XFRA:E4R Eagle Rock Energy Partners LP Quarterly Report 10-Q Filing - 6/30/2012
Effective Date 6/30/2012
| • FORM 10Q • EXHIBIT 10.2 • EXHIBIT 10.3 • EXHIBIT 10.4 • EXHIBIT 10.5 • EXHIBIT 10.6 • EXHIBIT 31.1 • EXHIBIT 31.2 • EXHIBIT 32.1 • EXHIBIT 32.2 • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA DOCUMENT • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION LABEL LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE DOCUMENT | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q
For the quarterly period ended June 30, 2012 OR
Commission File No. 001-33016  EAGLE ROCK ENERGY PARTNERS, L.P. (Exact Name of Registrant as Specified in Its Charter)
1415 Louisiana Street, Suite 2700 Houston, Texas 77002 (Address of principal executive offices, including zip code) (281) 408-1200 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x The issuer had 136,644,946 common units outstanding as of August 1, 2012. TABLE OF CONTENTS
1 PART I. FINANCIAL INFORMATION Item 1. Financial Statements EAGLE ROCK ENERGY PARTNERS, L.P. UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS ($ in thousands)
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See accompanying notes to unaudited condensed consolidated financial statements. 2 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ($ in thousands, except per unit amounts)
See accompanying notes to unaudited condensed consolidated financial statements. 3 UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF MEMBERS’ EQUITY FOR THE SIX MONTHS ENDED JUNE 30, 2012 ($ in thousands, except unit amounts)
See accompanying notes to unaudited condensed consolidated financial statements. 4 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ($ in thousands)
See accompanying notes to unaudited condensed consolidated financial statements. 5 EAGLE ROCK ENERGY PARTNERS, L.P. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ORGANIZATION AND DESCRIPTION OF BUSINESS Description of Business—Eagle Rock Energy Partners, L.P. ("Eagle Rock Energy" or the "Partnership") is a domestically-focused growth-oriented limited partnership engaged in the business of (i) gathering, compressing, treating, processing and transporting natural gas; fractionating and transporting natural gas liquids ("NGLs"); crude oil logistics and marketing; and natural gas marketing and trading (collectively the "Midstream Business"); and (ii) developing and producing interests in oil and natural gas properties (the "Upstream Business"). The Partnership's midstream assets are located in four significant natural gas producing regions; the Texas Panhandle, East Texas/Louisiana, South Texas and the Gulf of Mexico. These four regions are productive, mature, natural gas producing basins that have historically experienced significant drilling activity. Natural gas transported to the Partnership's gas processing plants, either in the Partnership's pipelines or third party pipelines, is treated to remove contaminants and conditioned or processed into marketable natural gas and NGLs. The Partnership reports its Midstream Business results through three segments: the Texas Panhandle Segment, the East Texas and Other Midstream Segment and the Marketing and Trading Segment. The Partnership's upstream assets are located in four significant oil and gas producing regions: (i) Southern Alabama (which includes the associated gathering, processing and treating assets); (ii) Mid-Continent (which includes areas in Oklahoma, Arkansas, Texas Panhandle and North Texas); (iii) Permian (which includes areas in West Texas); and (iv) East Texas/South Texas/Mississippi. The Partnership reports its Upstream Business through one segment. The general partner of Eagle Rock Energy is Eagle Rock Energy GP, L.P., and the general partner of Eagle Rock Energy GP, L.P. is Eagle Rock Energy G&P, LLC, both of which are wholly-owned subsidiaries of the Partnership. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Principles of Consolidation—The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements presented in the Partnership's Annual Report on Form 10-K for the year ended December 31, 2011. That report contains a more comprehensive summary of the Partnership's major accounting policies. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all appropriate adjustments, all of which are normally recurring adjustments unless otherwise noted, considered necessary to present fairly the financial position of the Partnership and its consolidated subsidiaries and the results of operations and cash flows for the respective periods. Operating results for the three and six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2012. Eagle Rock Energy is the owner of non-operating undivided interests in certain gas processing plants and gas gathering systems. Eagle Rock Energy owns these interests as tenants-in-common with the majority owner-operator of the facilities. Accordingly, Eagle Rock Energy includes its pro-rata share of assets, liabilities, revenues and expenses related to these assets in its financial statements. All intercompany accounts and transactions are eliminated in the unaudited condensed consolidated financial statements. The Partnership has provided a discussion of significant accounting policies in its Annual Report on Form 10-K for the year ended December 31, 2011. Certain items from that discussion are repeated or updated below as necessary to assist in the understanding of these financial statements. Use of Estimates—The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Significant estimates are required for proved oil and natural gas reserves, which can affect the carrying value of oil and natural gas properties. The Partnership evaluates its estimates and assumptions on a regular basis. The Partnership bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates and such differences could be material. Inventory—Inventory is stated at the lower of cost or market, with cost being determined using the average cost method. At June 30, 2012 and December 31, 2011, the Partnership had $1.1 million and $1.4 million, respectively, of crude oil finished goods inventory, which is recorded as part of Other Current Assets within the unaudited condensed consolidated 6 balance sheet. Impairment of Long-Lived Assets—Management evaluates whether the carrying value of non-oil and natural gas long-lived assets has been impaired when circumstances indicate the carrying value of those assets may not be recoverable. This evaluation is based on undiscounted cash flow projections. The carrying amount is not recoverable if it exceeds the undiscounted sum of cash flows expected to result from the use and eventual disposition of the assets. Management considers various factors when determining if these assets should be evaluated for impairment, including, but not limited to:
For its oil and natural gas long-lived assets, the Partnership reviews its proved properties at the field level when management determines that events or circumstances indicate that the recorded carrying value of the properties may not be recoverable. Such events include a negative revision or unfavorable projection of future oil and natural gas reserves and/or forward prices that will be produced from a field, the timing of this future production, future costs to produce the oil and natural gas, and future inflation levels. Unproved properties (both individually significant and insignificant) are assessed periodically within specific geographic areas and, if necessary, impairments are charged to expense. If the carrying value is not recoverable on an undiscounted basis, the impairment loss is measured as the excess of the asset's carrying value over its fair value. Management assesses the fair value of long-lived assets using commonly accepted techniques, and may use more than one method, including, but not limited to, recent third party comparable sales, internally developed discounted cash flow analysis and analysis from outside advisors. Significant changes in market conditions resulting from events such as the condition of an asset or a change in management's intent to utilize the asset would generally require management to reassess the cash flows related to the long-lived assets. See Notes 4 and 6 for further discussion on impairment charges. Revenue Recognition—Eagle Rock Energy's primary types of sales and service activities reported as operating revenue include:
Revenues associated with sales of natural gas, NGLs, crude oil, condensate and sulfur are recognized when title passes to the customer, which is when the risk of ownership passes to the customer and physical delivery occurs. Revenues associated with transportation and processing fees are recognized in the period when the services are provided. For gathering and processing services, the Partnership either receives fees or commodities from natural gas producers under various types of contracts including percentage-of-proceeds, fixed recovery and percent-of-index arrangements. The Partnership also recognizes fee-based service revenues for services such as transportation, compression and processing. The Partnership's Upstream Segment recognizes natural gas revenues based on the amount of natural gas sold to purchasers. The volumes of natural gas sold may differ from the volumes to which the Partnership is entitled based on its interests in the properties. Differences between volumes sold and volumes based on entitlements create natural gas imbalances. Material imbalances are reflected as adjustments to reported natural gas reserves and future cash flows. As of June 30, 2012 and December 31, 2011, the Partnership's Upstream Segment had an imbalance receivable balance of $0.2 million and $0.3 million, respectively, and it had a long-term payable balance of $1.4 million and $1.6 million as of June 30, 2012 and December 31, 2011, respectively. 7 Transportation and Exchange Imbalances—In the course of transporting natural gas and NGLs for others, the Partnership may receive for redelivery different quantities of natural gas or NGLs than the quantities actually delivered. These transactions result in transportation and exchange imbalance receivables or payables which are recovered or repaid through the receipt or delivery of natural gas or NGLs in future periods, if not subject to cash out provisions. Imbalance receivables are included in accounts receivable and imbalance payables are included in accounts payable on the unaudited condensed consolidated balance sheets and marked-to-market using current market prices in effect for the reporting period of the outstanding imbalances. For the Midstream Business, as of June 30, 2012, the Partnership had no imbalance receivables and imbalance payables totaling $1.1 million. For the Midstream Business, as of December 31, 2011, the Partnership had imbalance receivables totaling $0.6 million and imbalance payables totaling $0.5 million. Changes in market value and the settlement of any such imbalance at a price greater than or less than the recorded imbalance results in either an upward or downward adjustment, as appropriate, to the cost of natural gas sold. Derivatives—Authoritative guidance establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The guidance provides that normal purchase and sale contracts, when appropriately designated, are not subject to the guidance. Normal purchases and sales are contracts which provide for the purchase or sale of something, other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business. The Partnership's forward natural gas and crude oil purchase and sales contracts are designated as normal purchases and normal sales, with the exception of certain contracts with our natural gas trading and marketing business. The Partnership uses financial instruments such as swaps, collars and other derivatives to mitigate the risks to cash flows resulting from changes in commodity prices and interest rates. The Partnership recognizes these financial instruments on its unaudited condensed consolidated balance sheet at the instrument's fair value with changes in fair value reflected in the unaudited condensed consolidated statement of operations, as the Partnership has not designated any of these derivative instruments as hedges. The cash flows from derivatives are reported as cash flows from operating activities unless the derivative contract is deemed to contain a financing element. Derivatives deemed to contain a financing element are reported as a financing activity in the unaudited condensed consolidated statement of cash flows. See Note 10 for a description of the Partnership's risk management activities. Other Reclassifications—Certain prior period financial statement balances have been reclassified to conform to the current year presentation. These reclassifications had no effect on the recorded net income. NOTE 3. NEW ACCOUNTING PRONOUNCEMENTS In May 2011, the Financial Accounting Standards Board ("FASB") issued additional guidance intended to result in convergence between GAAP and International Financial Reporting Standards ("IFRS") requirements for measurement of and disclosures about fair value. The amendments are not expected to have a significant impact on companies applying GAAP. Key provisions of the amendments include: a prohibition on grouping financial instruments for purposes of determining fair value, except when an entity manages market and credit risks on the basis of the entity’s net exposure to the group; an extension of the prohibition against the use of a blockage factor to all fair value measurements (that prohibition currently applies only to financial instruments with quoted prices in active markets); and a requirement that for recurring Level 3 fair value measurements, entities disclose quantitative information about unobservable inputs, a description of the valuation process used and qualitative details about the sensitivity of the measurements. In addition, for items not carried at fair value but for which fair value is disclosed, entities will be required to disclose the level within the fair value hierarchy that applies to the fair value measurement disclosed. This guidance was effective for the Partnership on January 1, 2012 and did not have a significant impact on the Partnership’s fair value measurements, financial condition, results of operations or cash flows. In December 2011, the FASB issued new guidance related to disclosure requirements about the nature of an entity's rights of set-off and related arrangements associated with its financial instruments and derivative instruments. The new disclosures are designed to make financial statements that are prepared under U.S. GAAP more comparable to those prepared under IFRS. To better facilitate comparison between financial statements prepared under U.S. GAAP and IFRS, the new disclosures will give financial statement users information about both gross and net exposures. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required. The Partnership is currently evaluating the impact, if any, of the adoption of this guidance on its consolidated financial statements and related disclosures. 8 NOTE 4. PROPERTY PLANT AND EQUIPMENT Fixed assets consisted of the following:
The following table sets forth the total depreciation, depletion, capitalized interest costs and impairment expense by type of asset within the Partnership's unaudited condensed consolidated statements of operations:
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9 NOTE 5. ASSET RETIREMENT OBLIGATIONS The Partnership recognizes asset retirement obligations associated with the retirement of tangible long-lived assets that result from the acquisition, construction and development of the assets. The Partnership records the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. The Partnership makes estimates of property abandonment costs that, in some cases, will not be incurred until a substantial number of years in the future. Such cost estimates could be subject to significant revisions in subsequent years due to changes in regulatory requirements, technological advances and other factors that may be difficult to predict. Although uncertainty about the timing and/or method of settlement may exist and may be conditional upon a future event, the obligation to perform the asset retirement activity is unconditional. Accordingly, the Partnership is required to recognize a liability for the fair value of a conditional asset retirement obligation upon initial recognition if the fair value of the liability can be reasonably estimated. The fair value of additions to the asset retirement obligations is estimated using valuation techniques that convert future cash flows to a single discounted amount. Significant inputs to the valuation include estimates of (i) remediation costs, (ii) remaining lives, (iii) future inflation factors and (iv) a credit-adjusted risk free interest rate. A reconciliation of the Partnership's liability for asset retirement obligations is as follows:
NOTE 6. INTANGIBLE ASSETS Intangible assets consist of rights-of-way and easements and acquired customer contracts, which the Partnership amortizes over the term of the agreement or estimated useful life. The amortization period for the Partnership's rights-of-way and easements is 20 years. The amortization period for contracts ranges from 5 to 20 years. Intangible assets consist of the following:
10 The following table sets forth amortization and impairment expense by type of intangible asset within the Partnership's unaudited condensed consolidated statements of operations:
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Estimated future amortization expense related to the intangible assets at June 30, 2012, is as follows (in thousands):
NOTE 7. LONG-TERM DEBT Long-term debt consisted of the following:
The Partnership currently pays an annual fee on the unused commitment, which was 0.50%. As of June 30, 2012, the Partnership had approximately $77.6 million of availability under its revolving credit facility. As of June 30, 2012, the Partnership was in compliance with the financial covenants under the revolving credit facility. NOTE 8. MEMBERS’ EQUITY At June 30, 2012 and December 31, 2011, there were 133,019,853 and 127,606,229 common units outstanding, respectively. In addition, there were 3,585,918 and 2,560,110 unvested restricted common units outstanding at June 30, 2012 and December 31, 2011, respectively. During the six months ended June 30, 2012 and 2011, 5,300,588 and 7,649,544 warrants were exercised, respectively, for an equivalent number of newly issued common units. The final exercise date for the warrants was May 15, 11 2012, and on that date the remaining unexercised warrants expired. As of December 31, 2011, 5,707,705 warrants were outstanding. During the three months ended June 30, 2012, the Partnership announced a program through which it may issue common units, from time to time, with an aggregate market value of up to $100 million. The Partnership is under no obligation to issue equity under the program. As of June 30, 2012, no units had been issued under this program. The Partnership has declared a cash distribution for each quarter since its initial public offering. The table below summarizes the distributions paid and declared for the six months ended June 30, 2012.
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NOTE 9. RELATED PARTY TRANSACTIONS The following table summarizes transactions between the Partnership and affiliated entities:
NOTE 10. RISK MANAGEMENT ACTIVITIES Interest Rate Swap Derivative Instruments To mitigate its interest rate risk, the Partnership has entered into various interest rate swaps. These swaps convert the variable-rate term loan into a fixed-rate obligation. The purpose of entering into these swaps is to eliminate interest rate variability by converting LIBOR-based variable-rate payments to fixed-rate payments. Amounts received or paid under these swaps were recorded as reductions or increases in interest expense. The following table sets forth certain information regarding the Partnership's various interest rate swaps as of June 30, 2012:
The Partnership's interest rate derivative counterparties include Wells Fargo Bank National Association and The Royal Bank of Scotland plc. During July 2012, in conjunction with the Partnership's issuance of $250.0 million of senior unsecured notes (see Note 20), which increased its fixed interest rate exposure, the Partnership terminated the full $200.0 million notional amount of its 12 existing 4.295% and 4.095% fixed rate interest rate swaps at a cost of $3.9 million. Commodity Derivative Instruments The prices of crude oil, natural gas and NGLs are subject to fluctuations in response to changes in supply, demand, market uncertainty and a variety of additional factors which are beyond the Partnership's control. These risks can cause significant changes in the Partnership's cash flows and affect its ability to achieve its distribution objectives and comply with the covenants of its revolving credit facility. In order to manage the risks associated with changes in the future prices of crude oil, natural gas and NGLs on its forecasted equity production, the Partnership engages in risk management activities that take the form of commodity derivative instruments. The Partnership has determined that it is necessary to hedge a substantial portion of its expected production in order to meaningfully reduce its future cash flow volatility. The Partnership generally limits its hedging levels to 80%, on an incurrence basis, of expected future production and has historically hedged substantially less than 80%, on an incurrence basis, of its expected future production for periods beyond 24 months. While hedging at this level of production does not eliminate all of the volatility in the Partnership's cash flows, it allows the Partnership to mitigate the risk of situations where a modest loss of production would not put it in an over-hedged position. At times, the Partnership's strategy may involve entering into hedges with strike prices above current future prices or resetting existing hedges to higher price levels in order to meet its cash flow objectives or to stay in compliance with the covenants under its revolving credit facility. In addition, the Partnership may also terminate or unwind hedges or portions of hedges when the expected future volumes do not support the level of hedges. Expected future production for its Upstream Business is derived from the proved reserves, adjusted for price-dependent expenses and revenue deductions. For the Midstream Business, expected future production is based on the expected production from wells currently flowing to the Partnership's processing plants, plus additional volumes the Partnership expects to receive from future drilling activity by its producer customer base. The Partnership's expectations for its Midstream Business volumes associated with future drilling are based on information it receives from its producer customer base and historical observations. The Partnership applies the appropriate contract terms to these projections to determine its expected future equity share of the commodities. The Partnership uses fixed-price swaps, costless collars and put options to achieve its hedging objectives and often hedges its expected future volumes of one commodity with derivatives of the same commodity. In some cases, however, the Partnership believes it is better to hedge future changes in the price of one commodity with a derivative of another commodity, which it refers to as "proxy" hedging. The Partnership will often hedge the changes in future NGL prices using crude oil hedges because NGL prices have been highly correlated to crude oil prices and hedging NGLs directly is usually less attractive due to the relative illiquidity in the NGL forward market. The Partnership may use natural gas hedges to hedge a portion of its expected future ethane production because forward prices for ethane are often heavily discounted from its current prices. Also, natural gas prices provide support for ethane prices because in many processing plants ethane can be recombined with the residue gas stream and sold as natural gas. When the Partnership uses proxy hedging, it converts the expected volumes of the underlying commodity to equivalent volumes of the hedged commodity. In the case of NGLs hedged with crude oil derivatives, these conversions are based on the linear regression of the prices of the two commodities observed during the previous 36 months and management's judgment regarding future price relationships of the commodities. In the case where ethane is hedged with natural gas derivatives, the conversion is based on the thermal content of ethane. For accounting purposes, the Partnership has not designated any of its commodity derivative instruments as hedges; instead it marks these derivative contracts to fair value (see Note 11). Changes in fair values of the commodity derivative instruments are recorded as an adjustment to the mark-to-market gains (losses) on risk management transactions within revenue. By using derivative instruments to economically hedge exposure to changes in commodity prices, the Partnership exposes itself to counterparty credit risk. Historically, the Partnership's counterparties have all been participants or affiliates of participants within its revolving credit facility, which is secured by substantially all of the assets of the Partnership. Therefore, the Partnership is not required to post any collateral, nor does it require collateral from its counterparties. In July 2011, the Partnership created a subsidiary to enhance its ability to market natural gas on behalf of itself and third parties. Through this financial derivative activity, the Partnership will have credit exposure to additional counterparties. The Partnership minimizes the credit risk in derivative instruments by limiting its exposure to any single counterparty and monitoring the creditworthiness of its counterparties on an ongoing basis. In addition, the Partnership's derivative contracts, for certain counterparties, are subject to counterparty netting agreements governing such derivatives. The Partnership's commodity derivative counterparties include BNP Paribas, Wells Fargo Bank, National Association, Comerica Bank, Bank of Nova Scotia, The Royal Bank of Scotland plc, Bank of America N.A., J Aron and Company (an affiliate of Goldman Sachs), ING Capital Markets LLC, BBVA Compass Bank, Royal Bank of Canada and CITIBANK, N.A. 13 The following tables set forth certain information regarding the Partnership's commodity derivatives. Within each table, some trades of the same commodities with the same tenors have been aggregated and shown as weighted averages. Commodity derivatives, as of June 30, 2012, that will mature during the years ended December 31, 2012, 2013, 2014 and 2015:
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During July 2012, the Partnership enhanced its commodity derivative portfolio by paying $2.8 million to adjust the strike price from $68.30 to $92.00 (the forward market price at the date of the transaction) per barrel on an existing WTI crude oil swap of 20,000 barrels per month for the six months ended December 31, 2012. Commodity Derivative Instruments - Marketing & Trading The Partnership conducts natural gas marketing and trading activities. The Partnership engages in activities intended to capitalize on favorable price differentials between various receipt and delivery locations. The Partnership's activities are governed by its risk policy. As part of its natural gas marketing and trading activities, the Partnership enters into both financial derivatives and physical contracts. These financial derivatives, primarily basis swaps, are transacted: (i) to economically hedge subscribed capacity exposed to market rate fluctuations, and (ii) to mitigate the price risk related to other purchase and sales of natural gas. By entering into a basis swap, one pricing index is exchanged for another, effectively locking in the margin between the natural gas purchase and sale by removing index spread risk on the combined physical and financial transaction. 14 A commodity-related derivative contract may be designated as a "normal" purchase or sale if the commodity is to be physically received or delivered for use or sale in the normal course of business. If designated as "normal," the derivative contract is accounted for under the accrual method of accounting (not marked-to-market) with no balance sheet or income statement recognition of the contract until settlement. Commodity-related contracts that do not qualify for the normal designation are accounted for as derivatives and are marked-to-market each period. Marketing and Trading commodity derivative instruments, as of June 30, 2012, that will mature during the years ended December 31, 2012 and 2013:
Changes in the fair value of these financial and physical contracts are recorded as adjustments to natural gas sales. 15 Fair Value of Interest Rate and Commodity Derivatives Fair values of interest rate and commodity derivative instruments not designated as hedging instruments in the unaudited condensed consolidated balance sheet as of June 30, 2012 and December 31, 2011:
The following table sets forth the location of gains and losses for derivatives not designated as hedging instruments within the Partnership's unaudited condensed consolidated statement of operations:
NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Partnership utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk inherent in the inputs to the valuation technique. The authoritative guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). 16 The three levels of the fair value hierarchy are as follows: Level 1 – Quoted prices are available in active markets for identical assets and liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide information on an ongoing basis. Level 2 – Pricing inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the market place throughout the full term of the instrument, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace. Level 3 – Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management's best estimate of fair value. As of June 30, 2012, the Partnership has recorded its interest rate swaps and commodity derivative instruments (see Note 10), which includes crude oil, natural gas and NGLs, at fair value. The Partnership reviews the classification of the inputs at the end of each period and has classified the inputs to measure the fair value of its interest rate swaps, crude oil derivatives and natural gas derivatives as Level 2. In prior periods, the Partnership has classified the inputs to measure its NGL derivatives as Level 3 as the NGL market was considered to be less liquid and thinly traded. As of September 30, 2011, the Partnership concluded that the inputs for its NGL derivatives were considered to be more observable due to the NGL market being more liquid through the term of the Partnership's contracts and has classified these inputs as Level 2. The following tables disclose the fair value of the Partnership's derivative instruments as of June 30, 2012 and December 31, 2011:
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The following table sets forth a reconciliation of changes in the fair value of the Level 3 NGL derivatives during the three and six months ended June 30, 2012 and 2011:
The Partnership valued its Level 3 NGL derivatives using forward curves, interest rate curves, and volatility parameters, when applicable. In addition, the impact of counterparty credit risk is factored into the value of derivative assets, and the Partnership's credit risk is factored into the value of derivative liabilities. The Partnership recognized no gains (losses) in the three and six months ended June 30, 2012 related to Level 3 assets and liabilities. The Partnership recognized losses of $1.6 million and $7.5 million in the three and six months ended June 30, 2011, respectively, that are attributable to the change in unrealized gains or losses related to those Level 3 assets and liabilities still held at June 30, 2011, which are included in the commodity risk management (losses) gains. Realized and unrealized losses related to the interest rate derivatives are recorded as part of interest rate risk management gains and losses in the unaudited condensed consolidated statements of operations. Realized and unrealized gains and losses and premium amortization related to the Partnership's commodity derivatives are recorded as a component of revenue in the unaudited condensed consolidated statements of operations. 18 Fair Value of Assets and Liabilities Measured on a Non-recurring Basis The following table discloses the fair value of the Partnership's assets measured at fair value on a nonrecurring basis during the six months ended June 30, 2012:
The Partnership calculated the fair value of the impaired assets using a discounted cash flow analysis to determine the excess of the asset's carrying value over its fair value. Significant inputs to the valuation of fair value of the proved properties included estimates of (i) future estimated cash flows, including revenue, expenses and capital expenditures, (ii) estimated timing of cash flows, (iii) estimated forward commodity prices, adjusted for estimate location differentials and (iv) a discount rate reflective of our cost of capital. For other assets impaired by the Partnership during the six month ended June 30, 2012, the assets were fully written down and thus are not included in the table above. See Notes 4 and 6 for a further discussion of the impairment charges. The carrying amount of cash equivalents is believed to approximate their fair values because of the short maturities of these instruments. The fair value of accounts receivable and accounts payable are not materially different from their carrying amounts because of the short-term nature of these instruments. As of June 30, 2012, the outstanding debt associated with the Partnership's revolving credit facility bore interest at a floating rate; as such, the Partnership believes that the carrying value of this debt approximates its fair value. The Partnership's 8.375% Senior Notes due 2019 (the "Senior Notes") bear interest at a fixed rate; based on the market price of the Senior Notes as of June 30, 2012, the Partnership estimates that the fair value of the Senior Notes was $298.5 million compared to a carrying value of $298.1 million. Fair value of the senior notes was estimated based on prices quoted from third-party financial institutions, which are characteristic of Level 2 fair value measurement inputs. NOTE 12. COMMITMENTS AND CONTINGENCIES Litigation—The Partnership is subject to lawsuits which arise from time to time in the ordinary course of business, such as the interpretation and application of contractual terms related to the calculation of payment for liquids and natural gas proceeds. The Partnership had no accruals as of June 30, 2012 and December 31, 2011 related to legal matters, and current lawsuits are not expected to have a material adverse effect on our financial position, results of operations or cash flows. The Partnership has been indemnified up to a certain dollar amount for two lawsuits. If there ultimately is a finding against the Partnership in these two indemnified cases, the Partnership would expect to make a claim against the indemnification up to limits of the indemnification. Insurance—The Partnership covers its operations and assets with insurance which management believes is consistent with that in force for other companies engaged in similar commercial operations with similar type properties. This insurance includes: (1) commercial general liability insurance covering liabilities to third parties for bodily injury, property damage and pollution arising out of the Partnership's operations; (2) workers’ compensation liability coverage for employees to required statutory limits; (3) automobile liability insurance covering liability to third parties for bodily injury and property damage arising out of the operation of all owned, hired and non-owned vehicles by its employees on company business; (4) property insurance covering the replacement cost of all owned real and personal property, including coverage for losses due to boiler and machinery breakdown, earthquake, flood and consequent business interruption/extra expense; (5) control of well/operator's extra expense insurance for operated and non-operated wells in the Upstream Segment; and (6) corporate liability insurance including coverage for directors and officers and employment practices liabilities. In addition, the Partnership maintains excess liability insurance providing limits in excess of the established primary limits for commercial general liability and automobile liability insurance. All coverages are subject to industry accepted policy terms, conditions, limits and deductibles comparable to that obtained by other energy companies with similar operations. The cost of insurance for the energy industry continued to 19 fluctuate over the past year, reflecting the changing conditions in the insurance markets. Environmental—The operation of pipelines, plants and other facilities for gathering, transporting, processing, treating, or storing natural gas, NGLs and other products is subject to stringent and complex laws and regulations pertaining to health, safety and the environment. As an owner or operator of these facilities, the Partnership must comply with United States laws and regulations at the federal, state and local levels that relate to air and water quality, hazardous and solid waste management and disposal and other environmental matters. The cost of planning, designing, constructing and operating pipelines, plants, and other facilities must incorporate compliance with environmental laws and regulations and safety standards. Failure to comply with these laws and regulations may trigger a variety of administrative, civil and potentially criminal enforcement measures, including citizen suits, which can include the assessment of monetary penalties, the imposition of remedial requirements and the issuance of injunctions or restrictions on operation. Management believes that, based on currently known information, compliance with these laws and regulations will not have a material adverse effect on the Partnership's combined results of operations, financial position or cash flows. At June 30, 2012 and December 31, 2011, the Partnership had accrued approximately $3.1 million and $3.2 million, respectively, for environmental matters. In July 2012, the Alabama Department of Environmental Management (“ADEM”) notified one of the Partnership's subsidiaries that ADEM had made a determination that alleged violations warrant enforcement action and determined that the alleged violations are appropriate for resolution by Consent Order and proposed the terms of a to-be-mutually agreed-upon Consent Order (“Proposed Consent Order”). Such notification and the Proposed Consent Order are the result of findings made by ADEM relating to the Partnership's subsidiary's Flomaton/Fanny Church Oil and Gas Production and Treating Facility. The Proposed Consent Order primarily relates to allegations of emissions in excess of those allowed by the production rate. Prior to receiving the Proposed Consent Order, the Partnership self-reported its emission rates and worked with ADEM to complete a series of quality improvement plans to address the causes of the alleged violations. The fine amount proposed by ADEM in the Proposed Consent Order is $100,000, which may be negotiated to a lesser amount at the discretion of ADEM. Retained Revenue Interest—Certain assets of the Partnership's Upstream Segment are subject to retained revenue interests. These interests were established under purchase and sale agreements that were executed by the Partnership's predecessors in title. The terms of these agreements entitle the owners of the retained revenue interests to a portion of the revenues received from the sale of the hydrocarbons above specified base oil and natural gas prices. These retained revenue interests do not represent a real property interest in the hydrocarbons. The Partnership's reported revenues are reduced to account for the retained revenue interests on a monthly basis. The retained revenue interests affect the Partnership's interest at the Big Escambia Creek, Flomaton and Fanny Church fields in Escambia County, Alabama. With respect to the Partnership's Flomaton and Fanny Church fields, these retained revenue interests are in effect for any calendar year in which the Partnership surpasses certain average net production rates. The Partnership did not surpass such rates in 2011 and does not anticipate doing so in 2012. With respect to the Partnership's Big Escambia Creek field, the retained revenue interest commenced in 2010 and continues through the end of 2019. Other Commitments—The Partnership utilizes assets under operating leases for its corporate office, certain rights-of-way and facilities locations, vehicles and in several areas of its operations. Rental expense, including leases with no continuing commitment, amounted to approximately $2.0 million and $4.4 million for the three and six months ended June 30, 2012 and 2011, respectively. Rental expense for leases with escalation clauses is recognized on a straight-line basis over the initial lease term. NOTE 13. SEGMENTS During the fourth quarter of 2011, the Partnership's chief executive officer (who is it's chief operating decision-maker "CODM") decided that due to the relative size of the East Texas/Louisiana, South Texas and Gulf of Mexico segments, these three reporting segments would be collapsed into a single reporting segment and that a new Marketing and Trading reporting segment would be created. The Partnership's Marketing and Trading results were previously presented within its Texas Panhandle Segment. The Partnership now conducts, evaluates and reports on its Midstream Business within three distinct segments—the Texas Panhandle Segment, the East Texas and Other Midstream Segment, which consolidates its former East Texas/Louisiana, South Texas and Gulf of Mexico Segments, and the Marketing and Trading Segment. The Partnership's Upstream Segment and functional (Corporate and Other) segment remain unchanged from what has been previously reported. Based on the Partnership’s approach to managing its assets, the Partnership believes its operations consist of three segments in its Midstream Business, one Upstream Segment and one Corporate segment: (i) Midstream—Texas Panhandle Segment: 20 gathering, compressing, treating, processing and transporting natural gas; fractionating, transporting and marketing NGLs; (ii) Midstream—East Texas and Other Midstream Segment: gathering, compressing, processing and treating natural gas and marketing of natural gas, NGLs and condensate in South Texas, East Texas, Louisiana, Gulf of Mexico and inland waters of Texas; (iii) Midstream—Marketing and Trading Segment: crude oil logistics and marketing in the Texas Panhandle and Alabama; and natural gas marketing and trading; (iv) Upstream Segment: crude oil, condensate, natural gas, NGLs and sulfur production from operated and non-operated wells; and (v) Corporate and Other Segment: risk management, intersegment eliminations and other corporate activities such as general and administrative expenses. The Partnership's CODM currently reviews its operations using these segments. The CODM evaluates segment performance based on segment operating income or loss from continuing operations. Summarized financial information concerning the Partnership's reportable segments is shown in the following tables:
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