Fair Value Measurements

12 Months Ended

Dec. 31, 2012

Fair Value Measurements

Fair Value Measurements

5. Fair Value Measurements

Certain of our assets and liabilities are reported at fair value in our consolidated balance sheets.  The following methods and assumptions were used to estimate the fair values for each class of financial instruments:

Cash and Cash Equivalents, Accounts Receivable and Accounts Payable.  The carrying amounts approximate fair value due to the short-term nature or maturity of the instruments.

Derivative Instruments.  Our derivative instruments consist of variable to fixed price commodity swaps, costless collars and interest rate swaps.  The fair value measurement of our unrealized crude oil, natural gas and interest rate swaps and collars were obtained from financial institutions and adjusted for non-performance risk, and were evaluated for accuracy using our crude oil, natural gas and interest rate swap and collar agreements and future commodity and interest rate curves.  Differences between management’s calculation and that of the financial institution were evaluated for reasonableness.  See Note 6 — “Derivative Instruments” for further information.

Impairments.  We test proved oil and gas properties for impairment when events and circumstances indicate a decline in the recoverability of the carrying value of such properties, such as a downward revision of the reserve estimates or lower commodity prices.  We estimate the future cash flows expected in connection with the properties and compare such future cash flows to the carrying amounts of the properties to determine if the carrying amounts are recoverable.  The factors used to determine fair value include, but are not limited to, estimates of proved and probable reserves, future commodity prices, the timing of future production and capital expenditures and a discount rate commensurate with the risk reflective of the lives remaining for the respective oil and gas properties.  Additionally, we may use appropriate market data to determine fair value.  Because these significant fair value inputs are typically not observable, we classify impairments of long-lived assets as a level 3 fair value measure.

Asset Retirement Obligations.  The initial measurement of ARO at fair value is calculated using discounted cash flow techniques and based on internal estimates of future retirement costs associated with oil and gas properties.  The factors used to determine fair value include, but are not limited to, plugging costs and reserve lives.

Debt.  The fair value of floating-rate debt is estimated to be equivalent to carrying amounts because the interest rates paid on such debt are set for periods of three months or less.  See Note 9 - “Debt” for further information.

FASB guidance established a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three levels.  The fair value hierarchy gives the highest priority to quoted market prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).  Level 2 inputs are inputs, other than quoted prices included within Level 1, which are observable for the asset or liability, either directly or indirectly.  There have been no transfers between Level 1, Level 2 or Level 3.

Fair value information for financial assets and (liabilities) was as follows at December 31, 2012:

	Total		Fair Value Measurements Using
	Carrying Value		Level 1		Level 2		Level 3
Derivatives
Commodity price contracts	$	1,960,005	$	—	$	1,960,005	$	—

Fair value information for financial assets and (liabilities) was as follows at December 31, 2011:

	Total		Fair Value Measurements Using
	Carrying Value		Level 1		Level 2		Level 3
Derivatives
Commodity price contracts	$	4,248,194	$	—	$	4,248,194	$	—

Fair value information for non-financial assets and (liabilities) valued on a non-recurring basis was as follows:

	Carrying		Fair Value Measurements Using						Total Pre-tax (Non-cash) Impairment
	Value (1)		Level 1		Level 2		Level 3		Loss
Year Ended December 31, 2012
Impairment of proved properties	$	149,515,252	$	—	$	—	$	35,149,381	$	114,365,871
Year Ended December 31, 2011
Impairment of proved properties (2)	—		—		—		—		—
Year Ended December 31, 2010
Impairment of proved properties	2,320,977		—		—		1,847,872		473,105

(1) Amounts represent carrying value at the time of the assessment.

(2) We did not measure fair value of non-financial assets or liabilities on a non-recurring basis.

We have a policy to timely identify impairment triggers including a quarterly review of material negative changes to commodity price forward curves and production on a field-by-field basis.  We performed this review quarterly throughout 2012 and did not identify any impairment triggers. When we prepared our preliminary 2013 capital budget and drilling plan in the fourth quarter of 2012, we identified impairment triggers related to conventional gas assets in South Texas and unconventional gas assets in East Texas.  When preparing our  preliminary 2013 budget and following a continuous trend of a depressed natural gas and natural gas liquids price environment throughout 2012, and our success in developing our oil inventory in Southeast Texas in the second and third quarters of 2012, we concluded that we will not likely further develop or participate in new wells in certain fields in South Texas for the foreseeable future.  Accordingly, we reclassified certain proved undeveloped reserves to unproven reserves and risk-adjusted these reserves accordingly.  Additionally, due to a larger industry player’s shift in strategic focus in the fourth quarter of the year including suspension of their James Lime activity in East Texas, we determined it was uncertain whether we would develop the James Lime formation in East Texas and risk-adjusted these reserves accordingly.

As a result of a significant decline in natural gas forward curves and our decision, beginning in the fourth quarter of 2012, not to develop liquids-rich formations, we identified impairment indicators for certain of our conventional gas assets in South and East Texas.  In accordance with our impairment policy described above, we compared the net book value for these assets to future cash flows and concluded that fair value impairments were required for certain fields. We used income and market approaches to determine the fair value on a field-by-field basis using market prices based on commodity price forward curves and considering proven, probable and possible reserves.  We reduced estimated unproved reserve quantities to account for uncertainty associated with those reserves and discounted cash flows using a pre-tax discount rate between 10% and 15%.  We believe that these pre-tax discount rates reflect current market valuations for similar properties.  We also valued acreage in certain areas using a dollar amount per acre to determine fair value of probable and possible reserves.  See Note 4 - “Oil and Gas Properties” for additional detail related to the impairment of proved properties.