Fair Value Measurements

6 Months Ended

Jun. 30, 2011

Fair Value Measurements

Fair Value Measurements

Note 11 - Fair Value Measurements

The Company follows fair value measurement authoritative guidance for all assets and liabilities measured at fair value.  That 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 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 and 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 is a listing of the Company’s financial assets and liabilities that are measured at fair value on a recurring basis and where they are classified within the hierarchy as of June 30, 2011:

	Level 1		Level 2		Level 3
	(in thousands)
Assets:
Derivatives	$	—	$	39,609	$	—
Liabilities:
Derivatives	$	—	$	108,333	$	—
Net Profits Plan	$	—	$	—	$	133,419

The following is a listing of the Company’s financial assets and liabilities that are measured at fair value on a recurring basis and where they are classified within the hierarchy as of December 31, 2010:

	Level 1		Level 2		Level 3
	(in thousands)
Assets:
Derivatives	$	—	$	62,332	$	—
Liabilities:
Derivatives	$	—	$	114,601	$	—
Net Profits Plan	$	—	$	—	$	135,850

Both financial and non-financial assets and liabilities are categorized within the 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 hierarchy.  There were no nonfinancial assets or liabilities measured at fair value on a nonrecurring basis at June 30, 2011, or December 31, 2010.

Derivatives

The Company uses Level 2 inputs to measure the fair value of oil, natural gas, and NGL commodity derivatives.  Fair values are based upon interpolated data.  The Company derives internal valuation estimates taking into consideration the 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.

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 ask 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 liability position with a counterparty.  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 SM Energy’s credit facility bank syndicate.

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 accounting authoritative 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.

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 approach, 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 and gas 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 vice versa.

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.  For those pools currently in payout, a discount rate of 12 percent is used to calculate this liability.  A discount rate of 15 percent is used to calculate the liability for pools that have not reached payout.  These rates are intended to represent the 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, and the discount rates used in the calculations.  The Company continually evaluates the assumptions used in this calculation in order to consider the current market environment for oil and gas prices, costs, discount rates, and overall market conditions.  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 derivatives 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 crude oil, natural gas, and NGL commodity markets.

If the commodity prices used in the calculation changed by five percent, the liability recorded at June 30, 2011, would differ by approximately $10 million.  A one percentage point increase in the discount rate would decrease the liability by approximately $6 million whereas a one percentage point decrease in the discount rate would increase the liability by approximately $7 million.  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 the 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 on 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 Net Profits Plan liability measured at fair value using Level 3 inputs:

	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands)
Beginning balance	$	147,403		$	143,019		$	135,850		$	170,291
Net increase (decrease) in liability (a)	(6,092		)	1,318			18,193			(218		)
Net settlements (a)(b)(c)	(7,892		)	(7,917		)	(20,624		)	(33,653		)
Transfers in (out) of Level 3	—			—			—			—
Ending balance	$	133,419		$	136,420		$	133,419		$	136,420

(a) Net changes in the Net Profits Plan liability are shown in the Change in Net Profits Plan liability line item of the accompanying statements of operations.

(b) Settlements represent cash payments made or accrued under the Net Profits Plan.  Settlements made under the Net Profits Plan of $2.0 million and $1.9 million for the three months ended June 30, 2011, and 2010, respectively, and $6.3 million and $20.1 million for the six months ended June 30, 2011, and 2010, respectively, resulted from divestiture proceeds.

(c)During the first quarter of 2011, the Company made the decision to cash out several Net Profits Plan pools associated with the acquisition of Nance Petroleum Corporation in 1999, through a $2.6 million direct payment.  As a result, the Company reduced its Net Profits Plan liability by that amount.  There is no impact on the accompanying statements of operations for the three-month or six-month periods ended June 30, 2011, related to these settlements.

3.50% Senior Convertible Notes

Based on the secondary market trading price of the 3.50% Senior Convertible Notes, the estimated fair value of the notes was approximately $406 million and $351 million as of June 30, 2011, and December 31, 2010, respectively.  The fair value of the embedded contingent interest derivative on the 3.50% Senior Convertible Notes was zero as of June 30, 2011, and December 31, 2010.

6.625% Senior Notes

Based on the secondary market trading price of the 6.625% Senior Notes, the estimated fair value of the notes was approximately $357 million as of June 30, 2011.

Proved Oil and Gas Properties

Proved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication that the carrying costs exceeds the sum of the undiscounted cash flows.  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 a significant management estimate based on the best information available and estimated to be 12 percent for the six months ended June 30, 2011.  Management believes that the discount rate is representative of current market conditions and reflects the following factors: estimate of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk.  The price forecast is based on New York Mercantile Exchange (“NYMEX”) strip pricing, adjusted for basis differentials, for the first five years.  Future operating costs are also adjusted as deemed appropriate for these estimates.

There were no proved oil and gas properties measured at fair value within the accompanying balance sheets at June 30, 2011, or December 31, 2010.

Materials Inventory

Materials inventory is valued at the lower of cost or market.  The Company uses Level 2 inputs to measure the fair value of materials inventory, which is primarily comprised of tubular goods.  The Company uses third party market quotes and compares the quotes to the book value of the materials inventory.  If the book value exceeds the quoted market price, the Company reduces the book value to the market price.  The considered factors result in an estimated exit price that management believes provides a reasonable and consistent methodology for valuing materials inventory.

There were no materials inventory measured at fair value within the accompanying balance sheets at June 30, 2011, or December 31, 2010.

Asset Retirement Obligations

The income valuation technique is utilized by the Company to determine the fair value of the asset retirement obligation liability at the point of inception by applying a credit-adjusted risk-free rate to the undiscounted expected abandonment cash flows.  The credit-adjusted risk-free rate takes into account the Company’s credit risk, the time value of money, and the current economic state.  Given the unobservable nature of the inputs, the initial measurement of the asset retirement obligation liability is deemed to use Level 3 inputs.  There were no asset retirement obligations measured at fair value within the accompanying balance sheets at June 30, 2011, or December 31, 2010.

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