Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities

v2.4.0.6
Derivative Instruments and Hedging Activities
 6 Months Ended
Jun. 30, 2012
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivative Instruments and Hedging Activities
Derivative Instruments and Hedging Activities

Objectives and Strategies for Using Derivative Instruments

The Company is exposed to fluctuations in crude oil and natural gas prices on its production. Consequently, the Company believes it is prudent to manage the variability in cash flows on a portion of its crude oil and natural gas production. The Company utilizes primarily collar, options and swap derivative financial instruments to manage fluctuations in cash flows resulting from changes in commodity prices. The Company does not use these instruments for speculative purposes.

Counterparty Risk

The use of derivative transactions exposes the Company to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. To reduce the Company's risk in this area, counterparties to the Company's commodity derivative instruments include a large, well-known financial institution and/or a large, well-known oil and gas company.  The Company monitors counterparty creditworthiness on an ongoing basis; however, it cannot predict sudden changes in counterparties' creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments under lower commodity prices.
     
The Company executes commodity derivative transactions under master agreements that have netting provisions that provide for offsetting payables against receivables. In general, if a party to a derivative transaction incurs an event of default, as defined in the applicable agreement, the other party will have the right to demand the posting of collateral, demand a cash payment transfer or terminate the arrangement. Counterparty credit risk is considered when determining a derivative instruments' fair value; See Note 6 for additional information.
Derivative positions and settlements
In the second quarter of 2012, the Company entered into fixed price natural gas swaps at $3.52 for the period October 2012 through December 2013 for 1,371 MMBtu over the 15-month period. To finance the uplift in the natural gas swap price for the period hedged, the Company sold for fiscal year 2013 natural gas put options at $3.00 for 1,095 MMbtu and for fiscal year 2014 sold natural gas call options at $4.75 for 456 MMbtu.

Listed in the table below are the outstanding oil and natural gas derivative contracts as of June 30, 2012:
Commodity
 
Instrument
 
Average Notional Volumes per Month
 
Quantity Type
 
Average Floor Price per Instrument
 
Average Ceiling Price per Instrument
 
Period
 
Designation under ASC 815
Crude oil
 
Collar (1)
 
25
 
Bbls
 
$
90.00

 
$
122.00

 
Jul12 - Dec12
 
Designated
Crude oil
 
Collar (1)
 
25
 
Bbls
 
$
95.00

 
$
125.00

 
Jul12 - Dec12
 
Designated
Crude oil
 
Collar (1)
 
40
 
Bbls
 
$
90.00

 
$
116.00

 
Jan13 - Dec13
 
Not Designated
Natural gas
 
Swap (2)
 
91
 
MMbtu
 
$
3.52

 
$
3.52

 
Oct12 - Dec13
 
Not Designated
Natural gas
 
Put Option (2)
 
91
 
MMbtu
 
$
3.00

 
n/a

 
Jan13-Dec13
 
Not Designated
Natural gas
 
Call Option (2)
 
38
 
MMbtu
 
n/a

 
$
4.75

 
Jan14-Dec14
 
Not Designated

(1) A collar is a combination of a sold call option (ceiling) and a purchased put option (floor).

(2) The natural gas swap, put and call option were executed contemporaneously. The "above market" swap price the Company received was offset by the value of the two options sold by the Company. The short natural gas put option when combined with the swap creates the potential for a reduction in the effective swap price if NYMEX natural gas prices are below $3.00/MMbtu in 2013. The short natural gas call option when combined with the Company's long production position represents a "covered call," and creates a $4.75/MMbtu ceiling during the covered period.

Settlements of the Company's derivative instruments are based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange ("NYMEX") price. The fair value of the Company's derivative instruments, depending on the type of instruments, was determined by the use of present value methods or standard option valuation models with assumptions about commodity prices based on those observed in underlying markets. See Note 6 for additional information regarding fair value.

The following table reflects the fair values of the Company's derivative instruments:
 
 
Balance Sheet Presentation
 
Asset Fair Value
 
Liability Fair Value
 
Net Derivative Fair Value
Commodity
 
Classification
 
Line Description
 
06/30/12
 
12/31/11
 
06/30/12
 
12/31/11
 
06/30/12
 
12/31/11
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Derivatives designated as Hedging Instruments under ASC 815
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Natural gas
 
Current
 
Fair market value of derivatives
 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

Natural gas
 
Non-current
 
Other long-term assets
 
—

 
—

 
—

 
—

 
—

 
—

Crude oil
 
Current
 
Fair market value of derivatives
 
2,702

 
2,499

 
—

 
—

 
2,702

 
2,499

Crude oil
 
Non-current
 
Other long-term liabilities
 
—

 
—

 
—

 
—

 
—

 
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subtotals
 
 
 
$
2,702

 
$
2,499

 
$
—

 
$
—

 
$
2,702

 
$
2,499

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Derivatives not designated as Hedging Instruments under ASC 815
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Natural gas
 
Current
 
Fair market value of derivatives
 
$
19

 
$
—

 
$
—

 
$
—

 
$
19

 
$
—

Natural gas
 
Non-current
 
Other long-term liabilities
 
—

 
—

 
(350
)
 
—

 
(350
)
 
—

Crude oil
 
Current
 
Fair market value of derivatives
 
1,924

 
—

 
—

 
—

 
1,924

 
—

Crude oil
 
Non-current
 
Other long-term assets
 
1,982

 
—

 
—

 
—

 
1,982

 
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subtotals
 
 
 
$
3,925

 
$
—

 
$
(350
)
 
$
—

 
$
3,575

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Totals
 
 
 
$
6,627

 
$
2,499

 
$
(350
)
 
$
—

 
$
6,277

 
$
2,499


Derivatives designated as hedging instruments

Certain of the Company’s crude oil derivative contracts in effect during 2012 are designated as cash flow hedges, and are recorded at fair market value with the effective portion of the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity. The cash settlements on contracts for future production are recorded as an increase or decrease in crude oil revenues.  Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income).

The tables below present the effect of the Company's derivative financial instruments on the consolidated statements of operations as an increase (decrease) to crude oil revenues for the effective portion and as an increase (decrease) to other (income) expense for the ineffective portion and amounts excluded from effectiveness testing:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2012
 
2011
 
2012
 
2011
Amount of gain (loss) reclassified from OCI into income (effective portion)
 
$
512

 
$
(350
)
 
$
512

 
$
(449
)
Amount of gain (loss) recognized in income (ineffective portion and amount excluded from effectiveness testing)
 
92

 
59

 
322

 
18



Derivatives not designated as hedging instruments

As discussed in the Company's Form 10-K for the year ended December 31, 2011, the Company elected not to designate any of its derivative contracts entered into subsequent to December 31, 2011 as an accounting hedge under FASB ASC 815, nor does it expect to designate future derivative contracts. Consequently, any derivative contract not designated as an accounting hedge is carried at its fair value on the balance sheet with both realized and unrealized (mark-to-market) gains or losses on these derivatives recorded on the statement of operations as a component of the Company's other income and expenses.

For the periods indicated, the Company recorded the following related to its derivative instruments that were not designated as accounting hedges:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2012
 
2011
 
2012
 
2011
Natural gas derivatives
 
 
 
 
 
 
 
 
     Realized gain (loss), net
 
$
—

 
$
—

 
$
—

 
$
—

     Unrealized gain (loss), net
 
(331
)
 
—

 
(331
)
 
—

          Sub-total gain (loss), net
 
$
(331
)
 
$
—

 
$
(331
)
 
$
—

 
 
 
 
 
 
 
 
 
Crude oil derivatives
 
 
 
 
 
 
 
 
     Realized gain (loss), net
 
$
—

 
$
—

 
$
—

 
$
—

     Unrealized gain (loss), net
 
3,836

 
—

 
3,906

 
—

          Sub-total gain (loss), net
 
$
3,836

 
$
—

 
$
3,906

 
$
—

 
 
 
 
 
 
 
 
 
Total gain (loss) on derivative instruments, net
 
$
3,505

 
$
—

 
$
3,575

 
$
—