ITEM 1. Financial Statements

See accompanying notes to Consolidated Financial Statements.

See accompanying notes to Consolidated Financial Statements.

See accompanying notes to Consolidated Financial Statements.

See accompanying notes to Consolidated Financial Statements.

Note 1 – Organization

Carbon Natural Gas Company (“Carbon” or the “Company”) is an independent oil and gas company engaged in the exploration, development and production of oil and natural gas in the United States. The Company’s business is comprised of the assets and properties of Nytis Exploration (USA) Inc. (“Nytis USA”) and its subsidiary Nytis Exploration Company LLC (“Nytis LLC”) which conducts the Company’s operations in the Appalachian and Illinois Basins. Collectively, Carbon, Nytis USA and Nytis LLC are referred to as the Company.

Note 2 – Going Concern

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities in the normal course of business for the twelve month period following the date of these consolidated financial statements.

On May 17, 2016, Nytis LLC, entered into an amendment to its credit facility with Bank of Oklahoma that reduced the borrowing base under the credit facility from $20.0 million to $5.5 million (of which $500,000 is reserved for future interest payments as those payments become due under the credit facility) and changed the maturity date of the credit facility from May 31, 2017 to January 2, 2017. At March 31, 2016, the Company was in compliance with all of its financial covenants associated with the credit agreement. As a result of the reduction in the borrowing base (and associated borrowing base capacity), the Company is no longer in compliance with the minimum current ratio required under the credit facility nor does it expect to be throughout the remainder of the year. As such, without a waiver, Bank of Oklahoma would have the ability to call the debt. In addition, with the change in the maturity of the credit facility from May 31, 2017 to January 2, 2017, outstanding borrowings under the credit facility were classified as current on the Company’s Consolidated Balance Sheet as of March 31, 2016, resulting in negative working capital of approximately $7.3 million.

We are in the process of analyzing various alternatives to enhance our liquidity and capital structure including obtaining a new credit facility, issuing additional equity, divesting nonstrategic assets, reducing costs or similar type activities. Although management believes that it will be able to obtain the necessary funding to allow the Company to remain a going concern through the methods discussed above, there can be no assurance that such methods will prove successful. The accompanying Consolidated Financial Statements do not include any adjustments that might result from the outcome of this uncertainty.

Note 3 – Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited Consolidated Financial Statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying unaudited Consolidated Financial Statements include all adjustments (consisting of normal and recurring accruals) considered necessary to present fairly the Company’s financial position as of March 31, 2016 and the Company’s results of operations and cash flows for the three months ended March 31, 2016 and 2015. Operating results for the three months ended March 31, 2016 are not necessarily indicative of the results that may be expected for the full year because of the impact of fluctuations in prices received for oil and natural gas, natural production declines, the uncertainty of exploration and development drilling results and other factors. For a more complete understanding of the Company’s operations, financial position and accounting policies, the unaudited financial statements and the notes thereto should be read in conjunction with the Company’s audited Consolidated Financial Statements for the year ended December 31, 2015 filed on Form 10-K with the Securities and Exchange Commission (“SEC”).

In the course of preparing the unaudited financial statements, management makes various assumptions, judgments and estimates to determine the reported amount of assets, liabilities, revenue and expenses and in the disclosures of commitments and contingencies. Changes in these assumptions, judgments and estimates will occur as a result of the passage of time and the occurrence of future events and accordingly, actual results could differ from amounts initially established.

Note 3 – Summary of Significant Accounting Policies (continued)

Principles of Consolidation

The Consolidated Financial Statements include the accounts of Carbon, Nytis USA and its consolidated subsidiary. Carbon owns 100% of Nytis USA. Nytis USA owns approximately 99% of Nytis LLC.

Nytis LLC also holds an interest in various oil and gas partnerships. For partnerships where the Company has a controlling interest, the partnerships are consolidated. The Company is currently consolidating on a pro-rata basis 46 partnerships. In these instances, the Company reflects the non-controlling ownership interest in partnerships and subsidiaries as non-controlling interests on its Consolidated Statements of Operations and also reflects the non-controlling ownership interests in the net assets of the partnerships as non-controlling interests within stockholders’ equity on its Consolidated Balance Sheets. All significant intercompany accounts and transactions have been eliminated.

In accordance with established practice in the oil and gas industry, the Company’s Consolidated Financial Statements also include its pro-rata share of assets, liabilities, income, lease operating costs and general and administrative expenses of the oil and gas partnerships in which the Company has a non-controlling interest.

Non-majority owned investments that do not meet the criteria for pro-rata consolidation are accounted for using the equity method when the Company has the ability to significantly influence the operating decisions of the investee. When the Company does not have the ability to significantly influence the operating decisions of an investee, the cost method is used. All transactions, if any, with investees have been eliminated in the accompanying Consolidated Financial Statements.

Accounting for Oil and Gas Operations

The Company uses the full cost method of accounting for oil and gas properties. Accordingly, all costs incidental to the acquisition, exploration and development of oil and gas properties, including costs of undeveloped leasehold, dry holes and leasehold equipment, are capitalized. Overhead costs incurred that are directly identified with acquisition, exploration and development activities undertaken by the Company for its own account, and which are not related to production, general corporate overhead or similar activities, are also capitalized.

Unproved properties are excluded from amortized capitalized costs until it is determined whether or not proved reserves can be assigned to such properties. The Company assesses its unproved properties for impairment at least annually. Significant unproved properties are assessed individually.

Capitalized costs are depleted by an equivalent unit-of-production method, converting oil to gas at the ratio of one barrel of oil to six thousand cubic feet of natural gas. Depletion is calculated using capitalized costs, including estimated asset retirement costs, plus the estimated future expenditures (based on current costs) to be incurred in developing proved reserves, net of estimated salvage values.

No gain or loss is recognized upon disposal of oil and gas properties unless such disposal significantly alters the relationship between capitalized costs and proved reserves. All costs related to production activities, including work-over costs incurred solely to maintain or increase levels of production from an existing completion interval, are charged to expense as incurred.

The Company performs a ceiling test quarterly. The full cost ceiling test is a limitation on capitalized costs prescribed by SEC Regulation S-X Rule 4-10. The ceiling test is not a fair value based measurement, rather it is a standardized mathematical calculation. The ceiling test provides that capitalized costs less related accumulated depletion and deferred income taxes may not exceed the sum of (1) the present value of future net revenue from estimated production of proved oil and gas reserves using the un-weighted arithmetic average of the first-day-of-the month price for the previous twelve month period, excluding the future cash outflows associated with settling asset retirement obligations that have been accrued on the balance sheet, at a discount factor of 10%; plus (2) the cost of properties not being amortized, if any; plus (3) the lower of cost or estimated fair value of unproved properties included in the costs being amortized, if any; less (4) income tax effects related to differences in the book and tax basis of oil and gas properties. Should the net capitalized costs exceed the sum of the components noted above, a ceiling test write-down would be recognized to the extent of the excess capitalized costs. Such impairments are permanent and cannot be recovered in future periods even if the sum of the components noted above exceeds the capitalized costs in future periods.

Note 3 – Summary of Significant Accounting Policies (continued)

For the three months ended March 31, 2016, the Company recognized a ceiling test impairment of approximately $3.9 million. For the three months ended March 31, 2015, the Company did not recognize a ceiling test impairment as the Company’s full cost pool did not exceed the ceiling limitation. Future declines in oil and natural gas prices, and increases in future operating expenses and future development costs could result in additional impairments of our oil and gas properties in future periods. The effects of price declines will continue to impact the ceiling test value until such time prices stabilize or improve. Impairment charges are a non-cash charge and accordingly, do not affect cash flow, but adversely affect our net income and stockholders’ equity.

Investments in Affiliates

Investments in non-consolidated affiliates are accounted for under either the equity or cost method of accounting as appropriate. The cost method of accounting is used for investments in affiliates in which the Company has less than 20% of the voting interests of a corporate affiliate or less than a 5% interest of a partnership or limited liability company and does not have significant influence. Investments in non-consolidated affiliates, accounted for using the cost method of accounting, are recorded at cost and impairment assessments for each investment are made annually to determine if a decline in the fair value of the investment, other than temporary, has occurred. A permanent impairment is recognized if a decline in the fair value occurs. If the Company holds between 20% and 50% of the voting interest in non-consolidated corporate affiliates or greater than a 5% interest of a partnership or limited liability company and exercises significant influence or control, the equity method of accounting is used to account for the investment. The Company’s investment in an affiliate that is accounted for using the equity method of accounting, increases or decreases by the Company’s share of the affiliate’s profits or losses and such profits or losses are recognized in the Company’s Consolidated Statements of Operations. The Company reviews equity method investments for impairment whenever events or changes in circumstances indicate that an other than temporary decline in value has occurred. The amount of the impairment is based on quoted market prices, where available, or other valuation techniques.

Asset Retirement Obligations

The Company’s asset retirement obligations (“ARO”) relate to future costs associated with the plugging and abandonment of oil and gas wells, removal of equipment and facilities from leased acreage and returning such land to its original condition. The fair value of a liability for an ARO is recorded in the period in which it is incurred and the cost of such liability is recorded as an increase in the carrying amount of the related long-lived asset by the same amount. The liability is accreted each period and the capitalized cost is depleted on a units-of-production basis as part of the full cost pool. Revisions to estimated AROs result in adjustments to the related capitalized asset and corresponding liability.

The estimated ARO liability is based on estimated economic lives, estimates as to the cost to abandon the wells in the future, and federal and state regulatory requirements. The liability is discounted using a credit-adjusted risk-free rate estimated at the time the liability is incurred or increased as a result of a reassessment of expected cash flows and assumptions inherent in the estimation of the liability. Upward revisions to the liability could occur due to changes in estimated abandonment costs or well economic lives, or if federal or state regulators enact new requirements regarding the abandonment of wells. AROs are valued utilizing Level 3 fair value measurement inputs.

Earnings Per Common Share

Basic earnings or loss per common share is computed by dividing the net income or loss attributable to common shareholders for the period by the weighted average number of common shares outstanding during the period. The shares of restricted common stock granted to certain officers, directors and employees of the Company are included in the computation of basic net income or loss per share only after the shares become fully vested. Diluted earnings per common share includes both the vested and unvested shares of restricted stock and the potential dilution that could occur upon exercise of options and warrants to acquire common stock, computed using the treasury stock method, which assumes that the increase in the number of shares is reduced by the number of shares which could have been repurchased by the Company with the proceeds from the exercise of options and warrants (which were assumed to have been made at the average market price of the common shares during the reporting period).

The following table sets forth the calculation of basic and diluted (loss) income per share:

For the quarter ended March 31, 2016, the Company had a net loss and therefore, the diluted net loss per share calculation for that period excludes the anti-dilutive effect of approximately 250,000 warrants and approximately 5.8 million nonvested shares of restricted stock. In addition, approximately 6.3 million restricted performance units subject to future contingencies were excluded from the basic and diluted loss per share calculations.

For the quarter ended March 31, 2015, the Company had a net loss and therefore, the diluted net loss per share calculation for that period excludes the anti-dilutive effect of approximately 2.7 million stock options and warrants, approximately 4.1 million nonvested shares of restricted stock and approximately 4.7 million restricted performance units, subject to future contingencies, were excluded from the basic and diluted loss per share calculations.

Note 3 – Summary of Significant Accounting Policies (continued)

Adopted and Recently Issued Accounting Pronouncements

In March 2016, the FASB issued Accounting Standards Update No. 2016-09, Improvements To Employee Share-Based Payment Accounting (“ASU 2016-09”). The objective of this ASU is to simplify several aspects of the accounting for employee share-based payment transactions, including income tax consequences, classification of awards as either equity or liabilities and classification in the statement of cash flows. ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Portions of this ASU must be applied prospectively while other portions may be applied either prospectively or retrospectively. Early adoption is permitted. The Company is currently evaluating the impact on its consolidated financial statements of adopting ASU 2016-09.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (“ASU 2016-02”). The objective of this ASU is to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements. ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 and should be applied using a modified retrospective approach. Early adoption is permitted. The Company is currently evaluating the impact on its consolidated financial statements of adopting ASU 2016-02.

As of March 31, 2016 and December 31, 2015, the Company had approximately $3.2 million of unproved oil and gas properties not subject to depletion. The costs not subject to depletion relate to unproved properties that are excluded from amortized capital costs until it is determined whether or not proved reserves can be assigned to such properties. The excluded properties are assessed for impairment at least annually. Subject to industry conditions, evaluation of most of these properties and the inclusion of their costs in amortized capital costs is expected to be completed within five years.

During the three months ended March 31, 2016 and 2015, the Company capitalized general and administrative expenses applicable to development and exploration activities of approximately $133,000 and $132,000, respectively.

Depletion expense related to oil and gas properties for the three months ended March 31, 2016 and 2015 was approximately $472,000, or $0.79 per Mcfe, and $608,000, or $0.87 per Mcfe, respectively. Depreciation and amortization expense related to furniture and fixtures, computer hardware and software and other equipment for the three months ended March 31, 2016 and 2015 was approximately $31,000 and $37,000, respectively.

Note 5 – Equity Method Investment

The Company has a 50% interest in Crawford County Gas Gathering Company, LLC (“CCGGC”) which owns and operates pipelines and related gathering and treatment facilities. The Company’s gas production located in Illinois is gathered by CCGGC’s gathering facilities. The Company’s investment in CCGGC is accounted for under the equity method of accounting, and its share of income or loss is recognized. During the three months ended March 31, 2016 and 2015, the Company recorded equity method income of approximately nil and $1,000, respectively, related to this investment. In addition, during the first quarter of 2016, the Company received a cash distribution of $275,000 from CCGGC.

Note 6 – Bank Credit Facility

Nytis LLC’s credit facility with Bank of Oklahoma has a borrowing base of $20.0 million and a maximum line of credit available under hedging arrangements of $9.5 million. The credit facility matures in May 2017. Carbon and Nytis USA are guarantors of Nytis LLC’s obligations under its credit facility.

No repayments of principal are required until maturity, except to the extent that outstanding balances exceed the borrowing base then in effect. The Company has the right both to repay principal at any time and to reborrow. Subject to the agreement between the Company and the lender, the size of the credit facility may be increased up to $50.0 million. The borrowing base is redetermined semi-annually, and the available borrowing amount could be increased or decreased as a result of such redeterminations. Under certain circumstances the lender may request an interim redetermination. The facility has variable interest rates based upon the ratio of outstanding debt to the borrowing base. Interest rates are based on either an Alternate Base Rate or LIBOR. The portion of the loan based on an “Alternate Base Rate” is determined by the rate per annum equal to 1.5% plus the greatest of the following: (a) the Federal Funds Rate for such day plus one-half of one percentage point, (b) the Prime Rate for such day or (c) LIBOR for a one-month LIBOR Interest Period plus one percentage point. The portion based on LIBOR is determined by the rate per annum equal to LIBOR plus between 2.5% and 3.25% for each LIBOR tranche. The credit facility includes a hedging component that provides a line of credit under commodity swap, exchange, collar, cap and fixed price agreements in addition to agreements designed to protect the Company against changes in interest and currency exchange rates.

At March 31, 2016, there were approximately $3.9 million in outstanding borrowings and approximately $16.1 million of borrowing capacity available under the credit facility. The Company’s effective borrowing rate at March 31, 2016 was approximately 3.0%. The credit facility is collateralized by substantially all of the Company’s oil and gas assets. The credit facility includes terms that place limitations on certain types of activities including restrictions or requirements with respect to additional debt, liens, asset sales, hedging activities, investments, mergers and acquisitions, and the payment of dividends. The credit facility requires satisfaction of a minimum current ratio (the ratio of current assets (including borrowing base capacity) to current liabilities as defined) of 1.0 to 1.0 and a maximum funded debt ratio (the ratio of the outstanding balance of all interest bearing indebtedness to the sum of EBITDAX (net income plus interest expense, income taxes, depreciation, depletion, amortization, exploration and impairment expenses and other non-cash charges) for the most recently completed fiscal quarter times four) of 4.25 to 1.0 as of the end of any fiscal quarter.

The Company was in compliance with all covenants associated with the credit agreement as of March 31, 2016.

On May 17, 2016, Nytis LLC entered into an amendment to its credit facility with Bank of Oklahoma that reduced the borrowing base under the credit facility from $20.0 million to $5.5 million (of which $500,000 is reserved for future interest payments as those payments become due under the credit facility) and changed the maturity date of the credit facility from May 31, 2017 to January 2, 2017. On May 17, 2016 the Company had approximately $4.0 million in outstanding borrowings under the credit facility and approximately $300,000 of available cash. As a result of a reduction in the borrowing base (and associated borrowing base capacity), the Company is no longer is compliance with the minimum current ratio required under the credit facility. In addition, the amendment to the credit agreement provided waivers from Bank of Oklahoma regarding Nytis LLC’s consistent past practice of advancing funding for general and administrative expenses of Carbon and ratified and affirmed the respective obligations for both Bank of Oklahoma and Nytis LLC under the credit facility.

Note 7 – Income Taxes

The Company recognizes deferred income tax assets and liabilities for the estimated future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The Company has net operating loss carryforwards available in certain jurisdictions to reduce future taxable income. Future tax benefits for net operating loss carryforwards are recognized to the extent that realization of these benefits is considered more likely than not. To the extent that available evidence raises doubt about the realization of a deferred income tax asset, a valuation allowance is established.

At March 31, 2016, the Company has established a full valuation allowance against the balance of net deferred tax assets.

Note 8 – Stockholders’ Equity

Authorized and Issued Capital Stock

As of March 31, 2016, the Company had 200,000,000 shares of common stock authorized with a par value of $0.01 per share, of which 108,082,583 were issued and outstanding and 1,000,000 shares of preferred stock authorized with a par value of $0.01 per share, none of which were issued and outstanding. During the first three months of 2016, the increase in the Company’s issued and outstanding common stock was a result of restricted stock that vested during the period.

Equity Plans Prior to Merger

Pursuant to the merger of Nytis USA with and into the Company in 2011, all options, warrants and restricted stock were adjusted to reflect the conversion ratio used in the merger. As of March 31, 2016, the Company has 250,000 warrants outstanding and exercisable and approximately 489,000 shares of common stock outstanding that are subject to restricted stock agreements.

Nytis USA Restricted Stock Plan

As of March 31, 2016, there were approximately 489,000 shares of restricted stock issued under the Nytis USA Restricted Stock Plan (“Nytis USA Plan”). The Company accounted for these grants at their intrinsic value. From the date of grant through March 31, 2013, the Company estimated that none of these shares would vest and accordingly, no compensation cost had been recorded through March 31, 2013.

In June 2013, the vesting terms of these restricted stock grants were modified so that 25% of the shares would vest on the first of January from 2014 through 2017. As such, the Company is recognizing compensation expense for these restricted stock grants based on the fair value of the shares on the date the vesting terms were modified. Compensation expense recognized for these restricted stock grants was approximately $84,000 for the three months ended March 31, 2016 and 2015. As of March 31, 2016, there was approximately $252,000 of unrecognized compensation costs related to these restricted stock grants which the Company expects will be recognized ratably over the next nine months.

Note 8 – Stockholders’ Equity (continued)

Carbon Stock Incentive Plans

The Company has two stock plans, the Carbon 2011 and 2015 Stock Incentive Plans (collectively the “Carbon Plans”). The Carbon Plans were approved by the shareholders of the Company and in the aggregate provide for the issuance of 22.6 million shares of common stock to Carbon officers, directors, employees or consultants eligible to receive these awards under the Carbon Plans.

The Carbon Plans provide for granting Director Stock Awards to non-employee directors and for granting Incentive Stock Options, Non-qualified Stock Options, Restricted Stock Awards, Performance Awards and Phantom Stock Awards, or a combination of the foregoing as is best suited to the circumstances of the particular employee, officer, director or consultant.

Restricted Stock

During the three months ended March 31, 2016, approximately 1.7 million shares of restricted stock were granted under the terms of the Carbon Plan in addition to approximately 6.6 million shares granted during previous years. For employees, these restricted stock awards vest ratably over a three-year service period. For non-employee directors the awards vest upon the earlier of a change in control of the Company or the date their membership on the Board of Directors is terminated other than for cause. The Company recognizes compensation expense for these restricted stock grants based on the estimated grant date fair value of the shares, amortized ratably over three years for employee awards (based on the required service period for vesting) and seven years for non-employee director awards (based on a market survey of the average tenure of directors among U.S. public companies). As of March 31, 2016, approximately 3.0 million of these restricted stock grants have vested.

Compensation costs recognized for these restricted stock grants were approximately $201,000 and $160,000 for the three months ended March 31, 2016 and 2015, respectively. As of March 31, 2016, there was approximately $1.1 million of unrecognized compensation costs related to these restricted stock grants. This cost is expected to be recognized over the next 6.8 years.

Restricted Performance Units

As of March 31, 2016, approximately 6.4 million shares of restricted performance units have been granted under the terms of the Carbon Plan. The performance units represent a contractual right to receive one share of the Company’s common stock subject to the terms and conditions of the agreements including the achievement of the price of the Company’s stock, net asset value per share, net production and Adjusted EBITDA (defined as net income (loss) before interest expense, taxes, depreciation, depletion, amortization, accretion of asset retirement obligations, ceiling test write downs of oil and gas properties and the gain or loss on sold investments or properties) per share relative to a defined peer group and the lapse of forfeiture restrictions pursuant to the terms and conditions of the agreements, including for certain of the grants, the requirement of continuous employment by the grantee prior to a change in control of the Company. Based on the relative achievement of performance, approximately 6.3 million of the restricted performance units are outstanding as of March 31, 2016.

The Company accounts for the performance units granted during 2012, 2014 and 2015 at their fair value determined at the date of grant. The final measurement of compensation cost will be based on the number of performance units that ultimately vest. At March 31, 2016, the Company estimated that none of the performance units granted in 2012, 2014 and 2015 would vest due to change in control and other performance provisions and accordingly, no compensation cost has been recorded. As of March 31, 2016, if change in control and other performance provisions pursuant to the terms and conditions of these agreements are met in full, the estimated unrecognized compensation cost related to the performance units granted in 2012, 2014 and 2015 would be approximately $3.1 million.

Note 8 – Stockholders’ Equity (continued)

The performance units granted in 2013 contain specific vesting provisions, no change in control provisions nor any performance conditions other than stock price performance. Due to different earning requirements compared to the performance units granted in 2012, 2014 and 2015, the Company recognizes compensation expense for the performance units granted in 2013 based on the grant date fair value of the performance units, amortized ratably over three years (the performance period). The fair value of the performance units granted in 2013 was estimated using a Monte Carlo simulation (“MCS”) valuation model using the following key assumptions: no expected dividends, volatility of our stock and those of defined peer companies used to determine our performance relative to the defined peer group, a risk free interest rate and an expected life of three years. Compensation costs recognized for these performance unit grants were approximately $86,000 for the three months ended March 31, 2016 and 2015. As of March 31, 2016, there was approximately $41,000 of unrecognized compensation costs related to performance units granted in 2013. These costs are expected to be recognized over the next three months.

Note 10 – Fair Value Measurements

Authoritative 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. The 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 under the circumstances. The hierarchy is broken down into three levels based on the reliability of the inputs as follows:

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company’s policy is to recognize transfers in and/or out of the fair value hierarchy as of the end of the reporting period for which the event or change in circumstances caused the transfer. The Company has consistently applied the valuation techniques discussed below for all periods presented.

As of March 31, 2016, the Company’s commodity derivative financial instruments are comprised of three natural gas swap agreements and one natural gas and four oil costless collar agreements. The fair values of these agreements are determined under an income valuation technique. The valuation requires a variety of inputs, including contractual terms, published forward prices, volatilities for options, and discount rates, as appropriate. The Company’s estimates of fair value of derivatives include consideration of the counterparty’s credit worthiness, the Company’s credit worthiness and the time value of money. The consideration of these factors resulted in an estimated exit-price for each derivative asset or liability under a market place participant’s view. All of the significant inputs are observable, either directly or indirectly; therefore, the Company’s derivative instruments are included within the Level 2 fair value hierarchy. The counterparty in all of the Company’s commodity derivative financial instruments is the lender in the Company’s bank credit facility.

Assets Measured and Recorded at Fair Value on a Non-recurring Basis

The fair value of the following liabilities measured and recorded at fair value on a non-recurring basis are based on unobservable pricing inputs and therefore, are included within the Level 3 fair value hierarchy.

The Company uses the income valuation technique to estimate the fair value of asset retirement obligations using the amounts and timing of expected future dismantlement costs, credit-adjusted risk-free rates and time value of money. During the three months ended March 31, 2016 and 2015, the Company recorded asset retirement obligations for additions of approximately $5,000 and nil, respectively. See Note 3 for additional information.

Note 11– Physical Delivery Contracts and Oil and Gas Derivatives

The Company has historically used commodity-based derivative contracts to manage exposures to commodity price on certain of its oil and natural gas production. The Company does not hold or issue derivative financial instruments for speculative or trading purposes. The Company also enters into gas physical delivery contracts to effectively provide gas price hedges. Because these contracts are not expected to be net cash settled, they are considered to be normal sales contracts and not derivatives and therefore these contracts are not recorded at fair value in the Consolidated Financial Statements.

Note 11– Physical Delivery Contracts and Oil and Gas Derivatives (continued)

As of March 31, 2016, the Company has two short-term physical delivery contracts which require the Company to deliver fixed volumes of natural gas. The Company has sufficient production from its natural gas producing properties delivering to the specific meters under these contracts. The following table summarizes the future production volumes to be delivered and sold under these contracts:

The Company’s other oil and gas sales contracts approximate index prices.

The Company’s costless collar and swap agreements as of March 31, 2016 are summarized in the table below:

(a) NYMEX Henry Hub Natural Gas futures contract for the respective delivery month.

(b) NYMEX Light Sweet Crude West Texas Intermediate futures contract for the respective delivery month

(c) NYMEX costless collar floor to ceiling prices.

For its swap instruments, the Company receives a fixed price for the hedged commodity and pays a floating price to the counterparty. The fixed-price payment and the floating-price payment are netted, resulting in a net amount due to or from the counterparty.

Note 11– Physical Delivery Contracts and Oil and Gas Derivatives (continued)

The following table summarizes the fair value of the derivatives recorded in the Consolidated Balance Sheets.

These derivative instruments are not designated as cash flow hedging instruments for accounting purposes:

The table below summarizes the commodity settlements and unrealized gains and losses related to the Company’s derivative instruments for the three months ended March 31, 2016 and 2015. These commodity derivative settlements and unrealized gains and losses are recorded and included in commodity derivative income or loss in the accompanying Consolidated Statements of Operations.

Commodity derivative settlement gains and losses are included in cash flows from operating activities in the Company’s Consolidated Statements of Cash Flows.

The counterparty in all of the Company’s derivative instruments is the lender in the Company’s bank credit facility. Accordingly, the Company is not required to post collateral since the bank is secured by the Company’s oil and gas assets. The Company nets its derivative instrument fair value amounts executed with its counterparty pursuant to an ISDA master agreement, which provides for the net settlement over the term of the contract and in the event of default or termination of the contract. The following table summarizes the location and fair value amounts of all derivative instruments in the Consolidated Balance Sheet as of March 31, 2016, as well as the gross recognized derivative assets, liabilities and amounts offset in the Consolidated Balance Sheet:

Due to the volatility of oil and natural gas prices, the estimated fair values of the Company’s derivatives are subject to large fluctuations from period to period.

Note 12 – Commitments

The Company has entered into long-term firm transportation contracts to ensure the transport for certain of its natural gas production to purchasers. Firm transportation volumes and the related demand charges for the remaining term of these contracts at March 31, 2016 are summarized in the table below.

A liability of approximately $741,000 related to firm transportation contracts assumed in a 2011 asset acquisition, which represents the remaining commitment, is reflected on the Company’s Consolidated Balance Sheet as of March 31, 2016. The fair value of these firm transportation obligations were determined based upon the contractual obligations assumed by the Company and discounted based upon the Company’s effective borrowing rate. These contractual obligations are being amortized on a monthly basis as the Company pays these firm transportation obligations in the future.