Item 2. - Management's Discussion and Analysis of Financial Condition
and
Results of Operations
WARNING CONCERNING FORWARD LOOKING STATEMENTS
The following discussion should be read in conjunction with the financial
statements and notes thereto appearing elsewhere in this report.
This Report on Form 10-Q may contain forward-looking statements within
the meaning of the federal securities laws, principally, but not only, under the caption “Management’s Discussion and
Analysis of Financial Condition and Results of Operations.” We caution investors that any forward-looking statements in this
report, or which management may make orally or in writing from time to time, are based on management’s beliefs and on assumptions
made by, and information currently available to, management. When used, the words “anticipate,” “believe,”
“expect,” “intend,” “may,” “might,” “plan,” “estimate,”
“project,” “should,” “will,” “result” and similar expressions which do not relate
solely to historical matters are intended to identify forward-looking statements. These statements are subject to risks, uncertainties,
and assumptions and are not guarantees of future performance, which may be affected by known and unknown risks, trends, uncertainties,
and factors, that are beyond our control. Should one or more of these risks or uncertainties materialize, or should underlying
assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, or projected. We caution you
that while forward-looking statements reflect our good faith beliefs when we make them, they are not guarantees of future performance
and are impacted by actual events when they occur after we make such statements. We expressly disclaim any responsibility to update
our forward-looking statements, whether as a result of new information, future events or otherwise. Accordingly, investors should
use caution in relying on past forward-looking statements, which are based on results and trends at the time they are made, to
anticipate future results or trends.
`
Some of the risks and uncertainties that may cause our actual results,
performance or achievements to differ materially from those expressed or implied by forward-looking statements include, among others,
the factors listed and described at Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K, which
investors should review. There have been no changes from the risk factors previously described in the Company’s Form 10-K
for the fiscal year ended December 31, 2015 (the “Form 10-K”).
Uncertainties regarding the global economic and financial environment
could lead to an extended national or global economic recession. A slowdown in economic activity caused by a recession would likely
reduce national and worldwide demand for oil and natural gas and result in lower commodity prices for long periods of time. Costs
of exploration, development and production have not yet adjusted to current economic conditions, or in proportion to the significant
reduction in product prices. Prolonged, substantial decreases in oil and natural gas prices would likely have a material adverse
effect on the Company’s business, financial condition, and results of operations, and could further limit the Company's access
to liquidity and credit, and could hinder its ability to satisfy its capital requirements.
In the past several years, capital and credit
markets have experienced volatility and disruption. Given the levels of market volatility and disruption, the availability of funds
from those markets may diminish substantially. Further, arising from concerns about the stability of financial markets generally
and the solvency of borrowers specifically, the cost of accessing the credit markets has increased as many lenders have raised
interest rates, enacted tighter lending standards, or altogether ceased to provide funding to borrowers.
Due to these potential capital and credit market conditions, the
Company cannot be certain that funding will be available in amounts or on terms acceptable to the Company. The Company is evaluating
whether current cash balances and cash flow from operations alone would be sufficient to provide working capital to fully fund
the Company's operations. Accordingly, the Company is evaluating alternatives, such as joint ventures with third parties
,
or
sales of interest in one or more of its properties. Such transactions, if undertaken, could result in a reduction in the Company's
operating interests or require the Company to relinquish the right to operate the property. There can be no assurance that any
such transactions can be completed or that such transactions will satisfy the Company's operating capital requirements. If the
Company is not successful in obtaining sufficient funding or completing an alternative transaction on a timely basis on terms acceptable
to the Company, the Company would be required to curtail its expenditures or restructure its operations, and the Company would
be unable to continue its exploration, drilling, and recompletion program, any of which would have a material adverse effect on
its business, financial condition, and results of operations.
The Obama administration has set forth budget proposals which if
passed, would significantly curtail our ability to attract investors and raise capital. Proposed changes in the Federal income
tax laws which would eliminate or reduce the percentage depletion deduction and the deduction for intangible drilling and development
costs for small independent producers, will significantly reduce the investment capital available to those in the industry as well
as our Company. Lengthening the time to expense seismic costs will also have an adverse effect on our ability to explore and find
new reserves.
Other sections of this report may also include suggested factors
that could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing
environment. New risks may emerge from time to time and it is not possible for management to predict all such matters; nor can
we assess the impact of all such matters on our business or the extent to which any factor, or combination of factors, may cause
actual results to differ materially from those contained in any forward-looking statements. Given these uncertainties, investors
should not place undue reliance on forward-looking statements as a prediction of actual results. Investors should also refer to
our quarterly reports on Form 10-Q for future periods and current reports on Form 8-K as we file them with the SEC, and to other
materials we may furnish to the public from time to time through Forms 8-K or otherwise.
Oil and Gas Properties
The Company follows the full cost method of accounting for its oil
and gas properties. Accordingly, all costs associated with acquisition, exploration and development of oil and natural gas reserves
are capitalized in cost centers on a country-by-country basis. For each cost center, capitalized costs, less accumulated amortization
and related deferred income taxes, shall not exceed an amount (the cost center ceiling) equal to the sum of:
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a)
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The present value of estimated future net revenues computed by applying
current prices of oil and natural gas reserves (with consideration of price changes only to the extent provided by contractual
arrangements) to estimated future production of proved oil and gas reserves as of the date of the latest balance sheet presented,
less estimated future expenditures (based on current costs) to be incurred in developing and producing the proved reserves computed
using a discount factor of ten percent and assuming continuation of existing economic conditions; plus
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b)
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The cost of properties not being amortized; plus
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c)
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The lower of cost or estimated fair market value of unproven properties
included in the costs being amortized; less
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d)
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Income tax effects related to differences between the book and tax
basis of the properties.
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If unamortized costs capitalized within a cost center, less related
deferred income taxes, exceed the cost center ceiling (as defined), the excess is charged to expense and separately disclosed during
the period in which the excess occurs. Amounts required to be written off will not be reinstated for any subsequent increase in
the cost center ceiling. All of the Company’s oil and gas properties are located within the United States and are accounted
for in one cost center.
In order to test the cost center ceiling, the Company prepares a
“Standardized Measure of Discounted Future Net Cash Flows and Changes Therein Relating to Proved Oil and Natural Gas Reserves
(Unaudited)” as of the end of each calendar year (“the Reserve Report”). The Company will prepare its annual
Reserve Report as of December 31, 2016.
Reserve estimates are prepared in accordance with standard Security
and Exchange Commission guidelines. The estimated net future net cash flows for 2012, 2013, 2014, and 2015, were computed using
a 12-month average price, calculated as the un-weighted arithmetic average of the first-day-of-the month price for each month of
the year. Lease operating costs, compression, dehydration, transportation, ad valorem taxes, severance taxes, and federal income
taxes were deducted. Costs and prices were held constant and were not escalated over the life of the properties. No deductions
were made for interest, or general corporate overhead. The annual discount of estimated future cash flows is defined, for use herein,
as future cash flows discounted at 10% per year, over the expected period of realization. No impairment of oil and gas properties
charge was recorded for 2012, 2013 or 2014. For the year ended December 31, 2015, the Company recorded an impairment expense in
the carrying value of its proved oil and gas properties of $5,116,000, due primarily to declines in the average realized prices
for sales of its crude oil and natural gas.
These Reserve Reports do not purport to present the fair market value
of a company's oil and gas properties. An estimate of such value should consider, among other factors, anticipated future prices
of oil and natural gas, the probability of recoveries in excess of existing proved reserves, the value of probable reserves and
acreage prospects, and perhaps different discount rates.
It should be noted that estimates of reserve quantities, especially
from new discoveries, are inherently imprecise and subject to substantial revision. Accordingly, the estimates are expected to
change as more current information becomes available. It is reasonably possible that, because of changes in market conditions or
the inherent imprecision of these reserve estimates, that the estimates of future cash inflows, future gross revenues, the amount
of oil and natural gas reserves, the remaining estimated lives of the oil and natural gas properties, or any combination of the
above may be increased or reduced in the near term. If reduced, the carrying amount of capitalized oil and gas properties may be
reduced materially in the near term.
During the third quarter of 2014, oil and gas prices started to decline
worldwide. The Company has experienced a similar decline in the selling prices of its products as follows:
Average quarterly natural gas prices per mcf for the Company for
the year ended December 31, 2014 were $4.64, $4.71, $4.45, and $4.06, respectively. Average quarterly natural gas prices per mcf
for the Company for the year ended December 31, 2015 were $2.67, $2.46, $2.31, and $2.45, respectively. During the first nine months
of 2016, average quarterly natural gas prices per mcf for the Company were $1.34, $1.77, and $2.25 respectively.
Average quarterly crude oil prices per bbl for the Company for the
year ended December 31, 2014 were $113.76, $100.55, $98.05, and $83.03 respectively. Average quarterly crude oil prices per bbl
for the Company for the year ended December 31, 2015 were $46.33, $54.48, $45.68, and $41.03 respectively.
During the first nine months of 2016, average quarterly crude oil
prices per bbl for the Company were $30.62, $38.02, and $39.80 respectively.
The decreases in the Company’s product prices have a direct
effect on its cash flow, profits, projected development and drilling schedules, and the estimated net present value of its proved
reserves. Prolonged, substantial decreases in oil and natural gas prices would likely have a material adverse effect on the Company’s
business, financial condition, and results of operations, and could further limit the Company's access to liquidity and credit,
and could hinder its ability to satisfy its capital requirements.
We may incur impairments to our crude oil and natural gas properties
in 2016 if prices do not increase. The possibility and amount of any future impairment is difficult to predict, and will depend,
in part, upon future crude oil and natural gas prices to be utilized in the ceiling test, estimates of proved reserves and future
capital expenditures and operating costs. We cannot assure you that we will not experience write-downs in the future. If commodity
prices decline or if any of our proved reserves are revised downward, a write-down of the carrying value of our oil and gas properties
may be required.
Results of Operations
Nine months ended September 30, 2016 compared to Nine months
ended September 30, 2015
Oil and gas revenues for the first nine months of 2016 were $2,404,000,
as compared to $3,712,000 for the same period in 2015, a decrease of approximately $1,308,000 or 35.2%.
Natural gas revenue for the first nine months of 2016 was $820,000
compared to $1,289,000 for the same period in 2015, a decrease of approximately $469,000, or 36.4%. Natural gas sales volumes for
the first nine months of 2016 were approximately 423,000 mcf compared to approximately 508,000 mcf during the first nine months
of 2015, a decrease of approximately 85,000 mcf or 16.7%. In general, this decrease was due primarily to a decrease in natural
gas prices discussed below, and to a natural decline in production. In addition, several wells that went down were shut in rather
than repaired as a result of lower natural gas prices which contributed to an overall decline in gas production between the periods.
Average natural gas prices received were $1.80 per mcf in the first
nine months of 2016 as compared to $2.50 per mcf in the same time period in 2015, a decrease of approximately $0.70 per mcf or
28.0%.
Oil sales for the first nine months of 2016 were approximately $1,584,000
compared to approximately $2,423,000 for the first nine months of 2015, a decrease of approximately $839,000 or 34.6%. Oil sales
volumes for the first nine months of 2016 were approximately 37,700, compared to approximately 49,700 bbls during the same period
in 2015, a decrease of approximately 12,000 bbls, or 24.1%. This decrease was due primarily to a decrease in oil prices discussed
below, and to a decline on oil production between the two periods related to several non-operated horizontal wells in East Texas
in which the Company owns working and royalty interests.
Average oil prices received were $35.39 per bbl in the first nine
months of 2016 compared to $46.74 per bbl in the first nine months of 2015, a decrease of approximately $11.62 per bbl or 24.9%.
See the discussion of crude oil and natural gas prices under the
topic of “Oil and Gas Properties” on page 10.
Revenues from lease operations were $292,000 in the first nine months
of 2016 compared to $383,000 in the first nine months of 2015, a decrease of approximately $91,000 or 23.8%. This decrease is due
primarily to an approximate $26,000 decrease in field supervision charges due to a reduction in the number of operated wells that
were disposed of or that were shut in. In addition to the reduced number of operated wells, a reduction in the COPAS overhead rate
adjustment in April, 2016, led to a decrease of approximately $65,000 in operator overhead charged to the leases.
Revenues from gas gathering, compression and equipment rental for
the first nine months of 2016 were $97,000 compared to $106,000 for the same period in 2015, a decrease of $9,000 or 8.5%. This
decrease is due primarily to the lower volumes of gas that were transported.
Real estate rental revenue was approximately $233,000 during the
first nine months of 2016 compared to $168,000 for the first nine months of 2015, an increase of approximately $65,000, or 38.7%.
This increase is due to the addition of a new tenant at the Company’s corporate office building effective December 1, 2015.
Interest income was $61,000 during the first nine months of 2016
as compared to $66,000 during the same period in 2015, a decrease of approximately $5,000 or 7.6%. Interest income is derived from
investments in both short-term and long-term certificates of deposit as well as money market accounts at banks. Interest income
is lower due to generally lower interest rates and cash balances during the periods.
Other revenues for the first nine months of 2016 were $251,000 as
compared to $68,000 for the same time period in 2015, an increase of $183,000. This is due primarily due to the recognition of
fees earned under drilling ventures.
Lease operating expenses in the first nine months of 2016 were $927,000
as compared to $1,769,000 in the first nine months of 2015, a net decrease of $842,000, or 47.6%. Approximately $180,000 of the
decrease is due to a reduction in operating expenses billed by third-party operators on non-operated properties. There was an approximate
$138,000 decrease in expenses due to several wells that were either divested or plugged during 2015. A decrease in workovers of
approximately $314,000 was due to reduced activity as the result of lower oil and natural gas price economics. An increase of approximately
$50,000 is related to environmental remediation expenses associated with a nonrecurring weather event. The remaining represents
net increases and decreases on various properties due to general price fluctuations and levels of operation activity.
Production taxes, gathering and marketing expenses in the first nine
months of 2016 were approximately $305,000 as compared to $443,000 for the first nine months of 2015, a decrease of approximately
$138,000, or 31.2%. These decreases related directly to the decline in oil and gas production and revenues as described in the
above paragraphs.
Pipeline and rental expenses for the first nine months of 2016 were
$29,000 compared to $28,000 for the same time period in 2015, an increase of $1,000, or 3.6%.
Real estate expenses in the first nine months of 2016 were approximately
$110,000 compared to $119,000 during the same period in 2015, a decrease of approximately $9,000 or 7.6%. This decrease is due
primarily to lower utilities, maintenance and repair expenses.
Depreciation, depletion, and amortization expenses for first nine
months of 2016 were $928,000 as compared to $1,288,000 for the same period in 2015, a decrease of $360,000, or 28.0%. $878,000
of the amount for the first nine months of 2016 was for amortization of the full cost pool of capitalized costs compared to $1,240,000
for the same period of 2015, a decrease of $362,000 or 29.2%. The Company re-evaluated its proved oil and natural gas reserve quantities
as of December 31, 2015. This re-evaluated reserve base was adjusted for the first nine months as of September 30, 2016 by estimating
variances in average prices of oil and natural gas that occurred during the period, adding estimated quantities of oil and natural
gas reserves acquired during the period, and deducting oil and natural gas reserves that were produced or sold during the period.
A depletion rate of 3.350% for the first quarter of 2016, a depletion rate of 4.481% for the second quarter, and a depletion rate
of 3.228% for the third quarter of 2016 was calculated and applied to the Company’s full cost pool of capitalized oil and
natural gas properties compared to rates of 2.929%, 2.795%, and 2.975% for the first three quarters of 2015 respectively. Although
the depletion rate for the first nine months of 2016 is greater than the depletion rate for the same period in 2015, the decrease
of $362,000 in expense noted above is due to the depletion rate of 11.059% being applied to a smaller undepleted full cost pool
after the full cost pool was reduced by an impairment charge of $5,116,000 at December 31, 2015.
Asset Retirement Obligation (“ARO”) expense for the first
nine months of 2016 was approximately $26,000 as compared to approximately $31,000 for the same time period in 2015, a decrease
of approximately $5,000 or 16.1%. This decrease is due to a recalculation of the estimated present value to plug producing properties
compared to the estimate made in the previous year. This recalculation was made after the Company re-evaluated its proved oil and
natural gas reserves at the end of 2015.
General and administrative expenses for the first nine months of
2016 were approximately $1,907,000 as compared to approximately $2,424,000 for the same time period of 2015, a decrease of approximately
$517,000 or 21.3%. This decrease is due to a reduction in the number of personnel employed by the Company during 2015 and to date
during 2016, along with related reductions in salary, payroll taxes, benefits and other direct employee expenses.
Three months ended September 30, 2016 compared to three months
ended September 30, 2015
Oil and natural gas revenues for the three months ended September
30, 2016 were $855,000, compared to $1,278,000 for the same time period in 2015, a decrease of $423,000, or 33.1%.
Natural gas revenues for the third quarter of 2016 were $294,000
compared to $403,000 for the same period in 2015, a decrease of $109,000 or 27.0%. Natural gas volumes sold for the third quarter
of 2016 were approximately 136,000 mcf compared to approximately 163,000 mcf during the same period of 2015, a decrease of approximately
27,000 mcf, or 16.6%.
Average natural gas prices received were approximately $2.25 per
mcf in the third quarter of 2016 as compared to approximately $2.31 per mcf during the same period in 2015, a decrease of approximately
$0.06 or 2.6%.
Oil sales for the third quarter of 2016 were approximately $561,000
compared to approximately $875,000 for the same period of 2015, a decrease of approximately $314,000 or 35.9%. Oil volumes sold
for the third quarter of 2016 were approximately 17,200 bbls compared to approximately 18,800 bbls during the same period of 2015,
a decrease of 1,600 bbl or 8.5%.
Average oil prices received were approximately $39.80 per bbl in
the third quarter of 2016 compared to $45.68 per bbl during the same period of 2015, a decrease of approximately $6.01 per bbl,
or 13.2%.
See the discussion of crude oil and natural gas prices under the
topic of “Oil and Gas Properties” on page 10.
Revenues from lease operations for the third quarter of 2016 were
approximately $96,000 compared to approximately $139,000 for the third quarter of 2015, a decrease of approximately $43,000 or
30.9%. This decrease is due primarily to a $12,000 decrease in field supervision charges and operator overhead charged to the leases
due to a reduction in the number of operated wells that were disposed of or that were shut in. In addition to the reduced number
of operated wells, a reduction in the COPAS overhead rate adjustment led to a decrease of approximately $31,000 in operator overhead
charged to the leases.
Revenues from gas gathering, compression and equipment rental for
the third quarter of 2016 were approximately $28,000, compared to approximately $36,000 for the same period in 2015, a decrease
of approximately $8,000 or 22.2%. This decrease is due primarily to the lower volumes of gas that were transported.
Real estate rental revenue was approximately $77,000 during the third
quarter of 2016 compared to $54,000 for the same time period of 2015, an increase of approximately $23,000 or 42.6%. This increase
is due to the addition of a new tenant at the Company’s corporate office building effective December 1, 2015.
Interest income for the third quarter of 2016 was approximately $23,000
as compared with approximately $14,000 for the same period in 2015, an increase of approximately $9,000 or 64.3%. Interest income
is derived from investments in both short-term and long-term certificated of deposit. Interest income is lower due to generally
lower interest rates and cash balances during the periods.
Other revenues for third quarter of 2016 were approximately $10,000
as compared with approximately $30,000 for the same period in 2015, a reduction of $20,000 or 66.7%
Lease operating expenses in the third
quarter of 2016 were $356,000 as compared to $659,000 in the third quarter of 2016, a net decrease of approximately $303,000, or
46.0%. Approximately $50,000 of the decrease is due to a reduction in operating expenses billed by third-party operators
on non-operated properties. There was an approximate $69,000 decrease in expenses due to several wells that were either divested
or plugged during 2015. A decrease in workovers of approximately $205,000 was due to reduced activity as the result of lower oil
and natural gas price economics. An increase of approximately $50,000 is related to environmental remediation expenses associated
with a nonrecurring weather event. The remaining represents net increases and decreases on various properties due to general price
fluctuations and levels of operation activity
.
Production taxes, gathering, transportation and marketing expenses
for the third quarter of 2016 were approximately $79,000 as compared to $155,000 during the third quarter of 2015, a net decrease
of approximately $76,000 or 49.0%. These decreases related directly to the decline in oil and gas production and revenues as described
in the above paragraphs.
Pipeline and rental expenses for the third quarter of 2016 were $3,000
compared to $9,000 for the same time period in 2015, a decrease of $6,000 or 66.7%.
Real estate expenses during the third quarter 2016 were approximately
$39,000 compared to approximately $38,000 for the same period in 2015, an increase of approximately $1,000 or 2.6%.
Depreciation, depletion, and amortization expenses for the third
quarter of 2016 were $279,000 as compared to $451,000 for the same period in 2015, a decrease of $172,000, or 38.1%. $263,000 of
the amount for the third quarter of 2016 was for amortization of the full cost pool of capitalized costs compared to $437,000 for
the third quarter of 2015, a decrease of $174,000 or 39.8%. The Company re-evaluated its proved oil and natural gas reserve quantities
as of December 31, 2015. This re-evaluated reserve base was adjusted for the first nine months as of September 30, 2016 by estimating
variances in average prices of oil and natural gas that occurred during the period, adding estimated quantities of oil and natural
gas reserves acquired during the period, and deducting oil and natural gas reserves that were produced or sold during the period.
A depletion rate of 3.350% for the first quarter of 2016, a depletion rate of 4.481% for the second quarter, and a depletion rate
of 3.228% for the third quarter of 2016 was calculated and applied to the Company’s full cost pool of capitalized oil and
natural gas properties compared to rates of 2.929%, 2.795%, and 2.975% for the first three quarters of 2015 respectively. Although
the depletion rate for the third quarter of 2016 is greater than the depletion rate for the same period in 2015, the decrease of
$174,000 in expense noted above is due to the depletion rate of11.059% being applied to a smaller undepleted full cost pool after
the full cost pool was reduced by an impairment charge of $5,116,000 at December 31, 2015.
Asset Retirement Obligation (“ARO”) expense for the third
quarter of 2016 was approximately $9,000 as compared to approximately $10,000 for the same time period in 2015, a decrease of approximately
$1,000 or 10.0%. This decrease is due to a recalculation of the estimated present value to plug producing properties compared to
the estimate made in the previous year. This recalculation was made after the Company re-evaluated its proved oil and natural gas
reserves at the end of 2015.
General and administrative expenses for the third quarter of 2016
were $582,000 compared to $775,000 for the same period in 2015, a decrease of approximately $193,000 or 24.9%. This decrease is
due to a reduction in the number of personnel employed by the Company during 2015 and to date during 2016, along with related reductions
in salary, payroll taxes, benefits and other direct employee expenses.
Financial Condition and Liquidity
The Company's operating capital needs, as well as its capital spending
program are generally funded from cash flow generated by operations. Because future cash flow is subject to a number of variables,
such as the level of production and the sales price of oil and natural gas, the Company can provide no assurance that its operations
will provide cash sufficient to maintain current levels of capital spending. Accordingly, the Company may be required to seek additional
financing from third parties in order to fund its exploration and development programs.