AREX Approach Resources Inc

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

1.  Summary of Significant Accounting Policies

Organization and Nature of Operations

Approach Resources Inc. (“Approach,” the “Company,” “we,” “us” or “our”) is an independent energy company engaged in the exploration, development, production and acquisition of oil and gas properties.  We focus on finding and developing oil and natural gas reserves in oil shale and tight gas sands.  Our properties are primarily located in the Permian Basin in West Texas. We also own interests in the East Texas Basin.

Consolidation, Basis of Presentation and Significant Estimates

The interim consolidated financial statements of the Company are unaudited and contain all adjustments (consisting primarily of normal recurring accruals) necessary for a fair statement of the results for the interim periods presented. Results for interim periods are not necessarily indicative of results to be expected for a full year, due in part to the volatility in prices for oil, natural gas liquids (“NGLs”) and gas, future commodity prices for commodity derivative contracts, global economic and financial market conditions, interest rates, access to sources of liquidity, estimates of reserves, drilling risks, geological risks, transportation restrictions, the timing of acquisitions, product supply and demand, market competition and interruptions of production. You should read these consolidated interim financial statements in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the Securities and Exchange Commission on March 18, 2019.

The accompanying interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include the accounts of the Company and its wholly owned subsidiaries. Intercompany accounts and transactions are eliminated.  In preparing the accompanying financial statements, management has made certain estimates and assumptions that affect reported amounts in the financial statements and disclosures of contingencies. Actual results may differ from those estimates. Significant assumptions are required in the valuation of proved oil and gas reserves, which affect our estimate of depletion expense as well as our impairment analyses. Significant assumptions also are required in our estimation of accrued liabilities, commodity derivatives, income tax provision, share-based compensation and asset retirement obligations. It is at least reasonably possible these estimates could be revised in the near term, and these revisions could be material.  Certain prior-year amounts have been reclassified to conform to current-year presentation.  These classifications have no impact on the net loss reported.

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

Going Concern

These consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities and other commitments in the normal course of business for the twelve-month period following the date of issuance of these consolidated financial statements. As such, the accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets and their carrying amount, or the amount and classification of liabilities that may result should the Company be unable to continue as a going concern.

Our liquidity and ability to comply with debt covenants under our revolving credit facility have been negatively impacted by the volatility in commodity prices, and by the severe natural gas price discount in the Permian Basin. Our revolving credit facility contains three principal financial covenants: (i) a consolidated interest coverage ratio, (ii) a consolidated modified current ratio and (iii) a consolidated total leverage ratio. See Note 5 for additional information regarding the financial covenants under our revolving credit facility. As of March 31, 2019, we were not in compliance with the two of the financial covenants under our revolving credit facility, which represents an event of default under our revolving credit facility. As a result, we have classified the outstanding balance on our revolving credit facility as a current liability as of March 31, 2019. These factors raise substantial doubt about our ability to continue as a going concern.

In order to improve our leverage position, we are currently pursuing or considering a number of actions, which in certain cases may require the consent of current lenders, stockholders or bond holders. As part of our review of deleveraging transactions, we are currently engaged in discussions with Wilks Brothers, LLC, and its affiliate SDW Investments, LLC (collectively, “Wilks”) regarding their investment in the Company, including, without limitation, a possible debt for equity exchange of approximately $60 million aggregate principal amount of 7% Senior Notes due 2021 (the “Senior Notes”) currently held by Wilks and an additional capital infusion into Approach (the “Exchange Transaction”). There can be no assurance that these discussions will result in the consummation of any transaction in a timely matter, if at all.

We have also reached an agreement with our credit facility lenders to forgo enforcement of remedies for an event of default caused by our failure to comply with certain financial covenants in the credit facility, for a period of 45 days. This agreement will terminate on June 22, 2019, unless earlier terminated due to additional events of default under our credit facility, or a default under the agreement. In addition, we are in continuing discussions with the lenders regarding a potential extension of and amendments to the existing credit agreement. There can be no assurance that these discussions will result in the consummation of any extension or amendment in a timely matter, if at all.

As we have previously disclosed, our Board has formed a committee of independent directors (the “Committee”) to evaluate the Exchange Transaction as well as other financing alternatives and deleveraging transactions, including without limitation (i) amendments or waivers to the covenants or other provisions of our revolving credit facility, (ii) raising new capital in private or public markets and (iii) restructuring our balance sheet either through an in court Chapter 11 proceeding or through an out of court agreement with creditors. We are also considering operational matters such as adjusting our capital budget and improving cash flows from operations by continuing to reduce costs, and intend to continue to evaluate other strategic alternatives, including: (i) acquiring assets with existing production and cash flows by issuing preferred and common equity to finance such acquisitions; (ii) selling existing producing or midstream assets; and (iii) merging with a strategic partner.

As of March 31, 2019, we have incurred approximately $1.7 million in costs related to the potential issuance of equity in the above alternatives, which are recorded in prepaid expenses and other current assets. There can be no assurance that we will be able to implement any of these plans successfully, or that such plans, if executed, will result in compliance with our credit facility covenants.

Recent Accounting Pronouncements

On January 1, 2019, we adopted the Financial Accounting Standards Board (“FASB”) account standards update for “Leases”, which amended existing guidance to require lessees to recognize liabilities and right-of-use (“ROU”) assets on the balance sheet for the rights and obligations created by long-term leases and to disclose additional quantitative and qualitative information about leasing arrangements. We adopted this guidance using a modified retrospective approach on January 1, 2019 using the transition method that allows a cumulative-effect adjustment to the opening balance to retained earnings in the period of adoption.

We have completed our process to implement this standard, and we have designed processes and internal controls necessary for adoption of this standard. We have made policy elections to (i) not capitalize short-term leases for all asset classes, (ii) not separate non-lease components from lease components for all of our existing asset classes, (iii) apply the package of practical expedients that allows us to not reassess: whether any expired or existing contracts contain leases, lease classification for any expired or existing leases and initial direct costs for existing leases, (iv) apply the land easement practical expedient to not evaluate land easements that existed or expired prior to adoption and (v) apply the practical expedient to apply hindsight in estimating lease term and impairment.   

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

The impact of applying this standard is not expected to significantly impact our results of operations or cash flows. As of January 1, 2019, we recognize d ROU assets and liabilit ies of approximately $15 million from operating leases on our consolidated balance sheet . See Note 10 for additional disclosures related to our adoption this accounting standards update.

Prepaid Expenses and Other Assets

In April 2017, we entered into an agreement that secured pricing of a hydraulic fracturing services crew. Under this agreement, we made a prepayment of $5 million, to be used as we completed wells. We have used $1.2 million of this prepayment related to hydraulic fracturing services provided during the first year of the agreement. In March 2018, this agreement was terminated and $3.8 million of the unused prepaid balance was refunded to us.

2. Restructuring Expenses

During the three months ended March 31, 2019, we recorded restructuring charges of $6.3 million in connection with the departures of certain executives and in connection with the review of the potential transactions discussed above. Additionally, in connection with the departure of certain executives, 960,890 unvested shares of restricted stock and 691,509 unvested cash-settled performance awards were forfeited, which resulted in a reduction in general and administrative expenses of $1.1 million during the three months ended March 31, 2019. The following table summarizes the Company’s restructuring accrual for the three months ended March 31, 2019, which is included under the caption “accrued liabilities” on our consolidated balance sheet (in thousands).

3.  Revenue Recognition

Revenues for the sale of oil, NGLs, and gas are recognized as the product is delivered to our customers’ custody transfer points and collectability is reasonably assured. We fulfill the performance obligations under our customer contracts through daily delivery of oil, NGLs and gas to our customers’ custody transfer points and revenues are recorded on a monthly basis. The prices received for oil, NGLs and natural gas sales under our contracts are generally derived from stated market prices which are then adjusted to reflect deductions including transportation, fractionation and processing. As a result, our revenues from the sale of oil, natural gas and NGLs will decrease if market prices decline. The sales of oil, NGLs and gas as presented on the Consolidated Statements of Operations represent the Company’s share of revenues net of royalties and excluding revenue interests owned by others. When selling oil, NGLs and gas on behalf of royalty owners or working interest owners, the Company is acting as an agent and thus reports the revenue on a net basis. To the extent actual volumes and prices of oil and natural gas sales are unavailable for a given reporting period because of timing or information not received from third parties, the expected sales volumes and prices for those properties are estimated and recorded.

The following table presents our disaggregated revenue by major source for the three months ended March 31, 2019, and 2018 (in thousands).

4.  Earnings Per Common Share

We report basic earnings per common share, which excludes the effect of potentially dilutive securities, and diluted earnings per common share, which includes the effect of all potentially dilutive securities unless their impact is antidilutive. The following table

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

provides a reconciliation of the numerators and denominators of our basic and diluted earnings per share (dollars in thousands, except per-share amounts).

5. Long-Term Debt

The following table provides a summary of our long-term debt at March 31, 2019, and December 31, 2018 (in thousands).

Senior Secured Credit Facility

At March 31, 2019, the borrowing base and aggregate lender commitments under our amended and restated senior secured credit facility (the “Credit Facility”) were $325 million, with maximum commitments from the lenders of $1 billion. The Credit Facility has a maturity date of May 7, 2020.  The borrowing base is redetermined semi-annually based on our oil, NGLs and gas reserves.  We, or the lenders, can each request one additional borrowing base redetermination each calendar year.

At March 31, 2019, borrowings under the Credit Facility bore interest based on the agent bank’s prime rate plus an applicable margin ranging from 2% to 3%, or the sum of the LIBOR rate plus an applicable margin ranging from 3% to 4%.  In addition, we pay an annual commitment fee of 0.50% of unused borrowings available under the Credit Facility. Margins vary based on the borrowings outstanding compared to the borrowing base of the lenders.

We had outstanding borrowings of $322 million under the Credit Facility at March 31, 2019, compared to $301.5 million of outstanding borrowings at December 31, 2018. The weighted average interest rate applicable to borrowings under the Credit Facility for the three months ended March 31, 2019, was 6.5%. We had outstanding unused letters of credit under the Credit Facility totaling $0.3 million at March 31, 2019, and December 31, 2018, respectively, which reduce amounts available for borrowing under the Credit Facility.

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

Obligations under the Credit Facility are secured by mortgages on substantially all of the oil and gas properties of the Company and its subsidiaries. The Company is required to grant liens in favor of the lenders covering the o il and gas properties of the Company and its subsidiaries representing at least 95% of the total value of all oil and gas properties of the Company and its subsidiaries.

Covenants

The Credit Facility contains three principal financial covenants:

As of March 31, 2019, as a result of prolonged low commodity prices in the past twelve months and restructuring expenses incurred in the three months ended March 31, 2019, we were not in compliance with the interest coverage ratio and total leverage ratio financial covenants under the Credit Facility, which represents an Event of Default (as defined in the Credit Facility). As a result, we have presented the outstanding balance under the Credit Facility as a current liability as of March 31, 2019. In the case of an event of default, the lenders (i) are not required to lend any additional amounts to us, (ii) could elect to declare all outstanding borrowings, together with accrued and unpaid interest and fees to be payable, (iii) could require us to apply all of our available cash to repay these borrowings and (iv) could prevent us from making debt service payments under our other agreements. We have reached an agreement with our credit facility lenders to forgo enforcement of remedies for an event of default caused by our failure to comply with certain financial covenants in the credit facility, for a period of 45 days. This agreement will terminate on June 22, 2019, unless earlier terminated due to additional events of default under our credit facility, or a default under the agreement.

The Credit Facility also contains covenants restricting cash distributions and other restricted payments, transactions with affiliates, incurrence of other debt, consolidations and mergers, the level of operating leases, asset sales, investment in other entities and liens on properties.

In addition, the obligations of the Company may be accelerated upon the occurrence of other Events of Default (as defined in the Credit Facility). Events of Default include customary events for a financing agreement of this type, including, without limitation, payment defaults, the inaccuracy of representations and warranties, defaults in the performance of affirmative or negative covenants, defaults on other indebtedness of the Company or its subsidiaries, bankruptcy or related defaults, defaults related to judgments and the occurrence of a Change of Control (as defined in the Credit Facility), which includes instances where a third party becomes the beneficial owner of more than 50% of the Company’s outstanding equity interests entitled to vote.

Senior Notes

At March 31, 2019, and December 31, 2018, $85.2 million of Senior Notes were outstanding. We issued the Senior Notes under a senior indenture dated June 11, 2013, among the Company, our subsidiary guarantors and Wilmington Trust, National Association,

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

as successor trustee. The senior indenture, as supplemented by supplemental indentures dated June 11, 2013, and December 20, 2016, is referred to as the “Indenture.”

We may redeem some or all of the Senior Notes at specified redemption prices, plus accrued and unpaid interest to the redemption date. The Senior Notes are fully and unconditionally guaranteed on a senior unsecured basis by each of our subsidiaries, subject to certain customary release provisions. A subsidiary guarantor may be released from its obligations under the guarantee:

The Indenture contains limited events of default. An event of default under the Credit Facility does not result in an event of default under our Senior Notes.

Subsidiary Guarantors

The Senior Notes are guaranteed on a senior unsecured basis by each of our consolidated subsidiaries.  Approach Resources Inc. is a holding company with no independent assets or operations. The subsidiary guarantees are full and unconditional and joint and several, and any subsidiaries of the Company other than the subsidiary guarantors are minor. There are no significant restrictions on the Company’s ability, or the ability of any subsidiary guarantor, to obtain funds from its subsidiaries through dividends, loans, advances or otherwise.

6.  Commitments and Contingencies

Our contractual obligations include long-term debt, operating lease obligations, asset retirement obligations and employment agreements with our executive officers.  Since December 31, 2018, other than the restructuring expenses disclosed in Note 2, there have been no material changes to our contractual obligations.

We are involved in various legal and regulatory proceedings arising in the normal course of business.  While we cannot predict the outcome of these proceedings with certainty, we do not believe that an adverse result in any pending legal or regulatory proceeding, individually or in the aggregate, would be material to our consolidated financial condition or cash flows.

7.  Income Taxes

For the three months ended March 31, 2019, our income tax benefit was $4.3 million, compared to $1.6 million for the three months ended March 31, 2018. The following table reconciles our income tax benefit for the three months ended March 31, 2019, and 2018, to the U.S. federal statutory rates of 21% (dollars in thousands).

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8.  Derivative Instruments and Fair Value Measurements

The following table provides our outstanding commodity derivative positions at March 31, 2019.

The following table summarizes the fair value of our open commodity derivatives as of March 31, 2019, and December 31, 2018 (in thousands).

The following table summarizes the change in the fair value of our commodity derivatives (in thousands).

Derivative assets and liabilities , at fair value, are included on our consolidated balance sheets as current or non-current assets or liabilities based on the anticipated timing of cash settlements under the related contracts.  Changes in the fair value of our commodity derivative contracts, not designated as cash-flow hedges, are recorded in earnings as they occur and included in income (expense) on our consolidated statements of operations. As of March 31, 2019, we had no outstanding derivative instruments designated as cash-flow hedges. We estimate the fair values of swap contracts based on the present value of the difference in exchange-quoted forward price curves and contractual settlement prices multiplied by notional quantities. We internally valued the option contracts using industry-standard option pricing models and observable market inputs.  We use our internal valuations to determine the fair values of the contracts that are reflected on our consolidated balance sheets.

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

We are exposed to credit losses in the event of nonperforma nce by the counterparties on our commodity derivatives positions and have considered the exposure in our internal valuations. However, we do not anticipate nonperformance by the counterparties over the term of the commodity derivatives positions.

To estimate the fair value of our commodity derivatives positions, we use market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. We primarily apply the market approach for recurring fair value measurements and attempt to use the best available information. We determine the fair value based upon the hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and lowest priority to unobservable inputs (Level 3 measurement). The three levels of fair value hierarchy are as follows:

Nonrecurring Fair Value Measurements

Assets Held for Sale

During the three months ended March 31, 2019, we initiated a plan to market certain corporate assets for sale. The assets are available for immediate sale and are being actively marketed. The corporate assets held for sale were recorded at their estimated fair value less costs to sell as of March 31, 2019, which is a Level 3 fair value measurement.  As a result, we recognized an impairment loss of $0.3 million for the difference between the asset’s carrying value and the estimated fair value less costs to sell during the three months ended March 31, 2019.

The fair value of the Senior Notes is based on quoted market prices, but the Senior Notes are not actively traded in the public market. Accordingly, the fair value of the Senior Notes would be classified as Level 2 in the fair value hierarchy.

9.  Share-Based Compensation

Nonvested Shares

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

During th e three months ended March 31, 2019, 960,890 unvested shares of restricted stock were forfeited in connection with the departures of certain executives. As a result, we recorded a reduction in share-based compensation expense of $0.9 million related to the forfeitures.

Cash-settled performance awards

As of March 31, 2019, we had 191,731 unvested cash-settled performance awards, subject to certain performance conditions outstanding. The cash-settled performance awards represent a non-equity unit with a conversion value equal to the fair market value of a share of the Company’s common stock at the vesting date. These awards are classified as liability awards due to the cash settlement feature. Compensation costs associated with the cash-settled performance awards are re-measured at each interim reporting period and an adjustment is recorded in general and administrative expenses on our consolidated statements of operations. During the three months ended March 31, 2019, 691,509 unvested cash-settled performance awards were forfeited in connection with the departures of certain executives. As a result, we recorded a reduction in general and administrative expense of $0.2 million related to the forfeitures. For the three months ended March 31, 2019, including the forfeitures, we recognized a benefit of $0.5 million, compared to an expense of $0.3 million for the three months ended March 31, 2018. At March 31, 2019, we recorded a current liability of $0.1 million and a non-current liability of $12,000 related to the cash-settled performance awards on our consolidated balance sheets.  During the three months ended March 31, 2019, we paid $0.7 million related to vested cash-settled performance awards.

10.  Leases

We determine if an arrangement is a lease at inception of the arrangement. To the extent that we determine an arrangement represents a lease, we evaluate whether the lease will be classified as an operating lease or a finance lease. As of March 31, 2019, we do not have any finance leases. We capitalize our operating leases on our consolidated balance sheet under the caption entitled “Right of use operating lease assets” and a corresponding lease liability under the caption “operating lease liabilities”.  The operating lease liabilities are classified as current or non-current based on the estimated timing of payment. The ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Short-term leases that have an initial term of one year or less are not capitalized but are disclosed below. Short-term lease costs exclude expenses related to leases with a lease term of one month or less.

We currently enter into lease agreements to support our operations. These agreements are for leases on assets such as office space, compressors and well equipment. Below is a detailed description of our significant lease types.

Office Space

We lease our corporate office space under a non-cancelable agreement that expires on September 30, 2021. We have concluded that this arrangement represents an operating lease with a lease term that equals the primary non-cancelable contract term. Upon completion of the primary term, both parties have substantive rights to terminate the lease. As a result, enforceable rights and obligations do not exist under the rental agreements subsequent to the primary term.

Compressors

We lease compressors for gas lift on our wells and for delivery of gas to our purchasers. Our compressor contracts typically have an initial lease term of one to four years, cancelable at our option with thirty day written notice. Subsequent to the expiration of the initial term, the compressor leases will continue on a month-to-month basis cancelable by either party upon thirty day written notice. Upon completion of the initial term, both parties have substantive rights to terminate the lease. As a result, enforceable rights and obligations do not exist under the rental agreements subsequent to the initial term. We have concluded that the compressor rental agreements represent operating leases with a lease term that equals the initial term of the lease as it is reasonably certain that we will continue the lease over the initial term of the contract.

Other equipment

We lease other equipment to support our operations, with non-cancelable terms of two to three years. We have concluded that these arrangements represent operating leases with a lease term that equals the primary non-cancelable contract term. Upon completion of the primary term, both parties have substantive rights to terminate the lease. As a result, enforceable rights and obligations do not exist under the rental agreements subsequent to the primary term.

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

Discount Rate

Our leases typically do not provide an implicit rate. Accordingly, we are required to use our incremental borrowing rate in determining the present value of lease payments based on the information available at the lease commencement date. Our incremental borrowing rate reflects the estimated rate of interest that we would pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. Our operating leases have a weighted average remaining lease term of 2.2 years and a weighted average discount rate of 6.5%.

The following table summarizes our operating lease liabilities with contract terms that are greater than one year as follows (in thousands).

The following table summarizes the components of our total lease expenses for the three months ended March 31, 2019 (in thousands).

The following table summarizes the cash flow information related to our operating leases for the three months ended March 31, 2019 (in thousands).

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Approach Resources Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2019

11.  Related Party Transactions

Wilks, a related party, purchased a portion of our outstanding Senior Notes in the open market. The Company believes that Wilks held approximately $60 million of our outstanding Senior Notes as of March 31, 2019. The Senior Notes held by Wilks are included in Senior Notes, net on our consolidated balance sheets. Our interest expense includes interest attributable to any Senior Notes held by Wilks on our consolidated statements of operations. Wilks are currently engaged in discussions with the Company regarding their investment in the Company, including a possible debt for equity exchange of the Senior Notes and an additional capital infusion. There can be no assurance that these discussions will result in the consummation of any transaction in a timely matter, if at all.

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