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:

(in thousands)	Fair Value Measurements Using
	Level 1		Level 2		Level 3		Total
December 31, 2018
Asset:
Commodity derivatives	$	-	$	7,022	$	-	$	7,022
December 31, 2017
Asset:
Commodity derivatives	$	-	$	225	$	-	$	225
Liability:
Warrant derivative liability	$	-	$	-	$	2,017	$	2,017

Commodity Derivative

As of December 31, 2018, our commodity derivative financial instruments are comprised of fifteen natural gas swaps, twenty-eight oil swap, and eight natural gas costless collar agreements. As of December 31, 2017, our commodity derivative financial instruments were comprised of eight natural gas swaps, eight oil swaps, and one natural gas costless collar agreements. 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 of 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 of our outstanding commodity derivative financial instruments as of December 31, 2018 is BP Energy Company.

Warrant Derivative

A third-party valuation specialist is utilized to determine the fair value of our California Warrant and Appalachia Warrant. These warrants are designated as Level 3. We review these 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 reviews 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 remeasured the California Warrant as of December 31, 2017, 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. The California Warrant was exercised on February 1, 2018; therefore, the warrant liability was extinguished.

We estimated the fair value of the Appalachia Warrant on April 3, 2017, the grant date of the warrant, to be approximately $1.3 million, using a call option pricing model with the following assumptions: a seven-year term, exercise price of $7.20, volatility rate of 39.3% and a risk-free rate of 2.1%. As we will receive Class A units in Carbon Appalachia in the event the holder exercises the Appalachia Warrant, we also considered the fair value of the Class A units in its valuation. We remeasured the Appalachia Warrant as of November 1, 2017, immediately prior to its exercise, 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 Appalachia 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 6.5 years. As of December 31, 2017, the warrant liability had been extinguished.

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

(in thousands)	California Warrant			Appalachia Warrant			Total

Balance, December 31, 2016	$	-		$	-		$	-
Warrant liability		5,769			1,325			7,094
Unrealized (gain) loss included in warrant gain		(3,752	)		619			(3,133	)
Settlement of warrant liability		-			(1,944	)		(1,944	)
Balance, December 31, 2017	$	2,017		$	-		$	2,017
Unrealized (gain) included in warrant gain		(225	)		-			(225	)
Settlement of warrant liability		(1,792	)		-			(1,792	)
Balance, December 31, 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.

The fair value of the non-controlling interest in the partnerships we are required to consolidate was determined based on the net discounted cash flows of the proved developed producing properties attributable to the non-controlling interests in these partnerships. See Note 4 for the fair value of the non-controlling interest in Carbon California.

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 contract 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 on a monthly basis as we pay these firm transportation obligations in the future.

The fair value measurements associated with the assets acquired and liabilities assumed in the business combinations for the majority control of Carbon California and OIE Membership Acquisition of Carbon Appalachia are outlined within Note 4.

Debt Discount

The fair value of the debt discount from the 1,425 and 585 additional Class A Units issued in connection with the Subordinated Notes and 2018 Subordinated Notes was $1.3 million and $490,000, respectively. The debt discount was a Level 3 fair value assessment and was based on the relative fair value of Class A Units. Class A Units were issued contemporaneously at $1,000 per Class A Units.

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 $20,000 to $45,000, which is based on our historical experience and 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 between 1.52% to 2.79%; and a credit adjusted risk-free rate between 3.28% to 8.27%, 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 year ended December 31, 2018, we recorded additions to asset retirement obligations of approximately $14.1 million, which was the result of the Carbon California, Seneca, Liberty, and OIE Membership Acquisitions. 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.

Class B Units

We received Class B units from Carbon California and Carbon Appalachia as part of the entry into the Carbon California LLC Agreement and Carbon Appalachia LLC Agreement, respectively. 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.