Notes to Consolidated Financial Statements

(Unaudited)

Note 1 – Organization

Carbon Energy Corporation (formerly known as Carbon Natural Gas Company) and its subsidiaries (referred to herein as “we”, “us”, the “Company” or “Carbon”) business is comprised of the assets and properties of us and our subsidiaries.

An illustrative organizational chart as of March 31, 2019, is below:

Appalachian and Illinois Basin Operations

In the Appalachian and Illinois Basins, operations are conducted by Nytis Exploration Company, LLC (“ Nytis LLC ”). The following organizational chart illustrates this relationship as of March 31, 2019.

In December 2018, we completed the acquisition of all of the Class A Units of Carbon Appalachian Company, LLC, a Delaware limited liability company (“ Carbon Appalachia ”), owned by Old Ironside Fund II-A Portfolio Holding Company, LLC, a Delaware limited liability company (“ OIE II-A ”), and Old Ironside Fund II-B Portfolio Holding Company, LLC, a Delaware limited liability company (“ OIE II-B ”), collectively (“ Old Ironsides ”) for a purchase price of $58.1 million subject to customary and standard purchase price adjustments (“ OIE Membership Acquisition ”). As a result of the OIE Membership Acquisition, we now hold all of the issued and outstanding ownership interests of Carbon Appalachia, along with its direct and indirect subsidiaries (Carbon Appalachia Group, LLC, Carbon Tennessee Mining Company, LLC, Carbon Appalachia Enterprises, LLC, Carbon West Virginia Company, LLC, Cranberry Pipeline Corporation, Knox Energy, LLC, Coalfield Pipeline Company and Appalachia Gas Services Company, LLC).

Ventura Basin Operations

In California, Carbon California Operating Company, LLC (“ CCOC ”) conducts operations on behalf of Carbon California Company, LLC’s (“ Carbon California ”) operations. On February 1, 2018, Yorktown Energy Partners XI, L.P. (“ Yorktown ”) exercised the California Warrant, resulting in our aggregate sharing percentage in Carbon California increasing from 17.81% to 56.40%. On May 1, 2018, Carbon California closed the Seneca Acquisition. Following the exercise of the California Warrant by Yorktown and the Seneca Acquisition, we own 53.92% of the voting and profits interests and Prudential Legacy Insurance Company of New Jersey and Prudential Insurance Company of America or its affiliates (collectively, “ Prudential ”) owns 46.08% of the voting and profits interest in Carbon California. As of February 1, 2018, we consolidate Carbon California for financial reporting purposes. The following organizational chart illustrates this relationship as of March 31, 2019.

Collectively, references to “us” include Carbon California, CCOC, Nytis Exploration (USA) Inc. (“ Nytis USA ”), Nytis LLC, and Carbon Appalachia.

Note 2 – Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements 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 the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments considered necessary to present fairly our financial position as of March 31, 2019, and our results of operations and cash flows for the three months ended March 31, 2019 and 2018. Operating results for the three months ended March 31, 2019 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, seasonality, and other factors. The unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q should be read in conjunction with our consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2018. Except as disclosed herein, there have been no material changes to the information disclosed in the notes to the consolidated financial statements included in our 2018 Annual Report on Form 10-K.

Principles of Consolidation

The unaudited condensed consolidated financial statements include the accounts of our consolidated subsidiaries. Upon the closing of the OIE Membership Acquisition on December 31, 2018, we own 100% of Carbon Appalachia. In addition, we own 100% of Nytis USA, which owns approximately 98.1% of Nytis LLC. Nytis LLC holds interests in various oil and gas partnerships.

Partnerships and subsidiaries in which we have a controlling interest are consolidated. We are currently consolidating 46 partnerships, Carbon Appalachia, and Carbon California, and we reflect the non-controlling ownership interest in partnerships and subsidiaries as non-controlling interests on our unaudited consolidated statements of operations and also reflect the non-controlling ownership interest in the net assets of the partnerships as non-controlling interests within stockholders’ equity on our unaudited consolidated balance sheets. All significant intercompany accounts and transactions have been eliminated.

In accordance with established practice in the oil and gas industry, our unaudited condensed consolidated financial statements also include our pro-rata share of assets, liabilities, income, lease operating costs and general and administrative expenses of the oil and gas partnerships in which we have 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 we have the ability to significantly influence the operating decisions of the investee. When we do 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 unaudited condensed consolidated financial statements.

Reclassifications

Certain prior period balances in the consolidated balance sheets and statements of operations have been reclassified to conform to the current year presentation.  Specifically, a portion of credit facilities and notes payable balances as of December 31, 2018 were reclassified from non-current liabilities to current liabilities.  This reclassification had no impact on net income, cash flows or shareholders’ equity previously reported.

Insurance Receivable

Insurance receivable is comprised of insurance claims for the loss of property as a result of wildfires that impacted Carbon California in December 2017. The Company filed claims with its insurance provider. In January 2019, we reached a settlement agreement and received an $800,000 payment from our insurance provider related to the damage caused by the California wildfires. As of March 31, 2019, we are in receipt of all funds associated with the claims.  

Accounting for Oil and Gas Operations

We use 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 if proved reserves can be assigned to such properties. We assess our 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.

We perform 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.

For the three months ended March 31, 2019 and 2018, we did not recognize a ceiling test impairment as our full cost pool did not exceed the ceiling limitations. Future declines in oil and natural gas prices could result in impairments of our oil and gas properties in future periods. The effect of price declines will impact the ceiling test value until such time commodity prices stabilize or improve. Impairments are a non-cash charge and accordingly would not affect cash flows but would adversely affect our results of operations and members’ equity.

We capitalize the portion of general and administrative costs that is attributable to our acquisition, exploration and development activities.

Revenue

We recognize revenues for sales and services when persuasive evidence of an arrangement exists, when custody is transferred, or services are rendered, fees are fixed or determinable and collectability is reasonably assured.

Oil, Natural Gas and Natural Gas Liquid Sales

Oil, natural gas and natural gas liquid sales are recognized when production volumes are sold to a purchaser at a fixed or determinable price, delivery has occurred, title has transferred, and collectability is reasonably assured. Revenues are recognized based on our net revenue interest.

Marketing Gas Sales

We sell production purchased from third parties as well as production from our own oil and gas producing properties. Marketing gas sales are recognized on a gross basis as we purchase and take control of the gas prior to sale and are the principal in the transaction.

Storage

Under fee-based arrangements, we receive a fee for storing natural gas. The revenues earned are directly related to the volume of natural gas that flows through our systems and are not directly dependent on commodity prices.

Transportation, gathering, and compression

We generally purchase natural gas from producers at the wellhead or other receipt points, gather the wellhead natural gas through our gathering systems, and then sell the natural gas based on published index market prices. We remit to the producers either an agreed-upon percentage of the actual proceeds that we receive from our sales of natural gas or an agreed-upon percentage of the proceeds based on index related prices for the natural gas, regardless of the actual amount of the sales proceeds we receive. Our revenues under percent-of-proceeds/index arrangements generally correlate to the price of natural gas.

Investments in Affiliates

Investments in non-consolidated affiliates are accounted for under either the cost or equity method of accounting, as appropriate. The cost method of accounting is generally used for investments in affiliates in which we have less than 20% of the voting interests of a corporate affiliate (or less than a 3% to 5% interest of a partnership or limited liability company) and do 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 we hold between 20% and 50% of the voting interest in non-consolidated corporate affiliates or generally greater than a 3% to 5% interest of a partnership or limited liability company and can exert significant influence or control (e.g., through our influence with a seat on the board of directors or management of operations), the equity method of accounting is generally used to account for the investment. Equity method investments will increase or decrease by our share of the affiliate’s profits or losses and such profits or losses are recognized in our unaudited consolidated statements of operations. We review equity method investments for impairment whenever events or changes in circumstances indicate that an other than temporary decline in value has occurred. Upon the exercise of the California Warrant on February 1, 2018 and the closing of the OIE Membership Acquisition on December 31, 2018, we consolidate Carbon California and Carbon Appalachia for financial reporting purposes and no longer account for these investments under the equity method.

Related Party Transactions

Management Reimbursements

In our role as manager of Carbon California and Carbon Appalachia we receive reimbursements for management services. Prior to consolidation of Carbon California and Carbon Appalachia effective February 1, 2018 and December 31, 2018, respectively, these management service reimbursements were included in general and administrative – related party reimbursement on our unaudited consolidated statements of operations. As we now consolidate both Carbon California and Carbon Appalachia, these reimbursements are eliminated upon consolidation.

We received approximately $753,000 and $50,000 for the three months ended March 31, 2018, and for the one month ended January 31, 2018, from Carbon Appalachia and Carbon California, respectively. These reimbursements are included in general and administrative – related party reimbursement on our unaudited consolidated statements of operations. Effective February 1, 2018, the management reimbursements received from Carbon California were eliminated at consolidation. This elimination included $100,000 for the period February 1, 2018, through March 31, 2018.

In addition to the management reimbursements, approximately $299,000 and $14,000 in general and administrative expenses were reimbursed for the three months ended March 31, 2018, and for the one month ended January 31, 2018, by Carbon Appalachia and Carbon California, respectively. The elimination of Carbon California in consolidation includes approximately $28,000 for the period February 1, 2018, through March 31, 2018.

Operating Reimbursements

In our role as operator of Carbon California and Carbon Appalachia, we receive reimbursements of operating expenses. Prior to consolidation of Carbon California and Carbon Appalachia effective February 1, 2018 and December 31, 2018, respectively, these operating reimbursements were included in operating expenses on our unaudited consolidated statements of operations. As we now consolidate both Carbon California and Carbon Appalachia, any intercompany receivable and payable balances associated with these reimbursements are eliminated upon consolidation.

Carbon California Credit Facilities

The credit facilities of Carbon California, including the Senior Revolving Notes, Carbon California Notes and Carbon California 2018 Subordinated Notes (all defined below), are held by Prudential (see Note 7).

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and expenses and disclosure of contingent assets and liabilities. Significant items subject to such estimates and assumptions include the carrying value of oil and gas properties, estimates of proved oil and gas reserve volumes and the related depletion and present value of estimated future net cash flows and the ceiling test applied to capitalized oil and gas properties, determining the amounts recorded for fair value of commodity derivative instruments, fair value of assets acquired and liabilities assumed qualifying as business combinations or asset acquisitions, estimated lives of other property and equipment, asset retirement obligations, fair value of Class B issuances and accrued liabilities and revenues. There have been no changes in our critical accounting estimates from those that were disclosed in the 2018 Annual Report on Form 10-K. Actual results could differ from these estimates.

Earnings (Loss) Per Common Share

Basic earnings per common share is computed by dividing the net income or loss attributable to common stockholders for the period by the weighted average number of common shares outstanding during the period. The shares of restricted common stock granted to our officers, directors and employees are included in the computation of basic net income 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 us 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).

In periods when we report a net loss, all shares of restricted stock are excluded from the calculation of diluted weighted average shares outstanding because of its anti-dilutive effect on loss per share. As a result, approximately 269,000 potentially dilutive restricted stock awards are excluded from the calculation of diluted earnings per common share for the three months ended March 31, 2019. In addition, approximately 200,000 restricted performance units subject to future contingencies were excluded in the basic and diluted income per share calculations.

For the three months ended March 31, 2018, we had net income and the diluted income per common share calculation includes the dilutive effects of approximately 230,000 non-vested shares of restricted stock. In addition, approximately 254   ,000 restricted performance units subject to future contingencies were excluded in the basic and diluted income per share calculations.

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

Recently Adopted Accounting Pronouncement

In February 2016, the FASB issued Accounting Standards Update (“ ASU ”) 2016-02, Leases  (Topic 842), which establishes a comprehensive new lease standard designed to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The FASB subsequently issued various ASUs which provided additional implementation guidance, and these ASUs collectively make up FASB Accounting Standards Codification (“ ASC ”) Topic 842 –  Leases  (“ ASC 842 ”). ASC 842 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The standard permits retrospective application through recognition of a cumulative-effect adjustment at the beginning of either the earliest reporting period presented or the period of adoption. The Company adopted ASC 842 effective January 1, 2019 using the modified retrospective method as of the adoption date. Adoption of the standard resulted in the recognition of additional lease assets and liabilities on our unaudited consolidated balance sheet as well as additional disclosures. The adoption did not have a material impact to our unaudited consolidated statement of operations. Refer to Note 14 for further information on our implementation of this standard.

Recently Issued Accounting Pronouncements

There were various updates recently issued by the FASB, most of which represented technical corrections to the accounting literature or application to specific industries and are not expected to a have a material impact on our reported financial position, results of operations, or cash flows.

Note 3 – Acquisitions and Divestitures

Majority Control of Carbon Appalachia

On December 16, 2016, Carbon Appalachia was formed by us, entities managed by Yorktown and entities managed by Old Ironsides to acquire producing assets in the Appalachian Basin in Kentucky, Tennessee, Virginia and West Virginia. Carbon Appalachia began substantial operations on April 3, 2017 and is engaged primarily in acquiring, developing, exploiting, producing, processing, marketing, and transporting oil and natural gas in the Appalachian Basin.

On April 3, 2017, Carbon, Yorktown and Old Ironsides entered in to a limited liability company agreement (the “ Carbon Appalachia LLC Agreement ”), with an initial equity commitment of $100.0 million, of which $37.0 million had been contributed as of December 31, 2018. Carbon Appalachia (i) issued Class A Units to us, Yorktown and Old Ironsides for an aggregate cash consideration of $12.0 million, (ii) issued Class B Units to us, and (iii) issued Class C Units to us. Additionally, Carbon Appalachia Enterprises, LLC, formerly known as Carbon Tennessee Company, LLC (“ Carbon Appalachia Enterprises ”), a subsidiary of Carbon Appalachian Company, LLC, entered into a 4-year $100.0 million senior secured asset-based revolving credit facility with LegacyTexas Bank (the “Revolver” ) with an initial borrowing base of $10.0 million.

In connection with Carbon entering into the Carbon Appalachia LLC Agreement, and Carbon Appalachia engaging in the transactions described above, Carbon received 1,000 Class B Units and issued to Yorktown a warrant to purchase approximately 408,000 shares of our common stock at an exercise price dictated by the warrant agreement (the “Appalachia Warrant” ). The Appalachia Warrant was payable exclusively with Class A Units of Carbon Appalachia held by Yorktown. On November 1, 2017, Yorktown exercised the Appalachia Warrant, resulting in us acquiring 2,940 Class A Units from Yorktown. 

On August 15, 2017, the Carbon Appalachia LLC Agreement was amended and, as a result, we agreed to contribute an initial commitment of future capital contributions as well as Yorktown’s, and Yorktown will not participate in future capital contributions. Carbon Appalachia issued Class A Units to us and Old Ironsides for an aggregate cash consideration of $14.0 million. The borrowing base of the Revolver increased to $22.0 million and Carbon Appalachia Enterprises borrowed $8.0 million under the Revolver.

On September 29, 2017, Carbon Appalachia issued Class A Units to us and Old Ironsides for an aggregate cash consideration of $11.0 million.

Prior to the closing of the OIE Membership Acquisition, Old Ironsides held 27,195 Class A Units, which equated to a 72.76% aggregate share ownership of Carbon Appalachia and we held (i) 9,805 Class A Units, (ii) 1,000 Class B Units and (iii) 121 Class C Units, which equated to a 27.24% aggregate share ownership of Carbon Appalachia.

On December 31, 2018, we acquired all of Old Ironsides’ Class A Units of Carbon Appalachia for approximately $58.1 million, subject to customary and standard closing adjustments. We paid $33.0 million in cash and delivered promissory notes in the aggregate original principal amount of approximately $25.1 million to Old Ironsides (the “Old Ironsides Notes” ). The Old Ironsides Notes bear interest at 10% per annum and have a term of five years, the first three of which require interest-only payments at the end of each calendar quarter beginning with the quarter ending March 31, 2019. At the end of the three-year interest-only period, the then current outstanding principal balance and interest is to be paid in 24 equal monthly payments. The Old Ironsides Notes also provide for mandatory prepayments upon the occurrence of certain subsequent liquidity events. A mandatory, one-time principal reduction payment in the aggregate amount of $2.0 million was made to Old Ironsides on February 1, 2019.

The OIE Membership Acquisition is accounted for as a business combination in accordance with ASC 805,  Business Combinations  (“ ASC 805 ”). We recognized 100% of the identifiable assets acquired and liabilities assumed at their respective fair value as of the date of the acquisition. The $58.1 million purchase price, consisting of $33.0 million in cash and $25.1 million of Old Ironsides Notes, was paid for Old Ironsides’ outstanding interest, representing approximately 72.76% interest in Carbon Appalachia.

The Company, utilizing the assistance of third-party valuation specialists, considered various factors in its estimate of fair value of the acquired assets and liabilities including (i) reserves, (ii) production rates, (iii) future operating and development costs, (iv) future commodity prices, including price differentials, (v) future cash flows, (vi) a market participant-based weighted average cost of capital, and (vii) real estate market conditions.

We followed the fair value method to allocate the consideration transferred to the identifiable net assets acquired on a preliminary basis as follows:

Assets acquired and liabilities assumed are as follows:

The preliminary fair value of the assets acquired and liabilities assumed were determined using various valuation techniques, including an income approach.

On the date of the acquisition, we derecognized our equity investment in Carbon Appalachia and recognized a gain of approximately $1.3 million based on the fair value of our previously held interest compared to its carrying value.

For assets and liabilities accounted for as business combinations, including the OIE Membership Acquisition, to determine the fair value of the assets acquired, the Company primarily used the income approach and made market assumptions as to projections of estimated quantities of oil and natural gas reserves, future production rates, future commodity prices including price differentials as of the date of closing, future operating and development costs, a market participant weighted average cost of capital, and the condition of vehicles and equipment. The Company used the income approach and made market assumptions as to projections of utilization, future operating costs and a market participant weighted average costs of capital to determine the fair value of the firm transportation obligations as well as the plant facilities. The determination of the fair value of accounts payable and accrued liabilities assumed required significant judgement, including estimates relating to production assets.

Consolidation of Carbon California Unaudited Pro Forma Results of Operations

On February 1, 2018, Yorktown exercised the California Warrant resulting in the issuance of 1,527,778 shares of our common stock in exchange for Yorktown’s Class A Units of Carbon California representing approximately 46.96% of the outstanding Class A Units of Carbon California (a profits interest of approximately 38.59%). After giving effect to the exercise on February 1, 2018, we owned 56.4% of the voting and profits interests of Carbon California.

Below are unaudited pro forma consolidated results of operations for the three months ended March 31, 2019 and 2018 as though the Carbon California Acquisition had been completed as of January 1, 2018. The Carbon California Acquisition closed February 1, 2018, and accordingly, the Company’s unaudited consolidated statements of operations for the quarter ended March 31, 2018, includes the results of operations for the period February 1, 2018, through March 31, 2018.

As of March 31, 2019, and December 31, 2018, the Company had approximately $5.4 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 if 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, 2019 and 2018, there were no expiring leasehold costs that were reclassified into proved property. The excluded properties are assessed for impairment at least annually. Subject to industry conditions, evaluations of most of these properties and the inclusion of their costs in amortized capital costs is expected to be completed within five years.

We capitalized overhead applicable to acquisition, development and exploration activities of approximately $68,000 and $71,000 for the three months ended March 31, 2019 and 2018, respectively.

Depletion expense related to oil and gas properties for the three months ended March 31, 2019 and 2018 was approximately $3.5 million, or $0.54 per Mcfe, and $1.3 million, or $0.82 per Mcfe, respectively.

Note 5 – Asset Retirement Obligation

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.

The following table is a reconciliation of the ARO for the three months ended March 31, 2019 and 2018:

Note 6 – Investments in Affiliates

Carbon Appalachia

For the period April 3, 2017 (inception) through December 31, 2018, based on our 27.24% combined Class A, Class B and Class C interest (and our ability as of December 31, 2018 to earn up to an additional 14.7%) in Carbon Appalachia, our ability to appoint a member to the board of directors and our role of manager of Carbon Appalachia, we accounted for our investment in Carbon Appalachia under the equity method of accounting as we believed we exerted significant influence. We used the HLBV to determine our share of profits or losses in Carbon Appalachia and adjusted the carrying value of our investment accordingly. Our investment in Carbon Appalachia is represented by our Class A and C interests, which we acquired by contributing approximately $6.9 million in cash and unevaluated property. In the event of liquidation of Carbon Appalachia, available proceeds are first distributed to members holding Class C Units then to holders of Class A Units until their contributed capital is recovered with an internal rate of return of 10%. Any additional distributions would then be shared between holders of Class A, Class B and Class C Units.

On December 31, 2018, we acquired all of Old Ironsides’ Class A Units of Carbon Appalachia for approximately $58.1 million, subject to customary and standard closing adjustments. We paid $ 33.0 million in cash and issued the Old Ironsides Notes in the aggregate original principal amount of approximately $25.1 million to Old Ironsides.

Effective December 31, 2018, upon the closing of the OlE Membership Acquisition, we consolidate Carbon Appalachia in our consolidated financial statements.

Carbon California

For the period February 15, 2017 (inception) through January 31, 2018, based on our 17.81% interest in Carbon California, our ability to appoint a member to the board of directors and our role of manager of Carbon California, we accounted for our investment in Carbon California under the equity method of accounting as we believed we exerted significant influence. We used the Hypothetical Liquidation at Book Value Method (“ HLBV ”) to determine our share of profits or losses in Carbon California and adjusted the carrying value of our investment accordingly. The HLBV is a balance-sheet approach that calculates the amount each member of Carbon California would have received if Carbon California were liquidated at book value at the end of each measurement period. The change in the allocated amount to each member during the period represents the income or loss allocated to that member. In the event of liquidation of Carbon California, to the extent that Carbon California has net income, available proceeds are first distributed to members holding Class B Units and any remaining proceeds are then distributed to members holding Class A Units.

Effective February 1, 2018, upon the exercise of the California Warrant, we consolidate Carbon California in our consolidated financial statements.

Other Affiliates

At March 31, 2019 and December 31, 2018, we retained interests in two equity method investments associated with the development and transportation of oil and gas.

The current portion of the outstanding credit facilities and notes payable was approximately $9.9 million as of March 31, 2019 and $11.9 million as of December 31, 2018.

2018 Credit Facility

In connection with and concurrently with the closing of the OIE Membership Acquisition, the Company and its subsidiaries amended and restated our prior credit facilities for a new $500.0 million senior secured asset-based revolving credit facility maturing December 31, 2022 and a $15.0 million term loan which matures in 2020 (the “2018 Credit Facility” ). The 2018 Credit Facility includes a sublimit of $1.5 million for letters of credit. The borrowers under the 2018 Credit Facility are Carbon Appalachia Enterprises, LLC ( “CAE” ) and various other subsidiaries of the Company (including Nytis USA, together with CAE, the “Borrowers” ). Under the 2018 Credit Facility, Carbon Energy Corporation is neither a borrower nor a guarantor. The initial borrowing base under the 2018 Credit Facility was $75.0 million, and remained so as of March 31, 2019.

The 2018 Credit Facility is guaranteed by each existing and future direct or indirect subsidiary of the Borrowers and certain other subsidiaries of the Company (subject to various exceptions) and the obligations under the 2018 Credit Facility are secured by essentially all tangible, intangible and real property (subject to certain exclusions).

Interest accrues on borrowings under the 2018 Credit Facility at a rate per annum equal to either (i) the base rate plus an applicable margin equal to 0.25% - 0.75% depending on the utilization percentage or (ii) the Adjusted LIBOR rate plus an applicable margin equal to 2.75% - 3.75% depending on the utilization percentage, at the Borrowers’ option. The Borrowers are obligated to pay certain fees and expenses in connection the 2018 Credit Facility, including a commitment fee for any unused amounts of 0.50% and an origination fee of 0.50%. Loans under the 2018 Credit Facility may be prepaid without premium or penalty.

The 2018 Credit Facility also provides for a $15.0 million term loan which bears interest at a rate of 6.25% and is payable in 18 equal monthly installments beginning February 1, 2019 with the last payment due on June 30, 2020.

The 2018 Credit Facility contains certain affirmative and negative covenants that, among other things, limit the Company’s ability to (i) incur additional debt; (ii) incur additional liens; (iii) sell, transfer or dispose of assets; (iv) merge or consolidate, wind-up, dissolve or liquidate; (v) make dividends and distribution on, or repurchase of, equity; (vi) make certain investments; (vii) enter into certain transactions with their affiliates; (viii) enter in sale-leaseback transactions; (ix) make optional or voluntary payment of debt other than obligations under the 2018 Credit Facility; (x) change the nature of their business; (xi) change their fiscal year or make changes to the accounting treatment or reporting practices; (xii) amend their constituent documents; and (xiii) enter into certain hedging transactions.

The affirmative and negative covenants are subject to various exceptions, including certain basket amounts and acceptable transaction levels. In addition, the 2018 Credit Facility requires the Borrowers’ compliance, on a consolidated basis, with a maximum Net Debt (all debt of the Borrowing Parties minus all unencumbered cash and cash equivalents of the Borrowers not to exceed $3.0 million) / EBITDAX (as defined) ratio of 3.50 to 1.00 and a current ratio, as defined, minimum of 1.00 to 1.00, tested quarterly, commencing with the quarter ending March 31, 2019. We are in compliance with our financial covenants as of March 31, 2019 and expect to be in compliance with these covenants throughout the next twelve month period. We are currently engaged in discussions with LegacyTexas Bank to decrease the required hedging period of our expected future production from 30 months to 24 months.

As of March 31, 2019, there was approximately $70.2 million in outstanding borrowings and $4.8 million of additional borrowing capacity under the 2018 Credit Facility.

The terms of the 2018 Credit Facility require us to enter into derivative contracts at fixed pricing for a certain percentage of our production. We are party to an ISDA Master Agreement with BP Energy Company that establishes standard terms for the derivative contracts and an inter-creditor agreement with LegacyTexas Bank and BP Energy Company whereby any credit exposure related to the derivative contracts entered into by us and BP Energy Company is secured by the collateral and backed by the guarantees supporting the 2018 Credit Facility.

Fees paid in connection with the 2018 Credit Facility totaled $779,000, of which $134,000 was associated with the term loan. The current portion of unamortized fees is included in prepaid expense, deposits and other current assets and the non-current portion is included in other non-current assets. The unamortized portion associated with the term loan was $112,000 as of March 31, 2019, and is directly offset against the loan in non-current liabilities. As of March 31, 2019, we had unamortized deferred issuance costs of $604,000 associated with the 2018 Credit Facility. During the three months ended March 31, 2019, we amortized approximately $63,000 as interest expense associated with the 2018 Credit Facility.

Old Ironsides Notes

On December 31, 2018, as part of the OIE Membership Acquisition, we delivered unsecured, promissory notes in the aggregate original principal amount of approximately $25.1 million to Old Ironsides (the “ Old Ironsides Notes ”). The Old Ironsides Notes bear interest at 10% per annum and have a term of five years, the first three of which require interest-only payments at the end of each calendar quarter beginning with the quarter ending March 31, 2019. At the end of the three-year interest-only period, the then current outstanding principal balance and interest is to be paid in 24 equal monthly payments. The Old Ironsides Notes also require mandatory prepayments upon the occurrence of certain subsequent liquidity events. A mandatory, one-time principal reduction payment in the aggregate amount of $2.0 million was made to Old Ironsides on February 1, 2019. Subsequent to the closing of the OIE Membership Acquisition Old Ironsides ceased to be a related party.

The interest payable under the Old Ironsides Notes can be paid-in-kind at the election of the Company. This provision allows the Company to increase the principal balance associated with the Old Ironsides Notes. This election creates a second tranche of principal, which bears interest at 12% per annum. On March 31, 2019, the Company elected to pay-in-kind approximately $594,000.

Senior Revolving Notes, Related Party

On February 15, 2017, Carbon California entered into a Note Purchase Agreement (the “ Note Purchase Agreement ” ) for the issuance and sale of Senior Secured Revolving Notes to Prudential with an initial revolving borrowing capacity of $25.0 million which mature on February 15, 2022 (the “ Senior Revolving Notes ”). Carbon Energy Corporation is not a guarantor of the Senior Revolving Notes. The closing of the Note Purchase Agreement on February 15, 2017 resulted in the sale and issuance by Carbon California of Senior Revolving Notes in the principal amount of $10.0 million. The maximum principal amount available under the Senior Revolving Notes is based upon the borrowing base attributable to Carbon California’s proved oil and gas reserves which is to be determined at least semi-annually. As of March 31, 2019, the borrowing base was $41.0 million, of which $38.5 million was outstanding.

Carbon California may elect to incur interest at either (i) 5.50% plus the London interbank offered rate (“ LIBOR ”) or (ii) 4.50% plus the Prime Rate (which is defined as the interest rate published daily by JPMorgan Chase Bank, N.A.). As of March 31, 2019, the effective borrowing rate for the Senior Revolving Notes was 7.80%. In addition, the Senior Revolving Notes include a commitment fee for any unused amounts at 0.50% as well as an annual administrative fee of $75,000, payable on February 15 each year.

The Senior Revolving Notes are secured by all the assets of Carbon California. The Senior Revolving Notes require Carbon California, as of January 1 and July 1 of each year, to hedge its anticipated proved developed production at such time for year one, two and three at a rate of 75%, 65% and 50%, respectively. Carbon California may make principal payments in minimum installments of $500,000. Distributions to equity members are generally restricted.

Carbon California incurred fees directly associated with the issuance of the Senior Revolving Notes and amortizes these fees over the life of the Senior Revolving Notes. The current portion of these fees are included in prepaid expense and deposits and the long-term portion is included in other non-current assets for a combined value of approximately $939,000. For the three months ended March 31, 2019, Carbon California amortized fees of $74,000.

Carbon California may at any time repay the Senior Revolving Notes, in whole or in part, without penalty. Carbon California must pay down Senior Revolving Notes or provide mortgages of additional oil and natural gas properties to the extent that outstanding loans and letters of credit exceed the borrowing base.  

Subordinated Notes, Related Party

On February 15, 2017, Carbon California entered into a Securities Purchase Agreement (the “ Securities Purchase Agreement ”) with Prudential Capital Energy Partners, L.P. for the issuance and sale of Subordinated Notes due February 15, 2024, bearing interest of 12% per annum (the “ Subordinated Notes ”). Carbon Energy Corporation is not a guarantor of the Subordinated Notes. The closing of the Securities Purchase Agreement on February 15, 2017 resulted in the sale and issuance by Carbon California of Subordinated Notes in the original principal amount of $10.0 million, all of which remains outstanding as of March 31, 2019.

Prudential received an additional 1,425 Class A Units, representing 5% of total sharing percentage, for the issuance of the Subordinated Notes. Carbon California valued this unit issuance based on the relative fair value by valuing the units at $1,000 per unit and aggregating the amount with the outstanding Subordinated Notes of $10.0 million. The Company then allocated the non-cash value of the units of approximately $1.3 million, which was recorded as a discount to the Subordinated Notes. As of March 31, 2019, Carbon California has an outstanding discount of approximately $869,000, which is presented net of the Subordinated Notes within Credit facility-related party on the unaudited consolidated balance sheets. During the three months ended March 31, 2019, Carbon California amortized $45,000 associated with the Subordinated Notes.

The Subordinated Notes require Carbon California, as of January 1 and July 1 of each year, to hedge its anticipated production at such time for year one, two and three at a rate of 67.5%, 58.5% and 45%, respectively.

Prepayment of the Subordinated Notes is allowed at 100%, subject to a 3.0% fee of outstanding principal. Prepayment is not subject to a prepayment fee after February 17, 2020. Distributions to equity members are generally restricted.

2018 Subordinated Notes, Related Party

On May 1, 2018, Carbon California entered into an agreement with Prudential for the issuance and sale of $3.0 million in Subordinated Notes due February 15, 2024, bearing interest of 12% per annum (the “ 2018 Subordinated Notes ”), of which $3.0 million remains outstanding as of March 31, 2019.

Prudential received 585 Class A Units, representing an approximate 2% additional sharing percentage, for the issuance of the Carbon California 2018 Subordinated Notes. Carbon California valued this unit issuance based on the relative fair value by valuing the units at $1,000 per unit and aggregating the amount with the outstanding 2018 Subordinated Notes of $3.0 million. The Company then allocated the non-cash value of the units of approximately $490,000, which was recorded as a discount to the 2018 Subordinated Notes. As of March 31, 2019, Carbon California had an outstanding discount of $412,000 associated with these notes, which is presented net of the 2018 Subordinated Notes within Credit facility - related party on the unaudited consolidated balance sheets. During the three months ended March 31, 2019, Carbon California amortized $21,000 associated with the 2018 Subordinated Notes.

The 2018 Subordinated Notes require Carbon California, as of January 1 and July 1 of each year, to hedge its anticipated production at such time for year one, two and three at a rate of 67.5%, 58.5% and 45%, respectively.

Prepayment of the 2018 Subordinated Notes is allowed at 100%, subject to a 3.0% fee of outstanding principal. Prepayment is not subject to a prepayment fee after February 17, 2020. Distributions to equity members are generally restricted.

Restrictions and Covenants

The Senior Revolving Notes, Subordinated Notes and 2018 Subordinated Notes contain affirmative and negative covenants that, among other things, limit Carbon California’s ability to (i) incur additional debt; (ii) incur additional liens; (iii) sell, transfer or dispose of assets; (iv) merge or consolidate, wind-up, dissolve or liquidate; (v) make dividends and distributions on, or repurchases of, equity; (vi) make certain investments; (vii) enter into certain transactions with our affiliates; (viii) enter into sales-leaseback transactions; (ix) make optional or voluntary payments of debt; (x) change the nature of our business; (xi) change our fiscal year to make changes to the accounting treatment or reporting practices; (xii) amend constituent documents; and (xiii) enter into certain hedging transactions.

The affirmative and negative covenants are subject to various exceptions, including basket amounts and acceptable transaction levels. In addition, (i) the Senior Revolving Notes require Carbon California’s compliance, on a consolidated basis, with (A) a maximum Debt/EBITDA ratio of 4.0 to 1.0, stepping down to 3.5 to 1.0 starting with the quarter ending June 30, 2018, (B) a maximum Senior Revolving Notes/EBITDA ratio of 2.5 to 1.0, (C) a minimum interest coverage ratio of 3.0 to 1.0 and (D) a minimum current ratio of 1.0 to 1.0 and (ii) the Subordinated Notes require Carbon California’s compliance, on a consolidated basis, with (A) a maximum Debt/EBITDA ratio of 4.5 to 1.0, stepping down to 4.0 to 1.0 starting with the quarter ending June 30, 2018, (B) a maximum Senior Revolving Notes/EBITDA ratio of 3.0 to 1.0, (C) a minimum interest coverage ratio of 2.5 to 1.0, (D) an asset coverage test whereby indebtedness may not exceed the product of 0.65 times Adjusted PV-10 set forth in the most recent reserve report, (E) maintenance of a minimum borrowing base of $10,000,000 under the Senior Revolving Notes and (F) a minimum current ratio of 0.85 to 1.00.

Note 8 – Income Taxes

We recognize 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. We have 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, 2019 the Company has established a full valuation allowance against the balance of net deferred tax assets.

Note 9 – Stockholders’ Equity

Authorized and Issued Capital Stock

Effective March 15, 2017 and pursuant to a reverse stock split approved by the shareholders and Board of Directors, each 20 shares of issued and outstanding common stock became one share of common stock and no fractional shares were issued. References to the number of shares and price per share give retroactive effect to the reverse stock split for all periods presented. On June 1, 2018, we amended our charter to increase the number of authorized shares of our common stock from 10.0 million to 35.0 million.

As of March 31, 2019, we had 35.0 million shares of common stock authorized with a par value of $0.01 per share, of which approximately 7.8 million were issued and outstanding, and 1.0 million shares of preferred stock authorized with a par value of $0.01 per share. During the first three months of 2019, the increase in the Company’s issued and outstanding common stock was a result of restricted stock and performance units that vested during the period.

Carbon Stock Incentive Plans

We have two stock plans, the Carbon 2011 Stock Incentive Plan and the Carbon 2015 Stock Incentive Plan (collectively the “ Carbon Plans ”). The Carbon Plans were approved by our shareholders and in the aggregate provide for the issuance of approximately 1.1 million shares of common stock to our officers, directors, employees or consultants eligible to receive the awards under the Carbon Plans.

The Carbon Plans provide for the granting of incentive stock options, non-qualified stock options, restricted stock awards, performance awards and phantom stock awards, or a combination of the foregoing, to employees, officers, directors or consultants, provided that only employees may be granted incentive stock options and directors may only be granted restricted stock awards and phantom stock awards.

Restricted Stock

As of March 31, 2019, approximately 649,000 shares of restricted stock have been granted under the terms of the Carbon Plans. Restricted stock awards for employees vest ratably over a three-year service period or cliff vest at the end of a three-year service period. For non-employee directors, the awards vest upon the earlier of a change in control of us or the date their membership on the Board of Directors is terminated other than for cause. During the three months ended March 31, 2019, approximately 40,000 restricted stock units vested.

Compensation costs recognized for these restricted stock grants were approximately $179,000 for the three months ended March 31, 2019. For the three months ended March 31, 2018, we recognized compensation expense of approximately $158,000. As of March 31, 2019, there was approximately $1.2 million unrecognized compensation costs related to these restricted stock grants which we expect to be recognized over the next six years.

Restricted Performance Units

As of March 31, 2019, approximately 621,000 shares of performance units have been granted under the terms of the Carbon Plans. Performance units represent a contractual right to receive one share of our common stock subject to the terms and conditions of the agreements, including the achievement of certain performance measures relative to a defined peer group or the growth of certain performance measures over a defined period of time as well as, in some cases, continued service requirements.

We account for the performance units granted during 2015 through 2018 at their fair value determined at the date of grant, which were $8.00, $5.40, $7.20 and $9.80 per share, respectively. The final measurement of compensation cost will be based on the number of performance units that ultimately vest. At March 31, 2019, we estimated that none of the performance units granted in 2017 and 2018 would vest, and, accordingly, no compensation cost has been recorded for these performance units. We estimated that it was probable that the performance units granted in 2015 and 2016 would vest and therefore compensation costs of approximately $43,000 and $135,000 related to these performance units were recognized for the three months ended March 31, 2019 and 2018, respectively. As of March 31, 2019, compensation costs related to the performance units granted in 2015 and 2016 have been fully recognized. As of March 31, 2019, if change in control and other performance provisions pursuant to the terms and conditions of these award agreements are met in full, the estimated unrecognized compensation cost related to the performance units granted in 2012, 2017 and 2018 would be approximately $2.7 million.

Preferred Stock

Series B Convertible Preferred Stock - Related Party

In connection with the closing of the Seneca Acquisition, we raised $5.0 million through the issuance of 50,000 shares of Preferred Stock to Yorktown. The Preferred Stock converts into common stock at the election of the holder or will automatically convert into shares of our common stock upon completion of a qualifying equity financing event. The number of shares of common stock issuable upon conversion is dependent upon the price per share of common stock issued in connection with any such qualifying equity financing but has a floor conversion price equal to $8.00 per share. The conversion ratio at which the Preferred Stock will convert into common stock is equal to an amount per share of $100 plus all accrued but unpaid dividends payable in respect thereof divided by the greater of (i) $8.00 per share or (ii) the price that is 15% less than the lowest price per share of shares sold to the public in the next equity financing. Using the floor of $8.00 per share would yield 12.5 shares of common stock for every unit of Preferred Stock. The conversion price will be proportionately increased or decreased to reflect changes to the outstanding shares of common stock, such as the result of a combination, reclassification, subdivision, stock split, stock dividend or other similar transaction involving the common stock. Additionally, after the third anniversary of the issuance of the Preferred Stock, we have the option to redeem the shares for cash.

The Preferred Stock accrues cash dividends at a rate of six percent (6%) of the initial issue price of $100 per share per annum. The holders of the Preferred Stock are entitled to the same number of votes of common stock that such share of Preferred Stock would represent on an as converted basis. The holders of the Preferred Stock receive liquidation preference based on the initial issue price of $100 per share plus a preferred return over common stock holders and the holders of any junior ranking stock. As of March 31, 2019, the preferred return was approximately $299,000.

We apply the guidance in ASC 480 “ Distinguishing Liabilities from Equity ” when determining the classification and measurement of the Preferred Stock. The Preferred Stock does not feature any redemption rights within the holders’ control or conditional redemption features not within our control as of March 31, 2019. Accordingly, the Preferred Stock is presented as a component of consolidated stockholders’ equity.

We have evaluated the Preferred Stock in accordance with ASC 815, “ Derivatives and Hedging ”, including consideration of embedded derivatives requiring bifurcation. The issuance of the Preferred Stock could generate a beneficial conversion feature (“ BCF ”), which arises when a debt or equity security is issued with an embedded conversion option that is beneficial to the investor or in the money at inception because the conversion option has an effective strike price that is less than the market price of the underlying stock at the commitment date. Based on the conversion terms and the price at the commitment date, we determined that a BCF was required to be recorded related to the voluntary conversion option by the holder as of March 31, 2019. We recorded the BCF as a reduction of retained earnings and an increase to Additional Paid in Capital (“ APIC ”) of $1.1 million, which is based on the difference between the floor price of $8.00 and our stock price as of the commitment date multiplied by the number of shares to be issued. We are also required to evaluate a contingent BCF for the automatic conversion feature, but in accordance with ASC 470, “ Debt ”, we will not record the effect of the BCF until the contingency is resolved.

Note 10 – Revenue Recognition

Revenue from Contracts with Customers

The Company recognizes revenue in accordance with FASB ASC Topic 606 –  Revenue Recognition  (“ ASC 606 ”).  Revenue is recognized when it satisfies a performance obligation by transferring control over a product to a customer. Revenue is measured based on the consideration we expect to receive in exchange for those products. Revenues from contracts with customers are recorded on the unaudited consolidated statements of operations based on the type of product being sold.

Performance Obligations and Significant Judgments

We sell oil and natural gas products in the United States through a single reportable segment. We primarily sell products within two regions of the United States: Appalachian Basin and Ventura Basin. We enter into contracts that generally include one type of distinct product in variable quantities and priced based on a specific index related to the type of product. Most of our contract pricing provisions are tied to a market index, with certain adjustments based on, among other factors, whether a well delivers to a gathering or transmission line, quality of the oil or natural gas, and prevailing supply and demand conditions.

The oil and natural gas is typically sold in an unprocessed state to third party purchasers. We recognize revenue based on the net proceeds received from the purchaser when control of the oil or natural gas passes to the purchaser. For oil sales, control is typically transferred to the purchaser upon receipt at the wellhead or a contractually agreed upon delivery point. Under our natural gas contracts with purchasers, control transfers upon delivery at the wellhead or the inlet of the purchaser’s system. For our other natural gas contracts, control transfers upon delivery to the inlet or to a contractually agreed upon delivery point.

Transfer of control drives the presentation of transportation and gathering costs within the accompanying unaudited consolidated statements of operations. Transportation and gathering costs incurred prior to control transfer are recorded within the transportation and gathering expense line item on the accompanying unaudited consolidated statements of operations, while transportation and gathering costs incurred subsequent to control transfer are recognized as a reduction to the related revenue.

A portion of our product sales are short-term in nature. For those contracts, we use the practical expedient in ASC 606 exempting us from disclosure of the transaction price allocated to remaining performance obligations if the performance obligation is part of a contract that has an original expected duration of one year or less.

For our product sales that have a contract term greater than one year, we have utilized the practical expedient in ASC 606 which states we are not required to disclose the transaction price allocated to remaining performance obligations if the variable consideration is allocated entirely to an unsatisfied performance obligation. Under these sales contracts, each unit of product represents a separate performance obligation; therefore, future volumes are unsatisfied and disclosure of the transaction price allocated to remaining performance obligations is not required. We have no unsatisfied performance obligations at the end of each reporting period.

We do not believe that significant judgments are required with respect to the determination of the transaction price, including any variable consideration identified. There is a low level of uncertainty due to the precision of measurement and use of index-based pricing with predictable differentials. Additionally, any variable consideration identified is not constrained.

Disaggregation of Revenues

In the following tables, revenue for the three months ended March 31, 2019, is disaggregated by primary region within the United States and major product line. As noted above, we operate as one reportable segment.

For the three months ended March 31, 2019:

Contract Balances

Under our product sales contracts, we invoice customers once our performance obligations have been satisfied, at which point payment is unconditional. Accordingly, our product sales contracts do not typically give rise to contract assets or liabilities under ASC 606.

Prior Period Performance Obligations

We record revenue in the month production is delivered to the purchaser, but settlement statements may not be received until 30 to 90 days after the month of production. As such, we estimate the production delivered and the related pricing. Any differences between our initial estimates and actuals are recorded in the month payment is received from the customer. These differences have not historically been material. For the three months ended March 31, 2019, revenue recognized in the reporting period related to prior period performance obligations is immaterial.

The estimated revenue is recorded within Accounts receivable – Revenue on the unaudited consolidated balance sheets.

Note 12 – 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 us. Unobservable inputs are inputs that reflect our assumptions of what market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the reliability of the inputs as follows:

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

The following table presents our financial assets and liabilities that were accounted for at fair value on a recurring basis by level within the fair value hierarchy:

Commodity Derivative

As of March 31, 2019, our commodity derivative financial instruments are comprised of natural gas and oil swaps and costless collars. The fair values of these agreements are determined under an income valuation technique. The valuation model requires a variety of inputs, including contractual terms, published forward prices, volatilities for options and discount rates, as appropriate. Our estimates of fair value of derivatives include consideration of the counterparty’s credit worthiness, our credit worthiness and the time value of money. The consideration of these factors results in an estimated exit-price for each derivative asset or liability under a market place participant’s view. All the significant inputs are observable, either directly or indirectly; therefore, our derivative instruments are included within the Level 2 fair value hierarchy. The counterparty for all our outstanding commodity derivative financial instruments as of March 31, 2019, is BP Energy Company.

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

The fair value of each of the following assets and 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 fair value of the non-controlling interest in the partnerships we are required to consolidate was determined based on the net discounted cash flows of the proved developed producing properties attributable to the non-controlling interests in these partnerships.

We assume, at times, certain firm transportation contracts as part of our acquisitions of oil and natural gas properties. The fair value of the firm transportation contract obligations was determined based upon the contractual obligations assumed by us and discounted based upon our effective borrowing rate. These contractual obligations are reduced on a monthly basis as we pay these firm transportation obligations in the future.

The fair value measurements associated with the assets acquired and liabilities assumed in the business combination for the OIE Membership Acquisition of Carbon Appalachia are outlined within Note 3.

Debt Discount

The fair value of the debt discount from the 1,425 and 585 additional Class A Units issued in connection with the Subordinated Notes and 2018 Subordinated Notes was $1.3 million and $490,000, respectively. The debt discount was a Level 3 fair value assessment and was based on the relative fair value of Class A Units. Class A Units were issued contemporaneously at $1,000 per Class A Unit.

Asset Retirement Obligation

The fair value of our asset retirement obligation liability is recorded in the period in which it is incurred or assumed by taking into account the cost of abandoning oil and gas wells ranging from $20,000 to $45,000, which is based on our historical experience and industry expectations for similar work; the estimated timing of reclamation ranging from one to 75 years based on estimates from reserve engineers; an inflation rate between 1.52% to 2.79%; and a credit adjusted risk-free rate between 3.28% to 8.27%, which takes into account our credit risk and the time value of money. Given the unobservable nature of the inputs, the initial measurement of the asset retirement obligation liability is deemed to use Level 3 inputs (see Note 3). During the three month period ended March 31, 2019, we did not record any additions to asset retirement obligations. We use 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.

Class B Units

We received Class B units from Carbon California and Carbon Appalachia as part of the entry into the Carbon California LLC Agreement and Carbon Appalachia LLC Agreement, respectively. We estimated the fair value of the Class B units, in each case, by utilizing the assistance of third-party valuation specialists. The fair values were based upon enterprise values derived from inputs including estimated future production rates, future commodity prices including price differentials as of the dates of closing, future operating and development costs and comparable market participants.

Note 13 – Commodity Derivatives

We historically use commodity-based derivative contracts to manage exposures to commodity price on a portion of our oil and natural gas production. We do not hold or issue derivative financial instruments for speculative or trading purposes. We also have entered into, on occasion, oil and natural gas physical delivery contracts to effectively provide commodity price hedges. Because these contracts are not expected to be net cash settled, they are considered to be normal sales contracts and not derivatives. These contracts are not recorded at fair value in the unaudited condensed consolidated financial statements.

Pursuant to the terms of our credit facilities with LegacyTexas Bank and Prudential, we have entered into swap and costless collar derivative agreements to hedge a portion of our oil and natural gas production through 2021. As of March 31, 2019, these derivative agreements consisted of the following:

For our swap instruments, we receive a fixed price for the hedged commodity and pay 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. Costless collars are designed to establish floor and ceiling prices on anticipated future oil and gas production. The ceiling establishes a maximum price that the Company will receive for the volumes under contract, while the floor establishes a minimum price.

The following table summarizes the fair value of the derivatives recorded in the unaudited 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, 2019 and 2018. These commodity derivative settlements and unrealized gains and losses are recorded and included in commodity derivative income or loss in the accompanying unaudited consolidated statements of operations. 

Commodity derivative settlement gains and losses are included in cash flows from operating activities in our unaudited consolidated statements of cash flows.

The counterparty in all of our derivative instruments is BP Energy Company. We have entered into ISDA Master Agreements with BP Energy Company that establishes standard terms for the derivative contracts and inter-creditor agreements with LegacyTexas Bank, Prudential and BP Energy Company whereby any credit exposure related to the derivative contracts entered into by us and BP Energy Company is secured by the collateral and backed by the guarantees supporting the credit facilities.

We net our derivative instrument fair value amounts executed with BP Energy Company pursuant to ISDA master agreements, which provides for the net settlement over the term of the contracts and in the event of default or termination of the contracts. The following table summarizes the location and fair value amounts of all derivative instruments in the unaudited consolidated balance sheet, as well as the gross recognized derivative assets, liabilities and amounts offset in the unaudited consolidated balance sheet as of March 31, 2019.

Due to the volatility of oil and natural gas prices, the estimated fair value of our derivatives are subject to fluctuations from period to period. 

Note 14 – Leases

On January 1, 2019, we adopted ASC 842. Results for reporting periods beginning January 1, 2019 are presented in accordance with ASC 842, while prior period amounts are reported in accordance with FASB ASC Topic 840 –  Leases . On January 1, 2019, we recognized approximately $7.7 million in right-of-use assets and approximately $7.7 million in lease liabilities, representing the present value of minimum payment obligations associated with compressor, vehicle, and office space operating leases with non-cancellable lease terms in excess of one year. We do not have any finance leases, nor are we the lessor in any leasing arrangements. We have elected certain practical expedients available under ASC 842 including those that permit us to (i) account for lease and non-lease components in our contracts as a single lease component for all asset classes; (ii) not evaluate existing and expired land easements; (iii) not apply the recognition requirements of ASC 842 to leases with a lease term of twelve months or less; and (iv) retain our existing lease assessment and classification. As such, there was no cumulative-effect adjustment to retained earnings required at January 1, 2019. Additionally, the Company has elected the short-term lease recognition exemption for all classes of underlying assets and therefore, leases with a term of one year or less will not be recognized on the unaudited consolidated balance sheet. 

The lease amounts disclosed herein are presented on a gross basis. A portion of these costs may have been or will be billed to other working interest owners, and our net share of these costs, once paid, are included in lease operating expenses, pipeline operating expenses or general and administrative expenses, as applicable.

During the three months ended March 31, 2019, we did not acquire any right-of-use assets or incur any lease liabilities. Our right-of-use assets and lease liabilities are recognized at their discounted present value on the balance sheet at $7.3 million as of March 31, 2019. All leases recognized on our unaudited consolidated balance sheet are classified as operating leases, which include leases related to the asset classes reflected in the table below:

We recognize lease expense on a straight-line basis excluding short-term and variable lease payments which are recognized as incurred. Short-term lease cost represents payments for leases with a lease term of one year or less, excluding leases with a term of one month or less. Short-term leases include certain compressors and vehicles that have a non-cancellable lease term of less than one year.

The following table summarizes the components of our gross operating lease costs incurred during the three months ended March 31, 2019:

We do not have any leases with an implicit interest rate that can be readily determined. As a result, we calculate collateralized incremental borrowing rates to use as discount rates. We utilize the benchmark rates defined in our credit facilities, and adjust for facility utilization and term considerations, to establish collateralized incremental borrowing rates. Refer to Note 7 for additional information on our credit facilities.

Our weighted-average lease term and discount rate used are as follows:

The following table summarizes supplemental cash flow information related to leases:

Minimum future commitments by year for our long-term operating leases as of March 31, 2019 are presented in the table below. Such commitments are reflected at undiscounted values and are reconciled to the discounted present value recognized on the balance sheet as follows:

Note 15 – Commitments and Contingencies

We have entered into employment agreements with certain of our executives and officers. The term of the agreements generally ranges from one to two years and provides for renewal provisions in one-year increments thereafter. The agreements provide for, among other items, severance and continuation of benefit payments upon termination of employment or certain change of control events.

We have entered into non-current firm transportation contracts to ensure the transport for certain of our gas production to purchasers. Firm transportation volumes and the related demand charges for the remaining term of these contracts at March 31, 2019 are summarized in the table below.

As of March 31, 2019, the remaining commitment related to the firm transportation contracts assumed in the EXCO Acquisition in 2016 and OIE Membership Acquisition is $17.8 million and reflected in the Company’s unaudited consolidated balance sheet. The fair values 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 reduced monthly as the Company pays these firm transportation obligations in the future.

Natural gas processing agreement

We have entered into an initial five-year gas processing agreement. We have an option to extend the term of the agreement by another five years. The related demand charges for volume commitments over the remaining term of the agreement at March 31, 2019 are approximately $1.8 million per year. We will pay a processing fee of $2.50 per MCF for the term of the agreement, with a minimum annual volume commitment of 720,000 MCF.

Capital Commitments

As of March 31, 2019, we had no capital commitments associated with Carbon California.