CELP Cypress Environmental Partners LP

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Organization and Operations

Cypress Energy Partners, L.P. (“we”, “us”, “our”, or the “Partnership”) is a Delaware limited partnership formed in 2013. We offer essential services that help protect the environment and ensure sustainability. We provide a wide range of environmental services including independent inspection, integrity, and support services for pipeline and energy infrastructure owners and operators and public utilities. We also provide water pipelines, hydrocarbon recovery, disposal, and water treatment services. Trading of our common units began January 15, 2014 on the New York Stock Exchange under the symbol “CELP”. Our business is organized into the Pipeline Inspection Services (“Pipeline Inspection”), Pipeline & Process Services (“Pipeline & Process Services”), and Water and Environmental Services (“Environmental Services”) segments.

The Pipeline Inspection segment generates revenue primarily by providing essential environmental services including inspection and integrity services on a variety of infrastructure assets including midstream pipelines, gathering systems, and distribution systems. Services include non-destructive examination, in-line inspection support, pig tracking, survey, data gathering, and supervision of third-party contractors. Our results in this segment are driven primarily by the number of inspectors that perform services for our customers and the fees that we charge for those services, which depend on the type, skills, technology, equipment, and number of inspectors used on a particular project, the nature of the project, and the duration of the project. The number of inspectors engaged on projects is driven by the type of project, prevailing market rates, the age and condition of customers’ assets including pipelines, gas plants, compression stations, storage facilities, and gathering and distribution systems including the legal and regulatory requirements relating to the inspection and maintenance of those assets. We also bill our customers for per diem charges, mileage, and other reimbursement items. Revenue and costs in this segment may be subject to seasonal variations and interim activity may not be indicative of yearly activity considering many of our customers develop yearly operating budgets and enter into contracts with us during the winter season for work to be performed during the remainder of the year. Additionally, inspection work throughout the United States during the winter months (especially in the northern states) may be hampered or delayed due to inclement weather.

The Pipeline & Process Services segment (formerly our Integrity Services segment) generates revenue primarily by providing essential environmental services including hydrostatic testing services and chemical cleaning to energy companies and pipeline construction companies of newly-constructed and existing pipelines and related infrastructure. We generally charge our customers in this segment on a fixed-bid basis, depending on the size and length of the pipeline being tested, the complexity of services provided, and the utilization of our work force and equipment. Our results in this segment are driven primarily by the number of field personnel that perform services for our customers and the fees that we charge for those services, which depend on the type and number of field personnel used on a particular project, the type of equipment used and the fees charged for the utilization of that equipment, and the nature and duration of the project.

The Environmental Services segment owns and operates nine (9) Environmental Protection Agency Class II saltwater disposal facilities in the Williston Basin region of North Dakota. Eight (8) of the facilities are wholly-owned and we have ten (10) pipelines from multiple E&P customers connected to these saltwater disposal facilities, including two (2) that we developed and own. Our saltwater disposal facilities provide essential environmental services to oil and natural gas upstream producers and their transportation companies. All of the saltwater disposal facilities utilize specialized equipment and remote monitoring to minimize the facilities’ downtime and increase the facilities’ efficiency for peak utilization. These facilities also utilize oil skimming and recovery processes that remove residual oil from water delivered to our saltwater disposal facilities via pipeline or truck. We sell the oil recovered from these skimming processes, which contributes to our revenues. In addition to these saltwater disposal facilities, we provide management and staffing services to a saltwater disposal facility in which we own a 25% ownership interest (see Note 6).

2. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The Unaudited Condensed Consolidated Financial Statements as of September 30, 2019 and for the three and nine months ended September 30, 2019 and 2018 include our accounts and those of our controlled subsidiaries. Investments over which we exercise significant influence, but do not control, are accounted for using the equity method of accounting. All intercompany transactions and account balances have been eliminated in consolidation. The Unaudited Condensed Consolidated Balance Sheet at December 31, 2018 is derived from our audited financial statements.

The accompanying Unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim consolidated financial information and in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). The Unaudited Condensed Consolidated Financial Statements include all adjustments considered necessary for a fair presentation of the consolidated financial position and consolidated results of operations for the interim periods presented. Such adjustments consist only of normal recurring items, unless otherwise disclosed herein. Accordingly, the Unaudited Condensed Consolidated Financial Statements do not include all of the information and notes required by GAAP for complete consolidated financial statements. However, we believe that the disclosures made are adequate to make the information not misleading. These interim Unaudited Condensed Consolidated Financial Statements should be read in conjunction with our audited financial statements as of and for the year ended December 31, 2018 included in our Form 10-K. The results of operations for interim periods are not necessarily indicative of the results to be expected for a full year. Certain previously-reported amounts have been reclassified to conform to the current presentation.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Use of Estimates in the Preparation of Financial Statements

The preparation of our Unaudited Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in these financial statements and accompanying notes. Actual results could differ from those estimates.

Significant Accounting Policies

Our significant accounting policies are consistent with those disclosed in Note 2 to our audited financial statements as of and for the year ended December 31, 2018 included in our Form 10-K, except for the adoption of Accounting Standards Update (“ASU”) 2016-02 – Leases on January 1, 2019. We adopted the new standard on the effective date of January 1, 2019 and used a modified retrospective approach as permitted under ASU 2018-11. See Note 9 for lease disclosures. The effects of implementing ASU 2016-02 included the addition of right-of-use assets and associated lease liabilities to our Unaudited Condensed Consolidated Balance Sheets, but were immaterial to our Unaudited Condensed Consolidated Statements of Operations and Unaudited Condensed Consolidated Statements of Cash Flows.

Accounts Receivable and Allowance for Bad Debts

We grant unsecured credit to customers under normal industry standards and terms, and have established policies and procedures that allow for an evaluation of each of our customer’s creditworthiness. We typically receive payment from our customers 45 to 90 days after the services have been performed. We determine allowances for bad debts based on management’s assessment of the creditworthiness of our customers. Trade receivables are written off against the allowance when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when cash is received. During the second quarter of 2019, we recorded an allowance of $0.1 million against the accounts receivable from a customer of the Environmental Services segment. Also, during the second quarter of 2019, we received $0.1 million from a former customer of the Environmental Services segment on accounts receivable that we had previously written off. As of September 30, 2019 and December 31, 2018, we had an allowance for doubtful accounts of $0.2 million and less than $0.1 million, respectively.

Pacific Gas and Electric Bankruptcy

PG&E Corporation and its wholly-owned subsidiary Pacific Gas and Electric Company (collectively, “PG&E”) filed for bankruptcy protection on January 29, 2019. PG&E is a significant customer that accounted for $43.4 million of the revenue and $6.4 million of the gross margin of our Pipeline Inspection segment during the year ended December 31, 2018. As of December 31, 2018, the assets on our Consolidated Balance Sheet included $10.3 million of accounts receivable from PG&E. We collected $1.0 million of this balance in January 2019 prior to PG&E’s bankruptcy filing. We generated $2.8 million of revenue from PG&E during the period from January 1, 2019 through January 28, 2019, bringing the total accounts receivable from PG&E to $12.1 million as of the date of the bankruptcy filing. In October 2019, we reached an agreement to collect $1.7 million of the pre-petition receivables from PG&E under a court-approved program to pay certain pre-petition claims to certain vendors in advance of PG&E's emergence from bankruptcy, which will bring the total remaining pre-petition receivables from PG&E to $10.4 million.

We have continued to provide services to PG&E after the bankruptcy filing and have been receiving prompt payment for these services. We have not recorded an allowance against the accounts receivable from PG&E at September 30, 2019, as we do not believe it is probable that we will ultimately be unable to collect the full balance of the pre-petition receivables. However, due to uncertainties associated with the bankruptcy process, we cannot make assurances regarding the ultimate collection of these receivables nor can we make assurances regarding the timing of any such collections.

Sanchez Bankruptcy

Our former customer, Sanchez Energy Corporation and certain of its affiliates (collectively, “Sanchez”) filed for bankruptcy protection in August 2019. As of September 30, 2019, our Unaudited Condensed Consolidated Balance Sheet included $0.5 million of pre-petition accounts receivable from Sanchez. We have recorded an allowance of less than $0.1 million at September 30, 2019 against the accounts receivable from Sanchez. We do not believe it is probable that we will be unable to collect the remaining $0.4 million balance of the pre-petition receivables. However, due to uncertainties associated with the bankruptcy process, we cannot make assurances regarding the ultimate collection of these receivables nor can we make assurances regarding the timing of any such collections.

Foreign Currency Translation

Our Unaudited Condensed Consolidated Financial Statements are reported in U.S. dollars. We translate our Canadian-dollar-denominated assets and liabilities into U.S. dollars at the exchange rate in effect at the balance sheet date. We translate our Canadian-dollar-denominated revenues and expenses into U.S. dollars at the average exchange rate in effect during the period in which the applicable revenues and expenses were recorded.

Our Unaudited Condensed Consolidated Balance Sheet at September 30, 2019 includes $2.5 million of accumulated other comprehensive loss associated with accumulated currency translation adjustments, all of which relate to our Canadian operations. If at some point in the future we were to sell or substantially liquidate our Canadian operations, we would reclassify the balance in accumulated other comprehensive loss to other accounts within partners’ capital, which would be reported in the Unaudited Condensed Consolidated Statement of Operations as a reduction to net income. Our Canadian subsidiary has certain payables to our U.S.-based subsidiaries. These intercompany payables and receivables among our consolidated subsidiaries are eliminated on our Unaudited Condensed Consolidated Balance Sheets. We report currency translation adjustments on these intercompany payables and receivables within foreign currency gains (losses) in our Unaudited Condensed Consolidated Statements of Operations.

New Accounting Standards

In 2019, we adopted the following new accounting standard issued by the Financial Accounting Standards Board (“FASB”);

The FASB issued ASU 2016-02 – Leases in February 2016. This guidance attempts to increase transparency and comparability among organizations by recognizing certain lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The main difference between previous GAAP methodology and the method used in this new guidance is the recognition on the balance sheet of lease assets and lease liabilities by lessees for certain operating leases.

We made accounting policy elections to not capitalize leases with a lease term of twelve months or less and to not separate lease and non-lease components for all asset classes. We also elected the package of practical expedients within ASU 2016-02 that allows an entity to not reassess prior to the effective date (i) whether any expired or existing contracts are or contain leases, (ii) the lease classification for any expired or existing leases, or (iii) initial direct costs for any existing leases, but did not elect the practical expedient of hindsight when determining the lease term of existing contracts at the effective date.

In July 2018, the FASB issued ASU 2018-11 – Targeted Improvements, which provided entities with a transition option to not restate the comparative periods for the effects of applying the new leasing standard (i.e. comparative periods presented in the Unaudited Condensed Consolidated Financial Statements will continue to be in accordance with Accounting Standards Codification 840). We adopted the new standard on the effective date of January 1, 2019 and used a modified retrospective approach as permitted under ASU 2018-11. The effects of implementing ASU 2016-02 included the addition of right-of-use assets and associated lease liabilities to our Unaudited Condensed Consolidated Balance Sheets, but were immaterial to our Unaudited Condensed Consolidated Statements of Operations and Unaudited Condensed Consolidated Statements of Cash Flows. The cumulative effect adjustment was not material to partners' capital on our Unaudited Condensed Consolidated Balance Sheet. Upon adoption, we recorded operating lease right-of-use assets of $3.5 million and current and noncurrent operating lease obligations of $0.5 million and $3.0 million, respectively. Liabilities recorded as a result of this standard are excluded from the definition of indebtedness under our credit facility, and therefore do not adversely impact the leverage ratio under our credit facility.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Other accounting guidance proposed by the FASB that may impact our Unaudited Condensed Consolidated Financial Statements, which we have not yet adopted include:

The FASB issued ASU 2016-13 – Financial Instruments – Credit Losses in June 2016, which replaces the current “incurred loss” methodology for recognizing credit losses with an “expected loss” methodology. This guidance affects trade receivables, financial assets and certain other instruments that are not measured at fair value through net income. In August 2019, The FASB issued a proposal to delay the implementation of this new guidance for smaller reporting companies until fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The FASB expects to issue a final ASU with their decision in November 2019. We are currently evaluating the impact this ASU will have on our Unaudited Condensed Consolidated Financial Statements.

The FASB issued ASU 2018-15 – Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract in August 2018. This guidance requires a customer in a cloud computing arrangement to follow the internal use software guidance in ASC 350-40 to determine which costs should be capitalized as assets or expensed as incurred. The amendments in this ASU are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. We plan to adopt this guidance prospectively from the date of adoption (January 1, 2020) and do not believe this new guidance will have a material impact on our Unaudited Condensed Consolidated Financial Statements.

3. Debt

On May 29, 2018, we entered into an amended and restated credit agreement (as amended and restated, the “Credit Agreement”) that provided up to $90.0 million in borrowing capacity, subject to certain limitations. The Credit Agreement contains an accordion feature that allowed us to increase the borrowing capacity to $110.0 million if new lenders joined the facility. In October 2019, two new lenders joined the facility, and on October 25, 2019, we accordingly increased the total borrowing capacity to $110.0 million. The three-year Credit Agreement matures May 29, 2021. The obligations under the Credit Agreement are secured by a first priority lien on substantially all of our assets. The credit agreement as it existed prior to the May 29, 2018 amendment will hereinafter be referred to as the “Previous Credit Agreement” or, together with the Credit Agreement, as the “Credit Agreements”.

Outstanding borrowings at September 30, 2019 and December 31, 2018 were $80.9 million and $76.1 million, respectively, and are reflected as long-term debt on the Unaudited Condensed Consolidated Balance Sheets. We also had $0.5 million of finance lease liabilities at September 30, 2019 that count as indebtedness under the Credit Agreement. Debt issuance costs are reported as debt issuance costs, net on the Unaudited Condensed Consolidated Balance Sheets and total $0.9 million and $1.3 million at September 30, 2019 and December 31, 2018, respectively. The carrying value of our long-term debt approximates fair value, as the borrowings under the Credit Agreement are considered to be priced at market for debt instruments having similar terms and conditions (Level 2 of the fair value hierarchy).

We incurred certain debt issuance costs associated with the Previous Credit Agreement, which we were amortizing on a straight-line basis over the life of the Previous Credit Agreement. Upon amending the Credit Agreement in May 2018, we wrote off $0.1 million of these debt issuance costs, which represented the portion of the unamortized debt issuance costs attributable to lenders who are no longer participating in the credit facility subsequent to the amendment. The remaining debt issuance costs associated with the Previous Credit Agreement, along with $1.3 million of debt issuance costs associated with the amended and restated Credit Agreement, are being amortized on a straight-line basis over the three-year term of the Credit Agreement.

All borrowings under the Credit Agreement bear interest, at our option, on a leveraged based grid pricing at (i) a base rate plus a margin of 1.5% to 3.0% per annum (“Base Rate Borrowing”) or (ii) an adjusted LIBOR rate plus a margin of 2.5% to 4.0% per annum (“LIBOR Borrowings”). The applicable margin is determined based on the leverage ratio of the Partnership, as defined in the Credit Agreement.

The interest rate on our borrowings ranged between 5.54% and 6.02% for the nine months ended September 30, 2019 and 4.74% and 5.95% for the nine months ended September 30, 2018. As of September 30, 2019, the interest rate in effect on our outstanding borrowings was 5.54%. Interest on Base Rate Borrowings is payable monthly. Interest on LIBOR Borrowings is paid upon maturity of the underlying LIBOR contract, but no less often than quarterly. Commitment fees are charged at a rate of 0.50% on any unused credit and are payable quarterly. Interest paid, including commitment fees, was $1.3 million and $1.1 million for the three months ended September 30, 2019 and 2018, respectively. Interest paid, including commitment fees, was $3.7 million and $4.6 million for the nine months ended September 30, 2019 and 2018, respectively.

The Credit Agreement contains various customary covenants and restrictive provisions. The Credit Agreement also requires maintenance of certain financial covenants at each quarter end, including a leverage ratio (as defined in the Credit Agreement) of not more than 4.0 to 1.0 and an interest coverage ratio (as defined in the Credit Agreement) of not less than 3.0 to 1.0. At September 30, 2019, our leverage ratio was 2.8 to 1.0 and our interest coverage ratio was 6.4 to 1.0, pursuant to the Credit Agreement. Upon the occurrence and during the continuation of an event of default, subject to the terms and conditions of the Credit Agreement, the lenders may declare any outstanding principal, together with any accrued and unpaid interest, to be immediately due and payable and may exercise the other remedies set forth or referred to in the Credit Agreement. We were in compliance with all debt covenants as of September 30, 2019.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

In addition, the Credit Agreement restricts our ability to make distributions on, or redeem or repurchase, our equity interests, with certain exceptions detailed in the Credit Agreement. However, we may make distributions of available cash so long as, both at the time of the distribution and after giving effect to the distribution, no default exists under the Credit Agreement, we are in compliance with the financial covenants in the Credit Agreement, and we have at least $5.0 million of unused capacity on the Credit Agreement at the time of the distribution. As of September 30, 2019, we had $8.5 million of unused borrowing capacity under the Credit Agreement. In October 2019, our unused borrowing capacity increased to $28.5 million when two new lenders joined the Credit Agreement.

4. Income Taxes

The income tax expense reported in our Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2019 and 2018 differs from the statutory tax rate of 21% due to the fact that, as a partnership, we are generally not subject to U.S. federal or state income taxes. Our income tax provision relates primarily to (1) our U.S. corporate subsidiaries that provide services to public utility customers, which may not fit within the definition of qualified income as it is defined in the Internal Revenue Code, Regulations, and other guidance, which subjects this income to U.S. federal and state income taxes, (2) our Canadian subsidiary, which is subject to Canadian federal and provincial income taxes, and (3) certain other state income taxes, including the Texas franchise tax.

As a publicly-traded partnership, we are subject to a statutory requirement that 90% of our total gross income represents “qualifying income” (as defined by the Internal Revenue Code, related Treasury Regulations, and Internal Revenue Service pronouncements), determined on a calendar-year basis. If our qualifying income does not meet this statutory requirement, we could be taxed as a corporation for federal and state income tax purposes. Our income has met the statutory qualifying income requirement each year since our initial public offering.

5. Equity

Series A Preferred Units

On May 29, 2018 (the “Closing Date”), we entered into a Series A Preferred Unit Purchase Agreement (the “Preferred Unit Purchase Agreement”) with an entity controlled by Charles C. Stephenson, Jr. (the “Purchaser”), an affiliate of our General Partner, where we issued and sold in a private placement 5,769,231 Series A Preferred Units representing limited partner interests in the Partnership (the “Preferred Units”) to the Purchaser for a cash purchase price of $7.54 per Preferred Unit, resulting in gross proceeds to the Partnership of $43.5 million. We used proceeds from the transaction to reduce outstanding borrowings on our revolving credit facility. Concurrent with the closing of this transaction, we entered into an amended and restated Credit Agreement dated as of May 29, 2018, to amend and restate the terms of our credit facility, as more fully described in Note 3.

The Preferred Unit Purchase Agreement contains customary representations, warranties, and covenants of the Partnership and the Purchaser. The Partnership and the Purchaser agreed to indemnify each other and their respective officers, directors, managers, employees, agents, counsel, accountants, investment bankers, and other representatives against certain losses resulting from breaches of their respective representations, warranties, and covenants, subject to certain negotiated limitations and survival periods set forth in the Preferred Unit Purchase Agreement.

Pursuant to the Preferred Unit Purchase Agreement, and in connection with the closing of this transaction, our General Partner executed the First Amendment to First Amended and Restated Agreement of Limited Partnership of the Partnership, which authorizes and establishes the rights and preferences of the Preferred Units. The Preferred Units have voting rights that are identical to the voting rights of the common units into which such Preferred Units would be converted at the then-applicable conversion rate.

The Purchaser is entitled to receive quarterly distributions that represent an annual return of 9.5% on the Preferred Units. Of this 9.5% annual return, we are required to pay at least 2.5% in cash and will have the option to pay the remaining 7.0% in kind (in the form of issuing additional preferred units) for the first twelve quarters after the Closing Date.

After the third anniversary of the Closing Date, the Purchaser will have the option to convert the Preferred Units into common units on a one-for-one basis. If certain conditions are met after the third anniversary of the Closing Date, we will have the option to cause the Preferred Units to convert to common units. After the third anniversary of the Closing Date, we will also have the option to redeem the Preferred Units. We may redeem the Preferred Units (a) at any time after the third anniversary of the Closing Date and on or prior to the fourth anniversary of the Closing Date at a redemption price equal to 105% of the issue price, and (b) at any time after the fourth anniversary of the Closing Date at a redemption price equal to 101% of the issue price.

Earnings Per Unit

Our net income is attributable and allocable to three ownership groups: (1) our preferred unitholder, (2) the noncontrolling interests in certain subsidiaries, and (3) our common unitholders. Income attributable to our preferred unitholder represents the 9.5% annual return to which the owner of the Preferred Units is entitled. Net income attributable to noncontrolling interests represents 49% of the income generated by Brown and 51% of the income generated by CF Inspection. Net income attributable to common unitholders represents our remaining net income, after consideration of amounts attributable to our preferred unitholder and the noncontrolling interests.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Basic net income per common limited partner unit is calculated as net income attributable to common unitholders divided by the basic weighted average common units outstanding. Diluted net income per common limited partner unit includes the net income attributable to preferred unitholder and the dilutive effect of the potential conversion of the preferred units and the dilutive effect of the unvested equity compensation.

The following table summarizes the calculation of the basic net income per common limited partner unit for the three and nine months ended September 30, 2019 and 2018:

The following table summarizes the calculation of the diluted net income per common limited partner unit for the three and nine months ended September 30, 2019 and 2018:

Equity Compensation

Our General Partner has adopted a long-term incentive plan (“LTIP”) that authorizes the issuance of up to 2.5 million common units. Certain directors and employees of the Partnership have been awarded phantom restricted units (“Units”) under the terms of the LTIP in the form of time-based unit awards (“Service Units”), performance-based unit awards (“Performance Units”) and market-based unit awards (“Market Units”). We recorded expense of $0.7 million and $0.9 million during the nine months ended September 30, 2019 and 2018, respectively, related to the Unit awards.

Time-Based Unit Awards – The majority of the Service Units vest in three tranches, with one-third of the units vesting three years from the grant date, one-third vesting four years from the grant date, and one-third vesting five years from the grant date, contingent only on the continued service of the recipients through the vesting dates. However, certain of the Service Units have different, and typically shorter, vesting periods. The fair value of the Service Units is determined based on the quoted market value of the publicly-traded common units at the grant date, adjusted for a discount to reflect the fact that distributions are not paid on the Service Units during the vesting period. We recognize compensation expense on a straight-line basis over the vesting period of the grant. We account for forfeitures when they occur. Total unearned compensation associated with the Service Units at September 30, 2019 was $2.7 million with an average remaining life of 2.1 years. The following table summarizes the activity of the Service Units for the nine months ended September 30, 2019 and 2018:

Performance-Based Unit Awards – We have issued grants of Performance Units that vest three years from the grant date. Upon vesting, the recipient is entitled to receive a number of common units equal to a percentage of the units granted, based on the recipient meeting various performance targets in addition to the service condition.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

In addition, in the third quarter of 2019, we granted Performance Units to certain employees that are subject to performance conditions in addition to the service condition. These Performance Units will vest in April 2022, April 2023, April 2024, or not at all, depending on our performance relative to a specified profitability target. We recognize compensation expense on a straight-line basis over the estimated vesting period of the grant. We adjust the life-to-date expense recognized for the Performance Units for any changes in our estimates of the number of units that will vest and the timing of vesting. We account for forfeitures when they occur. The Performance Units granted in the third quarter of 2019 had an estimated grant date fair value of $4.19 per unit and are being expensed over a service period of 3.73 years.

Total unearned compensation associated with the Performance Units at September 30, 2019 was $0.4 million with an average remaining life of 2.88 years. The unvested Performance Units at September 30, 2019 also include one grant of 72,046 units that vests in November 2021, contingent upon the recipient meeting certain specified performance targets. The following table summarizes the activity of the Performance Units for the nine months ended September 30, 2019 and 2018:

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Market-Based Unit Awards – In the third quarter of 2019, we granted Units that are subject to market conditions in addition to the service condition (the “Market Units”). One-half of the Market Units will vest in April 2022, April 2023, April 2024, or not at all, depending on the market value of our common units relative to specified targets on those dates. These Market Units had an estimated fair value on the grant date of $3.51 per unit and will be expensed over a derived service period of 2.73 years. One-half of the Market Units will vest in April 2022, April 2023, April 2024, or not at all, depending on the yield on our common units relative to specified targets on those dates. These Market Units granted in 2019 had an estimated fair value on the grant date of $3.58 per unit and will be expensed over a derived service period of 2.73 years. Compensation expense is recognized on a straight-line basis over a derived service period, regardless of when, if ever, the market condition is satisfied. Total unearned compensation associated with the Market Units at September 30, 2019 was $0.3 million with an average remaining life of 2.5 years. The following table summarizes the activity of the Market Units for the nine months ended September 30, 2019:

6. Related-Party Transactions

Omnibus Agreement and Other Support from Holdings

We are party to an omnibus agreement with Holdings and other related parties. The omnibus agreement governs the following matters, among other things:

So long as Holdings controls our General Partner, the omnibus agreement will remain in full force and effect, unless we and Holdings agree to terminate it sooner. If Holdings ceases to control our General Partner, either party may terminate the omnibus agreement. We and Holdings may agree to further amend the omnibus agreement; however, amendments that the General Partner determines are adverse to our unitholders will also require the approval of the Conflicts Committee of our Board of Directors. As part of our new Credit Agreement, Holdings agreed to waive the omnibus fee to support us in the event our leverage ratio were to exceed 3.75 times our trailing twelve-month Adjusted EBITDA at any quarter-end during the term of the facility.

In an effort to simplify this arrangement so it will be easier for investors to understand, in November 2019, with the approval of the Conflicts Committee of the Board of Directors, we and Holdings agreed to terminate the management fee provisions of the Omnibus Agreement, effective December 31, 2019. Beginning on January 1, 2020, the executive management services and other general and administrative expenses that Holdings currently incurs and charges to us via the annual administrative fee will be charged directly to us as they are incurred. Under our current cost structure, we expect these direct expenses to be lower than the annual administrative fee that we are currently paying, although we expect to experience more variability in our quarterly general and administrative expense when we are incurring the expenses directly than when we paid a consistent administrative fee each quarter.

Alati Arnegard, LLC

The Partnership provides management services to a 25% owned company, Alati Arnegard, LLC (“Arnegard”), which is part of the Environmental Services segment. We recorded earnings from this investment of less than $0.1 million and $0.2 million for the nine months ended September 30, 2019 and 2018, respectively. These earnings are recorded in other, net in the Unaudited Condensed Consolidated Statements of Operations and equity in earnings of investee in the Unaudited Condensed Consolidated Statements of Cash Flows. Management fee revenue earned from Arnegard is included in revenue in the Unaudited Condensed Consolidated Statements of Operations and totaled $0.5 million for each of the nine months ended September 30, 2019 and 2018. Accounts receivable from Arnegard totaled $0.1 million at both September 30, 2019 and December 31, 2018, and is included in trade accounts receivable, net on the Unaudited Condensed Consolidated Balance Sheets. Our investment in Arnegard was $0.3 million at September 30, 2019 and December 31, 2018, and is included in other assets on the Unaudited Condensed Consolidated Balance Sheets.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

CF Inspection Management, LLC

We have also entered into a joint venture with CF Inspection, a nationally-qualified woman-owned inspection firm affiliated with one of Holdings’ owners and a Director of our General Partner. CF Inspection allows us to offer various services to clients that require the services of an approved Women’s Business Enterprise (“WBE”), as CF Inspection is certified as a Women’s Business Enterprise by the Supplier Clearinghouse in California and as a National Women’s Business Enterprise by the Women’s Business Enterprise National Council. We own 49% of CF Inspection and Cynthia A. Field, an affiliate of Holdings and a Director of our General Partner, owns the remaining 51% of CF Inspection. For the nine months ended September 30, 2019, CF Inspection, which is part of the Pipeline Inspection segment, represented approximately 3.0% of our consolidated revenue.

Sale of Preferred Equity

As described in Note 5, we issued and sold $43.5 million of preferred equity to an affiliate in May 2018.

7. Commitments and Contingencies

Security Deposits

The Partnership has various performance obligations that are secured with short-term security deposits (reflected as restricted cash equivalents in our Unaudited Condensed Consolidated Statements of Cash Flows) totaling $0.6 million at September 30, 2019 and December 31, 2018. These amounts are included in prepaid expenses and other on the Unaudited Condensed Consolidated Balance Sheets.

Compliance Audit Contingencies

Certain customer master service agreements (“MSA’s”) offer our customers the opportunity to perform periodic compliance audits, which include the examination of the accuracy of our invoices. Should our invoices be determined to be inconsistent with the MSA, or inaccurate, the MSA’s may provide the customer the right to receive a credit or refund for any overcharges identified. At any given time, we may have multiple audits ongoing. As of September 30, 2019 and December 31, 2018, we established a reserve of $0.1 million for potential liabilities related to these compliance audit contingencies.

Legal Proceedings

Fithian v. TIR LLC

On October 5, 2017, a former inspector for TIR LLC and Cypress Energy Management – TIR, LLC (“CEM TIR”) filed a putative collective action lawsuit alleging that TIR LLC, CEM TIR and Cypress Energy Partners – Texas, LLC failed to pay a class of workers overtime in compliance with the Fair Labor Standards Act (“FLSA”) titled James Fithian, et al v. TIR LLC, et al in the United States District Court for the Western District of Texas, Midland Division. The plaintiff subsequently withdrew his action and filed a similar action in Oklahoma State Court, District of Tulsa County. The plaintiff alleged he was a non-exempt employee of CEM TIR and that he and other potential class members were not paid overtime in compliance with the FLSA. The plaintiff sought to proceed as a collective action and to receive unpaid overtime and other monetary damages, including attorney’s fees. The Partnership, TIR LLC, CEM TIR and Cypress Energy Partners – Texas, LLC denied the claims.

On March 28, 2018, the court granted a joint stipulation of dismissal without prejudice in regard to TIR LLC and Cypress Energy Partners – Texas, LLC, as neither of those parties were employers of the plaintiff or the putative class members during the time period that is the subject of the lawsuit. On July 26, 2018, the plaintiff filed a motion for conditional class certification. CEM TIR subsequently filed pleadings opposing the motion. On January 25, 2019, the court denied the plaintiff’s motion for conditional class certification. On June 10, 2019, the court entered a scheduling order that proscribed, among other things, that the deadline for additional parties to join the lawsuit of August 1, 2019, and that the parties participate in a settlement conference or mediation no later than September 1, 2019. After the deadline, plaintiff’s counsel submitted consents for five additional inspectors to join the lawsuit, to which CEM TIR objected. On August 28, 2019, the parties participated in a settlement conference in which no settlement was reached. Subsequent to the settlement conference, CEM-TIR submitted offers of judgment in immaterial amounts to the named plaintiff and the two opt-in plaintiffs. All plaintiffs accepted the settlement offers. CEM TIR’s counterclaim against Mr. Fithian remains outstanding.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Sun Mountain LLC v. TIR-PUC

On February 27, 2019, Sun Mountain LLC (“Sun Mountain”), a subcontractor of TIR-PUC, filed a lawsuit alleging that TIR-PUC failed to pay invoices amounting to approximately $3.5 million for services subcontracted to Sun Mountain under TIR-PUC’s agreement to provide services to Pacific Gas and Electric Company. Sun Mountain filed the action in Federal District Court for the Northern District of Oklahoma. TIR-PUC denied that such amounts were owed, as conditions to TIR-PUC’s obligation to make the payments were not met. The full amount of these invoices is included within accounts payable on the accompanying Unaudited Condensed Consolidated Balance Sheets at September 30, 2019 and December 31, 2018. TIR-PUC denied the claims. On October 22, 2019, the parties participated in a settlement conference at which the parties agreed to settle the lawsuit. As part of the settlement, TIR-PUC will make specified cash payments in November 2019, January 2020, and July 2020. We expect to record a gain of $1.3 million in the fourth quarter of 2019 related to this settlement.

Other

From time to time, we are subject to various claims, lawsuits and other legal proceedings brought or threatened against us in the ordinary course of our business. These actions and proceedings may seek, among other things, compensation for alleged personal injury, workers' compensation, employment discrimination and other employment-related damages, breach of contract, property damage, environmental liabilities, multiemployer pension plan withdrawal liabilities, punitive damages and civil penalties or other losses, liquidated damages, consequential damages, or injunctive or declaratory relief. We have been and may in the future be subject to litigation involving allegations of violations of the Fair Labor Standards Act and state wage and hour laws. In addition, we generally indemnify our customers for claims related to the services we provide and actions we take under our contracts, including claims regarding the Fair Labor Standards Act and state wage and hour laws, and, in some instances, we may be allocated risk through our contract terms for actions by our customers or other third parties. Claims related to the Fair Labor Standards Act are generally not covered by insurance.

8. Sale of Saltwater Disposal Facilities

In 2018, we sold our subsidiaries Cypress Energy Partners – Orla SWD, LLC (“Orla”) and Cypress Energy Partners – Pecos SWD, LLC (“Pecos”), each of which owned a saltwater disposal facility in Texas, in separate transactions to unrelated parties for a combined $12.2 million of cash proceeds and a royalty interest in the future revenues of the Pecos facility. We recorded a combined gain on these transactions of $3.6 million during the nine months ended September 30, 2018, which represented the excess of the cash proceeds over the net book value of the assets sold. These gains are reported within gain on asset disposals, net in our Unaudited Condensed Consolidated Statements of Operations. The net book value of the assets sold included $5.0 million of allocated goodwill, calculated based on the estimated fair value of the Orla and Pecos facilities relative to the estimated fair value of the Environmental Services reporting unit as a whole. This calculation is considered Level 3 and the fair values included in this calculation were determined utilizing estimated discounted cash flows of the Orla and Pecos facilities and the Environmental Services reporting unit as a whole as of the date of sale. We used the proceeds from these transactions to reduce our outstanding debt.

9. Leases

We determine if an agreement contains a lease at the inception of the arrangement. If an arrangement is determined to contain a lease, we classify the lease as an operating lease or a finance lease depending on the terms of the arrangement. Right-of-use (“ROU”) assets represent the right to use an underlying asset for the lease term, and lease liabilities represent the obligation to make lease payments arising from the lease. These assets and liabilities are initially recognized based on the present value of lease payments over the lease term calculated using our incremental borrowing rate, unless the implicit rate is readily determinable. Lease assets also include any upfront lease payments made and exclude lease incentives. The lease terms of our leases include options to extend or terminate the lease when it is reasonably certain that those options will be exercised.

Practical Expedients and Accounting Policy Elections

We made accounting policy elections to not capitalize leases with a lease term of twelve months or less and to not separate lease and non-lease components for all asset classes. We also elected the package of practical expedients within ASU 2016-02 that allows an entity to not reassess prior to the effective date (i) whether any expired or existing contracts are or contain leases, (ii) the lease classification for any expired or existing leases, or (iii) initial direct costs for any existing leases, but did not elect the practical expedient of hindsight when determining the lease term of existing contracts at the effective date.

Discount Rate

Our lease agreements do not generally provide an implicit interest rate. As a result, we are required to use our incremental borrowing rate as the discount rate in calculating the present value of the lease payments. The incremental borrowing rate is the estimated rate of interest that we would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Operating Leases

Our operating leases include leases for office space and land lease agreements for four of our saltwater disposal facilities. Our lease for our office space headquarters constitutes $2.9 million of our Operating ROU asset at September 30, 2019 of $3.1 million. The lease expires in November of 2024 unless terminated earlier with a payment of a penalty under certain circumstances specified in our lease. In the determination of the lease term for this lease, we concluded the lease term would continue through November 2024 as it was not reasonably certain at the inception of the agreement that we would exercise any of the termination options in the agreement. As of September 30, 2019, the weighted average remaining lease term and weighted average discount rate for our operating leases was 5.4 years and 6.1%, respectively. Our operating leases are reflected as operating lease right-of-use assets within noncurrent assets and operating lease obligations within current and noncurrent liabilities on our Unaudited Condensed Consolidated Balance Sheet at September 30, 2019.

Our operating lease obligations at September 30, 2019 with terms that are greater than one year mature as follows (in thousands):

Finance Leases

Our finance leases primarily include leases for vehicles. As of September 30, 2019, the weighted average remaining lease term and weighted average discount rate for our finance leases was 3.2 years and 5.9%, respectively. Our finance leases are reflected as finance lease right-of-use assets, net within noncurrent assets and finance lease obligations within current and noncurrent liabilities on our Unaudited Condensed Consolidated Balance Sheet at September 30, 2019. Our finance lease obligations at September 30, 2019 with terms that are greater than one year mature as follows (in thousands):

10. Reportable Segments

The Partnership’s operations consist of three reportable segments: (i) Pipeline Inspection Services (“Pipeline Inspection”), (ii) Pipeline & Process Services and (iii) Water and Environmental Services (“Environmental Services”).

Pipeline Inspection – We generate revenue in this segment primarily by providing essential environmental services including inspection and integrity services on a variety of infrastructure assets including midstream pipelines, gathering systems, and distribution systems. Services include non-destructive examination, inline support, pig tracking, survey, data gathering and supervision of third-party contractors. Our results in this segment are driven primarily by the number of inspectors that perform services for our customers and the fees that we charge for those services, which depend on the type, skills, technology, equipment, and number of inspectors used on a particular project, the nature of the project, and the duration of the project. The number of inspectors engaged on projects is driven by the type of project, prevailing market rates, the age and condition of customers’ assets including pipelines, gas plants, compression stations, storage facilities, and gathering and distribution systems including the legal and regulatory requirements relating to the inspection and maintenance of those assets. We also bill our customers for per diem charges, mileage, and other reimbursement items. Revenue and costs in this segment may be subject to seasonal variations and interim activity may not be indicative of yearly activity, considering that many of our customers develop yearly operating budgets and enter into contracts with us for work to be performed during the remainder of the year. Additionally, inspection work throughout the United States during the winter months (especially in the northern states) may be hampered or delayed due to inclement weather, thus affecting our revenue and costs. During the three months ended September 30, 2019 and 2018, we recognized $0.2 million and $0.5 million of revenue, respectively, on services performed in previous years. We had constrained recognition of this revenue until the expiration of a contract provision that had given the customer the opportunity to reopen negotiation of the fee paid for the services. As of September 30, 2019 and December 31, 2018, we recognized a refund liability of $0.4 million for revenue associated with such variable consideration. In October 2019, we received a signed contract modification from one of our customers for a price increase that is retroactive to June 2019. We will record $0.6 million as a catch-up adjustment to revenue in the fourth quarter of 2019 related to this retroactive price increase.

Pipeline & Process Services – This segment provides essential environmental services including hydrostatic testing services and chemical cleaning to energy companies and pipeline construction companies of newly-constructed and existing pipelines and related infrastructure. We generally charge our customers in this segment on a fixed-bid basis, depending on the size and length of the pipeline being tested, the complexity of services provided, and the utilization of our work force and equipment. Our results in this segment are driven primarily by the number of field personnel that perform services for our customers and the fees that we charge for those services, which depend on the type and number of field personnel used on a particular project, the type of equipment used and the fees charged for the utilization of that equipment, and the nature and duration of the project. Revenue and costs in this segment may be subject to seasonal variations and interim activity may not be indicative of yearly activity, considering that many of our customers develop yearly operating budgets and enter into contracts with us for work to be performed during the remainder of the year. Additionally, field work during the winter months may be hampered or delayed due to inclement weather. Revenue during the nine months ended September 30, 2018 included $0.3 million associated with additional billings on a project that we completed in the fourth quarter of 2017 (we recognized the revenue upon receipt of customer acknowledgment of the additional fees).

CYPRESS ENERGY PARTNERS, L.P.

Notes to the Unaudited Condensed Consolidated Financial Statements

Environmental Services – This segment owns and operates nine (9) Environmental Protection Agency Class II saltwater disposal facilities in the Williston Basin region of North Dakota. Eight (8) of the facilities are wholly-owned and we have ten (10) pipelines from multiple E&P customers connected to these saltwater disposal facilities, including two (2) that were developed and are owned by the Partnership. During the nine months ended September 30, 2019, 92% of our volumes from our wholly-owned facilities were produced water and 41% of our volumes from our wholly-owned facilities were delivered via ten pipelines, including two that we constructed and own. Of the disposal volumes from Arnegard, a 25% owned company, 95% of the volumes were produced water and 61% were delivered via pipeline during the nine months ended September 30, 2019. Our saltwater disposal facilities provide essential environmental services to oil and natural gas upstream producers and their transportation companies. All of the saltwater disposal facilities utilize specialized equipment and remote monitoring to minimize the facilities’ downtime and increase the facilities’ efficiency for peak utilization. These facilities also utilize oil skimming and recovery processes that remove residual oil from water delivered to our saltwater disposal facilities via pipeline or truck. We sell the oil recovered from these skimming processes, which contributes to our revenues. In addition to these saltwater disposal facilities, we provide management and staffing services to a saltwater disposal facility in which we own a 25% ownership interest. Segment results are driven primarily by the volumes of water we inject into our saltwater disposal facilities and the fees we charge for transporting water in our two pipelines connected to these facilities. These fees are charged on a per-barrel basis and vary based on the quantity and type of saltwater disposed, competitive dynamics, and operating costs. In addition, for minimal marginal cost, we generate revenue by selling residual oil we recover from the disposed water. Revenue and costs in this segment may be subject to seasonal fluctuations and interim activity may not be indicative of yearly activity, given that our saltwater disposal facilities are located in North Dakota and weather conditions there (especially winter weather conditions) can affect drilling, operations, and trucking activity, and ultimately, our volumes, revenues, and costs.

Other – These amounts represent corporate and overhead items not specifically allocable to the other reportable segments.