Notes to Unaudited Condensed Consolidated Financial Statements

N OTE 1. S UMMARY OF SIGNIFICANT ACCOUNTING POLICIES

General

Cobalt International Energy, Inc., together with its wholly–owned subsidiaries (“we,” “our” or “us”) is an independent exploration and production company with operations currently focused in the deepwater U.S. Gulf of Mexico.  We also have a non–operated interest in the Diaba Block offshore Gabon in West Africa.  

Sustained low prices for oil, natural gas and natural gas liquids could reduce our access to the capital markets, which could have a material adverse effect on our liquidity. A further or extended decline in prices could also adversely have a significant impact on the value and quantities of our reserves, assuming no other changes in our development plans.  In response to continued depressed prices, we have taken steps going forward to continue to preserve our liquidity and financial flexibility.  These steps include (i) marketing and monetizing our Angolan assets; (ii) continuing cost cutting efforts for long–term rig and support services; (iii) focusing on aligning our debt instruments and maturities with upcoming development investments in the Gulf of Mexico; (iv) evaluating potential Gulf of Mexico asset farm down scenarios as a contingency for the Angola sale process; (v) concentrating investments on the highest value opportunities in order to facilitate development as soon as appraisal is complete; (vi) planning for production ramp up by 2021; and (vii) engaging financial and legal advisors to assist us in analyzing and evaluating potential strategic alternatives and initiatives to improve liquidity.

In August 2015, Cobalt International Energy Angola Ltd.(“Cobalt Angola”), a wholly–owned subsidiary, executed a purchase and sale agreement (the “Agreement”) with Sociedade Nacional de Combustíveis de Angola—Empresa Pública (“Sonangol”) for the sale by us to Sonangol of the entire issued and outstanding share capital of Cobalt Angola’s indirect wholly–owned subsidiaries CIE Angola Block 20 Ltd. and CIE Angola Block 21 Ltd., which respectively hold our 40% working interest in each of Block 20 and Block 21 offshore Angola.  The requisite Angolan government approvals were not received within one year from the execution date and the Agreement was terminated in August 2016.  We are working with Sonangol to understand and agree on the financial and operational implications of the termination of the Agreement.

We are currently marketing our Angolan assets and have continued to classify our unaudited condensed consolidated financial statements for all periods presented to reflect the operations of our working interests in Blocks 20 and 21 offshore Angola as discontinued operations (see Note 7).  Historically, our Angolan subsidiaries constituted a significant portion of our West Africa segment. Our operations in Gabon, which are deemed immaterial, have now been combined with our United States segment and we now operate in one reportable segment.

Basis of Presentation

Our unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Accordingly, certain information and disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted.  We believe that the presentations and disclosures herein are adequate to make the information not misleading.  The unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) for a fair presentation of the interim periods.  The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in Item 8 of our Annual Report on Form 10–K for the year ended December 31, 2015.  Certain reclassifications have been made to prior period amounts to conform to the current period’s presentation.

All intercompany accounts and transactions have been eliminated in consolidation.  In the Notes to Unaudited Condensed Consolidated Financial Statements, all dollar and share amounts in tabulations are in thousands of dollars and shares, respectively, unless otherwise indicated.

Correction of Immaterial Errors

Our unaudited condensed consolidated financial statements for the nine months ended September 30, 2016 include an $8.5 million reduction to an impairment charge recorded in 2015. This amount was not deemed material with respect to such prior year or the anticipated results and the trend of earnings for 2016.

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Notes to Unaudited Condensed Consolidated Financial Statements (continued)

Recently Issued Accounting Standards

In August 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014–15, Presentation of Financial Statements – Going Concern .  This ASU amends the accounting guidance for the presentation and disclosure of uncertainties about an entity’s ability to continue as a going concern.  It requires management to evaluate and disclose whether there is substantial doubt about its ability to continue as a going concern.  Management should consider relevant conditions or events that are known or reasonably known on the date the financial statements are issued.  The provisions of ASU 2014–15 are applicable to the annual reporting period ending after December 15, 2016 and for annual periods and interim periods thereafter.  We have not yet fully determined or quantified the effect ASU 2014–15 will have on our unaudited condensed consolidated financial statements.

In April 2015, the FASB issued ASU No. 2015–03, Interest—Imputation of Interest .  This ASU changes the presentation of debt issuance costs in financial statements.  Under ASU 2015–03, an entity presents such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset.  We adopted ASU 2015–03 on March 31, 2016, which required that we apply the guidance on a retrospective basis, wherein our unaudited condensed consolidated balance sheets for all periods presented were adjusted to reflect the effects of applying the guidance.  Accordingly, as of December 31, 2015, we reclassified $32.9 million of unamortized debt issuance costs previously reported in “Other assets” to “Long–term debt, net” on our unaudited condensed consolidated balance sheet.

In February 2016, the FASB issued ASU No. 2016-02, Leases .  Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months. Consistent with current accounting guidance, the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee primarily depends on its classification as a finance or operating lease.  However, unlike current accounting guidance, which requires only capital leases to be recognized on the balance sheet, ASU 2016–02 will require both types of leases to be recognized on the balance sheet.  ASU 2016-02 will also require disclosures to help investors and other financial statement users to better understand the amount, timing and uncertainty of cash flows arising from leases.  Although ASU 2016–02 does not apply to leases for oil and natural gas properties, it does apply to equipment used to explore and develop oil and natural gas resources.  ASU 2016–02 is effective for annual and interim periods beginning after December 15, 2018 and is to be applied using the modified retrospective approach.  We have not yet fully determined the effect that adopting ASU 2016-02 will have on our unaudited condensed consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Subtopic 718) .  This ASU simplifies several aspects of the accounting for employee share–based payment transactions, including the accounting for income taxes, forfeitures and statutory withholding requirements, as well as classification in the statement of cash flows.  The provision of ASU 2016–09 are applicable to annual reporting periods beginning after December 15, 2016 and interim period within those annual periods.  Early adoption is permitted for financial statements that have not yet been previously issued.  We have not yet fully determined or quantified the effect ASU 2016–09 will have on our unaudited condensed consolidated financial statements. 

In June 2016, the FASB issued ASU 2016–13, Financial Instruments – Credit Losses , which requires the measurement of expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable forecasts.  The main objective of ASU 2016–13 is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The provisions of ASU 2016–13 are effective for annual and interim periods beginning after December 15, 2019.  Early adoption is permitted for annual and interim periods beginning after December 15, 2018.  We have not yet fully determined the effect that adopting ASU 2016–13 will have on our unaudited condensed consolidated financial statements.

No other new accounting pronouncements issued or effective during the nine months ended September 30, 2016 have had or are expected to have a material impact on our unaudited condensed consolidated financial statements.

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Notes to Unaudited Condensed Consolidated Financial Statements (continued)

NOTE 2 . INVESTMENTS

We have investments in marketable debt securities that are classified as held–to–maturity and carried at amortized cost.  As the estimated fair value of each investment approximates its amortized cost, there were no significant unrecognized holding gains or losses.

Our investments in held–to–maturity securities consist of the following:

 These investments are recorded in our unaudited condensed consolidated balance sheet as follows:

At September 30, 2016 and December 31, 2015, the contractual maturities of our investments were within one year.  Actual maturities may differ from contractual maturities as some borrowers have the right to call or prepay obligations with or without call or prepayment penalties.  

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Notes to Unaudited Condensed Consolidated Financial Statements (continued)

NOTE 3 . FAIR VALUE MEASUREMENTS

The fair value hierarchy has three levels based on the reliability of the inputs used to determine fair value.  Level 1 refers to fair values determined based on quoted prices in active markets for identical assets or liabilities.  Level 2 refers to fair values determined based on quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration.  Level 3 refers to fair values determined based on our own assumptions used to measure assets and liabilities at fair value.

 Our investments are not traded on a public exchange and the fair value of these investments is based on inputs using valuations obtained from independent brokers.  As these valuations use readily observable market parameters that are actively quoted and can be validated through external sources, we have categorized these investments as Level 2.  There were no changes in valuation techniques or related inputs in the nine months ended September 30, 2016.

Financial Instruments

The estimated fair values of our financial instruments have been determined at discrete points in time based on relevant market information. Our financial instruments consist of cash and cash equivalents, joint interest and other receivables, short–term and long–term restricted funds and investments, accounts payable and accrued liabilities. The carrying amounts of our financial instruments other than long–term debt approximate fair value because of the short–term nature of the items.   

The estimated fair value of our 2.625% convertible senior notes due 2019 was $705.5 million and $793.5 million at September 30, 2016 and December 31, 2015, respectively, which differs from the carrying value of $1,166.2 million and $1,121.4 million at September 30, 2016 and December 31, 2015, respectively. The estimated fair value of our 3.125% senior convertible notes due 2024 was $502.1 million and $640.2 million at September 30, 2016 and December 31, 2015, respectively, which differs from the carrying value of $889.2 million and $860.5 million at September 30, 2016 and December 31, 2015, respectively. The fair values of our long–term debt were calculated using Level 2 inputs and were based on discounted cash flows and the fair value of similar debt instruments.

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Capitalized Exploration Well Costs

If an exploration well provides evidence as to the existence of sufficient quantities of hydrocarbons to justify evaluation for potential development, drilling costs associated with the well are initially capitalized, or suspended, pending a determination as to whether a commercially sufficient quantity of proved reserves can be attributed to the area as a result of drilling. This determination may take longer than one year in certain areas (generally, deepwater and international locations) depending upon, among other things, (i) the amount of hydrocarbons discovered, (ii) the outcome of planned geological and engineering studies, (iii) the need for additional appraisal drilling activities to determine whether the discovery is sufficient to support an economic development plan and (iv) the requirement for government sanctioning in international locations before proceeding with development activities.

The following tables reflect the net changes in and the cumulative costs of capitalized exploration well costs (excluding any related leasehold costs):

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As of September 30, 2016, capitalized exploration well costs that have been suspended longer than one year are associated with our Shenandoah, North Platte, Anchor, and Diaman discoveries. These well costs are suspended pending ongoing evaluation including, but not limited to, results of additional appraisal drilling, well–test analysis, additional geological and geophysical data and approval of a development plan. We believe these discoveries exhibit sufficient indications of hydrocarbons to justify potential development and are actively pursuing efforts to fully assess them. If additional information becomes available that raises substantial doubt as to the economic or operational viability of these discoveries, the associated costs will be expensed at that time.

In June 2016, Cobalt GOM #1 LLC, an indirect wholly–owned subsidiary, terminated the Borrowing Base Facility Agreement (the “Facility Agreement”) which provided for a limited recourse $150.0 million senior secured reserve–based term loan facility, with an amount available for borrowing at any time limited to a periodically adjusted borrowing base amount.  We terminated the Facility Agreement because the borrowing base amount under the Facility Agreement was expected to be materially reduced to a level that would not justify the ongoing expense of maintaining the facility.  In conjunction with the termination, we wrote off $3.3 million of debt issuance costs associated with the Facility Agreement in the nine months ended September 30, 2016.

NOTE 6. COMMITMENTS AND CONTINGENCIES

We are currently, and from time to time may be, subject to various lawsuits, claims and proceedings that arise in the normal course of business, including employment, commercial, environmental, safety and health matters.  It is not presently possible to determine whether any such matters will have a material adverse effect on our consolidated financial position, results of operations or liquidity.

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Notes to Unaudited Condensed Consolidated Financial Statements (continued)

NOTE 7 .  DISCONTINUED OPERATIONS

In 2016, we reclassified our unaudited condensed consolidated financial statements to reflect the operations of our Angola operations as discontinued operations.

Summarized financial information for our Angola operations is as follows:

NOTE 8.  EQUITY–BASED COMPENSATION

We grant various forms of equity–based compensation to our employees and directors.  These equity–based awards consist of non–qualified stock options (“NQSOs”), restricted stock awards (“RSAs”), stock appreciation rights (“SARs”) and restricted stock units (“RSUs”).  NQSOs and RSAs are accounted for as equity awards and compensation cost is recognized on a straight–line basis over the service period and is net of forfeitures.  SARs and RSUs are accounted for as liability awards and the fair value of these awards is remeasured at the end of each reporting period based on the current market price of our common stock until settlement.  

Grants in 2016

Non–Qualified Stock Options

In January 2016, we issued 1.1 million NQSOs to two executive officers under the terms of their employee agreements.  These NQSOs vest in three equal installments beginning in February 2017 subject to our common stock achieving certain market prices.  As these NQSO’s had both service and market conditions, we estimated the fair value of these NQSOs using the Monte Carlo simulation model.  The fair value of these NQSOs on the date of grant was $2.0 million.  

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Notes to Unaudited Condensed Consolidated Financial Statements (continued)

Restricted Stock Awards

In January 2016, we issued 0.6 million RSAs to two executive officers under the terms of their employee agreements.  These RSAs vest in three equal annual installments beginning in February 2017 subject to our common stock achieving certain market prices.  As these RSAs had both service and market conditions, we estimated the fair value of these RSAs using the Monte Carlo simulation model.  The fair value of these RSAs on the date of grant was $1.2 million.

Restricted Stock Units

In February 2016, we granted an aggregate of 3.5 million RSUs to our employees.  These RSU’s will vest in three equal annual installments beginning in March 2017 by, at our discretion, either the issuance of our common stock, cash, or a combination thereof.  The fair value of these RSUs on the date of grant was $10.4 million.

Non–Employee Director Grants

In the nine months ended September 30, 2016, we granted a total of 0.2 million shares of our common stock to our non–employee directors as retainer awards.  The directors have elected to defer the issuance of this stock.  Accordingly, we have recorded a liability for the future issuance of these shares.  In addition, we granted 0.4 million RSUs to our new non–employee directors.  These RSUs will vest in the first quarter of 2017 by, at our discretion, either the issuance of our common stock, cash or a combination thereof.  The fair value of these RSUs on the date of grant was $0.8 million.    

These costs are included in “General and administrative expenses” in our unaudited condensed consolidated statements of operations.  As of September 30, 2016, there was $27.7 million of unrecognized compensation costs which are expected to be recognized over a weighted average period of 1.8 years.

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Accrued liabilities consisted of the following:

NOTE 11.  OTHER MATTERS

In November 2011, a formal order of investigation was issued by the SEC related to our operations in Angola.  We were notified in January 2015 that the SEC’s investigation had concluded and that the SEC did not intend to recommend any enforcement action. We continue to cooperate with the Department of Justice (“DOJ”) with regard to its ongoing parallel investigation, but are unable to predict the outcome of the DOJ’s ongoing investigation or any action that the DOJ may decide to pursue.

In February 2016, we initiated a workforce reduction program in response to the pending sale of our Angola properties and prolonged commodity price weakness, which resulted in a reduction of our capital programs and other operations.  We recorded a charge for severance expense of $6.9 million.  In the three and nine months ended September 30, 2016, we recognized $0.6 million and $6.7 million, respectively, of severance costs associated with our workforce reduction plan.  As of September 30, 2016, we had accrued severance of $0.2 million, which we expect will be paid in 2017.  

In September 2016, we announced that we entered into an amendment to our drilling contract with Rowan (UK) Reliance Limited (“Rowan”) and recorded a charge of $95.9 million, of which $45.0 million was paid in September 2016.  This amendment provided for the early termination of our long–term drilling contract for one of their drillships.  The drilling contract was originally scheduled to terminate in February 2018, but the amendment provides for a contact termination date in March 2017.  This charge is recorded in “Loss on amendment of contract” in our unaudited condensed consolidated statements of operations.  As of September 30, 2016, we had accrued costs of $50.9 million, of which $31.3 million was paid in October 2016 and $19.6 million will be paid in March 2017.