(6) Fair Value Measurements

6 Months Ended

Jun. 30, 2013

Notes

(6) Fair Value Measurements

(6) Fair Value Measurements

We follow accounting guidance which defines fair value, establishes a framework for measuring fair value in U.S. GAAP, and requires additional disclosures about fair value measurements. As required, we applied the following fair value hierarchy:

Level 1 – Assets or liabilities for which the item is valued based on quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 – Assets or liabilities valued based on observable market data for similar instruments.

Level 3 – Assets or liabilities for which significant valuation assumptions are not readily observable in the market; instruments valued based on the best available data, some of which is internally-developed, and considers risk premiums that a market participant would require.

The level in the fair value hierarchy within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels. Our policy is to recognize transfer in and/or out of fair value hierarchy as of the end of the reporting period for which the event or change in circumstances caused the transfer. We have consistently applied the valuation techniques discussed below for the periods presented. These valuation policies are determined by our Chief Financial Officer, with the assistance of third party experts as needed, and approved by our Chief Executive Officer. They are discussed with our Audit Committee as deemed appropriate. Each quarter, our Chief Financial Officer and Chief Executive Officer update the inputs used in the fair value measurement and internally review the changes from period to period for reasonableness. We use data from peers as well as external sources in the determination of the volatility and risk free rates used in our fair value calculations. A sensitivity analysis is performed as well to determine the impact of inputs on the ending fair value estimate.

Assets and Liabilities Measure at Fair Value on a Recurring Basis

Derivative liabilities associated with our debt agreement – Derivative liabilities include the Warrants and fair value is estimated using an income valuation technique and a Monte Carlo Simulation Analysis, which is considered to be Level 3 fair value measurement. Significant inputs used in the Monte Carlo Simulation Analysis include the stock price of $1.63 per share, initial exercise price $0.01, term of 9.17 years, risk free rate of 2.44%, and expected volatility of 75.29%. The expected volatility is based on the 10 year historical volatilities of comparable public companies. Based on the Monte Carlo Simulation Analysis, the estimated fair value of the Warrants was $1.67 per share, or approximately $16.2 million, as of June 30, 2013. Since the Warrants were in the money upon issuance, we do not believe that changes in the inputs to the Monte Carlo Simulation Analysis will have a significant impact to the value of the Warrants other than changes in the value of our common stock. Increases in the value of our common stock will directly be correlated to increases in the value of the Warrants. Likewise, a decrease in the value of our common stock will result in a decrease in the value of the Warrants.

In addition, our Loan Agreement contains mandatory repayments subject to premiums as set forth in the agreement. Factors such as the sale of assets, distributions from our investment in Piceance Energy, issuance of additional debt or issuance of additional equity may result in a mandatory prepayment. We consider the contingent prepayment feature to be an embedded derivative which was bifurcated from the loan and accounted for as a derivative. The fair value of the embedded derivative is estimated using an income valuation technique and a crystal ball forecast. The fair value measurement is considered to be a Level 3 fair value measurement. We do not believe that changes to the inputs in the model would have a significant impact on the valuation of the embedded derivative, other than a change to the estimate of the probability that a triggering event would occur. An increase in the probability of a triggering event occurring would cause an increase in the fair value of the embedded derivative. Likewise, a decrease in the probability of a triggering event occurring would cause a decrease in the value of the embedded derivative. As of June 30, 2013, we do not believe that there is any probability of us repaying the loan prior to maturity; accordingly, we have concluded that the embedded derivative has no value.

Derivative instruments – With the acquisition of Texadian, we assumed certain open positions consisting of non-exchange traded fixed price physical contracts. These contracts were not treated as normal purchase or normal sales contracts and changes in fair value were recorded in earnings. In addition, we had certain exchange traded oil contracts that settled during the period and had no open positions as of June 30, 2013.  The fair value of our commodity derivatives is measured using the closing market price at the end of the reporting period obtained from the New York Mercantile Exchange and from third party broker quotes and pricing providers. As of June 30, 2013, we had no open positions relating to these non-exchange traded fixed price physical contracts except for contracts treated as normal purchase or normal sale contracts as discussed in our Summary of Significant Accounting Policies.

Our liabilities measured at fair value on a recurring basis as of June 30, 2013 consist of the following (in thousands):

	June 30, 2013
	Fair Value	Level 1	Level 2	Level 3
Liabilities
Derivatives:
Warrants	$(16,200)	—	—	$(16,200)
Embedded derivatives	—	—	—	—
	$(16,200)	—	—	$(16,200)

	Location on Consolidated Balance Sheet	Fair Value at June 30, 2013
		(in thousands)
Warrant derivatives	Noncurrent liabilities	$(16,200)
Embedded derivative	Noncurrent liabilities	—

 A rollforward of Level 3 derivative warrants and the embedded derivative measured at fair value using Level 3 on a recurring basis is as follows (in thousands):

Description
Balance, at December 31, 2012	$(10,945)
Purchases, issuances, and settlements	—
Total unrealized losses included in earnings	(5,255)
Transfers	—
Balance, at June 30, 2013	$(16,200)

The following table summarizes the pretax effect resulting from changes in fair value of derivative instruments charged directly to earnings (in thousands):

	For the three months ended June 30, 2013
	Income Statement Classification	Gain (loss) recognized in income
Derivatives not designated as hedges:
Warrants	Other income (expense)	$(3,300)
Embedded derivatives	Other income (expense)	285
Commodities - exchange traded futures	Other income (expense)	—
Commodities - physical forward contracts	Other income (expense)	—

	For the six months ended June 30, 2013
	Income Statement Classification	Gain (loss) recognized in income
Derivatives not designated as hedges:
Warrants	Other income (expense)	$(5,300)
Embedded derivatives	Other income (expense)	45
Commodities - exchange traded futures	Other income (expense)	104
Commodities - physical forward contracts	Other income (expense)	306