Note 12 - Fair Value Measurements

Authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions of what market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the reliability of the inputs as follows:

Level 1:

Quoted prices are available in active markets for identical assets or liabilities;

Level 2:

Quoted prices in active markets for similar assets or liabilities that are observable for the asset or liability; or

Level 3:

Unobservable pricing inputs that are generally less observable from objective sources, such as discounted cash flow models or valuations.

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. Our policy is to recognize transfers 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 all periods presented.

The following table presents our financial assets and liabilities that were accounted for at fair value on a recurring basis by level within the fair value hierarchy:

	Fair Value Measurements Using
(in thousands)	Level 1		Level 2		Level 3		Total
September 30, 2018
Liabilities
Commodity derivatives	$	-	$	10,801	$	-	$	10,801
December 31, 2017
Asset:
Commodity derivatives	$	-	$	225	$	-	$	225
Liabilities
Warrant derivative liability	$	-	$	-	$	2,017	$	2,017

Commodity Derivative

As of September 30, 2018, our commodity derivative financial instruments are comprised of natural gas and oil swaps and costless collars. The fair values of these agreements are determined under an income valuation technique. The valuation model requires a variety of inputs, including contractual terms, published forward prices, volatilities for options and discount rates, as appropriate. Our estimates of fair value of derivatives include consideration of the counterparty’s credit worthiness, our credit worthiness and the time value of money. The consideration of these factors results in an estimated exit-price for each derivative asset or liability under a market place participant’s view. All the significant inputs are observable, either directly or indirectly; therefore, our derivative instruments are included within the Level 2 fair value hierarchy. The counterparty for all our outstanding commodity derivative financial instruments as of September 30, 2018, is BP Energy Company.

Warrant Derivative

A third-party valuation specialist was utilized to determine the fair value our California Warrant. The warrant was designated as Level 3. We review the valuations, including the related model inputs and assumptions, and analyze changes in fair value measurements between periods. We corroborate such inputs, calculations and fair value changes using various methodologies, and review unobservable inputs for reasonableness utilizing relevant information from other published sources.

We estimated the fair value of the California Warrant on February 15, 2017, the grant date of the warrant, to be approximately $5.8 million, using a call option pricing model with the following assumptions: a seven-year term, exercise price of $7.20, volatility rate of 41.8% and a risk-free rate of 2.3%. As we will receive Class A Units in Carbon California in the event the holder exercises the California Warrant, we also considered the fair value of the Class A Units in its valuation. We utilized the same measurement as of December 31, 2017 for January 31, 2018, using a Monte Carlo valuation model which utilized unobservable inputs including the percentage return on our shares at various timelines, the percentage return on the privately-held Carbon California Class A Units at various timelines, an exercise price of $7.20, volatility rate of 45%, a risk-free rate of 2.1% and an estimated remaining term of 6.4 years. As of December 31, 2017, the fair value of the California Warrant was approximately $2.0 million. On February 1, 2018, Yorktown exercised the California Warrant, resulting in the issuance of 1,527,778 shares of our common stock. In exchange, we received Yorktown’s Class A Units of Carbon California representing approximately 46.96% of the outstanding Class A Units of Carbon California and a profits interest of approximately 38.59%.

The following table summarizes the changes in fair value of our financial instruments classified as Level 3 in the fair value hierarchy:

(in thousands)	Total
Balance, December 31, 2017	$	2,017
Warrant derivative gain for the period January 1- January 31, 2018		(225	)
CCC Warrant Exercise - liability extinguishment		(1,792	)
Balance, September 30, 2018	$	-

Assets and Liabilities Measured and Recorded at Fair Value on a Non-Recurring Basis

The fair value of each of the following assets and liabilities measured and recorded at fair value on a non-recurring basis are based on unobservable pricing inputs and therefore, are included within the Level 3 fair value hierarchy.

We use the income valuation technique to estimate the fair value of asset retirement obligations using the amounts and timing of expected future dismantlement costs, credit-adjusted risk-free rates and time value of money. During the nine months ended September 30, 2018 and 2017, we recorded approximately $4.1 million and $5,000, in additions to asset retirement obligations, respectively. Additions during the nine months ended September 30, 2018, primarily related to the Carbon California Acquisition. See note 3 for additional information.

The exercise of the California Warrant and the acquisition of the additional ownership interest in Carbon California on February 1, 2018, is accounted for as a step acquisition in which we obtained control in accordance with ASC 805, Business Combinations (“ASC 805”). We consolidate the results of Carbon California into our unaudited condensed consolidated financial statements from the date of the Carbon California Acquisition forward. The Carbon California Acquisition was accounted for as a business combination, and the identifiable assets acquired, and liabilities assumed, were recorded at their estimated fair value at the date of acquisition. We have completed our preliminary valuation to determine the fair value of the identifiable assets acquired and liabilities assumed. The fair value of the assets acquired was determined using various valuation techniques, including an income approach. The fair value measurements were primarily based on significant inputs that are not directly observable in the market and are considered Level 3 under the fair value measurements and disclosure framework. See note 3 for additional information.

We assume, at times, certain firm transportation contracts as part of our acquisitions of oil and natural gas properties. The fair value of the firm transportation obligations was determined based upon the contractual obligations assumed by us and discounted based upon our effective borrowing rate. These contractual obligations are being amortized monthly as we pay these firm transportation obligations in the future.

Asset Retirement Obligation

The fair value of our asset retirement obligation liability is recorded in the period in which it is incurred or assumed by taking into account the cost of abandoning oil and gas wells ranging from $15,000 to $45,000, which is based on industry expectations for similar work; the estimated timing of reclamation ranging from one to 75 years based on estimates from reserve engineers; an inflation rate of 1.92%; and a credit adjusted risk-free rate of 7.24%, which takes into account our credit risk and the time value of money. Given the unobservable nature of the inputs, the initial measurement of the asset retirement obligation liability is deemed to use Level 3 inputs (see note 3). During the nine months ended September 30, 2018, we recorded additions to asset retirement obligations of approximately $4.1 million, primarily due to the Carbon California Acquisition. Carbon California estimates the fair value of asset retirement obligations using the amounts and timing of expected future dismantlement costs, credit-adjusted risk-free rates and time value of money. Carbon California’s asset retirement obligation was calculated by taking into account the cost of abandoning oil and gas wells based on industry expectations for similar work, the economic lives of its properties between 1-49 years; an inflation rate between 2.01% and 2.03%; and a credit adjusted risk-free rate between 8.09% and 15.5%.

Class B Units

We received Class B Units from Carbon California and Carbon Appalachia as part of the entry into the Carbon California LLC and Carbon Appalachia LLC agreements. We estimated the fair value of the Class B units, in each case, by utilizing the assistance of third-party valuation specialists. The fair values were based upon enterprise values derived from inputs including estimated future production rates, future commodity prices including price differentials as of the dates of closing, future operating and development costs and comparable market participants.