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 September 30, 2017 and the Company’s results of operations
and cash flows for the three and nine months ended September 30, 2017 and 2016. Operating results for the three and nine months
ended September 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 64
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 unaudited 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 nine months ended September
30, 2017, the Company did not recognize a ceiling test impairment as the Company’s full cost pool did not exceed the ceiling
limitations. For the three months ended September 30, 2016, the Company did not recognize a ceiling test impairment as the Company’s
full cost pool did not exceed the ceiling limitations. For the nine months ended September 30, 2016, the Company recognized a ceiling
test impairment of approximately $4.3 million 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. Equity
method investments will increase or decrease 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 to make investments in California oil and gas projects. 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) management-related costs in connection with its role as manager of
Carbon California. Management-related reimbursements were $150,000 and $375,000 for the three months ended September 30, 2017 and
period February 15, 2017 (inception) through September 30, 2017, respectively.
On April 3, 2017, the Company entered into
the limited liability company agreement of Carbon Appalachia to make investments in Appalachia oil and gas projects. 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) management-related costs in connection with its role as manager of Carbon
Appalachia. Management-related reimbursements were approximately $273,000 and $348,000 for the three months ended September 30,
2017 and period April 3, 2017 (inception) through September 30, 2017, respectively. As of September 30, 2017, Carbon Appalachia
owes the Company approximately $273,000 in connection with its role as manager.
Warrant Derivative Liability
The Company issued warrants related to
investments in Carbon California and Carbon Appalachia. The Company accounts for these warrants in accordance with guidance contained
in Accounting Standards Codification (“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 nine months ended September 30, 2017, changes in the fair value of warrants accounted for gains of approximately
$811,000 and $2.5 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 nine months ended September 30, 2017 and 2016:
(in thousands)
|
|
Nine Months Ended
September 30,
|
|
|
|
2017
|
|
|
2016
|
|
Balance at beginning of period
|
|
$
|
5,120
|
|
|
$
|
3,095
|
|
Accretion expense
|
|
|
232
|
|
|
|
105
|
|
Additions during period
|
|
|
5
|
|
|
|
5
|
|
Obligations on sale of oil & gas properties
|
|
|
(93
|
)
|
|
|
-
|
|
|
|
|
5,264
|
|
|
|
3,205
|
|
Less: ARO recognized as a current liability
|
|
|
(144
|
)
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
Balance at end of period
|
|
$
|
5,120
|
|
|
$
|
3,205
|
|
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
September 30,
|
|
|
Nine Months Ended
September 30,
|
|
|
|
2017
|
|
|
2016
|
|
|
2017
|
|
|
2016
|
|
Basic Earnings (Loss) per Share
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) available to common shareholders, basic
|
|
$
|
(462
|
)
|
|
$
|
(1,599
|
)
|
|
$
|
4,834
|
|
|
$
|
(9,044
|
)
|
Weighted average shares outstanding, basic
|
|
|
5,628
|
|
|
|
5,507
|
|
|
|
5,579
|
|
|
|
5,455
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per common share, basic
|
|
$
|
(0.08
|
)
|
|
$
|
(0.29
|
)
|
|
$
|
0.87
|
|
|
|
(1.66
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted Earnings (Loss) per Share
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) available to common shareholders, basic
|
|
$
|
(462
|
)
|
|
$
|
(1,599
|
)
|
|
$
|
4,834
|
|
|
$
|
(9,044
|
)
|
Less: decrease in fair value of warrant
|
|
|
-
|
|
|
|
-
|
|
|
|
(2,494
|
)
|
|
|
-
|
|
Adjusted net income (loss) available to common shareholders, diluted
|
|
$
|
(462
|
)
|
|
$
|
(1,599
|
)
|
|
$
|
2,340
|
|
|
$
|
(9,044
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares outstanding, basic
|
|
|
5,628
|
|
|
|
5,507
|
|
|
|
5,579
|
|
|
|
5,455
|
|
Add: dilutive effects of warrant and nonvested shares of restricted stock
|
|
|
-
|
|
|
|
-
|
|
|
|
907
|
|
|
|
-
|
|
Weighted-average shares outstanding, diluted
|
|
|
5,628
|
|
|
|
5,507
|
|
|
|
6,486
|
|
|
|
5,455
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per common share, diluted
|
|
$
|
(0.08
|
)
|
|
$
|
(0.29
|
)
|
|
$
|
0.36
|
|
|
$
|
(1.66
|
)
|
For the three months ended September 30,
2017, the Company had a net loss, and therefore, the diluted net loss per share calculation excluded the anti-dilutive effect of
approximately 284,000 non-vested shares of restricted stock and approximately 617,000 in-the-money warrants. In addition, approximately
276,000 restricted performance units, subject to future contingencies, are excluded from the basic and diluted loss per share calculations.
For the nine months ended September 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 623,000 in-the-money warrants. In addition, 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 nine months ended September
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 291,000 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 using the modified retrospective
method. 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, internal controls and disclosures. The adoption is not expected to have a significant
impact on the Company’s net income or cash flows, however, the Company is currently evaluating the proper classification
of certain pipeline gathering, transportation and gas processing agreements to determine whether changes to total revenues and
expenses will be necessary under the new standards.
In June 2016, the FASB issued ASU 2016-13,
Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.
These amendments
change the measurement of credit losses for most financial assets and certain other instruments that are not measured at fair value
through net income. The amendments in this update affect investments in loans, investments in debt securities, trade receivables,
net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded
from the scope that have the contractual right to receive cash. The amendments replace the incurred loss impairment methodology
in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable
and supportable information to inform credit loss estimates. ASU 2016-13 is effective for fiscal years, and interim periods within
those fiscal years, beginning after December 15, 2019. The Company is currently evaluating the impact on its consolidated financial
statements of adopting ASU 2016-13.
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 was $9.0 million subject to customary closing adjustments plus certain
assumed obligations.
The
EXCO Acquisition included 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 nine months ended September 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 unaudited consolidated statement of operations
for the nine months ended September 30, 2017 includes the results of operations for the nine months ended September 30, 2017 of
the EXCO properties acquired.
|
|
Unaudited Pro Forma
Consolidated Results
|
|
|
|
For Nine Months Ended
September 30,
|
|
(in thousands, except per share amounts)
|
|
2017
|
|
|
2016
|
|
Revenue
|
|
$
|
17,565
|
|
|
$
|
10,990
|
|
Net income (loss) before non-controlling interests
|
|
|
4,926
|
|
|
|
(4,447
|
)
|
Net income (loss) attributable to non-controlling interests
|
|
|
92
|
|
|
|
(435
|
)
|
Net income (loss) attributable to controlling interests
|
|
|
4,834
|
|
|
|
(4,012
|
)
|
Net income (loss) income per share (basic)
|
|
|
0.87
|
|
|
|
(0.74
|
)
|
Net income (loss) income per share (diluted)
|
|
|
0.36
|
|
|
|
(0.74
|
)
|
Note
4 – Property and Equipment
Net
property and equipment as of September 30, 2017 and December 31, 2016 consists of the following:
(in thousands)
|
|
September 30,
2017
|
|
|
December 31,
2016
|
|
|
|
|
|
|
|
|
Oil and gas properties:
|
|
|
|
|
|
|
Proved oil and gas properties
|
|
$
|
112,211
|
|
|
$
|
111,771
|
|
Unproved properties not subject to depletion
|
|
|
1,926
|
|
|
|
1,999
|
|
Accumulated depreciation, depletion, amortization and impairment
|
|
|
(80,152
|
)
|
|
|
(78,559
|
)
|
Net oil and gas properties
|
|
|
33,985
|
|
|
|
35,211
|
|
|
|
|
|
|
|
|
|
|
Furniture and fixtures, computer hardware and software, and other equipment
|
|
|
1,661
|
|
|
|
990
|
|
Accumulated depreciation and amortization
|
|
|
(888
|
)
|
|
|
(665
|
)
|
Net other property and equipment
|
|
|
773
|
|
|
|
325
|
|
|
|
|
|
|
|
|
|
|
Total net property and equipment
|
|
$
|
34,758
|
|
|
$
|
35,536
|
|
As
of September 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 nine months ended September 30, 2017 and 2016, the Company capitalized general and administrative expenses applicable to development
and exploration activities of approximately $178,000 and $431,000, respectively.
Depletion
expense related to oil and gas properties for the three and nine months ended September 30, 2017 was approximately $521,000, or
$0.38 per Mcfe, and $1.6 million, or $0.40 per Mcfe, respectively. For the three and nine months ended September 30, 2016, depletion
expense was approximately $368,000, or $0.60 per Mcfe, and $1.2 million, or $0.68 per Mcfe, respectively.
Depreciation
and amortization expense related to furniture and fixtures, computer hardware and software and other equipment for the three months
ended September 30, 2017 and 2016 was approximately $91,000 and $25,000, respectively and for the nine months ended September
30, 2017 and 2016 was approximately $254,000 and $85,000, respectively.
Note 5– Investments in Affiliates
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.
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, of which $10.0 million is outstanding as of September 30, 2017.
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 may be 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 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 September 30, 2017, and for the period of February 15, 2017 through September 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 September 30, 2017,
the Company estimated that the fair value of the California Warrant was approximately $3.0 million. The difference in the fair
value of the California Warrant from the grant date though September 30, 2017 was approximately $2.8 million and approximately
$1.3 million and $2.8 million was recognized in warrant derivative gain in the Company’s unaudited Consolidated Statements
of Operations for the three and nine months ended September 30, 2017, respectively. See Note 10 for additional information.
The
following table sets forth, for the periods presented, selected historical financial data for Carbon California.
(in thousands, except per share amounts)
|
|
Three Months Ended September 30,
2017
|
|
|
February 15, 2017 (Inception) through September 30,
2017
|
|
Revenues
|
|
$
|
1,994
|
|
|
$
|
6,511
|
|
Operating expenses
|
|
|
2,625
|
|
|
|
6,578
|
|
Loss from continuing operations
|
|
|
(1,135
|
)
|
|
|
(1,313
|
)
|
Net loss
|
|
|
(1,135
|
)
|
|
|
(1,313
|
)
|
Carbon
Appalachia
Outlined
below is a summary of i) the Company’s contributions, ii) its resulting percent of Class A unit ownership and iii) the Company’s
overall resulting sharing percentage of Carbon Appalachia after giving effect of all classes of ownership. Each contribution and
its use is described in detail following the table.
Timing
|
|
Capital Contribution
|
|
Resulting Class A
Units (%)
|
|
Resulting Sharing %
|
April 2017
|
|
$0.24 million
|
|
2.00%
|
|
2.98%
|
August 2017
|
|
$3.71 million
|
|
15.20%
|
|
16.04%
|
September 2017
|
|
$2.92 million
|
|
18.55%
|
|
19.37%
|
November 2017*
|
|
Warrant exercise*
|
|
26.50%
|
|
27.24%
|
*
|
See Note 14 for further details regarding the November 1, 2017 exercise of the Appalachia
Warrant
|
On
April 3, 2017, the Company finalized a limited liability company agreement (the “Carbon Appalachia LLC Agreement”)
and the initial funding of Carbon Appalachia. Carbon Appalachia was formed by Carbon and two institutional investors to acquire
producing assets in the Southern Appalachian Basin and has an initial equity commitment of $100.0 million, of which $37.0 million
has been contributed as of September 30, 2017.
Pursuant
to the Carbon Appalachia LLC Agreement, Carbon acquired a 2.0% interest in Carbon Appalachia for $240,000 of Class A Units associated
with its initial equity commitment of $2.0 million. Carbon also has the ability to earn up to an additional 19.6% 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. The Company is not a guarantor of this credit facility.
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 “April 2017 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.
During
the quarter ended September 30, 2017, CAC completed two acquisitions, one on August 15, 2015 and the other on September 29, 2017.
Each acquisition is described in more detail below.
On
August 15, 2017, Carbon Appalachia completed the acquisition of natural gas producing properties and related facilities located
predominantly in the state of West Virginia (the “August 2017 Acquisition”). The purchase price was $21.5 million,
subject to normal and customary pre- and post-closing adjustments.
On
August 15, 2017, the Carbon Appalachia LLC Agreement was amended and restated. Pursuant to the amended and restated Carbon Appalachia
LLC Agreement, Carbon increased its capital commitment in Carbon Appalachia from $2.0 million to $23.6 million and its portion
of any subsequent capital call from 2.0% to 26.5%. Aggregate capital commitments of all Members remained at $100.0 million. As
each subsequent capital call is made, Carbon will contribute 26.5%. The Company is the sole manager of Carbon Appalachia and maintains
the ability to earn additional ownership interests of Carbon Appalachia (represented by Class B Units) after certain thresholds
to the holders of Class A Units are met. The Company also maintains its 1.0% carried interest represented by Class C Units.
In
connection with and concurrently with the closing of the August 2017 Acquisition, the borrowing base of its existing credit facility
with LegacyTexas Bank increased to $22.0 million and Carbon Appalachia Enterprises borrowed $8.0 million from its existing credit
facility with LegacyTexas Bank. Carbon Appalachia received equity funding in the amount of $14.0 million from its members, including
$3.7 million from Carbon. The contributed funds and funds drawn from the credit facility were used to pay the purchase price.
On September 29, Carbon Appalachia Enterprises amended its 4-year $100.0 million senior secured asset-based
revolving credit facility with LegacyTexas Bank, resulting in a borrowing base of $50.0 million with redeterminations as of April
1 and October 1 each year and the addition of East West Bank as a participating lender. As of September 30, 2017, there was approximately
$38.0 million outstanding under the credit facility.
On
September 29, 2017, Carbon Appalachia completed the acquisition of natural gas producing properties, natural gas gathering pipelines
and related facilities located predominantly in the state of West Virginia (the “September 2017 Acquisition”). The
purchase price was $41.3 million, subject to normal and customary pre- and post-closing adjustments.
In
connection with and concurrently with the closing of the September 2017 Acquisition described above, Carbon Appalachia Enterprises
borrowed $20.4 million from its credit facility. Carbon Appalachia received equity funding in the amount of $11.0 million from
its members, including $2.9 million from Carbon. The contributed funds and funds drawn from the credit facility were used to pay
the purchase price.
In
connection with the Company entering into the Carbon Appalachia LLC Agreement described above and Carbon Appalachia Enterprises
engaging in the April 2017 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 19.4% combined Class A and Class C interest (and its ability as of September 30, 2017 to earn up to an additional 16.3%)
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 approximately $6.9 million 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 September 30, 2017, Carbon Appalachia incurred
a net loss, of which the Company’s share is approximately $348,000. 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 the 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 September 30, 2017,
the Company estimated that the fair value of the Appalachia Warrant was approximately $1.6 million. The difference in the fair
value of the Appalachia Warrant from the grant date through September 30, 2017 was approximately $323,000 and approximately $497,000
and $323,000 was recognized in derivative warrant gain in the Company’s unaudited Consolidated Statements of Operations for
the three and nine months ended September 30, 2017. See Note 10 for additional information. On November 1, 2017, the holder of
the Appalachia Warrant exercised the warrant. See Note 14 for additional information.
The
following table sets forth, for the periods presented, selected historical financial data for Carbon Appalachia.
(in thousands, except per share amounts)
|
|
Three Months Ended September 30,
2017
|
|
|
April 3,
2017
(Inception) through September 30,
2017
|
|
Revenues
|
|
$
|
1,348
|
|
|
$
|
2,905
|
|
Operating expenses
|
|
|
2,691
|
|
|
|
4,449
|
|
Loss from continuing operations
|
|
|
(1,545
|
)
|
|
|
(1,874
|
)
|
Net loss
|
|
|
(1,545
|
)
|
|
|
(1,874
|
)
|
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
which services the Company’s natural gas production in the Illinois Basin. The Company accounts for its investment in CCGGC
under the equity method of accounting, and its share of income or loss is recognized in the Company’s statement of operations.
During the nine months ended September 30, 2017 and 2016, the Company recorded equity method income of approximately $32,000 and
equity method loss of approximately $10,000, respectively, related to this
investment. In
addition, during the third quarter of 2017 and first quarter of 2016, the Company received cash distributions from CCGGC of approximately
$68,000 and $275,000, respectively.
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. On March 30, 2017, the borrowing base was increased to $23.0 million. As of September
30, 2017, the borrowing base remained at $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.
In the third quarter of 2017, the Company contributed approximately $6.6 to Carbon Appalachia to fund
its share of producing oil and gas properties acquired during the third quarter. This funding was provided primarily with borrowings
under the credit facility. The funded Debt/EBITDA and current ratio covenants negotiated at the time the credit facility was established
did not contemplate the Company’s contributions for its investment in Carbon Appalachia and, as a result, the Company was
not in compliance with the financial covenants associated with the credit facility as of September 30, 2017. However, the Company
has obtained a waiver of the funded debt/EBITDA ratio and the current ratio covenants as of September 30, 2017. The Company has
requested that LegacyTexas Bank amend such financial covenants to take into account the Company’s investment in Carbon Appalachia.
While the Company believes its relationship with LegacyTexas Bank is such that the requested amendment is likely, there can be
no assurance that the bank will agree to an amendment.
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 September 30, 2017, there were approximately
$22.1 million in outstanding borrowings and approximately $860,000 of additional borrowing capacity available under the credit
facility. The Company’s effective borrowing rate at September 30, 2017 was approximately 5.82%.
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 September 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 September 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 nine 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.
Nytis USA Restricted Stock Plan
As of September 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 $252,000 for the three and nine months ended September 30, 2016, respectively. No compensation expense was recognized
for those restricted stock grants for the three and nine months ended September 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 nine months ended September
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 September 30,
2017, approximately 258,000 of these restricted stock grants have vested.
Compensation costs recognized for these
restricted stock grants were approximately $160,000 and $186,000 for the three months ended September 30, 2017 and 2016, respectively,
and $513,000 and $554,000 for the nine months ended September 30, 2017 and 2016, respectively. As of September 30, 2017, there
was approximately $1.3 million of unrecognized compensation costs related to these restricted stock grants. This cost is expected
to be recognized over the next 6.5 years.
Performance Units
During the nine months ended September
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 achievement 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 272,000 restricted performance units are outstanding as of September 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 September 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 or 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 $239,000 related to these performance units were recognized for the three and nine months ended September 30, 2017,
respectively. Compensation expense of approximately $1.1 million was recognized for these performance units for the three and nine
months ended September 30, 2016. As of September 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 $2.4 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 nil and
approximately $127,000 for the three and nine months ended September 30, 2016, respectively. As of September 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 September 30, 2017 and December 31, 2016 consist of the following:
(in thousands)
|
|
September 30,
2017
|
|
|
December 31,
2016
|
|
|
|
|
|
|
|
|
Accounts payable
|
|
$
|
1,801
|
|
|
$
|
2,315
|
|
Oil and gas revenue payable to oil and gas property owners
|
|
|
1,583
|
|
|
|
1,415
|
|
Gathering and transportation payables
|
|
|
498
|
|
|
|
468
|
|
Production taxes payable
|
|
|
212
|
|
|
|
113
|
|
Drilling advances received from joint venture partner
|
|
|
422
|
|
|
|
955
|
|
Accrued drilling costs
|
|
|
-
|
|
|
|
4
|
|
Accrued lease operating costs
|
|
|
535
|
|
|
|
282
|
|
Accrued ad valorem taxes
|
|
|
1,461
|
|
|
|
1,552
|
|
Accrued general and administrative expenses
|
|
|
1,085
|
|
|
|
1,572
|
|
Accrued interest
|
|
|
232
|
|
|
|
184
|
|
Other liabilities
|
|
|
264
|
|
|
|
261
|
|
|
|
|
|
|
|
|
|
|
Total accounts payable and accrued liabilities
|
|
$
|
8,093
|
|
|
$
|
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.
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 September 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
|
|
September 30, 2017
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivatives
|
|
$
|
-
|
|
|
$
|
247
|
|
|
$
|
-
|
|
|
$
|
247
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Warrant derivatives
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
4,600
|
|
|
$
|
4,600
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivatives
|
|
$
|
-
|
|
|
$
|
1,932
|
|
|
$
|
-
|
|
|
$
|
1,932
|
|
Level 2 Fair Value Measurements
As of September 30, 2017, the Company’s
commodity derivative financial instruments are comprised of twelve natural gas swap agreements, ten oil swap agreements and one
natural gas costless collar agreement. 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 September
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 September 30, 2017, using a Monte Carlo valuation model which utilized unobservable inputs including the percentage return
on the Company’s shares at various timelines, the percentage return on the privately-held Carbon California Class A units
at various timelines, an exercise price of $7.20, volatility rate of 45%, a risk-free rate of 2.1% and an estimated remaining term
of 6.4 years. For the quarter ended September 30, 2017, it was determined that a change from the Black Scholes model to the Monte
Carlo valuation model with the ability to incorporate the multitude of probabilities associated with various market participant
exercise scenarios was appropriate given the passage of time between the formation and funding of Carbon California in February
2017. As of September 30, 2017, the fair value of the California Warrant was approximately $3.0 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 September 30, 2017, using a Monte Carlo valuation model which utilized unobservable inputs including the percentage return
on the Company’s shares at various timelines, the percentage return on the privately-held Carbon Appalachia Class A units
at various timelines, an exercise price of $7.20, volatility rate of 45%, a risk-free rate of 2.1% and an estimated remaining term
of 6.5 years. For the quarter ended September 30, 2017, it was determined that a change from the Black Scholes model to the Monte
Carlo valuation model with the ability to incorporate the multitude of probabilities associated with various market participant
exercise scenarios was appropriate given the passage of time between the formation and funding of Carbon Appalachia in April 2017.
As of September 30, 2017, the fair value of the Appalachia Warrant was approximately $1.6 million.
The following table summarizes the changes
in fair value of our financial instruments classified as Level 3 in the fair value hierarchy:
(in thousands)
|
|
California Warrant
|
|
|
Appalachia Warrant
|
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Balance, December 31, 2016
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
-
|
|
Warrant derivative liability
|
|
|
5,769
|
|
|
|
1,325
|
|
|
|
7,094
|
|
Unrealized (gain) loss included in warrant derivative gain
|
|
|
(2,817
|
)
|
|
|
323
|
|
|
|
2,494
|
|
Balance, September 30, 2017
|
|
$
|
2,952
|
|
|
$
|
1,648
|
|
|
$
|
4,600
|
|
Assets Measured and Recorded at Fair
Value on a Non-Recurring Basis
The fair value of the Company’s asset
retirement obligations are 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 nine months ended September 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 a portion 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 and costless collar derivative agreements to hedge a portion
of its oil and natural gas production for 2017 through 2019. As of September 30, 2017, these derivative agreements consisted of
the following:
|
|
Natural Gas Swaps
|
|
|
Natural Gas Collars
|
|
|
Oil Swaps
|
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
Weighted
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
Average Price
|
|
|
|
|
|
Average
|
|
Year
|
|
MMBtu
|
|
|
Price (a)
|
|
|
MMBtu
|
|
|
Range (a)
|
|
|
Bbl
|
|
|
Price (b)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2017
|
|
|
900,000
|
|
|
$
|
3.27
|
|
|
|
30,000
|
|
|
|
$3.00 - $3.48
|
|
|
|
23,000
|
|
|
$
|
52.64
|
|
2018
|
|
|
3,390,000
|
|
|
$
|
3.01
|
|
|
|
90,000
|
|
|
|
$3.00 - $3.48
|
|
|
|
60,000
|
|
|
$
|
53.36
|
|
2019
|
|
|
1,920,000
|
|
|
$
|
2.85
|
|
|
|
-
|
|
|
|
-
|
|
|
|
48,000
|
|
|
$
|
53.76
|
|
(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.
Costless collars are designed to establish floor and ceiling prices on anticipated future oil and gas production. The ceiling
establishes a maximum price that the Company will receive for the volumes under contract, while the floor establishes a minimum
price.
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)
|
|
September 30,
2017
|
|
|
December 31,
2016
|
|
Commodity derivative contracts:
|
|
|
|
|
|
|
Current assets
|
|
$
|
190
|
|
|
$
|
-
|
|
Non-current assets
|
|
$
|
57
|
|
|
$
|
-
|
|
|
|
|
|
|
|
|
|
|
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 nine months ended September 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 unaudited
Consolidated Statements of Operations.
(in thousands)
|
|
Three Months Ended
September 30,
|
|
|
Nine Months Ended
September 30,
|
|
|
|
2017
|
|
|
2016
|
|
|
2017
|
|
|
2016
|
|
Commodity derivative contracts:
|
|
|
|
|
|
|
|
|
|
|
|
|
Settlement gains
|
|
$
|
345
|
|
|
$
|
17
|
|
|
$
|
463
|
|
|
$
|
349
|
|
Unrealized (losses) gains
|
|
|
(844
|
)
|
|
|
143
|
|
|
|
2,179
|
|
|
|
(823
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total settlement and unrealized (losses) gains, net
|
|
$
|
(499
|
)
|
|
$
|
160
|
|
|
$
|
2,642
|
|
|
$
|
(474
|
)
|
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 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 September 30, 2017.
|
|
|
|
|
|
|
|
Net
|
|
|
|
Gross
|
|
|
|
|
|
Recognized
|
|
|
|
Recognized
|
|
|
Gross
|
|
|
Fair Value
|
|
|
|
Assets/
|
|
|
Amounts
|
|
|
Assets/
|
|
Balance Sheet Classification
|
|
Liabilities
|
|
|
Offset
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivative assets:
|
|
|
|
|
|
|
|
|
|
Current assets
|
|
$
|
448
|
|
|
$
|
(258
|
)
|
|
$
|
190
|
|
Other long-term assets
|
|
|
305
|
|
|
|
(248
|
)
|
|
|
57
|
|
Total derivative assets
|
|
$
|
753
|
|
|
$
|
(506
|
)
|
|
$
|
247
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commodity derivative liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
Current liability
|
|
$
|
258
|
|
|
$
|
(258
|
)
|
|
$
|
-
|
|
Non-current liabilities
|
|
|
248
|
|
|
|
(248
|
)
|
|
|
-
|
|
Total derivative liabilities
|
|
$
|
506
|
|
|
$
|
(506
|
)
|
|
$
|
-
|
|
Due
to the volatility of oil and natural gas prices, the estimated fair values of the Company’s derivatives are subject to fluctuations from period to period.
Note
12 – Commitments
Employment Agreements
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.
Firm Transportation Contracts
The
Company has entered into long-term firm transportation contracts to ensure the transport for a portion of its gas production
to purchasers. Firm transportation volumes and the related demand charges for the remaining term of these contracts at
September 30, 2017 are summarized in the table below.
Period
|
|
Dekatherms
per day
|
|
|
Demand
Charges
|
|
Oct
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 $400,000 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 September 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.
Capital
Commitments
In
its participation as a Class A member of Carbon Appalachia, the Company has made a capital commitment of $23.6 million, of
which it has contributed $6.9 million as of September 30, 2017.
Litigation
From time to time, the Company is a party to various commercial and regulatory claims, pending or threatened
legal action, and other proceedings that arise in the ordinary course of business. It is the opinion of management that none of
the current matters of contention are reasonably likely to have a material adverse impact on our business, financial position,
results of operations, or cash flows.
Note
13 – Supplemental Cash Flow Disclosure
Supplemental
cash flow disclosures for the nine months ended September 30, 2017 and 2016 are presented below:
|
|
Nine Months Ended
September 30,
|
|
(in thousands)
|
|
2017
|
|
|
2016
|
|
|
|
|
|
|
|
|
Cash paid during the period for:
|
|
|
|
|
|
|
Interest
|
|
$
|
645
|
|
|
$
|
117
|
|
Non-cash transactions:
|
|
|
|
|
|
|
|
|
Increase in net asset retirement obligations
|
|
$
|
5
|
|
|
$
|
5
|
|
Decrease in accounts payable and accrued liabilities included in oil and
gas properties
|
|
$
|
(12
|
)
|
|
$
|
(23
|
)
|
Issuance of warrants for investment in affiliates
|
|
$
|
7,094
|
|
|
$
|
-
|
|
Note
14 – Subsequent Events
On November 1, 2017, the holder of the
Appalachia Warrant (see Note 5) exercised the warrant resulting in the issuance of 432,051 shares of the Company’s common
stock in exchange for Class A Units representing approximately 7.95% of then outstanding Class A Units of Carbon Appalachia. After
giving effect to the exercise, Carbon owns 26.5% of Carbon Appalachia outstanding Class A Units along with its 1% Class C ownership.
The Company is evaluating any accounting effects of the exercise.
On November 13, 2017, LegacyTexas Bank
reaffirmed the Company’s borrowing base associated with the credit facility at $23.0 million.