Note 11 - Fair Value Measurements

The Company follows fair value measurement authoritative accounting guidance for all assets and liabilities measured at fair value. This 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. Market or observable inputs are the preferred sources of values, followed by assumptions based on hypothetical transactions in the absence of market inputs. The fair value hierarchy for grouping these assets and liabilities is based on the significance level of the following inputs:


•	Level 1 – quoted prices in active markets for identical assets or liabilities


•	Level 2 – quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations whose inputs are observable or whose significant value drivers are observable


•	Level 3 – significant inputs to the valuation model are unobservable

The following table is a listing of the Company’s assets and liabilities that are measured at fair value in the accompanying balance sheets and where they are classified within the fair value hierarchy as of June 30, 2015:



	Level 1		Level 2		Level 3
	(in thousands)
Assets:
Derivatives ⁽¹⁾	$	—	$	400,486	$	—
Proved oil and gas properties ⁽²⁾	$	—	$	—	$	7,658
Oil and gas properties held for sale ⁽²⁾	$	—	$	—	$	5,801
Liabilities:
Derivatives ⁽¹⁾	$	—	$	9,133	$	—
Net Profits Plan ⁽¹⁾	$	—	$	—	$	18,326

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⁽¹⁾ This represents a financial asset or liability that is measured at fair value on a recurring basis.

⁽²⁾ This represents a non-financial asset or liability that is measured at fair value on a nonrecurring basis.

The following is a listing of the Company’s assets and liabilities that are measured at fair value in the accompanying balance sheets and where they were classified within the hierarchy as of December 31, 2014:



	Level 1		Level 2		Level 3
	(in thousands)
Assets:
Derivatives ⁽¹⁾	$	—	$	592,208	$	—
Proved oil and gas properties ⁽²⁾	$	—	$	—	$	33,423
Oil and gas properties held for sale ⁽²⁾	$	—	$	—	$	17,891
Liabilities:
Derivatives ⁽¹⁾	$	—	$	70	$	—
Net Profits Plan ⁽¹⁾	$	—	$	—	$	27,136

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⁽¹⁾ This represents a financial asset or liability that is measured at fair value on a recurring basis.

⁽²⁾ This represents a non-financial asset that is measured at fair value on a nonrecurring basis.

Both financial and non-financial assets and liabilities are categorized within the above fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. The following is a description of the valuation methodologies used by the Company as well as the general classification of such instruments pursuant to the above fair value hierarchy.

Derivatives

The Company uses Level 2 inputs to measure the fair value of oil, gas, and NGL commodity derivatives. Fair values are based upon interpolated data. The Company derives internal valuation estimates taking into consideration forward commodity price curves, counterparties’ credit ratings, the Company’s credit rating, and the time value of money. These valuations are then compared to the respective counterparties’ mark-to-market statements. The considered factors result in an estimated exit-price that management believes provides a reasonable and consistent methodology for valuing derivative instruments. The derivative instruments utilized by the Company are not considered by management to be complex, structured, or illiquid. The oil, gas, and NGL commodity derivative markets are highly active.

Generally, market quotes assume that all counterparties have near zero, or low, default rates and have equal credit quality. However, an adjustment may be necessary to reflect the credit quality of a specific counterparty to determine the fair value of the instrument. The Company monitors the credit ratings of its counterparties and may require counterparties to post collateral if their ratings deteriorate. In some instances, the Company will attempt to novate the trade to a more stable counterparty.

Valuation adjustments are necessary to reflect the effect of the Company’s credit quality on the fair value of any derivative liability position. This adjustment takes into account any credit enhancements, such as collateral margin that the Company may have posted with a counterparty, as well as any letters of credit between the parties. The methodology to determine this adjustment is consistent with how the Company evaluates counterparty credit risk, taking into account the Company’s credit rating, current credit facility margins, and any change in such margins since the last measurement date. All of the Company’s derivative counterparties are members of the Company’s credit facility lender group.

The methods described above may result in a fair value estimate that may not be indicative of net realizable value or may not be reflective of future fair values and cash flows. While the Company believes that the valuation methods utilized are appropriate and consistent with authoritative accounting guidance and with other marketplace participants, the Company recognizes that third parties may use different methodologies or assumptions to determine the fair value of certain financial instruments that could result in a different estimate of fair value at the reporting date.

Refer to Note 10 - Derivative Financial Instruments for more information regarding the Company’s derivative instruments.

Net Profits Plan

The Net Profits Plan is a standalone liability for which there is no available market price, principal market, or market participants. The inputs available for this instrument are unobservable and are therefore classified as Level 3 inputs. The Company employs the income valuation technique, which converts expected future cash flow amounts to a single present value amount. This technique uses the estimate of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk to calculate the fair value. There is a direct correlation between realized oil, gas, and NGL commodity prices driving net cash flows and the Net Profits Plan liability. Generally, higher commodity prices result in a larger Net Profits Plan liability and lower commodity prices result in a smaller Net Profits Plan liability.

The Company records the estimated fair value of the long-term liability for estimated future payments under the Net Profits Plan based on the discounted value of estimated future payments associated with each individual pool. The calculation of this liability is a significant management estimate. A discount rate of 12 percent is used to calculate this liability and is intended to represent the Company’s best estimate of the present value of expected future payments under the Net Profits Plan.

The Company’s estimate of its liability is highly dependent on commodity prices, cost assumptions, discount rates, and overall market conditions. The Company regularly assesses the current market environment. The Net Profits Plan liability is determined using price assumptions of five one-year strip prices with the fifth year’s pricing then carried out indefinitely. The average price is adjusted for realized price differentials and to include the effects of the forecasted production covered by derivative contracts in the relevant periods. The non-cash expense associated with this significant management estimate is highly volatile from period to period due to fluctuations that occur in the oil, gas, and NGL commodity markets.

If the commodity prices used in the calculation changed by five percent, the liability recorded at June 30, 2015, would differ by approximately $1.8 million. A one percent increase or decrease in the discount rate would result in a change of approximately $650,000. Actual cash payments to be made to participants in future periods are dependent on realized actual production, realized commodity prices, and costs associated with the properties in each individual pool of the Net Profits Plan. Consequently, actual cash payments are inherently different from the amounts estimated.

No published market quotes exist on which to base the Company’s estimate of fair value of its Net Profits Plan liability. As such, the recorded fair value is based entirely on management estimates that are described within this footnote. While some inputs to the Company’s calculation of fair value of the Net Profits Plan’s future payments are from published sources, others, such as the discount rate and the expected future cash flows, are derived from the Company’s own calculations and estimates.

The following table reflects the activity for the Company’s Net Profits Plan liability measured at fair value using Level 3 inputs:



	For the Six Months Ended June 30, 2015
	(in thousands)
Beginning balance	$	27,136
Net decrease in liability ⁽¹⁾	(1,796		)
Net settlements ^{(1) (2)}	(7,014		)
Transfers in (out) of Level 3	—
Ending balance	$	18,326

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⁽¹⁾	Net changes in the Company’s Net Profits Plan liability are shown in the Change in Net Profits Plan liability line item of the accompanying statements of operations.


⁽²⁾	Settlements represent cash payments made or accrued under the Net Profits Plan. The amount in the table includes cash payments made or accrued under the Net Profits Plan of $3.8 million for the six-month period ended June 30, 2015, as a result of the divestitures of properties subject to the Net Profits Plan.

Long-term Debt

The following table reflects the fair value of the Senior Notes measured using Level 1 inputs based on quoted secondary market trading prices. The Senior Notes were not presented at fair value on the accompanying balance sheets as of June 30, 2015, or December 31, 2014, as they are recorded at historical value.



	As of June 30, 2015		As of December 31, 2014
	(in thousands)
6.625% Senior Notes due 2019	$	—	$	350,018
6.50% Senior Notes due 2021	$	362,250	$	343,000
6.125% Senior Notes due 2022	$	621,000	$	556,500
6.50% Senior Notes due 2023	$	412,000	$	379,000
5.0% Senior Notes due 2024	$	471,250	$	435,000
5.625% Senior Notes due 2025	$	493,850	$	—

The carrying value of the Company’s credit facility approximates its fair value, as the applicable interest rates are floating, based on prevailing market rates.

Proved and Unproved Oil and Gas Properties

Proved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication the carrying costs may not be recoverable. The Company uses Level 3 inputs and the income valuation technique, which converts future amounts to a single present value amount, to measure the fair value of proved properties through an application of discount rates and price forecasts selected by the Company’s management. The calculation of the discount rate is based on the best information available and was estimated to be 12 percent as of June 30, 2015, and December 31, 2014. The Company believes the discount rate is representative of current market conditions and takes into account estimates of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk. The prices for oil and gas are forecast based on New York Mercantile Exchange (“NYMEX”) strip pricing, adjusted for basis differentials, for the first five years, after which a flat terminal price is used for each commodity stream. The prices for NGLs are forecast using OPIS Mont Belvieu pricing, for as long as the market is actively trading, after which a flat terminal price is used. Future operating costs are also adjusted as deemed appropriate for these estimates. The Company recorded impairment of proved oil and gas properties of $12.9 million and $68.4 million for the three months and six months ended June 30, 2015, respectively, due to continued declines in commodity strip prices since year-end 2014, the Company’s decision to reduce capital invested in the development of certain prospects in its South Texas & Gulf Coast and Permian regions, and a decline in performance of non-core assets. Proved properties measured at fair value within the accompanying balance sheets totaled $7.7 million as of June 30, 2015. As of December 31, 2014, proved oil and gas properties measured at fair value totaled $33.4 million.

Proved properties classified as held for sale, including the corresponding asset retirement obligation liability, are valued using a market approach, based on an estimated selling price, as evidenced by the most current bid prices received from third parties, if available. If an estimated selling price is not available, the Company utilizes the income valuation technique discussed above. For the three and six months ended June 30, 2015, the Company recorded write-downs to fair value less estimated costs to sell of $66.0 million and $99.9 million, respectively, for certain assets held for sale. These write-downs are included within the net gain on divestiture activity line item on the accompanying statements of operations. Please refer to Note 3 – Acquisitions, Divestitures, and Assets Held for Sale.

Unproved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication that the carrying costs may not be recoverable. To measure the fair value of unproved properties, the Company uses a market approach, which takes into account the following significant assumptions: future development plans, risk weighted potential resource recovery, and estimated reserve values. Unproved properties classified as held for sale are valued using a market approach, based on an estimated selling price, as evidenced by the most current bid prices received from third parties. If an estimated selling price is not available, the Company estimates acreage value based on the price received for similar acreage in recent transactions by the Company or other market participants in the principal market. The Company recorded abandonment and impairment of unproved oil and gas properties expense of $5.8 million and $17.4 million for the three and six months ended June 30, 2015, respectively, related to acreage the Company no longer intends to develop. Unproved properties measured at fair value were written down to zero in the accompanying balance sheets as of June 30, 2015, and December 31, 2014.

The fair value measurements of assets acquired and liabilities assumed are measured on a nonrecurring basis on the acquisition date using an income valuation technique based on inputs that are not observable in the market and therefore represent Level 3 inputs. Significant inputs to the valuation of acquired oil and gas properties include estimates of: (i) reserves; (ii) production rates; (iii) future operating and development costs; (iv) future commodity prices, including price differentials; (v) future cash flows; and (vi) a market participant-based weighted average cost of capital rate. These inputs require significant judgments and estimates by the Company’s management at the time of the valuation.