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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

OR

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                to               .

Commission File Number:  001-35344

LRR Energy, L.P.

(Exact name of registrant as specified in its charter)

Telephone Number:  (713) 292-9510

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x  No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o  No  x

There were 15,708,474 Common Units, 6,720,000 Subordinated Units and 22,400 General Partner Units outstanding as of November 5, 2012.  The Common Units trade on the New York Stock Exchange under the ticker symbol “LRE”.

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LRR Energy, L.P.

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

LRR Energy, L.P.

Consolidated Condensed Balance Sheets

(Unaudited)

(in thousands, except unit amounts)

See accompanying notes to the unaudited consolidated/combined condensed financial statements

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LRR Energy, L.P.

Condensed Statements of Operations

(Unaudited)

(in thousands, except per unit amounts)

See accompanying notes to the unaudited consolidated/combined condensed financial statements

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LRR Energy, L.P.

Consolidated Condensed Statement of Changes in Unitholders’ Equity

(Unaudited)

(in thousands)

See accompanying notes to the unaudited consolidated/combined condensed financial statements

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LRR Energy, L.P.

Condensed Statements of Cash Flows

(Unaudited)

(in thousands)

See accompanying notes to the unaudited consolidated/combined condensed financial statements

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LRR Energy, L.P.

Notes to Consolidated/Combined Condensed Financial Statements

(unaudited)

1.     Description of Business

LRR Energy, L.P. (“we,” “us,” “our,” or the “Partnership”) is a Delaware limited partnership formed in April 2011 by Lime Rock Management LP (“Lime Rock Management”), an affiliate of Lime Rock Resources A, L.P. (“LRR A”), Lime Rock Resources B, L.P. (“LRR B”) and Lime Rock Resources C, L.P. (“LRR C”), to operate, acquire, exploit and develop producing oil and natural gas properties in North America with long-lived, predictable production profiles. As used herein, references to “Fund I” or “predecessor” refer collectively to LRR A, LRR B and LRR C. References to “Lime Rock Resources” refer collectively to LRR A, LRR B, LRR C, Lime Rock Resources II-A, L.P. and Lime Rock Resources II-C, L.P. The properties conveyed to us in connection with our initial public offering (“IPO”) on November 16, 2011 (such conveyance described below) are located in the Permian Basin region in West Texas and southeast New Mexico, the Mid-Continent region in Oklahoma and East Texas and the Gulf Coast region in Texas. We conduct our operations through our wholly owned subsidiary, LRE Operating, LLC (“OLLC”).

Prior to our IPO, Fund I owned 100% of the properties conveyed to us in connection with our IPO. At the closing of our IPO, we entered into a purchase, sale, contribution, conveyance and assumption agreement with Fund I pursuant to which Fund I sold and contributed to us specified oil and natural gas properties and related net profits interests and operations and certain commodity derivative contracts (the “Partnership Properties”). Fund I received total consideration for the Partnership Properties of 5,049,600 common units, 6,720,000 subordinated units, $311.2 million in cash and our assumption of $27.3 million of LRR A’s indebtedness.

After reviewing applicable accounting literature, we consider the Partnership Properties to be under common control with Fund I. We have presented the combined historical financial statements of Fund I as our historical financial statements because we believe them to be “informative” to our investors and representative of our management’s ability to manage the Partnership Properties. The financial data and operations of Fund I are referred to herein as “predecessor.”

The following table presents the net assets conveyed by Fund I to the Partnership immediately prior to the closing of our IPO including the debt assumption (in thousands):

On June 1, 2012, we completed an acquisition from Fund I of certain oil and natural gas properties (the “Transferred Properties”) located in the Permian Basin region of New Mexico and onshore Gulf Coast region of Texas for $65.1 million in cash (the “Transaction”). The Transaction was effective as of March 1, 2012. We funded the acquisition with borrowings under our revolving credit facility (Note 7).  In September 2012, we received $1.1 million in cash from Fund I related to post-closing adjustments to the purchase price for the acquisition. Please refer to Notes 2 and 3 regarding the recast of financial information for transactions between entities under common control.

The following table presents the net assets conveyed by Fund I to us in the Transaction (in thousands):

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2.     Summary of Significant Accounting Policies

Our accounting policies are set forth in Note 2 of the audited consolidated/combined financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011, and are supplemented by the notes to these unaudited consolidated/combined condensed financial statements. There have been no significant changes to these policies other than noted below, and these unaudited consolidated/combined condensed financial statements should be read in conjunction with the audited consolidated/combined financial statements and notes in our Annual Report on Form 10-K for the year ended December 31, 2011.

Basis of Presentation

These interim financial statements are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete consolidated/combined financial statements and should be read in conjunction with the audited consolidated/combined financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011. While the year-end balance sheet data was derived from audited financial statements, this interim report does not include all disclosures required by GAAP for annual periods. These unaudited interim consolidated/combined financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented.

In the third quarter of 2012, we recorded an adjustment to correct an error in our calculation of depletion and depreciation expense related to a previous accounting period. The net impact of the adjustment was an increase to pre-tax income and net income of $1.9 million for the three months ended September 30, 2012.  The error occurred in the three months ended June 30, 2012; as such, the financial statements for th nine months ended September 30, 2012 were not impacted by the adjustment. We do not believe this adjustment is material to our unaudited condensed consolidated financial statements for the three months ended September 30, 2012 or our expected 2012 annual financial results.

Because Fund I owns 5,049,600 common units and all of our 6,720,000 subordinated units, representing an aggregate 52.4% limited partner interest in us, each acquisition of assets from Fund I is considered a transaction between entities under common control. As a result, we are required to revise our financial statements to include the activities of the Transferred Properties.

Accordingly, our historical financial statements previously filed with the SEC have been revised in this Quarterly Report on Form 10-Q to include the results attributable to the Transferred Properties as if the Partnership owned such assets for all periods presented in 2012 and 2011. The consolidated financial statements for periods prior to our acquisition of the Transferred Properties have been prepared from our predecessor’s historical cost-basis accounts and may not necessarily be indicative of the actual results of operations that would have occurred if we had owned the assets during the periods reported. See our accounting policy below under “Transactions Between Entities Under Common Control.”

Net income attributable to the Transferred Properties for periods prior to the Partnership’s acquisition of such assets was not available for distribution to our unitholders. Therefore, this income was not allocated to the limited partners for the purpose of calculating net income per common unit.

Revised Balance Sheet.  Our historical balance sheet as of December 31, 2011 was impacted based on revisions from the Transferred Properties by an increase in total assets of $62.9 million which primarily represented increases to our property, plant and equipment. Total liabilities and partners’ capital was also increased by $62.9 million,

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comprised of increases of less than $0.1 million in current liabilities, $1.0 million in noncurrent liabilities and $61.9 million in partners’ capital.

Revised Statements of Operations.  Our statements of operations for the nine months ended September 30, 2012 were impacted based on revisions from the Transferred Properties by an increase in net income of $2.3 million.

Transactions Between Entities Under Common Control

Master limited partnerships (“MLPs”) enter into transactions whereby the MLP receives a transfer of certain assets from its sponsor or predecessor for consideration of either cash, units, assumption of debt, or any combination thereof. We account for the net assets received using the carryover book value of the predecessor as these are transactions between entities under common control. Our historical financial statements have been revised to include the results attributable to the assets contributed from Fund I as if we owned such assets for all periods presented by us.  The following financial statement items were impacted:

Oil and Natural Gas Properties Received.  The book value and related activity of oil and natural gas properties received from our predecessor is determined using the carrying value of the specific assets contributed.

Asset Retirement Obligations Received.  The book value and related activity of asset retirement obligations received from our predecessor was determined by using the carrying value of the specific liabilities attributable to the assets contributed.

Oil, Natural Gas and NGL Revenues and Expenses.  Oil, natural gas and NGL revenues and expenses related to the Transferred Properties are based on the actual results of the Transferred Properties. Historical lease operating statements by individual asset were used as the basis for revenues and direct operating expenses.

General and Administrative Expense.  The general and administrative expense attributable to the Transferred Properties was determined by the ratio of production for the Transferred Properties to our total predecessor’s production for the period presented.

Recent Accounting Pronouncements

In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” The Amendments explain how to measure fair value and change the wording used to describe many of the fair value requirements in GAAP, but do not require additional fair value measurements. The guidance became effective for interim and annual periods beginning on or after December 15, 2011. We adopted these amendments on January 1, 2012 and they did not have a material impact on our consolidated financial position, results of operations or cash flows.

In December 2011, the FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities.” The amendments in this update require enhanced disclosures around financial instruments and derivative instruments that are either (1) offset in accordance with either ASC 210-20-45 or ASC 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either ASC 210-20-45 or ASC 815-10-45. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The amendments are effective during interim and annual periods beginning on or after January 1, 2013. We do not expect this guidance to have any impact on our consolidated financial position, results of operations or cash flows.

3.     Acquisitions and Divestitures

Acquisitions Between Entities Under Common Control

On June 1, 2012, we completed the acquisition of the Transferred Properties from Fund I for a total purchase price of $65.1 million, after giving effect to purchase price adjustments from the effective date of the Transaction (March 1, 2012). The post closing adjustments to the purchase price for the acquisition were finalized in September 2012, and we received $1.1 million in cash from Fund I. We financed the Transaction with borrowings under our

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existing credit facility as discussed in Note 7. The net assets were recorded using carryover book value of Fund I as the acquisition was a transaction between entities under common control. Our historical financial statements were revised to include the results attributable to the Transferred Properties as if we owned the properties for all periods presented in our consolidated condensed financial statements. See Note 2 for further disclosures regarding the Transaction.

Divestitures

We did not divest any significant properties during the nine months ended September 30, 2012 or 2011.

4.     Fair Value Measurements

Our financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, are carried at cost, which approximates fair value due to the short-term maturity of these instruments. Our financial and non-financial assets and liabilities that are measured on a recurring basis are measured and reported at fair value.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of fair value hierarchy are as follows:

Level 1 — Defined as inputs such as unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 — Defined as inputs other than quoted prices in active markets that are either directly or indirectly observable for the asset or liability.

Level 3 — Defined as unobservable inputs for use when little or no market data exists, requiring an entity to develop its own assumptions for the asset or liability.

As required by GAAP, we utilize the most observable inputs available for the valuation technique used. The financial assets and liabilities are classified in their entirety based on the lowest level of input that is of significance to the fair value measurement. The following table describes, by level within the hierarchy, the fair value of our financial assets and liabilities that were accounted for at fair value on a recurring basis as of the date indicated (in thousands).

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All fair values reflected in the table above and on the unaudited consolidated condensed balance sheets have been adjusted for non-performance risk. The following methods and assumptions were used to estimate the fair values of the assets and liabilities in the table above.

Commodity Derivative Instruments — The fair value of the commodity derivative instruments is estimated using a combined income and market valuation methodology based upon forward commodity price and volatility curves. The curves are obtained from independent pricing services reflecting broker market quotes.

Interest Rate Derivative Instruments — The fair value of the interest rate derivative instruments is estimated using a combined income and market valuation methodology based upon forward interest rates and volatility curves. The curves are obtained from independent pricing services reflecting broker market quotes. We did not have any outstanding interest rate derivative instruments at December 31, 2011.

The following table sets forth a reconciliation of changes in the fair value of financial assets and liabilities classified as Level 3 in the fair value hierarchy for the three and nine months ended September 30, 2012 and 2011 (in thousands):

(1)    As part of a review of our fair value financial statement disclosures in light of ASU 2011-04, management has determined, effective January 1, 2012, the fair values of our derivative instruments should be classified as Level 2. Management has determined the prices quoted by the independent pricing service are observable inputs that management is able to independently test and corroborate for reasonableness through market prices.  Accordingly, on January 1, 2012, we transferred all derivative instruments which are measured on a recurring basis from Level 3 into Level 2.

5.     Property and Equipment

The following table sets forth the components of property and equipment, net (in thousands):

We perform an impairment analysis of our oil and natural gas properties on a quarterly basis due to the volatility in commodity prices. For the three and nine months ended September 30, 2012, we recorded non-cash impairment charges of approximately $0.5 million and $3.5 million, respectively, to impair the value of our unproved properties and proved oil and natural gas properties in the Mid-Continent region. For each of the three and nine months ended September 30, 2011, we recorded non-cash impairment charges of approximately $16.8 million in the Mid-Continent region.

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The impairment of proved oil and natural gas properties was recorded because the net capitalized costs of the properties exceeded the fair value of the properties as measured by estimated cash flows reported in an internal reserve report. This report was based upon future oil and natural gas prices, which are based on observable inputs adjusted for basis differentials, which are Level 3 inputs. The fair values of proved properties are measured using valuation techniques consistent with the income approach, converting future cash flows to a single discounted amount. Significant inputs used to determine the fair values of proved properties include estimates of: (i) reserves; (ii) future operating and development costs; (iii) future commodity prices; and (iv) a market-based weighted average cost of capital rate. The underlying commodity prices embedded in our estimated cash flows are the product of a process that begins with New York Mercantile Exchange (“NYMEX”) forward curve pricing, adjusted for estimated location and quality differentials, as well as other factors that management believes will impact realizable prices. Furthermore, significant assumptions in valuing the proved reserves included the reserve quantities, anticipated drilling and operating costs, anticipated production taxes, future expected oil and natural gas prices and basis differentials, anticipated drilling schedules, anticipated production declines, and an appropriate discount rate commensurate with the risk of the underlying cash flow estimates. Cash flow estimates for the impairment testing excluded derivative instruments used to mitigate the risk of lower future oil and natural gas prices. Significant assumptions in valuing the unproved reserves included the evaluation of the probable and possible reserves included in the internal reserve report, future expected oil and natural gas prices and basis differentials, and our anticipated drilling schedules.

The asset impairment had no impact on our cash flows, liquidity position, or debt covenants. If future oil or natural gas prices decline further, the estimated undiscounted future cash flows for the proved oil and natural gas properties may not exceed the net capitalized costs for our recently acquired properties and a non-cash impairment charge may be required to be recognized in future periods.

6.     Asset Retirement Obligations

The following is a summary of our ARO as of and for the nine months ended September 30, 2012 (in thousands):

7.     Long-Term Debt

Credit Agreement

In July 2011, subject to consummation of our IPO, we, as guarantor, and our wholly owned subsidiary, OLLC, as borrower, entered into a five-year, $500 million senior secured revolving credit facility, as amended, (the “Credit Agreement”) that matures in July 2016. The Credit Agreement is reserve-based and we are permitted to borrow under our credit facility an amount up to the borrowing base, which was $240 million as of September 30, 2012. Our borrowing base, which is primarily based on the estimated value of our oil, NGL and natural gas properties and our commodity derivative contracts, is subject to redetermination semi-annually by our lenders at their sole discretion. Unanimous approval by the lenders is required for any increase to the borrowing base.

Borrowings under the Credit Agreement are secured by liens on at least 80% of the PV-10 value of our and our subsidiaries’ oil and natural gas properties and all of our equity interests in the OLLC and any future guarantor subsidiaries and all of our and our subsidiaries’ other assets including personal property. Borrowings under the Credit Agreement bear interest, at OLLC’s option, at either (i) the greater of the prime rate as determined by the Administrative Agent, the federal funds effective rate plus 0.50%, and the 30-day adjusted LIBOR plus 1.0%, all of which is subject to a margin that varies from 0.75% to 1.75% per annum according to the borrowing base usage

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(which is the ratio of outstanding borrowings and letter of credit exposure to the borrowing base then in effect), or (ii) the applicable reserve-adjusted LIBOR plus a margin that varies from 1.75% to 2.75% per annum according to the borrowing base usage. The unused portion of the borrowing base is subject to a commitment fee that varies from 0.375% to 0.50% per annum according to the borrowing base usage.

The Credit Agreement requires us to maintain a leverage ratio of Total Debt to EBITDAX (as each term is defined in the Credit Agreement) of not more than 4.0 to 1.0x, and a ratio of consolidated current assets to consolidated current liabilities of not less than 1.0 to 1.0x.

Additionally, the Credit Agreement contains various covenants and restrictive provisions which limit our, OLLC’s and any of our subsidiaries’ ability to incur additional debt, guarantees or liens; consolidate, merge or transfer all or substantially all of our assets; make certain investments, acquisitions or other restricted payments; modify certain material agreements; engage in certain types of transactions with affiliates; dispose of assets; incur commodity hedges exceeding a certain percentage of our production; and prepay certain indebtedness. As of September 30, 2012, we were in compliance with all covenants contained in the Credit Agreement.

We expect that our borrowing base will be redetermined by our lending group during the month of November. We currently do not expect any changes to our borrowing base that would materially impact our operations, capital program, or our ability to make quarterly cash distributions to our unitholders at currently anticipated levels.

Term Loan Agreement

On June 28, 2012, we, as parent guarantor, and our wholly owned subsidiary, OLLC, as borrower, entered into a Second Lien Credit Agreement (the “Term Loan Agreement”). The Term Loan Agreement provides for a $50 million senior secured second lien term loan to OLLC. OLLC borrowed $50 million under the Term Loan Agreement and used the borrowings to repay outstanding borrowings under the Credit Agreement.

The obligations under the Term Loan Agreement are guaranteed on a joint and several basis by us. The obligations are secured by a second priority mortgage and security interest in all assets of OLLC and us that secure OLLC’s and our existing indebtedness under the Credit Agreement.

Borrowings under the Term Loan Agreement mature on January 20, 2017, and, subject to the terms of the Intercreditor Agreement (as described below), OLLC has the ability at any time to prepay the Term Loan Agreement without premium or penalty. Borrowings under the Term Loan Agreement bear interest, at OLLC’s option, at either

·      the greatest of (i) the prime rate as defined in the Term Loan Agreement, (ii) the federal funds effective rate plus 0.50% and (iii) the 30-day adjusted LIBOR plus 1.0%, all of which is subject to an applicable margin as follows:

·      4.50% through March 31, 2013;

·      6.00% from April 1, 2013 to December 31, 2013; and

·      7.50% from January 1, 2014 to January 20, 2017; or

·      the applicable reserve-adjusted LIBOR plus an applicable margin as follows:

·      5.50% through March 31, 2013;

·      7.00% from April 1, 2013 to December 31, 2013; and

·      8.50% from January 1, 2014 to January 20, 2017.

Additionally, the Term Loan Agreement provides for an upfront fee of one percent of the aggregate maximum commitment amount, or $500,000.

The Term Loan Agreement contains various covenants and restrictive provisions which limit the ability of OLLC, us or any of our subsidiaries to incur additional debt, guarantees or liens; consolidate, merge or transfer all or substantially all of its assets; make certain investments, acquisitions or other restricted payments; modify certain material agreements; engage in certain types of transactions with affiliates; dispose of assets; incur commodity hedges exceeding a certain percentage of production; prepay certain indebtedness; and amend the Credit Agreement or grant any liens to secure any indebtedness under the Credit Agreement.

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The Term Loan Agreement also contains covenants that, among other things, require OLLC and us to maintain specified ratios including leverage ratio of Total Debt to EBITDAX of not more than 4.25 to 1.00x; a current ratio of consolidated current assets to consolidated current liabilities of not less than 1.0 to 1.0x; and an asset coverage ratio of Total Proved PV-10 to Total Debt of not less than 1.50 to 1.00x. As of September 30, 2012, we were in compliance with all covenants contained in the Term Loan Agreement.

The obligations under the Term Loan Agreement and the Credit Agreement are governed by an Intercreditor Agreement with OLLC as borrower and the Partnership as parent guarantor, which (i) provides that any liens on the assets and properties of OLLC, the Partnership or any of their subsidiaries securing the indebtedness under the Term Loan Agreement are subordinate to liens on the assets and properties of OLLC, the Partnership or any of their subsidiaries securing indebtedness under the Credit Agreement and derivative contracts with lenders and their affiliates and (ii) sets forth the respective rights, obligations and remedies of the lenders under the Credit Agreement with respect to their first-priority liens and the lenders under the Term Loan Agreement with respect to their second-priority liens.

As of September 30, 2012, we had approximately $233.0 million of outstanding debt and accrued interest was approximately $0.2 million. As of December 31, 2011, we had approximately $155.8 million of outstanding debt and accrued interest was approximately $0.5 million. Our outstanding debt increased primarily due to our June 2012 acquisition of oil and natural gas properties from Fund I for approximately $65.1 million and working capital borrowings.

Interest expense for the three months and nine months ended September 30, 2012 was approximately $2.1 million and $4.5 million, respectively. Interest expense for the three and nine months ended September 30, 2011 was approximately $0.3 million and $0.8 million, respectively. Interest expense for the 2011 periods is related to LRR A’s credit facility. As of September 30, 2012 and December 31, 2011, our weighted average interest rate on our outstanding indebtedness was 3.70% and 2.86%, respectively. Please refer to Note 8 below for a discussion of our interest rate derivative contracts.

8.              Derivatives

Objective and strategy—We are exposed to commodity price and interest rate risk and consider it prudent to periodically reduce our exposure to cash flow variability resulting from commodity price changes and interest rate fluctuations. Accordingly, we enter into derivative instruments to manage our exposure to commodity price fluctuations, locational differences between a published index and the NYMEX futures on natural gas or crude oil productions, and interest rate fluctuations.

At September 30, 2012 and December 31, 2011, our open positions consisted of contracts such as (i) crude oil and natural gas financial collar contracts, (ii) crude oil, NGL and natural gas financial swaps, (iii) natural gas basis financial swaps, (iv) crude oil and natural gas puts and (v) interest rate swap agreements. Our derivative instruments are with the counterparties that are also lenders in our Credit Agreement.

Swaps and options are used to manage our exposure to commodity price risk and basis risk inherent in our oil and natural gas production. Commodity price swap agreements are used to fix the price of expected future oil and natural gas sales at major industry trading locations such as Henry Hub Louisiana (“HH”) for gas and Cushing Oklahoma (“WTI”) for oil. Basis swaps are used to fix the price differential between the product price at one location versus another. Options are used to establish a floor and a ceiling price (collar) for expected oil or gas sales. Interest rate swaps are used to fix interest rates on existing indebtedness.

Under commodity swap agreements, we exchange a stream of payments over time according to specified terms with another counterparty. Specifically for commodity price swap agreements, we agree to pay an adjustable or floating price tied to an agreed upon index for the commodity, either gas or oil, and in return receive a fixed price based on notional quantities. Under basis swap agreements, we agree to pay an adjustable or floating price tied to two agreed upon indices for gas and in return receive the differential between a floating index and fixed price based on notional quantities. A collar is a combination of a put purchased by us and a call option written by us. In a typical collar transaction, if the floating price based on a market index is below the floor price, we receive from the

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counterparty an amount equal to this difference multiplied by the specified volume, effectively a put option. If the floating price exceeds the floor price and is less than the ceiling price, no payment is required by either party. If the floating price exceeds the ceiling price, we must pay the counterparty an amount equal to the difference multiplied by the specific quantity, effectively a call option.

The interest rate swap agreements effectively fix our interest rate on amounts borrowed under the credit facility. The purpose of these instruments is to mitigate our existing exposure to unfavorable interest rate changes. Under interest rate swap agreements, we pay a fixed interest rate payment on a notional amount in exchange for receiving a floating amount based on LIBOR on the same notional amount.

We elected not to designate any positions as cash flow hedges for accounting purposes and, accordingly, recorded the net change in the mark-to-market valuation of these derivative contracts in the statements of operations. We record our derivative activities on a mark-to-market or fair value basis. Fair values are based on pricing models that consider the time value of money and volatility and are comparable to values obtained from counterparties. Pursuant to the accounting standard that permits netting of assets, liabilities, and collateral where the right of offset exists, we present the fair value of derivative financial instruments on a net basis.

At September 30, 2012, we had the following open commodity derivative contracts: