NOTE 7 — FAIR VALUE MEASUREMENTS

The authoritative 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 the Company. Unobservable inputs are inputs that reflect the Company’s 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 and 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 flows models or valuations.

The financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels. The Company’s 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. The valuation policies are determined by the Chief Financial Officer and are approved by the President. Fair value measurements are discussed with the Company’s audit committee, as deemed appropriate. Each quarter, an outside consulting firm updates the inputs used in the fair value calculations and management reviews the changes from period to period for reasonableness. The Company has consistently applied the valuation techniques discussed below in all periods presented.

The following table presents the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2013 and December 31, 2012 by level within the fair value hierarchy


	Fair Value Measurements Using
	Level 1		Level 2		Level 3		Total
September 30, 2013

ASSETS:
Commodity contracts		—	$	522,733		—	$	522,733
LIABILITIES:
Warrant derivative liability		—		—		2,213,033		2,213,033

December 31, 2012

ASSETS:
Commodity contracts		—		—		—		—
LIABILITIES:
Warrant derivative liability		—		—		2,808,278		2,808,278

We use Level 2 inputs to measure the fair value of gas commodity collar derivatives. Level 2 assets consist of commodity derivative assets and liabilities (See Note 6 — Derivative and Hedging Financial Instruments). The fair value of the commodity derivative assets and liabilities are estimated by the Company using the income valuation techniques utilizing the income approach and an option pricing model, which take into account notional quantities, market volatility, market prices, contract parameters, counterparty credit risk and discount rates based on published LIBOR rates. The Company validates the data provided by third parties by understanding the pricing models used, obtaining market values from other pricing sources, analyzing pricing data in certain situations and confirming that those securities trade in active markets. Assumed credit risk adjustments, based on published credit ratings, public bond yield spreads and credit default swap spreads, are applied to the Company’s commodity derivatives.

As of September 30, 2013, the Company’s warrant derivative financial instrument issued as a part of the ASD Credit Agreement is comprised of the warrants issued by the Company to purchase 19,500 shares of American Shale common stock with a put option (See Note 6 — Derivative and Hedging Financial Instruments). The warrants are valued by third parties using a binomial lattice-based valuation model and are classified as Level 3 in the fair value hierarchy. The lattice-based valuation technique is utilized because it embodies all of the requisite assumptions (including the underlying price, exercise price, term, volatility, and risk-free interest-rate) that are necessary to measure the fair value of these instruments. The valuation policies are determined by the Chief Financial Officer and approved by the President. Fair value measurements are discussed with the Company’s audit committee, as deemed appropriate. Each quarter, the Chief Financial Officer reviews the updated inputs used in the fair value calculations and internally reviews the changes from period to period for reasonableness. The Company uses data from its peers as well as from external sources in the determination of the volatility and risk free interest rates used in the fair value calculations. A sensitivity analysis is performed as well to determine the impact of the inputs on the ending fair value estimate. Estimating fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument due to both internal and external market factors. In addition, option-based techniques are highly sensitive to volatility assumptions. An increase in the volatility would cause an increase in the fair value of the warrants. Likewise, a decrease in the volatility would cause a decrease in the value of the Warrants.

The significant assumptions used in the valuation of the warrant derivative liability as of September 30, 2013 Based on the Company’s stock are as follows:


Exercise price	$	1.63 per share
Stock price	$	2.89 per share
Volatility		75	%
Remaining Term of Warrants		1.41 years
Risk-free interest rate		0.20	%

The following table sets forth a reconciliation of changes in the fair value of financial liabilities classified as Level 3 in the fair value hierarchy:


	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2013			2012			2013			2012

Balance as of beginning of period	$	(2,216,839	)	$	(1,156,660	)	$	(2,808,278	)	$	—
Total unrealized gains (losses)
Included in earnings		3,806			(63,023	)		595,245			780,317
Issuances		—			—			—			(2,000,000	)
Settlements		—			—			—			—
Transfers in and out of Level 3		—			—			—			—

Balance as of September 30	$	(2,213,033	)	$	(1,219,683	)	$	(2,213,033	)	$	(1,219,683	)

Change in unrealized gains included in earnings Relating to instruments still held as of September 30,	$	(3,806	)	$	63,023		$	(595,245	)	$	(780,317	)