NOTE 8 - FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company measures the fair value of its financial assets on a three-tier value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:



	●	Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.



	●	Level 2 - Other inputs that are directly or indirectly observable in the marketplace.



	●	Level 3 - Unobservable inputs which are supported by little or no market activity.

The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

Determination of the fair values of our derivative contracts incorporates various factors, including not only the impact of our non-performance risk on our liabilities, but also the credit standing of the counterparties involved. The Company utilizes counterparty rate of default values to assess the impact of non-performance risk when evaluating both our liabilities to, and receivables from, counterparties.

Recurring Fair Value Measurements



	Fair Value Measurement Classification
	Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Total
	(In thousands)
As of December 31, 2019
Oil and natural gas derivative instruments:
Oil and natural gas derivative swap contracts	$	—	$	(3,932	)	$	—		$	(3,932	)
Oil and natural gas derivative collar contracts	—		301			—			301
Embedded derivative instruments:
Net settlement provisions under ARM sales agreement	—		—			(3,238		)	(3,238		)
Total	$	—	$	(3,631	)	$	(3,238	)	$	(6,869	)
As of December 31, 2018
Oil and natural gas derivative instruments:
Oil and natural gas derivative swap contracts	$	—	$	(2,923	)	$	—		$	(2,923	)
Oil and natural gas derivative collar contracts	—		4,047			—			4,047
Embedded derivative instruments:
Second Lien Term Loan conversion features	—		—			(1,965		)	(1,965		)
Total	$	—	$	1,124		$	(1,965	)	$	(841	)

Derivative assets and liabilities include unsettled amounts related to commodity derivative positions, including swaps and collars, as of December 31, 2019 and 2018. The fair value of the Company’s derivatives is based on third-party pricing models which utilize inputs that are either readily in the public market or which can be corroborated from active markets of broker quotes. Swaps and collars generally have observable inputs and these instruments are measured using Level 2 inputs.

In addition, derivative liabilities as of December 31, 2019 include an embedded derivative associated with the ARM sales agreement (see Note 21 - Commitments and Contingencies). The Company recognized a derivative liability and an unrealized loss of $3.2 million as of December 31, 2019. This embedded derivative has fewer observable inputs from objective sources and are therefore measured using Level 3 inputs. The fair value of the net settlement provisions under the agreement was determined based on certain assumptions including (1) forward pricing for crude oil basis differentials, (ii) future LIBOR rates and (iii) the Company’s implied credit rating.

The Company’s derivative liabilities as of December 31, 2018 also include embedded derivatives associated with the Second Lien Term Loan (as defined in Note 11 - Long-Term Debt). These instruments have fewer observable inputs from objective sources and are therefore measured using Level 3 inputs. The Company recorded an unrealized loss of $0.3 million and $58.3 million on the change in fair value of derivative liabilities associated with the Second Lien Term Loan conversion features for the years ended December 31, 2019 and 2018, respectively.

The fair value of the holder conversion features was determined using a binomial lattice model based on certain assumptions including (i) the Company’s stock price, (ii) risk-free rate, (iii) expected volatility, (iv) the Company’s implied credit rating, and (v) the implied credit yield of the Loan.

The following table sets forth a reconciliation of changes in the fair value of the Company’s financial assets and liabilities classified as Level 3 in the fair value hierarchy, except for the commodity derivatives classified as Level 2, as disclosed in Note 9, as of December 31, 2019 and 2018:



	Firm Takeaway and Pricing Agreement Net Settlement Provisions			Second Lien Term Loan Conversion Features			Total
	(in thousands)
Balance at January 1, 2019	$	—		$	(1,965	)	$	(1,965	)
Fair value of the converted portion of the embedded derivatives associated with the Second Lien Term Loan	—			2,300			2,300
Fair value of the embedded derivatives in ARM Sales Agreement	(3,238		)	(335		)	(3,573		)
Balance at December 31, 2019	$	(3,238	)	$	—		$	(3,238	)



	Second Lien Term Loan Conversion Features			Warrant Liabilities			Total
	(in thousands)
Balance at January 1, 2018	$	(72,714	)	$	(223	)	$	(72,937	)
Transferred to equity	—			223			223
Fair value of the converted portion of the embedded derivatives associated with the Second Lien Term Loan	12,406			—			12,406
Change in fair value of derivative liabilities	58,343			—			58,343
Balance at December 31, 2018	$	(1,965	)	$	—		$	(1,965	)