Basis of Presentation, Significant Accounting Policies, and Recently Issued Accounting Standards (Policies)

6 Months Ended

Jun. 30, 2011

Basis of Presentation, Significant Accounting Policies, and Recently Issued Accounting Standards

Amortization policy surrounding deferred financing fees

The Company received net proceeds of approximately $341.4 million after deducting fees of approximately $8.6 million, which will be amortized as deferred financing costs over the life of the 6.625% Senior Notes. 

Description and terms of the Performance Share Awards

PSAs are the primary form of long-term equity incentive compensation for the Company.  The PSA factor is based on the Company’s performance after completion of a three-year performance period.  The performance criteria for the PSAs are based on a combination of the Company’s annualized total shareholder return (“TSR”) for the performance period and the relative measure of the Company’s TSR compared with the annualized TSR of an index comprised of certain peer companies for the performance period.  In addition, there are separate employment service vesting provisions.  PSAs are recognized as general and administrative and exploration expense over the vesting period of the award. The number of awards vested assumes a multiplier of one. The final number of shares vested may vary depending on the ending three-year multiplier, which ranges from zero to two.

Pension Benefits Policy

The Company has a non-contributory pension plan covering substantially all employees who meet age and service requirements (the “Qualified Pension Plan”).  The Company also has a supplemental non-contributory pension plan covering certain management employees (the “Nonqualified Pension Plan”). Prior service costs are amortized on a straight-line basis over the average remaining service period of active participants.  Gains and losses in excess of ten percent of the greater of the benefit obligation or the market-related value of assets are amortized over the average remaining service period of active participants.

Fair Value Measurement Policy Surrounding Derivatives

The Company’s oil, natural gas, and NGL derivatives are measured at fair value and are included in the accompanying balance sheets as derivative assets and liabilities.  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 pertinent 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, natural gas, and NGL derivative markets are highly active. 

Discontinuance of Cash Flow Hedge Accounting Description

Prior to January 1, 2011, the Company designated its commodity derivative contracts as cash flow hedges, whose unrealized changes in fair value were recorded to accumulated other comprehensive income (loss) (“AOCIL”), to the extent the hedges were effective.  As of January 1, 2011, the Company elected to de-designate all of its commodity derivative contracts that had been previously designated as cash flow hedges at December 31, 2010.  As a result, subsequent to December 31, 2010, the Company recognizes all gains and losses from changes in commodity derivative fair values immediately in earnings rather than deferring any such amounts in AOCIL.

Fair value of financial instruments measured on a recurring Basis

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.