Warrant Derivative Liabilities

9 Months Ended

Sep. 30, 2015

Warrant Derivative Liabilities [Abstract]

Warrant Derivative Liabilities

Note 11 – Warrant Derivative Liabilities

MSD Warrants

As of September 30, 2015, warrant derivative financial instruments consisted of 3,393,827 warrants (1,846,088 warrants: December 31, 2014) issued as inducements under the warrant agreements dated October 2010 in connection with a $60 million term loan facility that was repaid in May 2011.  The fair value of these warrants as of September 30, 2015 and December 31, 2014 was $0.00 per warrant.  The Warrant Purchase Agreement dated as of October 28, 2010 includes certain anti-dilution provisions which adjust the number of warrants and the exercise price per warrant.  On October 28, 2015, the MSD Warrants expired.  The issuance of the CT Energy 9.0% Note, because of the initial conversion price and the CT Warrant of 34,070,820 shares triggered the anti-dilution provisions on the MSD Warrants which resulted in the issuance of 1,547,739 additional warrants during the nine months ended September 30, 2015.  In addition, the exercise price per share for all warrants was repriced to $6.97 per warrant during the nine months ended September 30, 2015.  The warrants are classified as a liability on our consolidated condensed balance sheets and marked to market.  The valuation for the warrants is based primarily on our stock price of $1.39 at September 30, 2015, their remaining life of 0.08 years and their strike price of $6.97 as of September 30, 2015.  We recognized $0.0 million in warrant liability income in our consolidated condensed statement of operations and comprehensive loss for the three and nine months ended September 30, 2015 for these warrants.  The assumptions summarized in the following table were used to calculate the fair value of the warrant derivative liability related to the MSD warrants that were outstanding as of the balance sheet date presented on our consolidated condensed balance sheet:

	Fair Value
	Hierarchy	As of September 30,			As of December 31,
	Level	2015			2014
Significant assumptions (or ranges):
Stock price	Level 1 input	$	1.39		$	1.81
Term (years)			0.08			0.83
Volatility	Level 2 input		67	%		67	%
Risk-free rate	Level 1 input		0.21	%		0.21	%
Dividend yield	Level 2 input		0.0	%		0.0	%
Scenario probability (fundamental change event/debt raise/equity raise)	Level 3 input		0%/100%/0	%		0%/100%/0	%

CT Warrant

On June 19, 2015, in connection with the transaction with CT Energy described in Note 1 – Organization, we issued a warrant exercisable for 34,070,820 shares of the Company’s common stock at an initial exercise price of $1.25 per share.  The CT Warrant may not be exercised until the volume weighted average price of the Company’s common stock over any consecutive 30-day period equals or exceeds $2.50 per share.

The CT Warrant can be exercised at the option of the investor in cash or by effecting a reduction in the principal amount of the 15.0% Note (See Note 10 – Debt and Financing).  If the CT Warrant is exercised through the reduction in the principal amount of the 15.0% Note, the reduction will be equal to the amount obtained by multiplying the number of shares of common stock for which the CT Warrant is exercised by (i) the exercise price then in effect divided by (ii) (A) the defined make-whole price with respect to the outstanding principal amount of such 15.0% Note divided by (B) the outstanding principal amount of such 15.0% Note.  The exercise price of the CT Warrant is subject to adjustment upon the occurrence of certain events, including stock issuance, dividend or stock split.

In addition, the holder of the CT Warrant has certain registration rights regarding the CT Warrant and the shares of common stock issuable upon exercise of the CT Warrant.

We have analyzed the CT Warrant to determine whether it should be classified as a derivative liability or equity instrument.  Provisions of the CT Warrant agreement allow for a change in the exercise price of the CT Warrant upon the occurrence of certain corporate events.  These exercise price adjustments incorporate variables other than those used to determine the fair value of a fixed-for-fixed forward or option on equity shares therefore the CT Warrant is not considered to be “indexed to the issuer’s own stock” and does not meet the exception from derivative treatment in ASC 815-10-15-74(a).  HNR continues to account for the CT Warrant as a derivative which was marked to market as of September 30, 2015.  

Estimating fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, option-based techniques (such as the Monte Carlo model) are highly volatile and sensitive to changes in the trading market price of our common stock. Since derivative financial instruments are initially and subsequently carried at fair value, our income will reflect the volatility in these estimate and assumption changes.  A Monte Carlo simulation model is used to value the CT Warrant to determine if the Stock Appreciation Date is achieved, which is based on the average stock price over a 30 day period (21 trading days) reaching $2.50.  This requires Level 3 inputs (see Note 3 – Summary of Significant Accounting Policies, Financial Instruments and Fair Value Measurements) which are based on our estimates of the probability and timing of potential future financings and fundamental transactions. The assumptions summarized in the following table were used to calculate the fair value of the warrant derivative liability that was outstanding as of the balance sheet date presented on our consolidated condensed balance sheet:

	Fair Value
	Hierarchy	As of September 30,
	Level	2015
Significant assumptions (or ranges):
Stock price	Level 1 input	$	1.39
Exercise price	Level 1 input	$	1.25
Stock appreciation date price (hurdle)	Level 1 input	$	2.50
Term (warrants)			2.7187
Term (claim date)			0.7186
Term (claim date extended)			1.2202
Volatility	Level 2 input		95.0	%
Risk-free rate (warrants)	Level 1 input		0.90	%
Risk-free rate (claim date)	Level 1 input		0.26	%
Risk-free rate (claim date extended)	Level 1 input		0.41	%
Dividend yield	Level 2 input		0.0	%
Scenario probability (future draws/no future draws)	Level 3 input		50%/50	%

Inherent in the Monte Carlo valuation model are assumptions related to expected stock price volatility, expected life, risk-free interest rate and dividend yield. As part of our overall valuation process, management employs processes to evaluate and validate the methodologies, techniques and inputs, including review and approval of valuation judgments, methods, models, process controls, and results. These processes are designed to help ensure that the fair value measurements and disclosures are appropriate, consistently applied, and reliable. We estimate the volatility of our common stock based on historical volatility that matches the expected remaining life of the longest instrument in the transaction, seven years. The risk-free interest rate is based on the U.S. Treasury yield curve as of the valuation dates for a maturity similar to the expected remaining life of the CT Warrant. The expected life of the CT Warrants is assumed to be equivalent to their remaining contractual term. The dividend rate is based on the historical rate, which we anticipate to remain at zero.

The fair value of the CT Warrant was $40.0 million at issuance and $27.6 million as of September 30, 2015.  We recognized $10.0 million and $12.4 million, respectively, in warrant liability income in our consolidated condensed statement of operations for the three and nine months ended September 30, 2015.