Notes
to Consolidated Financial Statements
(Unaudited)
Note
1 – Organization
The
Company’s business is comprised of the assets and properties of Carbon Natural Gas Company and its subsidiaries as well
as its equity investments in Carbon Appalachian Company, LLC (“Carbon Appalachia”) and Carbon California Company,
LLC (“Carbon California”).
Appalachian
and Illinois Basin Operations
In
the Appalachian and Illinois Basins, Nytis Exploration Company, LLC (“Nytis LLC”) conducts operations for the Company
and Carbon Appalachia.
California
Operations
In
California, Carbon California Operating Company, LLC (“CCOC”), conducts Carbon California’s operations.
Collectively,
Carbon Natural Gas Company, CCOC, Nytis Exploration (USA) Inc. (“Nytis USA”) and Nytis LLC are referred to as the
Company.
Note
2 – Summary of Significant Accounting Policies
Basis
of Presentation
The
accompanying unaudited Consolidated Financial Statements of the Company have been prepared in accordance with accounting principles
generally accepted in the United States (“GAAP”) for interim financial information. Accordingly, they do not include
all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying
unaudited Consolidated Financial Statements include all adjustments (consisting of normal and recurring accruals) considered necessary
to present fairly the Company’s financial position as of June 30, 2017 and the Company’s results of operations and
cash flows for the three and six months ended June 30, 2017 and 2016. Operating results for the three and six months ended June
30, 2017 are not necessarily indicative of the results that may be expected for the full year because of the impact of fluctuations
in prices received for oil and natural gas, natural production declines, the uncertainty of exploration and development drilling
results and other factors. For a more complete understanding of the Company’s operations, financial position and accounting
policies, the unaudited Consolidated Financial Statements and the notes thereto should be read in conjunction with the Company’s
audited Consolidated Financial Statements for the year ended December 31, 2016 filed on Form 10-K with the Securities and Exchange
Commission (“SEC”).
In
the course of preparing the unaudited Consolidated Financial Statements, management makes various assumptions, judgments and estimates
to determine the reported amount of assets, liabilities, revenue and expenses and in the disclosures of commitments and contingencies.
Changes in these assumptions, judgments and estimates will occur as a result of the passage of time and the occurrence of future
events and accordingly, actual results could differ from amounts initially established.
Principles
of Consolidation
The
Consolidated Financial Statements include the accounts of Carbon, CCOC, Nytis USA and its consolidated subsidiary, Nytis LLC.
Carbon owns 100% of Nytis USA and CCOC. Nytis USA owns approximately 99% of Nytis LLC.
Nytis
LLC also holds an interest in various oil and gas partnerships. For partnerships where the Company has a controlling interest,
the partnerships are consolidated. The Company is currently consolidating on a pro-rata basis 46 partnerships. In these instances,
the Company reflects the non-controlling ownership interest in partnerships and subsidiaries as non-controlling interests on its
Consolidated Statements of Operations and reflects the non-controlling ownership interests in the net assets of the partnerships
as non-controlling interests within stockholders’ equity on its Consolidated Balance Sheets. All significant intercompany
accounts and transactions have been eliminated.
In
accordance with established practice in the oil and gas industry, the Company’s unaudited Consolidated Financial Statements
also include its pro-rata share of assets, liabilities, income, lease operating costs and general and administrative expenses
of the oil and gas partnerships in which the Company has a non-controlling interest.
Non-majority
owned investments that do not meet the criteria for pro-rata consolidation are accounted for using the equity method when the
Company has the ability to significantly influence the operating decisions of the investee. When the Company does not have the
ability to significantly influence the operating decisions of an investee, the cost method is used. All transactions, if any,
with investees have been eliminated in the accompanying Consolidated Financial Statements.
Accounting
for Oil and Gas Operations
The
Company uses the full cost method of accounting for oil and gas properties. Accordingly, all costs incidental to the acquisition,
exploration and development of oil and gas properties, including costs of undeveloped leasehold, dry holes and leasehold equipment,
are capitalized. Overhead costs incurred that are directly identified with acquisition, exploration and development activities
undertaken by the Company for its own account, and which are not related to production, general corporate overhead or similar
activities, are also capitalized.
Unproved
properties are excluded from amortized capitalized costs until it is determined if proved reserves can be assigned to such properties.
The Company assesses its unproved properties for impairment at least annually. Significant unproved properties are assessed individually.
Capitalized
costs are depleted by an equivalent unit-of-production method, converting oil to gas at the ratio of one barrel of oil to six
thousand cubic feet of natural gas. Depletion is calculated using capitalized costs, including estimated asset retirement costs,
plus the estimated future expenditures (based on current costs) to be incurred in developing proved reserves, net of estimated
salvage values.
No
gain or loss is recognized upon disposal of oil and gas properties unless such disposal significantly alters the relationship
between capitalized costs and proved reserves. All costs related to production activities, including work-over costs incurred
solely to maintain or increase levels of production from an existing completion interval, are charged to expense as incurred.
The
Company performs a ceiling test quarterly. The full cost ceiling test is a limitation on capitalized costs prescribed by SEC Regulation
S-X Rule 4-10. The ceiling test is not a fair value based measurement, rather it is a standardized mathematical calculation. The
ceiling test provides that capitalized costs less related accumulated depletion and deferred income taxes may not exceed the sum
of (1) the present value of future net revenue from estimated production of proved oil and gas reserves using the un-weighted
arithmetic average of the first-day-of-the month price for the previous twelve month period, excluding the future cash outflows
associated with settling asset retirement obligations that have been accrued on the balance sheet, at a discount factor of 10%;
plus (2) the cost of properties not being amortized, if any; plus (3) the lower of cost or estimated fair value of unproved properties
included in the costs being amortized, if any; less (4) income tax effects related to differences in the book and tax basis of
oil and gas properties. Should the net capitalized costs exceed the sum of the components noted above, a ceiling test write-down
would be recognized to the extent of the excess capitalized costs. Such impairments are permanent and cannot be recovered in future
periods even if the sum of the components noted above exceeds the capitalized costs in future periods.
For
the three and six months ended June 30, 2017, the Company did not recognize a ceiling test impairment as the Company’s full
cost pool did not exceed the ceiling limitation. For the three and six months ended June 30, 2016, the Company recognized a ceiling
test impairment of approximately $409,000 and $4.3 million, respectively, as the Company’s full cost pool exceeded its ceiling
limitations. Future declines in oil and natural gas prices, and increases in future operating expenses and future development
costs could result in additional impairments of our oil and gas properties in future periods. Impairment charges are a non-cash
charge and accordingly, do not affect cash flow, but adversely affect our net income and stockholders’ equity.
Investments
in Affiliates
Investments
in non-consolidated affiliates are accounted for under either the cost or equity method of accounting, as appropriate. The cost
method of accounting is generally used for investments in affiliates in which the Company has less than 20% of the voting interests
of a corporate affiliate or less than a 3% to 5% interest of a partnership or limited liability company and does not have significant
influence. Investments in non-consolidated affiliates, accounted for using the cost method of accounting, are recorded at cost
and impairment assessments for each investment are made annually to determine if a decline in the fair value of the investment,
other than temporary, has occurred. A permanent impairment is recognized if a decline in the fair value occurs.
If
the Company holds between 20% and 50% of the voting interest in non-consolidated corporate affiliates or generally greater than
a 3% to 5% interest of a partnership or limited liability company and exerts significant influence or control (e.g., through its
influence with a seat on the board of directors or management of operations), the equity method of accounting is generally used
to account for the investment. The Company’s investment in affiliates that is accounted for using the equity method of accounting,
increases or decreases by the Company’s share of the affiliate’s profits or losses and such profits or losses are
recognized in the Company’s Consolidated Statements of Operations. For its equity method investments in Carbon Appalachia
and Carbon California, the Company uses the hypothetical liquidation at book value method to recognize its share of the affiliate’s
profits or losses. The Company reviews equity method investments for impairment whenever events or changes in circumstances indicate
that an other than temporary decline in value has occurred.
Related
Party Transactions
On
February 15, 2017, the Company entered into a limited liability company agreement of Carbon California. Pursuant to the limited
liability agreement, Carbon California reimbursed the Company for (i) due diligence costs incurred on behalf of Carbon California,
(ii) transaction-related costs and (iii) $225,000 for the period February 15, 2017 through June 30, 2017, in connection with its
role as manager of Carbon California. See Note 5 for additional information.
On
April 3, 2017, the Company entered into the limited liability company agreement of Carbon Appalachia. Pursuant to the limited
liability agreement, Carbon Appalachia reimbursed the Company for (i) due diligence costs incurred on behalf of Carbon Appalachia,
(ii) transaction-related costs and (iii) $75,000 for the period April 3, 2017 through June 30, 2017, in connection with its role
as manager of Carbon Appalachia. See Note 5 for additional information.
Warrant
Derivative Liability
The
Company issued warrants related to its investments in Carbon California and Carbon Appalachia. The Company accounts for these
warrants in accordance with guidance contained in ASC 815,
Derivatives and Hedging
, which requires these warrants to be
recorded on the balance sheet as either an asset or a liability measured at fair value, with changes in fair value recognized
in earnings. Based on this guidance, the Company determined that the Company’s warrants do not meet the criteria for classification
as equity. Accordingly, the Company classified the warrants as liabilities. The warrants are subject to remeasurement at each
balance sheet date, with any change in the fair value recognized as a component of other income or expense, net in the statement
of operations. For the three and six months ended June 30, 2017, changes in the fair value of warrants accounted for gains of
approximately $853,000 and $1.7 million, respectively.
Asset
Retirement Obligations
The
Company’s asset retirement obligations (“ARO”) relate to future costs associated with the plugging and abandonment
of oil and gas wells, removal of equipment and facilities from leased acreage and returning such land to its original condition.
The fair value of a liability for an ARO is recorded in the period in which it is incurred and the cost of such liability is recorded
as an increase in the carrying amount of the related long-lived asset by the same amount. The liability is accreted each period
and the capitalized cost is depleted on a units-of-production basis as part of the full cost pool. Revisions to estimated AROs
result in adjustments to the related capitalized asset and corresponding liability.
The
estimated ARO liability is based on estimated economic lives, estimates as to the cost to abandon the wells in the future, and
federal and state regulatory requirements. The liability is discounted using a credit-adjusted risk-free rate estimated at the
time the liability is incurred or increased as a result of a reassessment of expected cash flows and assumptions inherent in the
estimation of the liability. Upward revisions to the liability could occur due to changes in estimated abandonment costs or well
economic lives, or if federal or state regulators enact new requirements regarding the abandonment of wells. AROs are valued utilizing
Level 3 fair value measurement inputs.
The
following table is a reconciliation of the ARO for the six months ended June 30, 2017 and 2016:
(in thousands)
|
|
Six Months Ended June 30,
|
|
|
|
2017
|
|
|
2016
|
|
Balance at beginning of period
|
|
$
|
5,120
|
|
|
$
|
3,095
|
|
Accretion expense
|
|
|
155
|
|
|
|
70
|
|
Additions during period
|
|
|
5
|
|
|
|
5
|
|
|
|
|
5,280
|
|
|
|
3,170
|
|
Less: ARO recognized as a current liability
|
|
|
(183
|
)
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
Balance at end of period
|
|
$
|
5,097
|
|
|
$
|
3,170
|
|
Earnings
(Loss) Per Common Share
Basic
earnings or loss per common share is computed by dividing the net income or loss attributable to common shareholders for the period
by the weighted average number of common shares outstanding during the period. The shares of restricted common stock granted to
certain officers, directors and employees of the Company are included in the computation of basic net income or loss per share
only after the shares become fully vested. Diluted earnings per common share includes both the vested and unvested shares of restricted
stock and the potential dilution that could occur upon exercise of warrants to acquire common stock, computed using the treasury
stock method, which assumes that the increase in the number of shares is reduced by the number of shares which could have been
repurchased by the Company with the proceeds from the exercise of warrants (which were assumed to have been made at the average
market price of the common shares during the reporting period).
The
following table sets forth the calculation of basic and diluted income (loss) per share:
in thousands except per share amounts
|
|
Three Months Ended June 30,
|
|
|
Six Months Ended June 30,
|
|
|
|
2017
|
|
|
2016
|
|
|
2017
|
|
|
2016
|
|
Basic Earnings (Loss) per Share
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) available to common shareholders, basic
|
|
$
|
2,004
|
|
|
$
|
(2,518
|
)
|
|
$
|
5,296
|
|
|
$
|
(7,445
|
)
|
Weighted average shares outstanding, basic
|
|
|
5,620
|
|
|
|
5,498
|
|
|
|
5,554
|
|
|
|
5,429
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per common share, basic
|
|
$
|
0.36
|
|
|
$
|
(0.46
|
)
|
|
$
|
0.95
|
|
|
|
(1.37
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted Earnings (Loss) per Share
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) available to common shareholders, basic
|
|
$
|
2,004
|
|
|
$
|
(2,518
|
)
|
|
$
|
5,296
|
|
|
$
|
(7,445
|
)
|
Less: decrease in fair value of warrant
|
|
|
(853
|
)
|
|
|
-
|
|
|
|
(1,684
|
)
|
|
|
-
|
|
Adjusted net income (loss) available to common shareholders, diluted
|
|
$
|
1,151
|
|
|
$
|
(2,518
|
)
|
|
$
|
3,612
|
|
|
$
|
(7,445
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares outstanding, basic
|
|
|
5,620
|
|
|
|
5,498
|
|
|
|
5,554
|
|
|
|
5,429
|
|
Add: dilutive effects of warrant and nonvested
shares of restricted stock
|
|
|
968
|
|
|
|
-
|
|
|
|
904
|
|
|
|
-
|
|
Weighted-average shares outstanding, diluted
|
|
|
6,588
|
|
|
|
5,498
|
|
|
|
6,458
|
|
|
|
5,429
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per common share, diluted
|
|
$
|
0.17
|
|
|
$
|
(0.46
|
)
|
|
$
|
0.56
|
|
|
$
|
(1.37
|
)
|
For
the three months ended June 30, 2017, the Company had net income and the diluted net income per share calculation for that period
includes the dilutive effect of approximately 284,000 non-vested shares of restricted stock and approximately 684,000 in-the-money
warrants. In addition, approximately 13,000 out-of-the-money warrants and approximately 276,000 restricted performance units,
subject to future contingencies, are excluded from the basic and diluted loss per share calculations.
For
the six months ended June 30, 2017, the Company had net income and the diluted net income per share calculation for that period
includes the dilutive effect of approximately 284,000 non-vested shares of restricted stock and approximately 620,000 in-the-money
warrants. In addition, approximately 13,000 out-of-the-money warrants and approximately 276,000 restricted performance units,
subject to future contingencies, are excluded from the basic and diluted loss per share calculations.
For
the three and six months ended June 30, 2016, the Company had a net loss and therefore, the diluted net loss per share calculation
excluded the anti-dilutive effect of approximately 13,000 warrants and approximately 246,000 non-vested shares of restricted stock
in each period. In addition, approximately 298,000 restricted performance units, in each period, subject to future contingencies
were excluded from the basic and diluted loss per share calculations.
Use
of Estimates in the Preparation of Financial Statements
The
preparation of financial statements in conformity with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts of assets, liabilities and expenses and disclosure
of contingent assets and liabilities. Significant items subject to such estimates and assumptions include the carrying value of
oil and gas properties, the estimate of proved oil and gas reserve volumes and the related depletion and present value of estimated
future net cash flows and the ceiling test applied to capitalized oil and gas properties, determining the amounts recorded for
deferred income taxes, stock-based compensation, fair value of commodity derivative instruments, fair value of warrants, equity
method investments, fair value of assets acquired qualifying as business contributions and asset retirement obligations. Actual
results could differ from those estimates and assumptions used, and the use of such estimates may result in volatility within
the Company’s financial statements.
Adopted
and Recently Issued Accounting Pronouncements
In
February 2016, the FASB issued Accounting Standard Update (“ASU”) No. 2016-02,
Leases
(“ASU 2016-02”).
The objective of this ASU is to increase transparency and comparability among organizations by recognizing lease assets and liabilities
on the balance sheet and disclosing key information about leasing arrangements. ASU 2016-02 is effective for fiscal years, and
interim periods within those fiscal years, beginning after December 15, 2018 and should be applied using a modified retrospective
approach. Early adoption is permitted. The Company is currently evaluating the impact on its consolidated financial statements
of adopting ASU 2016-02.
In
May 2014, the FASB issued ASU No. 2014-09,
Revenue from Contracts with Customers
(“ASU 2014-09”). The objective
of ASU 2014-09 is to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and
International Financial Reporting Standards. The FASB subsequently issued ASU 2015-14, ASU 2016-08, ASU 2016-10, ASU 2016-12 and
ASU 2016-20, which deferred the effective date of ASU 2014-09 and provided additional implementation guidance. These ASUs are
effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The standards permit retrospective
application using either of the following methodologies: (i) restatement of each prior reporting period presented or (ii) recognition
of a cumulative-effect adjustment as of the date of initial application. The Company plans to adopt these ASUs effective January
1, 2018. The Company is in the process of assessing its contracts with customers and evaluating the effect of adopting these standards
on its financial statements, accounting policies and internal controls.
In
January 2017, the FASB issued ASU 2017-01,
Clarifying the Definition of a Business,
which clarifies the definition of “a
business” to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of
assets or businesses. The standard introduces a screen for determining when assets acquired are not a business and clarifies that
a business must include, at a minimum, an input and a substantive process that contribute to an output to be considered a business.
This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within that reporting
period. The Company elected to early adopt this pronouncement effective January 1, 2017.
Note
3 – Acquisitions and Divestitures
In
October 2016, Nytis LLC completed an acquisition (the “EXCO Acquisition”) consisting of producing natural gas wells
and natural gas gathering facilities located in the Company’s Appalachian Basin operating area. The natural gas gathering
facilities are primarily used to gather the Company’s natural gas production. The acquisition was pursuant to a purchase
and sale agreement, effective October 1, 2016 (the “EXCO Purchase Agreement”) by and among EXCO Production Company
(WV), LLC, BG Production Company (WV), LLC and EXCO Resources (PA) LLC (collectively, the “Sellers”) and Nytis LLC,
as the buyer. The purchase price of the acquired assets pursuant to the EXCO Purchase Agreement was $9.0 million subject to customary
closing adjustments plus certain assumed obligations.
The
EXCO Acquisition provided the Company with proved developed reserves, production and operating cash flow in a location where the
Company has similar assets.
EXCO
Acquisition Unaudited Pro Forma Results of Operations
Below
are consolidated results of operations for the six months ended June 30, 2017 and 2016 as though the EXCO Acquisition had been
completed as of January 1, 2016. The EXCO Acquisition closed October 3, 2016, and accordingly, the Company’s consolidated
statement of operations for the six months ended June 30, 2017 includes the results of operations for the six months ended June
30, 2017 of the EXCO properties acquired.
|
|
Unaudited Pro Forma Consolidated Results
|
|
|
|
For Six Months Ended
June 30,
|
|
(in thousands, except per share amounts)
|
|
2017
|
|
|
2016
|
|
Revenue
|
|
$
|
13,370
|
|
|
$
|
6,348
|
|
Net income (loss) before non-controlling interests
|
|
|
5,372
|
|
|
|
(3,560
|
)
|
Net income (loss) attributable to non-controlling interests
|
|
|
76
|
|
|
|
(432
|
)
|
Net income (loss) attributable to controlling interests
|
|
|
5,296
|
|
|
|
(3,128
|
)
|
Net income (loss) income per share (basic)
|
|
|
0.95
|
|
|
|
(0.58
|
)
|
Net income (loss) income per share (diluted)
|
|
|
0.82
|
|
|
|
(0.58
|
)
|
Note
4 – Property and Equipment
Net
property and equipment as of June 30, 2017 and December 31, 2016 consists of the following:
(in thousands)
|
|
June 30,
2017
|
|
|
December 31, 2016
|
|
|
|
|
|
|
|
|
Oil and gas properties:
|
|
|
|
|
|
|
Proved oil and gas properties
|
|
$
|
112,273
|
|
|
$
|
111,771
|
|
Unproved properties not subject to depletion
|
|
|
1,917
|
|
|
|
1,999
|
|
Accumulated depreciation, depletion, amortization and impairment
|
|
|
(79,630
|
)
|
|
|
(78,559
|
)
|
Net oil and gas properties
|
|
|
34,560
|
|
|
|
35,211
|
|
|
|
|
|
|
|
|
|
|
Furniture and fixtures, computer hardware and software, and other equipment
|
|
|
1,563
|
|
|
|
990
|
|
Accumulated depreciation and amortization
|
|
|
(797
|
)
|
|
|
(665
|
)
|
Net other property and equipment
|
|
|
766
|
|
|
|
325
|
|
|
|
|
|
|
|
|
|
|
Total net property and equipment
|
|
$
|
35,326
|
|
|
$
|
35,536
|
|
As
of June 30, 2017 and December 31, 2016, the Company had approximately $1.9 million and $2.0 million, respectively, of unproved
oil and gas properties not subject to depletion. The costs not subject to depletion relate to unproved properties that are excluded
from amortized capital costs until it is determined if proved reserves can be assigned to such properties. The excluded properties
are assessed for impairment at least annually. Subject to industry conditions, evaluation of most of these properties and the
inclusion of their costs in amortized capital costs is expected to be completed within five years.
During
the six months ended June 30, 2017 and 2016, the Company capitalized general and administrative expenses applicable to development
and exploration activities of approximately $131,000 and $289,000, respectively.
Depletion
expense related to oil and gas properties for the three and six months ended June 30, 2017 was approximately $539,000, or $0.40
per Mcfe, and $1.1 million, or $0.41 per Mcfe, respectively. For the three and six months ended June 30, 2016, depletion expense
was approximately $407,000, or $0.65 per Mcfe, and $879,000, or $0.72 per Mcfe, respectively.
Depreciation
and amortization expense related to furniture and fixtures, computer hardware and software and other equipment for the three months
ended June 30, 2017 and 2016 was approximately $123,000 and $29,000, respectively and for the six months ended June 30, 2017 and
2016 was approximately $163,000 and $59,000, respectively.
Note
5– Investments in Affiliates
Crawford
County Gas Gathering Company
The
Company has a 50% interest in Crawford County Gas Gathering Company, LLC (“CCGGC”) which owns and operates pipelines
and related gathering and treatment facilities. The Company’s gas production located in Illinois is gathered by CCGGC’s
gathering facilities. The Company’s investment in CCGGC is accounted for under the equity method of accounting, and its
share of income or loss is recognized. During the six months ended June 30, 2017 and 2016, the Company recorded equity method
income of approximately $7,000 and equity method loss of approximately $6,000, respectively, related to this
investment.
In addition, during the first quarter of 2016, the Company received a cash distribution of $275,000 from CCGGC.
Carbon
California
On
February 15, 2017, the Company entered into a limited liability company agreement (the “Carbon California LLC Agreement”)
of Carbon California, a Delaware limited liability company established by the Company. Pursuant to the Carbon California LLC Agreement,
Carbon acquired a 17.8% interest in Carbon California represented by Class B Units. The Class B Units were acquired for no cash
consideration. No further equity commitments have been made or are required by the Company under the Carbon California LLC Agreement;
however, should the Company choose not to participate in future equity calls, its interest would be diluted.
On
February 15, 2017, Carbon California (i) issued and sold Class A Units to two institutional investors for an aggregate cash consideration
of $22.0 million, (ii) entered into a Note Purchase Agreement (the
“Note Purchase Agreement”
) with two institutional
investors for the issuance and sale of up to $25.0 million of Senior Secured Revolving Notes (the
“Senior Revolving Notes”
)
due February 15, 2022 and (iii) entered into a Securities Purchase Agreement (the “
Securities Purchase Agreement”
)
with one institutional investor for the issuance and sale of $10.0 million of Senior Subordinated Notes (the
“Subordinated
Notes”
) due February 15, 2024. The Company is not a guarantor of the Senior Revolving Notes or the Subordinate Notes.
The closing of the Note Purchase Agreement and the Securities Purchase Agreement on February 15, 2017, resulted in the sale and
issuance by Carbon California of (i) Senior Revolving Notes in the principal amount of $10.0 million and (ii) Subordinated Notes
in the original principal amount of $10.0 million. The maximum principal amount available under the Senior Revolving Notes is
based upon the borrowing base attributable to Carbon California’s proved oil and gas reserves which is to be determined
at least semi-annually. The current borrowing base is $15.0 million.
Net
proceeds from the offering transaction were used by Carbon California to complete the acquisitions of oil and gas assets in the
Ventura Basin of California, which acquisitions also closed on February 15, 2017. The remainder of the net proceeds are being
used to fund field development projects and to fund future complementary acquisitions and for general working capital purposes
of Carbon California.
In connection with the Company entering into the Carbon California LLC Agreement described above and Carbon California engaging
in the transactions also described above, the Company issued to an affiliate of one of the institutional investors which purchased
Class A Units of Carbon California (which is also an affiliate of the Company’s largest stockholders), a warrant to purchase
approximately 1.5 million shares of the Company’s common stock at an exercise price of $7.20 per share (the “California
Warrant”). The exercise price for the California Warrant is payable exclusively with Class A Units of Carbon California
held by this investor and the number of shares of the Company’s common stock for which the California Warrant is exercisable
is determined, as of the time of exercise, by dividing (a) the aggregate unreturned capital of the warrantholder’s Class
A Units of Carbon California by (b) the exercise price. The California Warrant has a term of seven years and includes certain
standard registration rights with respect to the shares of the Company’s common stock issuable upon exercise of the California
Warrant. If exercised, the California Warrant provides Carbon an opportunity to increase its ownership stake in Carbon California
without requiring the payment of cash.
Based
on its 17.8% interest in Carbon California, its ability to appoint a member to the board of directors and its role of manager
of Carbon California, the Company is accounting for its investment in Carbon California under the equity method of accounting
as it believes it can exert significant influence. The Company uses the hypothetical liquidation at book value method (“HLBV”)
to determine its share of profits or losses in Carbon California and adjusts the carrying value of its investment accordingly.
The HLBV is a balance-sheet oriented approach that calculates the amount each member of Carbon California would receive if Carbon
California were liquidated at book value at the end of each measurement period. The change in the allocated amount to each member
during the period represents the income or loss allocated to that member. In the event of liquidation of Carbon California, to
the extent that Carbon California has net income, available proceeds are first distributed to members holding Class A and Class
B units and any remaining proceeds are then distributed to members holding Class A units, of which the Company holds none. For
the three months ended June 30, 2017, and for the period of February 15, 2017 through June 30, 2017, Carbon California incurred
a net loss. Should Carbon California report income, the Company will not record income (or losses) until the Company’s share
of such income equals the amount of its share of losses not previously reported. While income may be recorded in future periods,
the ability of Carbon California to make distributions to its owners, including us, is dependent upon the terms of its credit
facilities, which currently prohibit distributions unless agreed to by the lender.
The
Company accounted for the California Warrant, at issuance, as the initial investment in Carbon California and a liability based
on the fair value of the California Warrant as of the date of grant (February 15, 2017). Future changes to the fair value of the
California Warrant are recognized in earnings.
As
of grant date of the California Warrant, the Company estimated that the fair market value of the California Warrant was approximately
$5.8 million and recorded that amount to its investment in Carbon California and a long-term liability. As of June 30, 2017, the
Company estimated that the fair value of the California Warrant was approximately $4.3 million. The difference in the fair value
of the California Warrant from the grant date though June 30, 2017 was approximately $1.5 million and approximately $680,000 and
$1.5 million was recognized in other income in the Company’s Consolidated Statements of Operations for the three and six
months ended June 30, 2017, respectively. See Note 10 for additional information.
Carbon
Appalachia
On
April 3, 2017, the Company finalized a limited liability company agreement (the “Carbon Appalachia LLC Agreement”)
and the initial funding of Carbon Appalachian Company, LLC (“Carbon Appalachia”). Carbon Appalachian was formed by
Carbon and two institutional investors to acquire producing assets in Southern Appalachia and has an initial equity commitment
of $100.0 million, of which $12.0 million has been contributed as of June 30, 2017.
Pursuant
to the Carbon Appalachia LLC Agreement, Carbon acquired a 2.0% interest in Carbon Appalachia for $240,000 represented by Class
A Units associated with its total equity commitment of $2.0 million. Carbon also has the ability to earn up to an additional 20.0%
of Carbon Appalachia distributions (represented by Class B Units) after certain return thresholds to the holders of Class A Units
are met. The Class B Units were acquired for no cash consideration.
In
addition, Carbon acquired a 1.0% interest represented by Class C Units which were obtained in connection with the contribution
to Carbon Appalachia of a portion of its working interest in undeveloped properties in Tennessee. If Carbon Appalachia agrees
to drill horizontal Chattanooga Shale wells on these properties, it will pay 100% of the cost of drilling and completion of the
first 20 wells to earn a 75% working interest in such properties. Carbon, through its subsidiary, Nytis LLC, will retain a 25%
working interest in the properties.
In
connection with and concurrently with the closing of the acquisition described below, Carbon Appalachia Enterprises, LLC, formerly
known as Carbon Tennessee Company, LLC (“Carbon Appalachia Enterprises”), an indirect subsidiary of Carbon Appalachia,
entered into a 4-year $100.0 million senior secured asset-based revolving credit facility with LegacyTexas Bank with an initial
borrowing base of $10.0 million.
Borrowings
under the credit facility, along with the initial equity contributions made to Carbon Appalachia, were used to complete the acquisition
of natural gas producing properties and related facilities located predominantly in Tennessee (the “Acquisition”).
The purchase price was $20.0 million, subject to normal and customary pre and post-closing adjustments, and Carbon Appalachia
Enterprises used $8.5 million drawn from the credit facility toward the purchase price.
In
connection with the Company entering into the Carbon Appalachia LLC Agreement described above and Carbon Appalachia Enterprises
engaging in the Acquisition, the Company issued to an affiliate of one of the institutional investors which purchased Class A
Units of Carbon Appalachia (which is also an affiliate of the Company’s largest stockholders), a warrant to purchase approximately
408,000 shares of the Company’s common stock at an exercise price of $7.20 per share (the “Appalachia Warrant”).
The exercise price for the Appalachia Warrant is payable exclusively with Class A Units of Carbon Appalachia held by this investor
and the number of shares of the Company common stock for which the Appalachia Warrant is exercisable is determined, as of the
time of exercise, by dividing (a) the aggregate unreturned capital of the warrantholder’s Class A Units of Carbon Appalachia
plus a 10% internal rate of return by (b) the exercise price. The Appalachia Warrant has a term of seven years and includes certain
standard registration rights with respect to the shares of Carbon’s common stock issuable upon exercise of the Appalachia
Warrant. If exercised, the Appalachia Warrant provides Carbon an opportunity to increase its ownership stake in Carbon Appalachia
without requiring the payment of cash.
Based
on its 3.0% combined Class A and Class C interest (and its ability to earn up to an additional 20.0%) in Carbon Appalachia, its
ability to appoint a member to the board of directors and its role of manager of Carbon Appalachia, the Company is accounting
for its investment in Carbon Appalachia under the equity method of accounting as it believes it can exert significant influence.
The Company uses the HLBV to determine its share of profits or losses in Carbon Appalachia and adjusts the carrying value of its
investment accordingly. The Company’s investment in Carbon Appalachia is represented by its Class A and C interests, which
it acquired by contributing $240,000 in cash and unevaluated property. In the event of liquidation of Carbon Appalachia, available
proceeds are first distributed to members holding Class A and Class C Units until their contributed capital is recovered with
an internal rate of return of 10%. Any additional distributions would then be shared between holders of Class A, Class B and Class
C Units. For the period of April 3, 2017 through June 30, 2017, Carbon Appalachia incurred a net loss, of which the Company’s
share is approximately $7,000. While income may be recorded in future periods, the ability of Carbon Appalachia to make distributions
to its owners, including us, is dependent upon the terms of its credit facilities, which currently prohibit distributions unless
agreed to by the lender.
The
Company accounted for the Appalachia Warrant, at issuance, as an investment in Carbon Appalachia and a liability based on the
fair value of the Appalachia Warrant as of the date of grant (April 3, 2017). Future changes to the fair value of the Appalachia
Warrant are recognized in earnings.
As
of grant date of the Appalachia Warrant, the Company estimated that the fair value of the Appalachia Warrant was approximately
$1.3 million and recorded that amount to its investment in Carbon Appalachia and a long-term liability. As of June 30, 2017, the
Company estimated that the fair value of the Appalachia Warrant was approximately $1.1 million. The difference in the fair value
of the Appalachia Warrant from the grant date though June 30, 2017 was approximately $174,000 and was recognized in other income
in the Company’s Consolidated Statements of Operations for the three and six months ended June 30, 2017. See Note 10 for
additional information.
Note
6 – Bank Credit Facility
In
2016, Carbon entered into a 4-year $100.0 million senior secured asset-based revolving credit facility with LegacyTexas Bank.
LegacyTexas Bank is the initial lender and acts as administrative agent.
The
credit facility has a maximum availability of $100.0 million (with a $500,000 sublimit for letters of credit), which availability
is subject to the amount of the borrowing base. The initial borrowing base established under the credit facility was $17.0 million.
The borrowing base is subject to semi-annual redeterminations in March and September commencing March 2017. On March 30, 2017,
the borrowing base was increased to $23.0 million.
The
credit facility is guaranteed by each existing and future direct or indirect subsidiary of Carbon (subject to certain exceptions).
The obligations of Carbon and the subsidiary guarantors under the credit facility are secured by essentially all tangible and
intangible personal and real property of the Company (subject to certain exclusions).
Interest
is payable quarterly and accrues on borrowings under the credit facility at a rate per annum equal to either (i) the base rate
plus an applicable margin between 0.50% and 1.50% or (ii) the Adjusted LIBOR rate plus an applicable margin between 3.50% and
4.50% at Carbon’s option. The actual margin percentage is dependent on the credit facility utilization percentage. Carbon
is obligated to pay certain fees and expenses in connection with the credit facility, including a commitment fee for any unused
amounts of 0.50%.
The
credit facility contains certain affirmative and negative covenants that, among other things, limit the Company’s ability
to (1) incur additional debt; (ii) incur additional liens; (iii) sell, transfer or dispose of assets; (iv) merge or consolidate,
wind-up, dissolve or liquidate; (v) make dividends and distributions on, or repurchases of, equity; (vi) make certain investments;
(vii) enter into certain transactions with its affiliates; (viii) enter into sales-leaseback transaction; (ix) make optional or
voluntary payment of debt; (x) change the nature of its business; (xi) change its fiscal year to make changes to the accounting
treatment or reporting practices; (xii) amend constituent documents; and (xiii) enter into certain hedging transactions.
The
affirmative and negative covenants are subject to various exceptions, including certain basket amounts and acceptable transaction
levels. In addition, the credit facility requires Carbon’s compliance, on a consolidated basis, with (i) maximum funded
Debt/EBITDA ratio of 3.5 to 1.0 and (ii) a minimum current ratio of 1.0 to 1.0, commencing with the quarter ended March 31, 2017.
The Company was in compliance with the financial covenants associated with the credit facility as of June 30, 2017.
Carbon
may at any time repay the loans under the credit facility, in whole or in part, without penalty. Carbon must pay down borrowings
under the credit facility or provide mortgages of additional oil and natural gas properties to the extent that outstanding loan
and letters of credit exceed the borrowing base.
As
required under the terms of the credit facility, the Company entered into derivative contracts at fixed pricing for a certain
percentage of its production. The Company is party to an ISDA Master Agreement with BP Energy Company that establishes standard
terms for the derivative contracts and an inter-creditor agreement with LegacyTexas Bank and BP Energy Company whereby any credit
exposure related to the derivative contracts entered into by the Company and BP Energy Company is secured by the collateral and
backed by the guarantees supporting the credit facility.
As
of June 30, 2017, there were approximately $15.5 million in outstanding borrowings and approximately $7.5 million of additional
borrowing capacity available under the credit facility. The Company’s effective borrowing rate at June 30, 2017 was approximately
5.40%.
Note
7 – Income Taxes
The
Company recognizes deferred income tax assets and liabilities for the estimated future tax consequences attributable to temporary
differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
The Company has net operating loss carryforwards available in certain jurisdictions to reduce future taxable income. Future tax
benefits for net operating loss carryforwards are recognized to the extent that realization of these benefits is considered more
likely than not. To the extent that available evidence raises doubt about the realization of a deferred income tax asset, a valuation
allowance is established.
At
June 30, 2017, the Company has established a full valuation allowance against the balance of net deferred tax assets.
Note
8 – Stockholders’ Equity
Authorized
and Issued Capital Stock
Effective
March 15, 2017 and pursuant to a reverse stock split approved by the shareholders and Board of Directors, each 20 shares of issued
and outstanding common stock became one share of common stock and no fractional shares were issued. References to the number of
shares and price per share give retroactive effect to the reverse stock split for all periods presented.
As
of June 30, 2017, the Company had 200,000,000 shares of common stock authorized with a par value of $0.01 per share, of which
approximately 5.6 million were issued and outstanding and 1,000,000 shares of preferred stock authorized with a par value of $0.01
per share, none of which were issued and outstanding. During the first six months of 2017, the increase in the Company’s
issued and outstanding common stock was a result of restricted stock and performance units that vested during the period.
Equity
Plans Prior to Merger
Pursuant
to the merger of Nytis USA with and into the Company in 2011, all options, warrants and restricted stock were adjusted to reflect
the conversion ratio used in the merger. As of June 30, 2017, the Company has approximately 13,000 warrants outstanding and exercisable
related to these plans.
Nytis
USA Restricted Stock Plan
As
of June 30, 2017, all restricted stock issued under the Nytis USA Restricted Stock Plan (“Nytis USA Plan”) have vested.
The Company accounted for these grants at their intrinsic value. From the date of grant through March 31, 2013, the Company estimated
that none of these shares would vest and accordingly, no compensation cost had been recorded through March 31, 2013.
In
June 2013, the vesting terms of these restricted stock grants were modified so that 25% of the shares would vest on the first
of January from 2014 through 2017. As such, the Company recognized compensation expense for those restricted stock grants based
on the fair value of the shares on the date the vesting terms were modified. Compensation expense recognized for those restricted
stock grants was approximately $84,000 and approximately $168,000 for the three and six months ended June 30, 2016, respectively.
No compensation expense was recognized for those restricted stock grants for the three and six months ended June 30, 2017. As
of December 31, 2016, compensation costs relative to those restricted stock grants were fully recognized.
Carbon
Stock Incentive Plans
The
Company has two stock plans, the Carbon 2011 and 2015 Stock Incentive Plans (collectively the “Carbon Plans”). The
Carbon Plans were approved by the shareholders of the Company and in the aggregate provide for the issuance of approximately 1.1
million shares of common stock to Carbon officers, directors, employees or consultants eligible to receive these awards under
the Carbon Plans.
The
Carbon Plans provide for granting Director Stock Awards to non-employee directors and for granting Incentive Stock Options, Non-qualified
Stock Options, Restricted Stock Awards, Performance Awards and Phantom Stock Awards, or a combination of the foregoing, as is
best suited to the circumstances of the particular employee, officer, director or consultant.
Restricted
Stock
During
the six months ended June 30, 2017, approximately 81,000 shares of restricted stock were granted under the terms of the Carbon
Plan in addition to 462,000 shares granted during previous years. For employees, these restricted stock awards either vest ratably
over a three-year service period or cliff vest after a three-year service period. For non-employee directors, the awards vest
upon the earlier of a change in control of the Company or the date their membership on the Board of Directors is terminated other
than for cause. The Company recognizes compensation expense for these restricted stock grants based on the estimated grant date
fair value of the shares, amortized ratably over three years for employee awards (based on the required service period for vesting)
and seven years for non-employee director awards (based on a market survey of the average tenure of directors among U.S. public
companies). As of June 30, 2017, approximately 258,000 of these restricted stock grants have vested.
Compensation
costs recognized for these restricted stock grants were approximately $166,000 and $167,000 for the three months ended June 30,
2017 and 2016, respectively, and $354,000 and $368,000 for the six months ended June 30, 2017 and 2016, respectively. As of June
30, 2017, there was approximately $1.5 million of unrecognized compensation costs related to these restricted stock grants. This
cost is expected to be recognized over the next 6.8 years.
Performance
Units
During
the six months ended June 30, 2017, approximately 60,000 shares of performance units were granted under the terms of the Carbon
plans in addition to approximately 401,000 shares granted during previous years. The performance units represent a contractual
right to receive one share of the Company’s common stock subject to the terms and conditions of the agreements including
the achievement of certain performance measures relative to a defined peer group or the growth of certain performance measures
over a defined period of time for the Company as well as the lapse of forfeiture restrictions pursuant to the terms and conditions
of the agreements, including for certain of the grants, the requirement of continuous employment by the grantee prior to a change
in control of the Company. Based on the relative achievement of performance, approximately 276,000 restricted performance units
are outstanding as of June 30, 2017.
The
Company accounts for the performance units granted during 2012 and 2014 through 2017 at their fair value determined at the date
of grant. The final measurement of compensation cost will be based on the number of performance units that ultimately vest. At
June 30, 2017, the Company estimated that none of the performance units granted in 2012 and 2016 through 2017 would vest due to
change in control and other performance provisions and accordingly, no compensation cost has been recorded for these performance
units. At September 30, 2016, the Company estimated that it was probable that certain of the performance units granted in 2014
and 2015 would vest. Compensation costs of approximately $53,000 and $185,000 related to these performance units were recognized
for the three and six months ended June 30, 2017, respectively. No compensation expense was recognized for these performance units
for the three and six months ended June 30, 2016. As of June 30, 2017, if change in control and other performance provisions pursuant
to the terms and conditions of these agreements are met in full, the estimated unrecognized compensation cost related to the performance
units granted in 2012 and 2014 through 2017 would be approximately $2.5 million.
The
performance units granted in 2013 contain specific vesting provisions, no change in control provisions nor any performance conditions
other than stock price performance. Due to different earning requirements compared to the performance units granted in 2012 and
2014 through 2017, the Company recognized compensation expense for the performance units granted in 2013 based on the grant date
fair value of the performance units, amortized ratably over three years (the performance period). The fair value of the performance
units granted in 2013 was estimated using a Monte Carlo simulation (“MCS”) valuation model using the following key
assumptions: no expected dividends, volatility of our stock and those of defined peer companies used to determine our performance
relative to the defined peer group, a risk-free interest rate and an expected life of three years. Compensation costs recognized
for these performance unit grants were approximately $41,000 and $127,000 for the three and six months ended June 30, 2016, respectively.
As of June 30, 2016, compensation costs relative to these performance units had been fully recognized.
Note
9 – Accounts Payable and Accrued Liabilities
Accounts
payable and accrued liabilities at June 30, 2017 and December 31, 2016 consist of the following:
(in thousands)
|
|
June 30,
2017
|
|
|
December 31,
2016
|
|
|
|
|
|
|
|
|
Accounts payable
|
|
$
|
1,809
|
|
|
$
|
2,315
|
|
Oil and gas revenue payable to oil and gas property owners
|
|
|
1,770
|
|
|
|
1,415
|
|
Gathering and transportation payables
|
|
|
430
|
|
|
|
468
|
|
Production taxes payable
|
|
|
238
|
|
|
|
113
|
|
Drilling advances received from joint venture partner
|
|
|
778
|
|
|
|
955
|
|
Accrued drilling costs
|
|
|
-
|
|
|
|
4
|
|
Accrued lease operating costs
|
|
|
272
|
|
|
|
282
|
|
Accrued ad valorem taxes
|
|
|
1,522
|
|
|
|
1,552
|
|
Accrued general and administrative expenses
|
|
|
864
|
|
|
|
1,572
|
|
Accrued interest
|
|
|
185
|
|
|
|
184
|
|
Other liabilities
|
|
|
342
|
|
|
|
261
|
|
|
|
|
|
|
|
|
|
|
Total accounts payable and accrued liabilities
|
|
$
|
8,210
|
|
|
$
|
9,121
|
|
Note
10 – Fair Value Measurements
Authoritative
guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit
price) in an orderly transaction between market participants at the measurement date. The guidance establishes a hierarchy
for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable
inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market
participants would use in pricing the asset or liability developed based on market data obtained from sources independent of
the Company. Unobservable inputs are inputs that reflect the Company’s assumptions of what market participants would
use in pricing the asset or liability developed based on the best information available under the circumstances. The
hierarchy is broken down into three levels based on the reliability of the inputs as follows:
|
Level 1:
|
Quoted prices are available in active markets for identical assets or liabilities;
|
|
|
|
|
Level 2:
|
Quoted prices in active markets for similar assets or liabilities that are observable for the asset or liability; or
|
|
|
|
|
Level 3:
|
Unobservable pricing inputs that are generally less observable from objective sources, such as discounted cash flow models or valuations.
|
Financial
assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The
Company’s policy is to recognize transfers in and/or out of the fair value hierarchy as of the end of the reporting period
for which the event or change in circumstances caused the transfer. The Company has consistently applied the valuation techniques
discussed below for all periods presented.
Note
10 – Fair Value Measurements (continued)
Assets
Measured and Recorded at Fair Value on a Recurring Basis
The
following table presents the Company’s financial assets and liabilities that were accounted for at fair value on a recurring
basis as of June 30, 2017 and December 31, 2016 by level within the fair value hierarchy:
(in thousands)
|
|
Fair Value Measurements Using
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
|
Total
|
|
June 30, 2017
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivatives
|
|
$
|
-
|
|
|
$
|
1,091
|
|
|
$
|
-
|
|
|
$
|
1,091
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Warrant derivatives
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
5,410
|
|
|
$
|
5,410
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivatives
|
|
$
|
-
|
|
|
$
|
1,932
|
|
|
$
|
-
|
|
|
$
|
1,932
|
|
Level
2 Fair Value Measurements
As
of June 30, 2017, the Company’s commodity derivative financial instruments are comprised of eight natural gas and nine oil
swap agreements. The fair values of these agreements are determined under an income valuation technique. The valuation requires
a variety of inputs, including contractual terms, published forward prices, volatilities for options, and discount rates, as appropriate.
The Company’s estimates of fair value of derivatives include consideration of the counterparty’s credit worthiness,
the Company’s credit worthiness and the time value of money. The consideration of these factors resulted in an estimated
exit-price for each derivative asset or liability under a market place participant’s view. All the significant inputs are
observable, either directly or indirectly; therefore, the Company’s derivative instruments are included within the Level
2 fair value hierarchy. The counterparty for all the Company’s commodity financial instruments as of June 30, 2017 is BP
Energy Company.
Level
3 Fair Value Measurements
A
third-party valuation specialist is utilized to determine the fair value of the Company’s California Warrant and Appalachia
Warrant. These warrants are designated as Level 3. The Company reviews these valuations, including the related model inputs and
assumptions, and analyzes changes in fair value measurements between periods. The Company corroborates such inputs, calculations
and fair value changes using various methodologies, and reviews unobservable inputs for reasonableness utilizing relevant information
from other published sources. Due to the limited trading volume of the Company’s shares, adjustments are made to the per
share value.
The
Company estimated the fair value of the California Warrant on February 15, 2017, the grant date of the warrant, to be approximately
$5.8 million, using a call option pricing model with the following assumptions: a seven-year term, exercise price of $7.20, volatility
rate of 41.8% and a risk-free rate of 2.3%. As the Company will receive Class A units in Carbon California in the event the holder
exercises the California Warrant, the Company also considered the fair value of the Class A units in its valuation. The Company
remeasured the California Warrant as of June 30, 2017, using the same call option pricing model, using the following assumptions:
a term of 6.6 years, exercise price of $7.20, volatility rate of 44.5% and a risk-free rate of 2.0%. As of June 30, 2017, the
fair value of the California Warrant was approximately $4.3 million.
The
Company estimated the fair value of the Appalachia Warrant on April 3, 2017, the grant date of the warrant, to be approximately
$1.3 million, using a call option pricing model with the following assumptions: a seven-year term, exercise price of $7.20, volatility
rate of 39.3% and a risk-free rate of 2.1%. As the Company will receive Class A units in Carbon Appalachia in the event the holder
exercises the Appalachia Warrant, the Company also considered the fair value of the Class A units in its valuation. The Company
remeasured the Appalachia Warrant as of June 30, 2017, using the same call option pricing model, using the following assumptions:
a term of 6.8 years, exercise price of $7.20, volatility rate of 44.5% and a risk-free rate of 2.0%. As of June 30, 2017, the
fair value of the Appalachia Warrant was approximately $1.1 million.
Assets
Measured and Recorded at Fair Value on a Non-Recurring Basis
The
fair value of the following liabilities measured and recorded at fair value on a non-recurring basis are based on unobservable
pricing inputs and therefore, are included within the Level 3 fair value hierarchy.
The
Company uses the income valuation technique to estimate the fair value of asset retirement obligations using the amounts and timing
of expected future dismantlement costs, credit-adjusted risk-free rates and time value of money. During the six months ended June
30, 2017 and 2016, the Company recorded additions to asset retirement obligations of approximately $5,000 in each period. See
Note 2 for additional information.
Note
11 – Physical Delivery Contracts and Gas Derivatives
The
Company has historically used commodity-based derivative contracts to manage exposures to commodity price on certain of its oil
and natural gas production. The Company does not hold or issue derivative financial instruments for speculative or trading purposes.
The Company also enters into, on occasion, oil and natural gas physical delivery contracts to effectively provide commodity price
hedges. Because these contracts are not expected to be net cash settled, they are considered to be normal sales contracts and
not derivatives. Therefore, these contracts are not recorded at fair value in the unaudited Consolidated Financial Statements.
Pursuant
to the terms of the Company’s credit facility with LegacyTexas Bank, the Company has entered into swap derivative agreements
to hedge certain of its oil and natural gas production for 2017 through 2019. As of June 30, 2017, these derivative agreements
consisted of the following:
|
|
Natural Gas
|
|
|
|
|
|
Oil
|
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
Average
|
|
Year
|
|
MMBtu
|
|
|
Price (a)
|
|
|
Bbl
|
|
|
Price (b)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2017
|
|
|
1,680,000
|
|
|
$
|
3.30
|
|
|
|
35,000
|
|
|
$
|
52.98
|
|
2018
|
|
|
3,120,000
|
|
|
$
|
3.01
|
|
|
|
48,000
|
|
|
$
|
54.11
|
|
2019
|
|
|
1,320,000
|
|
|
$
|
2.85
|
|
|
|
36,000
|
|
|
$
|
54.90
|
|
(a)
NYMEX Henry Hub Natural Gas futures contract for the respective delivery month.
(b)
NYMEX Light Sweet Crude West Texas Intermediate futures contract for the respective delivery month
For
its swap instruments, the Company receives a fixed price for the hedged commodity and pays a floating price to the counterparty.
The fixed-price payment and the floating-price payment are netted, resulting in a net amount due to or from the counterparty.
The
following table summarizes the fair value of the derivatives recorded in the unaudited Consolidated Balance Sheets.
These
derivative instruments are not designated as cash flow hedging instruments for accounting purposes:
(in thousands)
|
|
June 30,
2017
|
|
|
December 31,
2016
|
|
Commodity derivative contracts:
|
|
|
|
|
|
|
Current assets
|
|
$
|
604
|
|
|
$
|
-
|
|
Non-current assets
|
|
$
|
487
|
|
|
$
|
-
|
|
|
|
|
|
|
|
|
|
|
Current liabilities
|
|
$
|
-
|
|
|
$
|
1,341
|
|
Non-current liabilities
|
|
$
|
-
|
|
|
$
|
591
|
|
The
table below summarizes the commodity settlements and unrealized gains and losses related to the Company’s derivative instruments
for the three and six months ended June 30, 2017 and 2016. These commodity derivative settlements and unrealized gains and losses
are recorded and included in commodity derivative income or loss in the accompanying Consolidated Statements of Operations.
Note
11 – Physical Delivery Contracts and Gas Derivatives (continued)
(in thousands)
|
|
Three Months Ended June 30,
|
|
|
Six Months Ended June 30,
|
|
|
|
2017
|
|
|
2016
|
|
|
2017
|
|
|
2016
|
|
Commodity derivative contracts:
|
|
|
|
|
|
|
|
|
|
|
|
|
Settlement (losses) gains
|
|
$
|
142
|
|
|
$
|
130
|
|
|
$
|
118
|
|
|
$
|
332
|
|
Unrealized gains (losses)
|
|
|
856
|
|
|
|
(904
|
)
|
|
|
3,023
|
|
|
|
(966
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total settlement and unrealized gains (losses), net
|
|
$
|
998
|
|
|
$
|
(774
|
)
|
|
$
|
3,141
|
|
|
$
|
(634
|
)
|
Commodity
derivative settlement gains and losses are included in cash flows from operating activities in the Company’s unaudited Consolidated
Statements of Cash Flows.
The
counterparty in all the Company’s derivative instruments is BP Energy Company. The Company has entered into an ISDA Master
Agreement with BP Energy Company that establishes standard terms for the derivative contracts and an inter-creditor agreement
with LegacyTexas Bank and BP Energy Company whereby any credit exposure related to the derivative contracts entered into by the
Company and BP Energy Company is secured by the collateral and backed by the guarantees supporting the credit facility.
The
Company nets its derivative instrument fair value amounts executed with is its counterparty pursuant to an ISDA master agreement,
which provides for the net settlement over the term of the contracts and in the event of default or termination of the contracts.
The following table summarizes the location and fair value amounts of all derivative instruments in the unaudited Consolidated
Balance Sheet, as well as the gross recognized derivative assets, liabilities and amounts offset in the unaudited Consolidated
Balance Sheet as of June 30, 2017.
|
|
|
|
|
|
|
|
Net
|
|
|
|
Gross
|
|
|
|
|
|
Recognized
|
|
|
|
Recognized
|
|
|
Gross
|
|
|
Fair Value
|
|
|
|
Assets/
|
|
|
Amounts
|
|
|
Assets/
|
|
Balance
Sheet Classification
|
|
Liabilities
|
|
|
Offset
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivative assets:
|
|
|
|
|
|
|
|
|
|
Current assets
|
|
$
|
844
|
|
|
$
|
(240
|
)
|
|
$
|
604
|
|
Other long-term assets
|
|
|
593
|
|
|
|
(106
|
)
|
|
|
487
|
|
Total derivative assets
|
|
$
|
1,437
|
|
|
$
|
(346
|
)
|
|
$
|
1,091
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivative liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
Current liability
|
|
$
|
240
|
|
|
$
|
(240
|
)
|
|
$
|
-
|
|
Non-current liabilities
|
|
|
106
|
|
|
|
(106
|
)
|
|
|
-
|
|
Total derivative liabilities
|
|
$
|
346
|
|
|
$
|
(346
|
)
|
|
$
|
-
|
|
Due
to the volatility of oil and natural gas prices, the estimated fair values of the Company’s derivatives are subject to large
fluctuations from period to period.
Note
12 – Commitments
The
Company has entered into employment agreements with certain executives and officers of the Company. The term of the agreements
generally range from one to two years and provide for renewal provisions in one year increments thereafter. The agreements provide
for, among other items, severance and continuation of benefit payments upon termination of employment or certain change of control
events.
The
Company has entered into long-term firm transportation contracts to ensure the transport for certain of its gas production to
purchasers. Firm transportation volumes and the related demand charges for the remaining term of these contracts at June 30, 2017
are summarized in the table below.
Period
|
|
Dekatherms per day
|
|
|
Demand Charges
|
|
Jul 2017 - Apr 2018
|
|
|
5,530
|
|
|
|
$0.20 - $0.65
|
|
May 2018 - May 2020
|
|
|
3,230
|
|
|
|
$0.20 - $0.62
|
|
Apr 2020 – May 2020
|
|
|
2,150
|
|
|
$
|
0.20
|
|
Jun 2020 – May 2036
|
|
|
1,000
|
|
|
$
|
0.20
|
|
A
liability of approximately $541,000 related to firm transportation contracts assumed in asset acquisitions, which represents the
remaining commitment, is reflected on the Company’s unaudited Consolidated Balance Sheet as of June 30, 2017. The fair value
of these firm transportation obligations was determined based upon the contractual obligations assumed by the Company and discounted
based upon the Company’s effective borrowing rate. These contractual obligations are being amortized on a monthly basis
as the Company pays these firm transportation obligations.
In
its participation as a member of Carbon Appalachia, the Company has made a capital commitment of $2.0 million, of which it has
contributed $240,000 as of June 30, 2017.
Note
13 – Supplemental Cash Flow Disclosure
Supplemental
cash flow disclosures for the six months ended June 30, 2017 and 2016 are presented below:
|
|
Six Months Ended June 30,
|
|
(in thousands)
|
|
2017
|
|
|
2016
|
|
|
|
|
|
|
|
|
Cash paid during the period for:
|
|
|
|
|
|
|
Interest
|
|
$
|
433
|
|
|
$
|
110
|
|
Non-cash transactions:
|
|
|
|
|
|
|
|
|
Increase in net asset retirement obligations
|
|
$
|
5
|
|
|
$
|
5
|
|
Decrease in accounts payable and accrued liabilities included in oil and gas properties
|
|
$
|
(79
|
)
|
|
$
|
(59
|
)
|
Issuance of warrants for investment in affiliates
|
|
$
|
7,094
|
|
|
$
|
-
|
|
Note
14 – Subsequent Events
In
July 2017, the Company increased its outstanding borrowings under its credit facility with LegacyTexas Bank and contributed approximately
$3.7 million to Carbon Appalachia.