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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2022

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

For the transition period from to

Commission file number: 001-38770

EPSILON ENERGY LTD.

(Exact name of registrant as specified in its charter)

Alberta, Canada

98-1476367

(State or other jurisdiction of incorporation or organization)

(I.R.S Employer Identification No.)

16945 Northchase Drive, Suite 1610

Houston, Texas 77060

(281) 670-0002

(Address of principal executive offices including zip code and

telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading Symbol

Name of each exchange on which registered

Common Shares, no par value

EPSN

NASDAQ Global Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes No

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

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Yes No

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes No

As of November 10, 2022, there were 23,027,441 Common Shares outstanding.

Table of Contents

Contents

    

FORWARD-LOOKING STATEMENTS

4

PART I-FINANCIAL INFORMATION

5

ITEM 1. FINANCIAL STATEMENTS

5

Unaudited Condensed Consolidated Balance Sheets

5

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)

6

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity

7

Unaudited Condensed Consolidated Statements of Cash Flows

9

Notes to the Unaudited Condensed Consolidated Financial Statements

10

1.

Description of Business

10

2.

Basis of Preparation

10

Interim Financial Statements

10

Principles of Consolidation

10

Use of Estimates

10

Recently Issued Accounting Standards

10

3.

Cash, Cash Equivalents, and Restricted Cash

11

4.

Property and Equipment

12

Property Impairment

12

5.

Revolving Line of Credit

12

6.

Shareholders’ Equity

13

7.

Revenue Recognition

17

8.

Income Taxes

19

9.

Commitments and Contingencies

19

Litigation

19

10.

Net Income Per Share

20

11.

Operating Segments

21

12.

Risk Management Activities

24

Commodity Price Risks

24

Commodity Derivative Contracts

24

13.

Asset Retirement Obligations

26

14.

Fair Value Measurements

26

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

27

Overview

27

Business Strategy

27

Operational Highlights

27

Non-GAAP Financial Measures-Adjusted EBITDA

28

Net Operating Revenues

30

Operating Costs

31

Loss on Derivative Contracts

32

Capital Resources and Liquidity

32

Cash Flow

32

Credit Agreement

33

Repurchase Transactions

33

Derivative Transactions

34

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute forward-looking statements. The use of any of the words ‘‘anticipate,’’ ‘‘continue,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘may,’’ ‘‘will,’’ ‘‘project,’’ ‘‘should,’’ ‘‘believe,’’ and similar expressions and statements relating to matters that are not historical facts constitute ‘‘forward looking information’’ within the meaning of applicable securities laws. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated. Such forward-looking statements are based on reasonable assumptions, but no assurance can be given that these expectations will prove to be correct and the forward-looking statements included in this report should not be unduly relied upon. These statements are made only as of the date of this report. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future — including statements relating to natural gas and oil production rates, commodity prices for crude oil or natural gas, supply and demand for natural gas and oil; the estimated quantity of natural gas and oil reserves, including reserve life; future development and production costs, and statements expressing general views about future operating results — are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2021, and those described from time to time in our future reports filed with the Securities and Exchange Commission. You should consider carefully the statements under Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2021. Our Annual Report on Form 10-K for the year ended December 31, 2021 is available on our website at www.epsilonenergyltd.com.

4

PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets

    

September 30, 

    

December 31, 

2022

2021

ASSETS

Current assets

Cash and cash equivalents

$

40,254,729

$

26,497,305

Accounts receivable

10,069,516

4,596,931

Fair value of derivatives

32,326

Other current assets

775,587

569,870

Total current assets

51,132,158

31,664,106

Non-current assets

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

147,196,218

138,032,413

Unproved properties

18,085,385

21,700,926

Accumulated depletion, depreciation, amortization and impairment

(106,457,257)

(102,480,972)

Total oil and gas properties, net

58,824,346

57,252,367

Gathering system

42,617,954

42,475,086

Accumulated depletion, depreciation, amortization and impairment

(34,262,838)

(33,443,949)

Total gathering system, net

8,355,116

9,031,137

Land

637,764

637,764

Buildings and other property and equipment, net

295,446

309,102

Total property and equipment, net

68,112,672

67,230,370

Other assets:

Restricted cash

569,883

568,118

Total non-current assets

68,682,555

67,798,488

Total assets

$

119,814,713

$

99,462,594

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities

Accounts payable trade

$

2,203,443

$

1,189,905

Gathering fees payable

1,020,921

963,546

Royalties payable

2,827,880

1,853,508

Income taxes payable

3,119,671

1,098,425

Accrued capital expenditures

398,026

1,016,830

Other accrued liabilities

1,001,792

1,098,127

Fair value of derivatives

239,824

Asset retirement obligations

85,207

Total current liabilities

10,571,733

7,545,372

Non-current liabilities

Asset retirement obligations

2,758,831

2,748,449

Deferred income taxes

10,345,297

9,905,440

Total non-current liabilities

13,104,128

12,653,889

Total liabilities

23,675,861

20,199,261

Commitments and contingencies (Note 9)

Shareholders' equity

Common shares, no par value, unlimited shares authorized and 23,571,108 issued and 23,011,608 outstanding at September 30, 2022 and 24,202,218 issued and 23,668,203 shares outstanding at December 31, 2021

127,231,845

131,815,739

Treasury shares, 559,500 at September 30, 2022 and 534,015 at December 31, 2021

(3,326,880)

(2,423,007)

Additional paid-in capital

9,672,152

8,835,203

Accumulated deficit

(47,208,598)

(68,783,207)

Accumulated other comprehensive income

9,770,333

9,818,605

Total shareholders' equity

96,138,852

79,263,333

Total liabilities and shareholders' equity

$

119,814,713

$

99,462,594

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

5

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income

Three months ended September 30, 

Nine months ended September 30, 

    

2022

    

2021

    

2022

    

2021

Revenues from contracts with customers:

Gas, oil, NGL, and condensate revenue

$

19,171,121

$

11,062,443

$

48,566,282

$

22,740,352

Gas gathering and compression revenue

2,072,806

2,038,616

6,180,747

5,891,868

Total revenue

21,243,927

13,101,059

54,747,029

28,632,220

Operating costs and expenses:

Lease operating expenses

2,399,092

2,240,259

6,791,496

5,618,585

Gathering system operating expenses

225,809

138,887

556,515

503,381

Development geological and geophysical expenses

2,387

11,583

7,159

34,573

Depletion, depreciation, amortization, and accretion

1,706,030

1,846,911

4,898,988

5,175,865

Gain on sale of oil and gas properties

(221,642)

General and administrative expenses:

Stock based compensation expense

500,597

300,249

836,949

738,789

Other general and administrative expenses

2,015,272

1,461,703

4,651,547

4,837,164

Total operating costs and expenses

6,849,187

5,999,592

17,521,012

16,908,357

Operating income

14,394,740

7,101,467

37,226,017

11,723,863

Other income (expense):

Interest income

89,638

11,070

126,804

27,786

Interest expense

(17,501)

(16,962)

(33,565)

(66,380)

Loss on derivative contracts

(929,637)

(5,055,130)

(1,124,547)

(6,417,123)

Other (expense) income

(32,777)

(907)

(99,896)

756

Other income (expense), net

(890,277)

(5,061,929)

(1,131,204)

(6,454,961)

Net income before income tax expense

13,504,463

2,039,538

36,094,813

5,268,902

Income tax expense

3,896,010

643,072

10,097,484

1,621,894

NET INCOME

$

9,608,453

$

1,396,466

$

25,997,329

$

3,647,008

Currency translation adjustments

(34,524)

(15)

(48,272)

(1,256)

NET COMPREHENSIVE INCOME

$

9,573,929

$

1,396,451

$

25,949,057

$

3,645,751

Net income per share, basic

$

0.42

$

0.06

$

1.11

$

0.15

Net income per share, diluted

$

0.41

$

0.06

$

1.11

$

0.15

Weighted average number of shares outstanding, basic

23,011,729

23,564,288

23,419,666

23,757,895

Weighted average number of shares outstanding, diluted

23,169,658

23,772,943

23,524,574

23,871,495

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

6

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity

    

  

  

  

  

  

Accumulated

  

  

Other

Total

Common Shares Issued

Treasury Shares

Additional

Comprehensive

Accumulated

Shareholders'

Shares

Amount

Shares

Amount

paid-in Capital

Income

Deficit

Equity

Balance at January 1, 2022

24,202,218

$

131,815,739

(534,015)

$

(2,423,007)

$

8,835,203

$

9,818,605

$

(68,783,207)

$

79,263,333

Net income

5,805,888

5,805,888

Dividends

(1,483,027)

(1,483,027)

Stock-based compensation expenses

142,302

142,302

Exercise of stock options

38,750

209,312

209,312

Retirement of treasury shares

(534,015)

(2,423,007)

534,015

2,423,007

Other comprehensive income

5,402

5,402

Balance at March 31, 2022

23,706,953

$

129,602,044

$

$

8,977,505

$

9,824,007

$

(64,460,346)

$

83,943,210

Net income

10,582,988

10,582,988

Dividends

(1,486,650)

(1,486,650)

Stock-based compensation expenses

194,050

194,050

Exercise of stock options

72,500

399,475

399,475

Buyback of common shares

(697,100)

(4,554,822)

(4,554,822)

Retirement of treasury shares

(423,000)

(2,907,999)

423,000

2,907,999

Other comprehensive loss

(19,150)

(19,150)

Balance at June 30, 2022

23,356,453

$

127,093,520

(274,100)

$

(1,646,823)

$

9,171,555

$

9,804,857

$

(55,364,008)

$

89,059,101

Net income

9,608,453

9,608,453

Dividends

(1,453,043)

(1,453,043)

Stock-based compensation expenses

500,597

500,597

Exercise of stock options

27,500

138,325

138,325

Buyback of common shares

(285,400)

(1,680,057)

(1,680,057)

Vesting of shares of restricted stock

187,155

Other comprehensive loss

(34,524)

(34,524)

Balance at September 30, 2022

23,571,108

$

127,231,845

(559,500)

$

(3,326,880)

$

9,672,152

$

9,770,333

$

(47,208,598)

$

96,138,852

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

7

    

  

  

  

  

  

Accumulated

  

  

Other

Total

Common Shares Issued

Treasury Shares

Additional

Comprehensive

Accumulated

Shareholders'

Shares

Amount

Shares

Amount

paid-in Capital

Income

Deficit

Equity

Balance at January 1, 2021

23,985,799

$

131,730,401

$

$

7,879,119

$

9,820,647

$

(80,410,724)

$

69,019,443

Net income

2,735,567

2,735,567

Stock-based compensation expenses

202,499

202,499

Buyback of common shares

(123,200)

(492,479)

(492,479)

Other comprehensive income

242

242

Balance at March 31, 2021

23,985,799

$

131,730,401

(123,200)

$

(492,479)

$

8,081,618

$

9,820,889

$

(77,675,157)

$

71,465,272

Net loss

(485,025)

(485,025)

Stock-based compensation expenses

236,041

236,041

Buyback of common shares

(141,015)

(568,989)

(568,989)

Other comprehensive loss

(1,484)

(1,484)

Balance at June 30, 2021

23,985,799

$

131,730,401

(264,215)

$

(1,061,468)

$

8,317,659

$

9,819,405

$

(78,160,182)

$

70,645,816

Net income

1,396,466

1,396,466

Stock-based compensation expenses

300,249

300,249

Buyback of common shares

(261,400)

(1,315,713)

(1,315,713)

Vesting of shares of restricted stock

20,834

Other comprehensive loss

(15)

(15)

Balance at September 30, 2021

24,006,633

$

131,730,401

(525,615)

$

(2,377,181)

$

8,617,908

$

9,819,391

$

(76,763,716)

$

71,026,803

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

8

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows

Nine months ended September 30, 

    

2022

    

2021

Cash flows from operating activities:

Net income

$

25,997,329

$

3,647,008

Adjustments to reconcile net income to net cash provided by operating activities:

Depletion, depreciation, amortization, and accretion

4,898,988

5,175,865

Loss on derivative contracts

1,124,547

6,417,123

Gain on sale of oil and gas properties

(221,642)

Settlement paid on derivative contracts

(1,396,697)

(2,488,702)

Settlement of asset retirement obligation

(118,260)

Stock-based compensation expense

836,949

738,789

Deferred income tax expense (benefit)

439,857

(651,606)

Changes in assets and liabilities:

Accounts receivable

(5,472,585)

(3,558,519)

Other current assets

(205,717)

(6,920)

Accounts payable, royalties payable and other accrued liabilities

1,511,652

3,237,559

Income taxes payable

2,021,246

1,016,153

Net cash provided by operating activities

29,415,667

13,526,750

Cash flows from investing activities:

Additions to unproved oil and gas properties

(226,439)

(140,498)

Additions to proved oil and gas properties

(5,528,037)

(3,479,386)

Additions to gathering system properties

(129,985)

(199,801)

Additions to land, buildings and property and equipment

(13,258)

(5,745)

Proceeds from sale of oil and gas properties

200,000

Prepaid drilling costs

379

Net cash used in investing activities

(5,697,719)

(3,825,051)

Cash flows from financing activities:

Buyback of common shares

(6,234,879)

(2,377,181)

Exercise of stock options

747,112

Dividends

(4,422,720)

Net cash used in financing activities

(9,910,487)

(2,377,181)

Effect of currency rates on cash, cash equivalents and restricted cash

(48,272)

(1,257)

Increase in cash, cash equivalents and restricted cash

13,759,189

7,323,261

Cash, cash equivalents and restricted cash, beginning of period

27,065,423

13,836,771

Cash, cash equivalents and restricted cash, end of period

$

40,824,612

$

21,160,032

Supplemental cash flow disclosures:

Income taxes paid

$

7,626,000

$

1,164,025

Interest paid

$

50,872

$

78,980

Non-cash investing activities:

Change in unproved properties accrued in accounts payable and accrued liabilities

$

$

(65,000)

Change in proved properties accrued in accounts payable and accrued liabilities

$

(194,391)

$

(18,150)

Change in gathering system accrued in accounts payable and accrued liabilities

$

12,882

$

16,225

Asset retirement obligation asset additions and adjustments

$

10,821

$

(29,853)

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

9

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

Epsilon Energy Ltd. (the “Company” or “Epsilon” or “we”) was incorporated under the laws of the Province of Alberta, Canada on March 14, 2005. On October 24, 2007, the Company became a publicly traded entity trading on the Toronto Stock Exchange (“TSX”) in Canada. On February 14, 2019, Epsilon’s registration statement on Form 10 was declared effective by the United States Securities and Exchange Commission and on February 19, 2019, the Company began trading in the United States on the NASDAQ Global Market under the trading symbol “EPSN.” The Company is engaged in the acquisition, development, gathering and production of primarily natural gas reserves in the United States.

2. Basis of Preparation

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the appropriate rules and regulations of the SEC. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. All adjustments which are, in the opinion of management, necessary for a fair statement of the financial position and results of operations for the interim periods presented have been included. The interim financial information and notes hereto should be read in conjunction with the Company’s consolidated financial statements as of and for the year ended December 31, 2021. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.

Principles of Consolidation

The Company’s unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Epsilon Energy USA, Inc. and its wholly owned subsidiaries, Epsilon Midstream, LLC, Dewey Energy GP, LLC, Dewey Energy Holdings, LLC, Epsilon Operating, LLC, and Altolisa Holdings, LLC. With regard to the gathering system, in which Epsilon owns an undivided interest in the asset, proportionate consolidation accounting is used. All inter-company transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates pertain to proved natural gas and oil reserves and related cash flow estimates used in impairment tests of natural gas and oil, and gathering system properties, asset retirement obligations, accrued natural gas and oil revenues and operating expenses, accrued gathering system revenues and operating expenses, as well as the valuation of commodity derivative instruments. Actual results could differ from those estimates.

Recently Issued Accounting Standards

The Company, an emerging growth company (“EGC”), has elected to take advantage of the benefits of the extended transition period provided for in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised accounting standards which allows the Company to defer adoption of certain accounting standards until those standards would otherwise apply to private companies.

In March 2020, the FASB issued ASU No. 2020-04 - Reference Rate Reform (Topic 848), codified as ASC 848 (“ASC 848”). This was followed by ASU No. 2021-01, Reference Rate Reform (Topic 848): Scope (“ASU 2021-01”), issued in January 2021. The purpose of ASC 848 is to provide optional guidance to ease the potential effects on financial reporting of the market-wide migration away from Interbank Offered Rates (“IBORs”) to alternative reference rates. ASC

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

848 applies only to contracts, hedging relationships, and other transactions that reference a reference rate expected to be discontinued because of reference rate reform. The guidance may be applied upon issuance of ASC 848 through December 31, 2022. We do not expect a material impact from the adoption of this ASU.

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all recognition thresholds and will require companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the Company expects to collect over the instrument’s contractual life. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and must be applied retrospectively. Early adoption is permitted. Epsilon will adopt ASU 2016-13 as of January 1, 2023. We do not expect a material impact from the adoption of this ASU.

In February 2016, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842), which will require lessees to recognize a right of use asset and a lease liability on their balance sheet for all leases, including operating leases, with a term of greater than 12 months. In July 2018, the FASB issued ASU 2018-11, which adds a transition option permitting entities to apply the provisions of the new standard at its adoption date instead of the earliest comparative period presented in the consolidated financial statements. Under this transition option, comparative reporting would not be required, and the provisions of the standard would be applied prospectively to leases in effect at the date of adoption.

The Company has determined its portfolio of leased assets and is completing its review of all related contracts to determine the impact the adoption will have on its consolidated financial statements and related disclosures. Upon adoption, the Company will recognize a right of use asset and lease liability for certain commitments related to office space that will be accounted for as an operating lease. To track these lease arrangements and facilitate compliance with this ASU, the Company is in the process of designing processes and internal controls.

The adoption of this ASU will increase asset and liability balances on the consolidated balance sheets due to the required recognition of a right of use asset and corresponding lease liabilities. The Company plans to elect the available package practical expedients provided in the standard and adopt Topic 842 as of January 1, 2022 at December 31, 2022 on its Form 10-K for the year ending December 31, 2022, using the optional transition method provided by ASU 2018-11 and continues to assess potential effects of the standard.

3. Cash, Cash Equivalents, and Restricted Cash

Cash and cash equivalents include cash on hand and short term, highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Restricted cash consists of amounts deposited to back bonds or letters of credit for potential well liabilities. The Company presents restricted cash with cash and cash equivalents in the Consolidated Statements of Cash Flows.

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported in the Consolidated Balance Sheets to the total of the amounts in the Consolidated Statements of Cash Flows as of September 30, 2022 and December, 31 2021:

    

September 30, 

    

December 31,

2022

2021

Cash and cash equivalents

$

40,254,729

$

26,497,305

Restricted cash included in other assets

569,883

568,118

Cash, cash equivalents and restricted cash in the statement of cash flows

$

40,824,612

$

27,065,423

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

4.  Property and Equipment

The following table summarizes the Company’s property and equipment as of September 30, 2022 and December 31, 2021:

    

September 30, 

    

December 31, 

2022

2021

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

$

147,196,218

$

138,032,413

Unproved properties

18,085,385

21,700,926

Accumulated depletion, depreciation, amortization and impairment

(106,457,257)

(102,480,972)

Total oil and gas properties, net

58,824,346

57,252,367

Gathering system

42,617,954

42,475,086

Accumulated depletion, depreciation, amortization and impairment

(34,262,838)

(33,443,949)

Total gathering system, net

8,355,116

9,031,137

Land

637,764

637,764

Buildings and other property and equipment, net

295,446

309,102

Total property and equipment, net

$

68,112,672

$

67,230,370

Property Impairment

Epsilon uses the successful efforts method of accounting for crude oil and natural gas producing activities. Under this method, exploration costs, such as exploratory geological and geophysical costs, expiration of unproved leasehold, delay rentals and exploration overhead are expensed as incurred. All costs related to production, general corporate overhead and similar activities are also expensed as incurred. All property acquisition costs and development costs are capitalized when incurred.

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, GAAP requires that the Company first compares expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the oil and natural gas properties to their estimated fair values is required, which is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions. During the three and nine months ended September 30, 2022 and 2021, no impairment was required.

5. Revolving Line of Credit

The Company has a senior secured revolving credit facility (“Facility”) which includes a total commitment of up to $100 million. The current borrowing base is $14 million, which is subject to semi-annual redetermination. There are currently no borrowings under the Facility. If Epsilon decided to access the Facility, depending on the level of borrowing, the Company might need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (2.75%-3.75% based on the percent of the line of credit utilized), b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Effective April 6, 2021, the agreement was amended to extend the maturity date to March 1, 2024. In addition, the agreement was amended to include a Benchmark Replacement definition and transition plan to be used at such time when the LIBOR rate is discontinued.

On August 2, 2022, the borrowing base of $14 million was reaffirmed until the next periodic redetermination of the borrowing base.

The lender under the Credit Facility has a first priority security interest in the tangible and intangible assets, including the gathering system, of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

Leverage ratio less than 3.0 based on income adjusted for interest, taxes and non-cash amounts.

The Company was in compliance with the financial covenants of the Credit Facility as of September 30, 2022 and expects to be in compliance with the financial covenants for the next 12 months.

An annual commitment fee of 0.50% is assessed and paid quarterly on the daily average unused borrowing base on the Credit Facility.

    

Balance at

    

Balance at

    

    

September 30, 

    

December 31, 

Current

Interest Rate

    

2022

2021

    

Borrowing Base

    

3 mo.

Revolving line of credit

$

$

$

14,000,000

LIBOR + 3.25% (1)

(1) At September 30, 2022, the interest rate was 6.394%.

6. Shareholders’ Equity

(a)Authorized shares

The Company is authorized to issue an unlimited number of Common Shares with no par value and an unlimited number of Preferred Shares with no par value.

(b)Purchases of Equity Shares

Normal Course Issuer Bid

Commencing on March 8, 2022, the Company conducted a normal course issuer bid (“NCIB”) to repurchase our issued and outstanding common shares, when doing so was accretive to management’s estimates of intrinsic value per share. The NCIB ends on March 7, 2023. The Company uses discretionary cash to fund these repurchases. During the three and nine months ended September 30, 2022, Epsilon repurchased 285,400 common shares and 982,500 common shares, respectively, of the authorized 1,183,410 purchase amount and spent $1,680,057 and $6,234,879, respectively, under the NCIB. The repurchased stock had an average price of $6.32 per share (excluding commissions). During the three and nine months ended September 30, 2022, the Company cancelled zero and 423,000 common shares, respectively.

Commencing on January 1, 2021, Epsilon conducted a normal course issuer bid (“NCIB”) to repurchase our issued and outstanding common shares, when doing so was accretive to management's estimates of intrinsic value per share. The NCIB ended on December 31, 2021. The Company used discretionary cash to fund these repurchases. During

13

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

the year ended December 31, 2021, Epsilon repurchased 534,015 common shares of the authorized 1,193,000 purchase amount and spent $2,423,007 under the NCIB. The repurchased stock had an average price of $4.51 per share (excluding commissions) and were subsequently cancelled during the three months ended March 31, 2022.

Repurchases may be made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares will be, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company intends to fund the purchase out of available cash and does not expect to incur debt to fund the share repurchase program. The shares are accounted for as treasury shares until such a time as they are cancelled.

The following table contains activity relating to our acquisition of equity securities during the nine months ended September 30, 2022:

    

Maximum number

of shares that

may yet be

Total number

Average price

purchased under

of shares

paid per

the plans or

    

purchased

share

    

programs

Beginning of normal-course issuer bid, March 8, 2022

1,183,410

March 2022 (1)

$

April 2022 (1)

23,700

$

6.63

May 2022 (1)

254,500

$

6.99

June 2022 (1)

418,900

$

6.21

July 2022 (1)

249,800

$

5.83

August 2022 (1)

33,200

$

6.09

September 2022 (1)

2,400

$

6.00

Total as of September 30, 2022

982,500

$

6.32

200,910

(1) Epsilon repurchased these shares under its share repurchase program that commenced on March 8, 2022, as described above.

(c)Equity Incentive Plan

Epsilon’s board of directors (the “Board”) adopted the 2020 Equity Incentive Plan (the “2020 Plan”) on July 22, 2020 subject to approval by Epsilon’s shareholders at Epsilon’s 2020 Annual General and Special Meeting of Shareholders, which occurred on September 1, 2020 (the “Meeting”). Shareholders approved the 2020 Plan at the Meeting. Following Epsilon’s listing on the NASDAQ Global Market, the Board determined that it is in the best interest of the shareholders to approve a new incentive plan that is compliant with U.S. public company equity plan rules and practices that would replace Epsilon’s Amended and Restated 2017 Stock Option Plan (including its predecessors) and the Share Compensation Plan (collectively referred to as the “Predecessor Plans”). No further awards will be granted under the Predecessor Plans.

The 2020 Plan provides for incentive compensation in the form of stock options, stock appreciation rights, restricted stock and stock units, performance shares and units, other stock-based awards and cash-based awards. Under the 2020 Plan, Epsilon will be authorized to issue up to 2,000,000 Common Shares. As of December 31, 2021, the Company granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, 20,834 common shares and 48,000 time-based restricted shares to the CEO and the board of directors.

14

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Restricted Stock Awards

For the nine months ended September 30, 2022, 246,135 shares of Restricted Stock with a weighted average market price at the grant date of $6.22 were awarded to the Company’s board of directors and employees. For the year ended December 31, 2021, 48,000 common shares of Restricted Stock with a weighted average market price at the grant date of $5.04 were awarded to the Company’s board of directors. These shares vest over a three-year period, with one-third of the shares being issued per period on the anniversary of the award resolution. The vesting of the shares is contingent on the individuals’ continued employment or service. The Company determined the fair value of the granted Restricted Stock-based on the market price of the common shares of the Company on the date of grant.

The following table summarizes Restricted Stock activity for the nine months ended September 30, 2022, and the year ended December 31, 2021:

Nine months ended

Year ended

September 30, 2022

December 31, 2021

Number of

Weighted

Number of

Weighted

Restricted

Average

Restricted

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested Restricted Stock at beginning of period

166,002

1.38

290,070

1.60

Granted

246,135

1.91

48,000

3.00

Vested

(83,155)

(137,668)

Forfeited

(34,400)

Balance non-vested Restricted Stock at end of period

328,982

1.59

166,002

1.38

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three and nine months ended September 30, 2022 was $366,763 and $608,735, respectively (for the three and nine months ended September 30, 2021, $127,834 and $402,247, respectively).

At September 30, 2022, the Company had unrecognized stock-based compensation related to these shares of $1,551,041 to be recognized over a weighted average period of 1.62 years (at December 31, 2021: $696,833 over 1.11 years).

Performance Share Unit Awards (“PSU”)

For the nine months ended September 30, 2022, 104,000 PSUs vested and were issued. For the year ended December 31, 2021, a total of 62,501 common shares vested and were issued, of which 20,834 of the common shares were granted as a result of the Company exceeding its 2020 TSR performance target. The Company grants PSUs, which are paid in stock, to certain key employees. PSUs are based on a three-year performance period with performance being measured each year at December 31. The PSUs will vest on the last day of the performance period. The number of PSUs that will ultimately vest is based on two performance targets as follows:

The targets for the PSUs are based on (i) the relative total stockholder return (“TSR”) percentile ranking and (ii) the relative cash flow per debt adjusted share – growth (“CFDAS Growth”) percentile ranking of the Company, each as compared to the Company’s Performance Peer Group during the applicable one-year performance period ending on December 31.
Cash Flow per Debt Adjusted Share (“CFDAS”) is defined as EBITDA (earnings before interest, taxes, depreciation and amortization) divided by the sum of the 1) the total debt plus the value of preferred stock minus cash and the amount of dividends paid for the year divided by the share price at the end of the year; and 2) the actual share count at year end.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The vesting of each PSU Award will be based 50% on TSR performance and 50% based on CFDAS Growth performance.
The recipient of the award must be employed with the Company at the time of vesting.

The number of shares ultimately issued under these awards can range from zero to 200% of target award amounts at the discretion of the Compensation Committee of the Board of Directors.

The PSUs are accounted for as equity awards. The fair value of the 50% for performance based on CFDAS Growth was determined as the market price of the common shares of the Company on the date of grant. Weighted average fair value of CFDAS PSUs granted during the year ended December 31, 2021 was $3.41 per unit. The fair value of the 50% for performance based on TSR was determined on the grant date by the application of a Monte Carlo simulation model.  For the year ended December 31, 2021, the Compensation Committee did not approve the issuance of any new PSU’s.

The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the performance stock awards, to calculate the fair value of the awards. Expected volatilities in the model were estimated using a historical period consistent with the expected term for each annual performance period of the awards. The risk-free interest rate was based on the United States Treasury rate measured over a term commensurate with the expected term for each annual performance period of the awards. The expected term is based on the time between the valuation date and the end of each annual performance period of the awards. The valuation model assumes dividends are immediately reinvested.

The following table summarizes PSUs for the nine months ended September 30, 2022 and the year ended December 31, 2021:

Nine months ended

Year ended

September 30, 2022

December 31, 2021

Number of

Weighted

Number of

Weighted

Performance

Average

Performance

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested PSUs at beginning of period

151,500

0.75

193,167

1.60

Granted

20,834

Vested

(104,000)

(62,501)

Balance non-vested PSUs at end of period

47,500

0.67

151,500

0.75

Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three and nine months ended September 30, 2022 related to PSUs was $133,834 and $228,214, respectively (for the three and nine months ended September 30, 2021, $172,415 and $336,542, respectively.

At September 30, 2022, the Company had unrecognized stock-based compensation related to these shares of $79,202 to be recognized over a weighted average period of 0.75 years (at December 31, 2021: $310,790 over 1.01 years).

Stock Options

As of September 30, 2022, the Company had outstanding stock options covering 70,000 Common Shares at an overall average exercise price of $5.03 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 70,000 options have a weighted average expected remaining term of approximately 1.30 years.

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Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes stock option activity for the nine months ended September 30, 2022 and the year ended December 31, 2021:

Nine months ended

Year ended

September 30, 2022

December 31, 2021

Weighted

Weighted