatives. For example, the estimated fair value of the embedded derivatives will generally decrease with; (1) a decline in the stock price; (2) increases in the estimated stock volatility; and (3) increase in the estimated credit spread.  The change in the estimated fair value of the embedded derivatives during the three months ended March 31, 2014 and 2013 represents an unrealized gain and loss, respectively, which has been recorded as gain/(loss) from change in fair value of embedded derivatives in the consolidated statements of operations.

Derivative Warrant Liability

In December 2013, the Company sold 21,303,750 common stock units. Each common stock unit consisted of one share of the Company’s common stock and a warrant (each a “Warrant”) to purchase one share of the Company’s common stock. The agreement governing the Warrants (the “Warrant Agreement”) includes the following terms:

— the Warrants have an exercise price of $1.85 per share, subject to adjustment for certain events, including the issuance of stock dividends on the Company’s common stock and, in certain instances, the issuance of the Company’s common stock or instruments convertible into the Company’s common stock at a price per share less than the exercise price of the Warrants;

— the Warrants have an expiration date of December 16, 2018;

— a holder of Warrants may exercise the Warrants through a cashless exercise if, and only if, the Company does not have an effective registration statement then available for the issuance of the shares of its common stock. If an effective registration statement is available for the issuance of its common stock a holder may only exercise the Warrants through a cash exercise;

— the exercise price and the number and type of securities purchasable upon exercise of Warrants are subject to adjustment upon certain corporate events, including certain combinations, consolidations, liquidations, mergers, recapitalizations, reclassifications, reorganizations, stock dividends and stock splits, a sale of all or substantially all of the Company’s assets and certain other events; and

— in the event of an extraordinary transaction (as defined in the Warrant Agreement), generally including any merger with or into another entity, sale of all or substantially all of the Company’s assets, tender offer or exchange offer, or reclassification of its common stock, the Company or any successor entity will pay the Warrant holder, at such holder’s option, exercisable at any time concurrently with or within 30 days after the consummation of the extraordinary transaction, an amount of cash equal to the value of such holder’s Warrants as determined in accordance with the Black Scholes option pricing model and the terms of the Warrants.

Based on these terms, the Company has determined that the Warrants qualify as a derivative and, as such, are presented as derivative warrant liability on the consolidated balance sheets and recorded at fair value each reporting period.  The fair value was estimated to be $6.0 million and $7.2 million as of March 31, 2014 and December 31, 2013, respectively.  The decrease in the estimated fair value of the Warrants represents an unrealized gain which has been recorded as a gain from the change in fair value of derivative warrant liability in the consolidated statements of operations.