1. Organization and Description of Business

Organization

        Jones Energy, Inc. (the "Company") was formed in March 2013 as a Delaware corporation to become a publicly-traded entity and the holding company of Jones Energy Holdings, LLC ("JEH"). As the sole managing member of JEH, the Company is responsible for all operational, management and administrative decisions relating to JEH's business and consolidates the financial results of JEH and its subsidiaries.

        JEH was formed as a Delaware limited liability company on December 16, 2009 through investments made by the Jones family and through private equity funds managed by Metalmark Capital and Wells Fargo Energy Capital. JEH acts as a holding company of operating subsidiaries that own and operate assets that are used in the exploration, development, production and acquisition of oil and natural gas properties.

        The Company's certificate of incorporation authorizes two classes of common stock, Class A common stock and Class B common stock. The Class B common stock is held by the owners of JEH prior to the Company's initial public offering ("IPO") and can be exchanged (together with a corresponding number of units representing membership interests in JEH ("JEH Units")) for shares of Class A common stock on a one-for-one basis, subject to customary conversion rate adjustments for stock splits, stock dividends and reclassifications and other similar transactions. The Class B common stock has no economic rights but entitles its holder to one vote on all matters to be voted on by the Company's stockholders generally. As a result of the IPO, the pre-IPO owners retained 74.7% of the total economic interest in JEH, but with no voting rights or management power over JEH, resulting in the Company reporting this ownership interest as a non-controlling interest. Prior to the IPO, JEH owned the controlling interest in the Company; hence all of the net income earned prior to the IPO date is reflected in the net income attributable to non-controlling interests on the Consolidated Statement of Operations for the year ended December 31, 2013.

Description of Business

        The Company is engaged in the acquisition, exploration, and production of oil and natural gas properties in the mid-continent United States. The Company's assets are located within two distinct basins in the Texas Panhandle and Oklahoma, the Anadarko Basin and the Arkoma Basin, and are owned by JEH and its operating subsidiaries. The Company is headquartered in Austin, Texas.

 

2. Significant Accounting Policies

Basis of Presentation

        The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). All significant intercompany transactions and balances have been eliminated in consolidation. The financial statements reported for December 31, 2014 and 2013 and the results of the operations and the cash flows for each of the three years in the period ended December 31, 2014 include the Company and all of its subsidiaries.

Segment Information

        The Company operates in one industry segment, which is the exploration, development and production of oil and natural gas, and all of its operations are conducted in one geographic area of the United States.

Use of Estimates

        In preparing the accompanying financial statements, management has made certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent liabilities, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. Changes in estimates are recorded prospectively.

        Significant assumptions are required in the valuation of proved oil and natural gas reserves, which affect the Company's estimates of depletion expense, impairment, and the allocation of value in our business combinations. Significant assumptions are also required in the Company's estimates of the net gain or loss on commodity derivative assets and liabilities, fair value associated with business combinations, and asset retirement obligations ("ARO").

Financial Instruments

        Cash, accounts receivable and accounts payable are recorded at cost. The fair value of accounts receivable and accounts payable are not materially different from their carrying amounts because of the short-term nature of these instruments. The carrying value of the outstanding balance under the Company's Revolver (as defined in Note 6) represents fair value because the Revolver has variable interest rates, which are reflective of the Company's credit risk. The Company's senior notes have a fixed interest rate and are reported at historical value as of the initial measurement date when issued and their fair value is discussed in Note 4. Derivative instruments are recorded at fair value, as discussed below.

Cash

        Cash and cash equivalents include highly liquid investments with a maturity of three months or less. At times, the amount of cash on deposit in financial institutions exceeds federally insured limits. Management monitors the soundness of the financial institutions and believes the Company's risk is not significant.

Accounts Receivable

        Accounts receivable—Oil and gas sales consist of uncollateralized accrued revenues due under normal trade terms, generally requiring payment within 30 to 60 days of production. Accounts receivable—Joint interest owners consist of uncollateralized joint interest owner obligations due within 30 days of the invoice date. Accounts receivable—Other consists at December 31, 2014 of derivative positions not settled as of the balance sheet date and severance tax refunds due from state agencies and at December 31, 2013 of the adjustments to the purchase price of the Sabine properties purchased in December 2013 and severance tax refunds due from state agencies. No interest is charged on past-due balances. The Company routinely assesses the recoverability of all material trade, joint interest and other receivables to determine their collectability, and reduces the carrying amounts by a valuation allowance that reflects management's best estimate of the amounts that may not be collected. As of December 31, 2014 and 2013, the Company did not have significant allowances for doubtful accounts.

Concentration of Risk

        Substantially all of the Company's accounts receivable are related to the oil and gas industry. This concentration of entities may affect the Company's overall credit risk in that these entities may be affected similarly by changes in economic and other conditions, including declines in commodity prices. As of December 31, 2014, 70% of Accounts receivable—Oil and gas sales are due from 5 purchasers and 67% of Accounts receivable—Joint interest owners are due from 5 working interest owners. As of December 31, 2013, 79% of Accounts receivable—Oil and gas sales were due from 8 purchasers, and 77% of 2013 Accounts receivable—Joint interest owners were due from 5 working interest owners. If any or all of these significant counterparties were to fail to pay amounts due to the Company, the Company's financial position and results of operations could be materially and adversely affected.

Dependence on Major Customers

        The Company maintains a portfolio of crude oil and natural gas marketing contracts with large, established refiners and oil and gas purchasers. During the year ended December 31, 2014, the largest purchasers were Valero Energy Corp. ("Valero"), NGL Energy Partners LP, PVR Midstream LLC ("PVR Midstream"), Plains Marketing LP ("Plains Marketing"), and Monarch Natural Gas LLC which accounted for approximately 22%, 12%, 12%, 10% and 10% of consolidated oil and gas sales, respectively. During the year ended December 31, 2013, the largest purchasers were PVR Midstream, Unimark LLC, Mercuria Energy Group Ltd. ("Mercuria"), Valero, and Plains Marketing, which accounted for approximately 15%, 13%, 13%, 13% and 6% of consolidated oil and gas sales, respectively. During the year ended December 31, 2012, the largest purchasers were Unimark LLC, Mercuria, PVR Midstream, and Plains Marketing, which accounted for approximately 24%, 18%, 18% and 15% of consolidated oil and gas sales, respectively.

        Management believes that there are alternative purchasers and that it may be necessary to establish relationships with such new purchasers. However, there can be no assurance that the Company can establish such relationships and that those relationships will result in an increased number of purchasers. Although the Company is exposed to a concentration of credit risk, management believes that all of the Company's purchasers are credit worthy.

Dependence on Suppliers

        The Company's industry is cyclical, and from time to time, there can be an imbalance between the supply of and demand for drilling rigs, equipment, services, supplies and qualified personnel. During periods of oversupply, there can be financial pressure on suppliers. If the financial pressure leads to work interruptions or stoppages, the Company could be materially and adversely affected. Management believes that there are adequate alternative providers of drilling and completion services although it may become necessary to establish relationships with new contractors. However, there can be no assurance that the Company can establish such relationships and that those relationships will result in increased availability of drilling rigs or other services, or that they could be obtained on the same terms.

Oil and Gas Properties

        The Company accounts for its oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas properties consisted of the following at December 31, 2014 and 2013:

                                                                                                                                                                                    

        Costs to acquire mineral interests in oil and natural gas properties are capitalized. Costs to drill and equip development wells and the related asset retirement costs are capitalized. The costs to drill and equip exploratory wells are capitalized pending determination of whether the Company has discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are charged to expense. In some circumstances, it may be uncertain whether proved commercial reserves have been found when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the anticipated reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. As of December 31, 2014 and 2013, we had no material capitalized costs associated with exploratory wells.

        The Company capitalizes interest on expenditures for significant exploration and development projects that last more than six months while activities are in progress to bring the assets to their intended use. The Company capitalized less than $0.1 million in interest costs during 2014 for one project. No interest costs were capitalized in 2013. Costs incurred to maintain wells and related equipment are charged to expense as incurred.

        On the sale or retirement of a proved field, the cost and related accumulated depletion, depreciation and amortization are eliminated from the field accounts, and the resultant gain or loss is recognized.

        Capitalized amounts attributable to proved oil and gas properties are depleted by the unit-of-production method over proved reserves, using the unit conversion ratio of six thousand cubic feet of gas to one barrel of oil equivalent. Depletion of the costs of wells and related equipment and facilities, including capitalized asset retirement costs, net of salvage values, is computed using proved developed reserves. The reserve base used to calculate depreciation, depletion, and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. Depletion of oil and gas properties amounted to $180.6 million, $113.3 million and $79.9 million for the years ended December 31, 2014, 2013 and 2012, respectively.

        The Company reviews its proved oil and natural gas properties, including related wells and equipment, for impairment by comparing expected undiscounted future cash flows at a producing field level to the net capitalized cost of the asset. If the future undiscounted cash flows, based on the Company's estimate of future commodity prices, operating costs, and production, are lower than the net capitalized cost, the capitalized cost is reduced to fair value. Fair value is calculated by discounting the future cash flows at an appropriate risk-adjusted discount rate. Due to the significant assumptions associated with the inputs and calculations described, the fair value of oil and gas properties used in estimating impairment represents a nonrecurring Level 3 measurement. No impairments of proved properties were recorded in 2014 or 2013. The Company incurred impairment charges of $18.8 million related to its proved oil and natural gas properties and equipment in 2012.

        The Company evaluates its unproved properties for impairment on a property-by-property basis. The Company's unproved property consists of acquisition costs related to its undeveloped acreage. The Company reviews the unproved property for indicators of impairment based on the Company's current exploration plans with consideration given to results of any drilling and seismic activity during the period and known information regarding exploration and development activity by other companies on adjacent blocks. The Company incurred no impairment charges related to its unproved properties in 2014 or 2012. In the fourth quarter of 2013, the Company recorded an impairment charge of $14.4 million related to its unproved Southridge properties in the Arkoma basin. As the Company did not drill the required number of wells by October 31, 2013 necessary to keep its joint development agreement with Southridge in effect, the Company lost its right to the undeveloped acreage. Impairment of oil and gas properties charges are recorded on the Consolidated Statement of Operations.

        On the sale of an entire interest in an unproved property, gain or loss on the sale is recognized, taking into consideration the amount of any recorded impairment if the property had been assessed individually. If a partial interest in an unproved property is sold, the amount received is treated as a reduction of the cost of the interest retained.

Other Property, Plant and Equipment

        Other property, plant and equipment consisted of the following at December 31, 2014 and 2013:

                                                                                                                                                                                    

        Other property, plant and equipment is depreciated on a straight-line basis over the estimated useful lives of the property, plant and equipment, which range from three years to ten years. Depreciation and amortization of other property, plant and equipment amounted to $1.1 million, $0.8 million and $0.8 million during the years ended December 31, 2014, 2013 and 2012, respectively.

Oil and Gas Sales Payable

        Oil and gas sales payable represents amounts collected from purchasers for oil and gas sales, which are due to other revenue interest owners. Generally, the Company is required to remit amounts due under these liabilities within 60 days of receipt.

Commodity Derivatives

        The Company records its commodity derivative instruments on the Consolidated Balance Sheet as either an asset or liability measured at its fair value. Changes in the derivative's fair value are recognized currently in earnings, unless specific hedge accounting criteria are met. During the years ended December 31, 2014, 2013 and 2012, the Company elected not to designate any of its commodity price risk management activities as cash flow or fair value hedges. The changes in the fair values of outstanding financial instruments are recognized as gains or losses in the period of change.

        Although the Company does not designate its commodity derivative instruments as cash-flow hedges, management uses those instruments to reduce the Company's exposure to fluctuations in commodity prices related to its natural gas and oil production. Net gains and losses, at fair value, are included on the Consolidated Balance Sheet as current or noncurrent assets or liabilities based on the anticipated timing of cash settlements under the related contracts. Changes in the fair value of commodity derivative contracts are recorded in earnings as they occur and are included in other income (expense) on the Consolidated Statement of Operations. See Note 4, "Fair Value Measurement," for disclosure about the fair values of commodity derivative instruments.

Asset Retirement Obligations

        The Company's asset retirement obligations ("ARO") consist of future plugging and abandonment expenses on oil and natural gas properties. The Company estimates an ARO for each well in the period in which it is incurred based on estimated present value of plugging and abandonment costs, increased by an inflation factor to the estimated date that the well would be plugged. The resulting liability is recorded by increasing the carrying amount of the related long- lived asset. The liability is then accreted to its then-present value each period and the capitalized cost is depleted over the useful life of the related asset. If the liability is settled for an amount other than the recorded amount, a gain or loss is recognized. The ARO is classified as current or noncurrent based on the expect timing of payments. A summary of the Company's ARO for the years ended December 31, 2014 and 2013 is as follows:

                                                                                                                                                                                    

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Revenue Recognition

        Revenues from the sale of crude oil, natural gas, and natural gas liquids are recognized when the product is delivered at a fixed or determinable price, title has transferred, collectability is reasonably assured and evidenced by a contract. The Company follows the "sales method" of accounting for its oil and natural gas revenue, so it recognizes revenue on all crude oil, natural gas, and natural gas liquids sold to purchasers. A receivable or liability is recognized only to the extent that the Company has an imbalance on a specific property greater than the expected remaining proved reserves.

Production Costs

        Production costs, including compressor rental, pumpers' salaries, saltwater disposal, ad valorem taxes, insurance, repairs and maintenance, expensed workovers and other operating expenses are expensed as incurred and included in lease operating expense on the Consolidated Statement of Operations.

Exploration Expenses

        Exploration expenses include dry hole costs, lease extensions, delay rentals and geological and geophysical costs.

Income Taxes

        Following its IPO on July 29, 2013, the Company began recording a federal and state income tax liability associated with its status as a corporation. No provision for federal income taxes was recorded prior to the IPO because the taxable income or loss was includable in the income tax returns of the individual partners and members. The Company is also subject to state income taxes. The State of Texas includes in its tax system a franchise tax applicable to the Company and an accrual for franchise taxes is included in the financial statements when appropriate.

        Income taxes are accounted for under the asset and liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which differences are expected to be recovered or settled pursuant to the provisions of ASC 740—Income Taxes. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

        The Company records a valuation allowance if it is deemed more likely than not that all or a portion of its deferred income tax assets will not be realized. In addition, income tax rules and regulations are subject to interpretation and the application of those rules and regulations require judgment by the Company and may be challenged by the taxation authorities. The Company follows ASC 740-10-25, which requires the use of a two-step approach for recognizing and measuring tax benefits taken or expected to be taken in a tax return and disclosures regarding uncertainties in income tax positions. Only tax positions that meet the more likely than not recognition threshold are recognized. The Company's policy is to include any interest and penalties recorded on uncertain tax positions as a component of income tax expense. The Company's unrecognized tax benefits or related interest and penalties are immaterial.

Liability under Tax Receivable Agreement

        In connection with the IPO, the Company entered into a Tax Receivable Agreement (the "TRA") which obligated the Company to make payments to certain current and former owners equal to 85% of the applicable cash savings that the Company realizes as a result of tax attributes arising from exchanges of JEH Units and JEI Class B shares held by those owners for Class A shares of JEI common stock. The Company will retain the benefit of the remaining 15% of these tax savings.

        As a result of exchanges made through December 31, 2014, the Company has accrued future tax benefits of $0.9 million and has recorded this amount as a deferred tax asset on its consolidated balance sheet. As of December 31, 2014, the Company has recorded a liability of $0.8 million associated with its future TRA obligation. The actual amount and timing of payments made under the TRA will depend upon a number of factors, including the amount and timing of taxable income generated in the future, changes in future tax rates, the use of loss carryovers, and the portion of the Company's payments under the TRA constituting imputed interest. To the extent the Company does not realize all of the tax benefits in future years or in the event of a change in future tax rates, this liability may change.

        As of December 31, 2014, the Company has made no payments under the TRA and does not anticipate making a material payment under the TRA in 2015.

Comprehensive Income

        The Company has no elements of comprehensive income other than net income.

Statement of Cash Flows

        The Company presents its cash flows using the indirect method.

Related Party Transactions

        In the years ended December 31, 2013 and 2012, the Company paid an annual administration fee to Metalmark of $0.7 million. This amount was charged to expense. As a result of the IPO, this fee is no longer payable to Metalmark.

        On May 7, 2013, the Company entered into a natural gas sale and purchase agreement with Monarch Natural Gas, LLC, ("Monarch"), under which Monarch has the first right to gather the natural gas the Company produces from dedicated properties, process the NGLs from this natural gas production and market the processed natural gas and extracted NGLs. Under the Monarch agreement, the Company is paid a specified percentage of the value of the NGLs extracted and sold by Monarch, based on a set liquids recovery percentage, and the amount received from the sale of the residue gas, after deducting a fixed volume for fuel, lost and unaccounted for gas. The Company produced approximately 1.4 MMBoe of natural gas and NGLs for the year ended December 31, 2014 and 0.8 MMBoe of natural gas and NGLs for the year ended December 31, 2013, from the properties that became subject to the Monarch agreement. The initial term of the agreement runs for 10 years from the effective date of September 1, 2013.

        At the time the Company entered into the agreement, Metalmark Capital owned approximately 81% of the outstanding equity interests of Monarch. In addition, Metalmark Capital beneficially owns in excess of five percent of the Company's outstanding equity interests and two of our directors, Howard I. Hoffen and Gregory D. Myers, are managing directors of Metalmark Capital. In connection with the Company's entering into the Monarch agreement, Monarch issued to JEH equity interests in Monarch having a deemed value of $15 million. JEH assigned $2.4 million of the Monarch equity interests to Jonny Jones, the Company's chief executive officer and chairman of the board, and reserved $2.6 million of the Monarch equity interests to a benefit plan established for certain of the Company's officers, including Mike McConnell, Robert Brooks and Eric Niccum. The remaining $10 million of Monarch equity was distributed to certain of the pre-IPO owners, which include Metalmark Capital, Wells Fargo, the Jones family entities, and certain of the Company's officers and directors, including Jonny Jones, Mike McConnell and Eric Niccum.

        In September 2014, the Company signed a 10-year oil gathering and transportation agreement with Monarch Oil Pipeline LLC, pursuant to which Monarch Oil Pipeline, LLC will build, at its expense, a new oil gathering system and connect to dedicated Company leases in Texas. At the time the Company entered into the agreement, Metalmark Capital owned the majority of the outstanding equity interests of Monarch Oil Pipeline, LLC and/or its parent. The system is expected to begin service during the second quarter of 2015 and provide connectivity to both a regional refinery market as well as the Cushing market hub. The Company has reserved capacity of up to 12,000 barrels per day on the system with the potential to increase throughput at a future date.

Stock Compensation

        JEH implemented a management incentive plan effective January 1, 2010, that provided awards of membership interests in JEH to members of senior management ("management units"). The management unit grants awarded prior to the initial filing of the IPO registration statement in March 2013 had a dual vesting schedule and were fully vested as of December 31, 2014. Grants awarded after the initial IPO registration statement generally have a single vesting structure of five equal annual installments and were valued at the IPO price, adjusted for equivalent shares. Both the vested and unvested management units were converted into JEH Units and shares of Class B common stock at the IPO date. At December 31, 2014, there were 274,385 unvested JEH Units and shares of Class B common stock that will become convertible into a like number of shares of Class A common stock upon vesting.

        Under the Jones Energy, Inc. 2013 Omnibus Incentive Plan, established in conjunction with the Company's IPO, the Company reserved 3,850,000 shares of Class A common stock for director and employee stock-based compensation awards.

        During 2014, the Company granted performance unit and restricted stock unit awards to certain officers and employees under the Jones Energy, Inc. 2013 Omnibus Incentive Plan. The fair value of the performance units was based on the grant date fair value (using a Monte Carlo simulation model) and is expensed on a straight-line basis over the applicable three-year performance period. The number of shares of Class A common stock issuable upon vesting of the performance unit awards ranges from zero to 200% based on the Company's total shareholder return relative to an industry peer group over the applicable three-year performance period. The fair value of the restricted stock unit awards was based on the value of the Company's Class A common stock on the date of grant and is expensed on a straight-line basis over the applicable three-year vesting period.

        In September 2014 and 2013, the Company granted each of the outside members of the Board of Directors 5,486 and 6,645 shares, respectively, of restricted Class A common stock under the Jones Energy, Inc. 2013 Omnibus Incentive Plan. The fair value of the restricted stock grants was based on the value of the Company's Class A common stock on the date of grant and is expensed on a straight-line basis over the one-year vesting period.

        Refer to Note 7, "Stock-based Compensation," for additional information regarding director and employee stock-based compensation awards

Business Combinations

        For acquisitions of working interests that are accounted for as business combinations, the results of operations are included in the Consolidated Statement of Operations from the date of acquisition. Purchase prices are allocated to assets acquired based on their estimated fair values at the time of acquisition. Fair value is the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value measurement is based on the assumptions of market participants and not those of the reporting entity. Therefore, entity-specific intentions do not impact the measurement of fair value. The fair value of oil and natural gas properties is determined using a risk-adjusted after-tax discounted cash flow analysis based upon significant inputs including: 1) oil and gas prices, 2) projections of estimated quantities of oil and natural gas reserves, including those classified as proved, probable and possible, 3) projections of future rates of production, 4) timing and amount of future development and operating costs, 5) projected reserve recovery factors, and 6) weighted average cost of capital.

Recent Accounting Pronouncements

        In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers," which creates a new topic in the Accounting Standards Codification ("ASC"), topic 606, "Revenue from Contracts with Customers." This ASU sets forth a five-step model for determining when and how revenue is recognized. Under the model, an entity will be required to recognize revenue to depict the transfer of goods or services to a customer at an amount reflecting the consideration it expects to receive in exchange for those goods or services. Additional disclosures will be required to describe the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2016 and may be applied on either a full or modified retrospective basis. Early adoption is not permitted. We do not expect the adoption of these provisions to have a significant impact on the Company's consolidated financial statements. However, we will continue to assess the anticipated impact as further implementation guidance is released from the FASB.

        In August 2014, the FASB issued ASU No. 2014-15, "Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern." This ASU requires management to evaluate whether there are conditions or events that raise substantial doubt about an entity's ability to continue as a "going concern" and to provide disclosures when certain criteria are met. Substantial doubt exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or available to be issued). The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. Early adoption is permitted. We do not expect the adoption of these disclosures to have a significant impact on the Company's consolidated financial statements.

        In January 2015, the FASB issued Accounting Standards Update No. 2015-01, Income Statement—Extraordinary and Unusual Items ("ASU 2015-01"). ASU 2015-01 removes the concept of extraordinary items from GAAP. Under existing guidance, an entity is required to separately disclose extraordinary items, net of tax, in the income statement after income from continuing operations if an event or transaction is of an unusual nature and occurs infrequently. This separate, net-of-tax presentation will no longer be allowed. ASU 2015-01 is effective for interim and annual reporting periods beginning after December 15, 2015. The Company does not expect the adoption of this guidance to have a material impact on its financial position, cash flows or results of operations.

 

3. Acquisition of Properties

        No property acquisitions that would qualify as a business combination occurred during the twelve months ended December 31, 2014.

        On December 18, 2013, JEH closed on the purchase of certain oil and natural gas properties located in Texas and western Oklahoma from Sabine Mid-Continent, LLC, for a purchase price of $193.5 million (referred to herein as the "Sabine acquisition" or "Sabine"), subject to customary closing adjustments. The acquired assets included both producing properties and undeveloped acreage. The purchase was financed with borrowings under the Revolver. In the second quarter of 2014, the Company made a final determination with the sellers as to the purchase price resulting in a final purchase price of $179.2 million. The amount of the total purchase price allocated to undeveloped oil and gas properties was reduced by these adjustments. The adjustments were retroactively applied to our December 31, 2013 Consolidated Balance Sheet as a reduction to oil and gas properties and an increase in receivables. The adjusted purchase price was allocated as follows:

                                                                                                                                                                                    

        The unaudited pro forma results presented below have been prepared to include the effect of the Sabine acquisition on our results of operations for the year ended December 31, 2013. The unaudited pro forma results do not purport to represent what our actual results of operations would have been if the acquisition had been completed on January 1, 2013 or to project our results of operations for any future date or period.

                                                                                                                                                                                    

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        On December 20, 2012, JEH acquired certain oil and natural gas properties located in Texas for a purchase price of $251.9 million (referred to herein as the "Chalker acquisition" or "Chalker"). The acquired assets included both producing properties and undeveloped acreage. The purchase was financed with additional equity capital and borrowings under the Revolver. In the second quarter of 2013, the Company made a final determination with the sellers as to the purchase price adjustments resulting in a final purchase price of $253.5 million. The final purchase price was allocated as follows:

                                                                                                                                                                                    

        The unaudited pro forma results presented below have been prepared to include the effect of the Chalker acquisition on our results of operations for the year ended December 31, 2012. The unaudited pro forma results do not purport to represent what our actual results of operations would have been if the acquisition had been completed on January 1, 2012 or to project our results of operations for any future date or period.

                                                                                                                                                                                    

        Both acquisitions qualified as a business combination under ASC 805. The valuation to determine the fair values were principally based on the discounted cash flows of the producing and undeveloped properties, including projected drilling and equipment costs, recoverable reserves, production streams, future prices and operating costs, and risk-adjusted discount rates reflective of the market at the time of acquisition.

 

4. Fair Value Measurement

Fair Value of Financial Instruments

        The Company determines fair value amounts using available market information and appropriate valuation methodologies. Fair value is the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. Considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions and/or estimation methods may have a material effect on the estimated fair value amounts.

        The Company enters into a variety of derivative financial instruments, which may include over-the-counter instruments, such as natural gas, crude oil, and natural gas liquid contracts. The Company utilizes valuation techniques that maximize the use of observable inputs, where available. If listed market prices or quotes are not published, fair value is determined based upon a market quote, adjusted by other market-based or independently sourced market data, such as trading volume, historical commodity volatility, and counterparty-specific considerations. These adjustments may include amounts to reflect counterparty credit quality, the time value of money, and the liquidity of the market.

        Counterparty credit valuation adjustments are necessary when the market price of an instrument is not indicative of the fair value as a result of the credit quality of the counterparty. Generally, market quotes assume that all counterparties have low default rates and equal credit quality. Therefore, an adjustment may be necessary to reflect the quality of a specific counterparty to determine the fair value of the instrument. The Company currently has all derivative positions placed and held by members of its lending group, which have strong credit quality.

        Liquidity valuation adjustments are necessary when the Company is not able to observe a recent market price for financial instruments that trade in less active markets. Exchange traded contracts are valued at market value without making any additional valuation adjustments; therefore, no liquidity reserve is applied.

Valuation Hierarchy

        Fair value measurements are grouped into a three-level valuation hierarchy. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument's categorization within the hierarchy is based upon the input that requires the highest degree of judgment in the determination of the instrument's fair value. The three levels are defined as follows:

                                                                                                                                                                                    

        The financial instruments carried at fair value as of December 31, 2014 and 2013, by consolidated balance sheet caption and by valuation hierarchy, as described above are as follows:

                                                                                                                                                                                    

 

                                                                                                                                                                                    

        The following table represents quantitative information about Level 3 inputs used in the fair value measurement of the Company's commodity derivative contracts as of December 31, 2014.

                                                                                                                                                                                    

        Significant increases/decreases in natural gas liquid prices in isolation would result in a significantly lower/higher fair value measurement. The following table presents the changes in the Level 3 financial instruments for the years ended December 31, 2014 and 2013. Changes in fair value of Level 3 instruments represent changes in gains and losses for the periods that are reported in other income (expense). New contracts entered into during the year are generally entered into at no cost with changes in fair value from the date of agreement representing the entire fair value of the instrument. Transfers between levels are evaluated at the end of the reporting period.

                                                                                                                                                                                    

        Transfers from Level 3 to Level 2 represent the Company's natural gas basis swaps for which observable forward curve pricing information has become readily available. Purchases represent natural gas liquid swaps that the Company entered into that do not have observable forward curve pricing information. There were no transfers into Level 3 for the years ended December 31, 2014 and 2013.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

        The following table provides the fair value of financial instruments that are not recorded at fair value in the consolidated financial statements:

                                                                                                                                                                                    

        The Revolver is categorized as Level 3 in the valuation hierarchy as the debt is not publicly traded and no observable market exists to determine the fair value; however, the carrying value of the Revolver approximates fair value, as it is subject to short-term floating interest rates that approximate the rates available to the Company for those periods.

        The fair value of the 2022 Notes (as defined in Note 6) is based on pricing that is readily available in the public market. Accordingly, the 2022 Notes are classified as Level 2 in the valuation hierarchy as the pricing is based on quoted market prices for the debt securities.

        Assets and liabilities acquired in business combinations are recorded at their fair value on the date of acquisition. Significant Level 3 assumptions associated with the calculation of future cash flows used in the analysis of fair value of the oil and gas property acquired include the Company's estimate of future commodity prices, production costs, development expenditures, production, risk-adjusted discount rates, and other relevant data. Additionally, fair value is used to determine the inception value of the Company's AROs. The inputs used to determine such fair value are primarily based upon costs incurred historically for similar work, as well as estimates from independent third parties for costs that would be incurred to restore leased property to the contractually stipulated condition. Additions to the Company's ARO represent a nonrecurring Level 3 measurement.

        The Company reviews its proved oil and gas properties for impairment purposes by comparing the expected undiscounted future cash flows at a producing field level to the unamortized capitalized cost of the asset. No impairment charges on the Company's proved properties were recorded during the years ended December 31, 2014 and 2013. During 2012, unamortized capitalized costs of certain properties were higher than their expected undiscounted future cash flows due primarily to downward reserve revisions, drilling of marginal or uneconomic wells, or development dry holes in certain producing fields. As a result, the Company recorded charges of $18.8 million during the year ended December 31, 2012.

        Additionally, the Company reviews its unproved properties for indicators of impairment based on the Company's current exploration plans. In the fourth quarter of 2013, the Company recorded an impairment charge of $14.4 million related to the Southridge properties. As the Company did not drill the required number of wells by October 31, 2013 necessary to keep its joint development agreement with Southridge in effect, the Company lost its right to the undeveloped acreage and associated reserves. The Company incurred no impairment charges related to its unproved properties in 2014 or 2012.

        Impairment charges are recorded on the Consolidated Statement of Operations. Significant assumptions associated with the calculation of future cash flows used in the impairment analysis include the Company's estimate of future commodity prices, production costs, development expenditures, production, risk-adjusted discount rates, and other relevant data. As such, the fair value of oil and gas properties used in estimating impairment represents a nonrecurring Level 3 measurement.

 

5. Derivative Instruments and Hedging Activities

        The Company had various commodity derivatives in place that could affect its future operations as of December 31, 2014 and 2013, as follows:

Hedging Positions

                                                                                                                                                                                    

 

                                                                                                                                                                                    

        The Company recognized a net gain on derivative instruments of $189.6 million for the year ended December 31, 2014, a net loss of $2.6 million for the year ended December 31, 2013, and a net gain of $16.7 million for the year ended December 31, 2012.

Offsetting Assets and Liabilities

        As of December 31, 2014, the counterparties to our commodity derivative contracts consisted of seven financial institutions. Substantially, all of our counterparties or their affiliates are also lenders under the Revolver. We are not generally required to post additional collateral under our derivative agreements.

        Our derivative agreements contain set-off provisions that state that in the event of default or early termination, any obligation owed by the defaulting party may be offset against any obligation owed to the defaulting party.

        We adopted the guidance requiring disclosure of both gross and net information about financial instruments eligible for netting in the balance sheet under our derivative agreements. The following table presents information about our commodity derivative contracts that are netted on our Consolidated Balance Sheet as of December 31, 2014 and December 31, 2013:

                                                                                                                                                                                    

 

 

6. Long-Term Debt

Senior Notes

        On April 1, 2014, JEH and its wholly-owned subsidiary, Jones Energy Finance Corp. (together the "Issuers"), sold $500.0 million in aggregate principal amount of the Issuers' 6.75% Senior Notes due 2022 (the "2022 Notes"). The Company used the net proceeds from the issuance of the 2022 Notes to repay all outstanding borrowings under the Term Loan ($160.0 million), a portion of the outstanding borrowings under the Revolver ($308.0 million) and for working capital and general corporate purposes. The Company subsequently terminated the Term Loan in accordance with its terms. The 2022 Notes bear interest at a rate of 6.75% per year, payable semi-annually on April 1 and October 1 of each year beginning October 1, 2014. As of December 31, 2014, the Company had $8.4 million in interest accrued related to the 2022 Notes. Total interest expense related to the 2022 Notes amounted to $25.3 million for the year ended December 31, 2014.

        The 2022 Notes are guaranteed on a senior unsecured basis by the Company and by all of its significant subsidiaries. The 2022 Notes will be senior in right of payment to any future subordinated indebtedness of the Issuers.

        The Company may redeem the 2022 Notes at any time on or after April 1, 2017 at a declining redemption price set forth in the indenture, plus accrued and unpaid interest.

        The indenture governing the 2022 Notes contains covenants that, among other things, limit the ability of the Company to incur additional indebtedness or issue certain preferred stock, pay dividends on capital stock, transfer or sell assets, make investments, create certain liens, enter into agreements that restrict dividends or other payments from the Company's restricted subsidiaries to the Company, consolidate, merge or transfer all of the Company's assets, engage in transactions with affiliates or create unrestricted subsidiaries. However, many of these covenants will be suspended if the Notes are rated investment grade by Standard & Poor's or Moody's.

Other Long-Term Debt

        The Company entered into two credit agreements dated December 31, 2009, with Wells Fargo Bank N.A, the Senior Secured Revolving Credit Facility (the "Revolver") and the Second Lien Term Loan (the "Term Loan"), each of which have been amended periodically. On April 1, 2014, the Term Loan was repaid in full and terminated in connection with the issuance of the 2022 Notes. On November 6, 2014, the Company amended the Revolver to, among other things, increase the borrowing base under the Revolver from $550.0 million to $625.0 million until the next redetermination thereof, and extend the maturity date of the Revolver to November 6, 2019. The Company's oil and gas properties are pledged as collateral to secure its obligations under the Revolver. The borrowing base on the Revolver was subsequently adjusted to $562.5 million in accordance with its terms as a result of the issuance of the 2023 Notes in February 2015.

        The terms of the Revolver require the Company to make periodic payments of interest on the loans outstanding thereunder, with all outstanding principal and interest under the Revolver due on the maturity date thereof. The Revolver is subject to a borrowing base which limits the amount of borrowings which may be drawn thereunder. The borrowing base will be redetermined by the lenders at least semi-annually on or about April 1 and October 1 of each year. Interest on the Revolver is calculated, at the Company's option, at either (a) the LIBO rate for the applicable interest period plus a margin of 1.50% to 2.50% based on the level of borrowing base utilization at such time or (b) the greatest of the federal funds rate plus 0.50%, the one-month adjusted LIBO rate plus 1.00%, or the prime rate announced by Wells Fargo Bank, N.A. in effect on such day, in each case plus a margin of 0.50% to 1.50% based on the level of borrowing base utilization at such time. For the year ended December 31, 2014, the average interest rate under the Revolver was 2.51% on an average outstanding balance of $333.8 million. For the year ended December 31, 2013, the average interest rate under the Revolver was 3.01% on an average outstanding balance of $384.9 million.

        Total interest and commitment fees under the Revolver and Term Loan were $13.0 million, $27.0 million, and $21.2 million for the years ended December 31, 2014, 2013 and 2012, respectively. $3.8 million in unamortized deferred financing costs were charged to interest expense during 2014 in connection with repayment of the Term Loan.

        The Revolver is categorized as Level 3 in the valuation hierarchy as the debt is not publicly traded and no observable market exists to determine the fair value; however, the carrying value approximates fair value, as it is subject to short-term floating interest rates that approximate the rates available to the Company for those periods.

        We are subject to certain covenants under the Revolver which include, but are not limited to, restrictions on asset sales, distributions to members, and incurrence of additional indebtedness, and financial covenants which require the maintenance of certain financial ratios, including a maximum leverage ratio, and a minimum current ratio. The Company was in compliance with these covenants at December 31, 2014.

 

7. Stock-based Compensation

Management Units

        Prior to the IPO, JEH granted management units under a previously existing management incentive plan. These awards had various vesting schedules, and a portion of the management units vested in a lump sum at the IPO date. Both the vested and unvested management units were converted into JEH Units and shares of Class B common stock at the IPO date. As of December 31, 2014, there were 274,385 unvested JEH Units and shares of Class B common stock under this plan. No new JEH Units and Class B shares are created upon a vesting event. The JEH Units (together with a corresponding number of shares of Class B common stock) will become exchangeable into a like number of shares of Class A common stock upon vesting or forfeiture. The following table summarizes information related to the vesting of JEH Units:

                                                                                                                                                                                    

        Stock compensation expense associated with the management units and JEH Units for the years ended December 31, 2014, 2013 and 2012 was $1.6 million, $10.7 million, and $0.6 million, respectively, and is included in general and administrative expenses on the Company's Consolidated Statement of Operations.

Restricted Stock Awards

        On September 23, 2014, the Company granted restricted stock awards to non-employee members of the Board of Directors. Each of the five directors was awarded 5,486 restricted shares of Class A common stock, contingent on the director serving as a director of the Company for a one-year service period in accordance with the terms of the award. The fair value of the awards was based on the value of the Company's Class A common stock on the date of grant.

        On September 4, 2013, the Company granted restricted stock awards to non-employee members of the Board of Directors. Each of the four directors was awarded 6,645 restricted shares of Class A common stock, contingent on the director serving as a director of the Company for a one-year service period from the date of grant. The fair value of the awards was based on the value of the Company's Class A common stock on the date of grant. These awards are fully vested as of December 31, 2014. The total number of shares awarded to the directors is as follows:

Director Restricted Stock Awards

                                                                                                                                                                                    

        Stock compensation expense associated with the Board of Directors awards for the year ended December 31, 2014 was $0.4 million and for the year ended December 31, 2013 was $0.1 million and is included in general and administrative expenses on the Company's Consolidated Statement of Operations.

Restricted Stock Unit Awards

        During the year ended December 31, 2014, the Company granted 340,001 restricted stock unit awards to certain officers and employees of the Company. The fair value of the restricted stock unit awards was based on the value of the Company's Class A common stock on the date of grant and is expensed on a straight-line basis over the applicable three-year vesting period. The total number of units awarded to the officers and employees is as follows:

Employee Restricted Stock Unit Awards

                                                                                                                                                                                    

        Stock compensation expense associated with the employee restricted stock unit awards for the twelve months ended December 31, 2014 was $1.1 million, and is included in general and administrative expenses on the Company's Consolidated Statement of Operations.

Performance Unit Awards

        During the twelve months ended December 31, 2014, the Company granted 201,318 performance unit awards to certain officers of the Company. Upon the completion of the applicable three-year performance period, each officer will vest in a number of performance units. The number of performance units in which each officer vests at such time will range from 0% to 200% based on the Company's total shareholder return relative to an industry peer group over the applicable three-year performance period. Each vested performance unit is exchangeable for one share of the Company's Class A common stock. The grant date fair value of the performance units was determined using a Monte Carlo simulation model, which results in an expected percentage of performance units earned. The fair value of the performance units is expensed on a straight-line basis over the applicable three-year performance period.

        The total number of units awarded to the officers is as follows:

Employee Performance Unit Awards

                                                                                                                                                                                    

        Stock compensation expense associated with the performance unit awards for the twelve months ended December 31, 2014 was $0.9 million, and is included in general and administrative expenses on the Company's Consolidated Statement of Operations.

        The Monte Carlo simulation process is a generally accepted statistical technique used, in this instance, to simulate future stock prices for the Company and the components of the peer group. The simulation uses a risk-neutral framework along with the risk-free rate of return, the volatility of each entity, and the correlations of each entity with the other entities in the peer group. A stock price path has been simulated for the Company and each peer company and is used to determine the payout percentages and the stock price of the Company's common stock as of the vesting date. The ending stock price is multiplied by the payout percentage to determine the projected payout, which is then discounted with the risk-free rate of return to the grant date to determine the grant date fair value for that simulation. When enough simulations are generated, the resulting distribution gives a reasonable estimate of the range of future expected stock prices.

        The following assumptions were used for the Monte Carlo simulation model to determine the grant date fair value and associated compensation expense during the twelve months ended December 31, 2014:

                                                                                                                                                                                    

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        Based on these assumptions, the Monte Carlo simulation model resulted in a simulated fair value of $21.65 based on an expected percentage of performance units earned of 126.80%.