CRBO Carbon Energy Corporation (CE)

Notes to Condensed Consolidated Financial Statements

(Unaudited)

NOTE 1 – ORGANIZATION

Carbon Energy Corporation (formerly known as Carbon Natural Gas Company) is an independent oil and natural gas company engaged in the acquisition, exploration, development and production of oil, natural gas and natural gas liquids properties located in the United States. The terms “we”, “us”, “our”, the “Company” or “Carbon” refer to Carbon Energy Corporation and our consolidated subsidiaries (described below). The following is an organization chart of the key subsidiaries as of September 30, 2019 discussed in this report:

Appalachian and Illinois Basin Operations

In the Appalachian and Illinois Basins, operations are conducted by Nytis Exploration Company, LLC (“Nytis LLC”). The following organizational chart illustrates this relationship as of September 30, 2019:

In December 2018, we completed the acquisition of all of the Class A Units of Carbon Appalachian Company, LLC, a Delaware limited liability company (“Carbon Appalachia”), owned by Old Ironside Fund II-A Portfolio Holding Company, LLC, a Delaware limited liability company, and Old Ironside Fund II-B Portfolio Holding Company, LLC, a Delaware limited liability company, collectively (“Old Ironsides”) for a purchase price of $58.1 million, subject to customary and standard purchase price adjustments (“OIE Membership Acquisition”). As a result of the OIE Membership Acquisition, we now hold all of the issued and outstanding ownership interests of Carbon Appalachia, along with its direct and indirect subsidiaries (Carbon Appalachia Group, LLC, Carbon Tennessee Mining Company, LLC, Carbon Appalachia Enterprises, LLC, Carbon West Virginia Company, LLC, Cranberry Pipeline Corporation, Knox Energy, LLC, Coalfield Pipeline Company and Appalachia Gas Services Company, LLC). 

Ventura Basin Operations

In California, Carbon California Operating Company, LLC conducts operations on behalf of Carbon California Company, LLC, a Delaware limited liability company (“Carbon California”). On February 1, 2018, Yorktown Energy Partners XI, L.P. (“Yorktown”) exercised a warrant, collectively resulting in our aggregate sharing percentage in Carbon California increasing from 17.81% to 56.40%. On May 1, 2018, Carbon California closed the acquisition with Seneca Resources Corporation (the “Seneca Acquisition”). Following the exercise of the warrant by Yorktown and the Seneca Acquisition, we own 53.92% of the voting and profits interests and Prudential Legacy Insurance Company of New Jersey and Prudential Insurance Company of America or its affiliates (collectively, “Prudential”) owns 46.08% of the voting and profits interest in Carbon California. As of February 1, 2018, we consolidate Carbon California for financial reporting purposes. The following organizational chart illustrates this relationship as of September 30, 2019:

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) and in accordance with U.S. generally accepted accounting principles (“GAAP”) applicable to interim financial statements. These unaudited condensed consolidated financial statements reflect all normal recurring adjustments that are, in the opinion of management, necessary for a fair presentation of the results of the interim period. Operating results for the interim periods presented require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes and are not necessarily indicative of the results that may be expected for the full year. The condensed consolidated balance sheet data as of December 31, 2018 was derived from audited financial statements but does not include all disclosures required by GAAP. These unaudited condensed consolidated financial statements should be read in conjunction with our consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2018. The Company follows the same accounting policies for preparing quarterly and annual reports.

Principles of Consolidation

The unaudited condensed consolidated financial statements include the accounts of our consolidated subsidiaries. Upon the closing of the OIE Membership Acquisition on December 31, 2018, we own 100% of Carbon Appalachia. In addition, we own 100% of Nytis USA, which owns approximately 98.11% of Nytis LLC. Nytis LLC holds interests in various oil and gas partnerships.

Partnerships and subsidiaries in which we have a controlling interest are consolidated. We are currently consolidating 46 partnerships, Carbon Appalachia, and Carbon California, and we reflect the non-controlling ownership interest in partnerships and subsidiaries as non-controlling interests on our unaudited condensed consolidated statements of operations and also reflect the non-controlling ownership interest in the net assets of the partnerships as non-controlling interests within stockholders’ equity on our unaudited condensed consolidated balance sheets. All significant intercompany accounts and transactions have been eliminated.

In accordance with established practice in the oil and gas industry, our unaudited condensed consolidated financial statements also include our pro-rata share of assets, liabilities, income, lease operating costs and general and administrative expenses of the oil and gas partnerships in which we have 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 we have the ability to significantly influence the operating decisions of the investee. When we do 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 condensed consolidated financial statements.

Reclassifications

Certain prior period balances in the consolidated balance sheets and statements of operations have been reclassified to conform to the current year presentation.  Specifically, a portion of credit facilities and notes payable balances as of December 31, 2018 were reclassified from non-current liabilities to current liabilities. This reclassification had no impact on net income, cash flows or stockholders’ equity previously reported.

Insurance Receivable

Insurance receivable is comprised of insurance claims for the loss of property as a result of wildfires that impacted Carbon California in December 2017. The Company filed claims with its insurance provider. In January 2019, we reached a settlement agreement and received an $800,000 final settlement payment from our insurance provider related to the damage caused by the California wildfires. As of September 30, 2019, we were in receipt of all funds associated with the claims.

Revenue

Upon completion of the OIE Membership Acquisition, our revenue recognition policy was amended to account for the additional revenue we receive for transportation and handling and marketing gas sales, as described below.

Transportation and Handling

We generally purchase natural gas from producers at the wellhead or other receipt points, gather the wellhead natural gas through our gathering systems, and then sell the natural gas based on published index market prices. We remit to the producers either an agreed-upon percentage of the actual proceeds that we receive from our sales of natural gas or an agreed-upon percentage of the proceeds based on index related prices for the natural gas, regardless of the actual amount of the sales proceeds we receive. Our revenues under percent-of-proceeds/index arrangements generally correlate to the price of natural gas. Under fee-based arrangements, we receive a fee for storing natural gas. The storage revenues earned are directly related to the volume of natural gas that flows through our systems and are not directly dependent on commodity prices.

Marketing Gas Sales

We sell production purchased from third parties as well as production from our own oil and gas producing properties. Marketing gas sales are recognized on a gross basis as we purchase and take control of the gas prior to sale and are the principal in the transaction.

Recently Adopted Accounting Pronouncement

On January 1, 2019, we adopted Accounting Standards Update No. 2016-02, Leases (“Topic 842”) (ASU 2016-02), as amended, which supersedes the lease accounting guidance under Topic 840, and generally requires lessees to recognize operating and financing lease liabilities and corresponding right-of-use assets on the balance sheet and to provide enhanced disclosures surrounding the amount, timing and uncertainty of cash flows arising from leasing arrangements. We adopted the new guidance using the modified retrospective transition approach by applying the new standard to all leases existing at the date of initial application and not restating comparative periods. The most significant impact was the recognition of right-of-use assets and lease liabilities for operating leases. See Note 8 for further information on our implementation of this standard.

NOTE 3 – ACQUISITIONS

Majority Control of Carbon Appalachia

On December 31, 2018, we acquired all of Old Ironsides’ Class A Units of Carbon Appalachia for approximately $58.1 million. We paid $33.0 million in cash and delivered promissory notes in the aggregate original principal amount of approximately $25.1 million to Old Ironsides (the “Old Ironsides Notes”). See Note 7 for additional information.

Prior to the closing of the OIE Membership Acquisition, Old Ironsides held 27,195 Class A Units, which equated to a 72.76% aggregate share ownership of Carbon Appalachia and we held (i) 9,805 Class A Units, (ii) 1,000 Class B Units and (iii) 121 Class C Units, which equated to a 27.24% aggregate share ownership of Carbon Appalachia.

The OIE Membership Acquisition was accounted for as a business combination in accordance with ASC 805, Business Combinations. For assets and liabilities accounted for as business combinations, including the OIE Membership Acquisition, we utilized the assistance of third-party valuation specialists to determine the fair value of the assets and liabilities acquired. We primarily used the income approach and made market assumptions as to projections of estimated quantities of oil and natural gas reserves, future production rates, future commodity prices including price differentials as of the date of closing, future operating and development costs, a market participant weighted average cost of capital, and the condition of vehicles and equipment. We used the income approach and made market assumptions as to projections of utilization, future operating costs and a market participant weighted average cost of capital to determine the fair value of the firm transportation obligations as well as the plant facilities. The determination of the fair value of accounts payable and accrued liabilities assumed required significant judgement, including estimates relating to production assets.

The following summarizes the estimated fair values of the identifiable assets acquired and liabilities assumed in the acquisition based on their relative fair values at the acquisition date. These estimates of fair value of identifiable assets acquired and liabilities assumed are preliminary, pending final evaluation of certain assets and liabilities, and therefore are subject to revisions that may result in adjustments to the values presented below:

Assets acquired and liabilities assumed are as follows:

On the date of the acquisition, we derecognized our equity investment in Carbon Appalachia and recognized a gain of approximately $1.3 million based on the fair value of our previously held interest compared to its carrying value.

Consolidation of Carbon Appalachia and OIE Membership Acquisition Unaudited Pro Forma Results of Operations

Below are unaudited pro forma consolidated results of operations for the three and nine months ended September 30, 2018 as though the OIE Membership Acquisition had been completed as of January 1, 2018. Results for the three and nine months ended September 30, 2019 are reflected in the unaudited condensed consolidated statements of operations.

Consolidation of Carbon California Unaudited Pro Forma Results of Operations

Below are unaudited pro forma consolidated results of operations for the three and nine months ended September 30, 2018 as though the Carbon California Acquisition occurred on January 1, 2018. Results for the three and nine months ended September 30, 2019 are reflected in the unaudited condensed consolidated statements of operations.

As of September 30, 2019, and December 31, 2018, the Company had approximately $5.0 million and $5.4 million, respectively, of unproved oil and gas properties not subject to depletion. Such costs are excluded from the full cost pool until it is determined if reserves can be assigned to the related properties. Subject to industry conditions, evaluation of most of these properties and the inclusion of their costs in the full cost pool is expected to be completed within five years. Unproved properties are assessed for impairment at least annually. During the three and nine months ended September 30, 2019, approximately $513,000 and $719,000 of expiring leasehold costs were reclassified into proved property. There were no expiring leasehold costs during the three and nine months ended September 30, 2018.

We capitalized overhead applicable to acquisition, development and exploration activities of approximately $167,000 and $540,000 for the three and nine months ended September 30, 2019, respectively. For the three and nine months ended September 30, 2018, we capitalized overhead applicable to acquisition, development, and exploration activities of approximately $106,000 and $306,000, respectively.

Depletion expense related to oil and gas properties for the three and nine months ended September 30, 2019 was approximately $3.7 million and $10.7 million, respectively. Depletion expense related to oil and gas properties for the three and nine months ended September 30, 2018 was approximately $2.4 million and $5.6 million, respectively.

For the three and nine months ended September 30, 2019 and 2018, we did not recognize any ceiling test impairments as our full cost pool did not exceed the ceiling limitations.

NOTE 6 – ASSET RETIREMENT OBLIGATION

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 the estimated ARO liability result in adjustments to the related capitalized asset and corresponding liability.

The ARO liability is based on estimated economic lives, estimates of 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 adjusted as a result of a reassessment of expected cash flows and assumptions inherent in the estimation of the liability. 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. 

The following table is a reconciliation of ARO:

Carbon Appalachia

2018 Credit Facility

In connection with and concurrently with the closing of the OIE Membership Acquisition, the Company and its subsidiaries amended and restated our prior credit facilities and entered into a $500.0 million senior secured asset-based revolving credit facility maturing December 31, 2022 and a $15.0 million term loan maturing in 2020 (the “2018 Credit Facility”). The 2018 Credit Facility includes a sublimit of $1.5 million for letters of credit. The borrowers under the 2018 Credit Facility are Carbon Appalachia Enterprises, LLC (“CAE”) and various other subsidiaries of the Company (including Nytis USA, together with CAE, the “Borrowers”). Under the 2018 Credit Facility, Carbon Energy Corporation is neither a borrower nor a guarantor. The initial borrowing base under the 2018 Credit Facility was $75.0 million and remained so as of September 30, 2019.

The 2018 Credit Facility is guaranteed by each existing and future direct or indirect subsidiary of the Borrowers and certain other subsidiaries of the Company (subject to various exceptions) and the obligations under the 2018 Credit Facility are secured by essentially all tangible, intangible and real property (subject to certain exclusions).

Interest accrues on borrowings under the 2018 Credit Facility at a rate per annum equal to either (i) the base rate plus a margin equal to 0.25% - 0.75% depending on the utilization percentage or (ii) the Adjusted London interbank offered rate (“LIBOR”) plus a margin equal to 2.75% - 3.75% depending on the utilization percentage, at the Borrowers’ option. The Borrowers are obligated to pay certain fees and expenses in connection with the 2018 Credit Facility, including a commitment fee for any unused amounts of 0.50% and an origination fee of 0.50%. Loans under the 2018 Credit Facility may be prepaid without premium or penalty.

The 2018 Credit Facility also provides for a $15.0 million term loan which bears interest at a rate of 6.25% and is payable in 18 equal monthly installments beginning February 1, 2019 with the last payment due on July 1, 2020.

The 2018 Credit Facility contains certain affirmative and negative covenants that, among other things, limit the Borrowers’ ability to (i) 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 distribution on, or repurchase of, equity; (vi) make certain investments; (vii) enter into certain transactions with their affiliates; (viii) enter in sale-leaseback transactions; (ix) make optional or voluntary payment of debt other than obligations under the 2018 Credit Facility; (x) change the nature of their business; (xi) change their fiscal year or make changes to the accounting treatment or reporting practices; (xii) amend their 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 2018 Credit Facility requires the Borrowers’ compliance, on a consolidated basis, with a maximum Net Debt (all debt of the Borrowing Parties minus all unencumbered cash and cash equivalents of the Borrowers not to exceed $3.0 million) / EBITDAX (as defined) ratio of 3.50 to 1.00 and a current ratio, as defined, minimum of 1.00 to 1.00, tested quarterly, commencing with the quarter ending March 31, 2019.

In August 2019, we amended the 2018 Credit Facility, effective October 1, 2019, to restrict the aging of our accounts payable to 90 days or less, maintain minimum liquidity of $3.0 million and require the sale of certain non-core assets by December 31, 2019. 

As of September 30, 2019, there was approximately $71.2 million in outstanding borrowings and $3.8 million of additional borrowing capacity under the 2018 Credit Facility. As of September 30, 2019, we were in compliance with our financial covenants.

The terms of the 2018 Credit Facility require us to enter into derivative contracts at fixed pricing for a certain percentage of our production. We are party to an International Swaps and Derivatives Association Master Agreements (“ISDA Master Agreements”) 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 us and BP Energy Company is secured by the collateral and backed by the guarantees supporting the 2018 Credit Facility.

Fees paid in connection with the 2018 Credit Facility totaled approximately $779,000, of which $134,000 was associated with the term loan. The current portion of unamortized fees associated with the credit facility is included in prepaid expense, deposits and other current assets and the non-current portion is included in other non-current assets. The unamortized portion associated with the term loan was $67,000 as of September 30, 2019 and is directly offset against the loan in current liabilities. As of September 30, 2019, we had unamortized deferred issuance costs of approximately $524,000 associated with the 2018 Credit Facility. During the three and nine months ended September 30, 2019, we amortized approximately $63,000 and $188,000, respectively, as interest expense associated with the 2018 Credit Facility.

Old Ironsides Notes

On December 31, 2018, as part of the OIE Membership Acquisition, we delivered unsecured, promissory notes in the aggregate original principal amount of approximately $25.1 million to Old Ironsides (the “Old Ironsides Notes”). The Old Ironsides Notes bear interest at 10.0% per annum and have a term of five years, the first three of which require interest-only payments at the end of each calendar quarter beginning with the quarter ending March 31, 2019. At the end of the three-year interest-only period, the then current outstanding principal balance and interest is to be paid in 24 equal monthly payments. The Old Ironsides Notes also require mandatory prepayments upon the occurrence of certain subsequent liquidity events. A mandatory, one-time principal reduction payment in the aggregate amount of $2.0 million was made to Old Ironsides on February 1, 2019. Subsequent to the closing of the OIE Membership Acquisition, Old Ironsides ceased to be a related party.

The interest payable under the Old Ironsides Notes can be paid-in-kind at the election of the Company. This provision allows the Company to increase the principal balance associated with the Old Ironsides Notes. This election creates a second tranche of principal, which bears interest at 12.0% per annum. For the nine months ended September 30, 2019, the Company elected payment-in-kind interest of approximately $1.8 million.

Senior Revolving Notes, Related Party

On February 15, 2017, Carbon California entered into a Note Purchase Agreement (the “Note Purchase Agreement”) for the issuance and sale of Senior Secured Revolving Notes to Prudential with an initial revolving borrowing capacity of $25.0 million which mature on February 15, 2022 (the “Senior Revolving Notes”). Carbon Energy Corporation is not a guarantor of the Senior Revolving Notes. The closing of the Note Purchase Agreement on February 15, 2017 resulted in the sale and issuance by Carbon California of Senior Revolving Notes in the 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. As of September 30, 2019, the borrowing base was $45.0 million, of which $32.8 million was outstanding.  

Carbon California may elect to incur interest at either (i) 5.50% plus LIBOR or (ii) 4.50% plus the Prime Rate (which is defined as the interest rate published daily by JPMorgan Chase Bank, N.A.). As of September 30, 2019, the effective borrowing rate for the Senior Revolving Notes was 7.60%. In addition, the Senior Revolving Notes include a commitment fee for any unused amounts at 0.50% as well as an annual administrative fee of $75,000, payable on February 15 each year.

The Senior Revolving Notes are secured by all the assets of Carbon California. The Senior Revolving Notes require Carbon California, as of January 1 and July 1 of each year, to hedge its anticipated proved developed production at such time for year one, two and three at a rate of 75%, 65% and 50%, respectively. Carbon California may make principal payments in minimum installments of $500,000. Distributions to equity members are generally restricted.

Carbon California incurred fees directly associated with the issuance of the Senior Revolving Notes and amortizes these fees over the life of the Senior Revolving Notes. The current portion of these fees are included in prepaid expense and deposits and the long-term portion is included in other non-current assets for a combined value of approximately $669,000. For the three and nine months ended September 30, 2019, Carbon California amortized fees of $70,000 and $202,000, respectively.

Carbon California may at any time repay the Senior Revolving Notes, in whole or in part, without penalty. Carbon California must pay down Senior Revolving Notes or provide mortgages of additional oil and natural gas properties to the extent that outstanding loans and letters of credit exceed the borrowing base.   

Subordinated Notes, Related Party

On February 15, 2017, Carbon California entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”) with Prudential Capital Energy Partners, L.P. for the issuance and sale of Subordinated Notes due February 15, 2024, bearing interest of 12.0% per annum (the “Subordinated Notes”). Carbon Energy Corporation is not a guarantor of the Subordinated Notes. The closing of the Securities Purchase Agreement on February 15, 2017 resulted in the sale and issuance by Carbon California of Subordinated Notes in the original principal amount of $10.0 million, all of which remains outstanding as of September 30, 2019.

Prudential received an additional 1,425 Class A Units, representing 5.0% of the total sharing percentage, for the issuance of the Subordinated Notes. Carbon California valued this unit issuance based on the relative fair value by valuing the units at $1,000 per unit and aggregating the amount with the outstanding Subordinated Notes of $10.0 million. The Company then allocated the non-cash value of the units of approximately $1.3 million, which was recorded as a discount to the Subordinated Notes. As of September 30, 2019, Carbon California has an outstanding discount of approximately $780,000, which is presented net of the Subordinated Notes within Notes payable-related party on the unaudited condensed consolidated balance sheets. During the three and nine months ended September 30, 2019, Carbon California amortized $45,000 and $134,000, respectively, associated with the Subordinated Notes.

The Subordinated Notes require Carbon California, as of January 1 and July 1 of each year, to hedge its anticipated production at such time for year one, two and three at a rate of 67.5%, 58.5% and 45.0%, respectively.

Prepayment of the Subordinated Notes is allowed at 100%, subject to a 3.0% fee of outstanding principal. Prepayment is not subject to a prepayment fee after February 17, 2020. Distributions to equity members are generally restricted. 

2018 Subordinated Notes, Related Party

On May 1, 2018, Carbon California entered into an agreement with Prudential for the issuance and sale of $3.0 million in subordinated notes due February 15, 2024, bearing interest of 12.0% per annum (the “2018 Subordinated Notes”), of which $3.0 million remains outstanding as of September 30, 2019.

Prudential received 585 Class A Units, representing an approximate 2.0% additional sharing percentage, for the issuance of the 2018 Subordinated Notes. Carbon California valued this unit issuance based on the relative fair value by valuing the units at $1,000 per unit and aggregating the amount with the outstanding 2018 Subordinated Notes of $3.0 million. The Company then allocated the non-cash value of the units of approximately $490,000, which was recorded as a discount to the 2018 Subordinated Notes. As of September 30, 2019, Carbon California had an outstanding discount of $370,000 associated with these notes, which is presented net of the 2018 Subordinated Notes within Notes payable - related party on the unaudited condensed consolidated balance sheets. During the three and nine months ended September 30, 2019, Carbon California amortized $21,000 and $63,000, respectively, associated with the 2018 Subordinated Notes.

The 2018 Subordinated Notes require Carbon California, as of January 1 and July 1 of each year, to hedge its anticipated production at such time for year one, two and three at a rate of 67.5%, 58.5% and 45.0%, respectively.

Prepayment of the 2018 Subordinated Notes is allowed at 100%, subject to a 3.0% fee of outstanding principal. Prepayment is not subject to a prepayment fee after February 17, 2020. Distributions to equity members are generally restricted.

Restrictions and Covenants

The Senior Revolving Notes, Subordinated Notes and 2018 Subordinated Notes contain affirmative and negative covenants that, among other things, limit Carbon California’s ability to (i) 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 our affiliates; (viii) enter into sales-leaseback transactions; (ix) make optional or voluntary payments of debt; (x) change the nature of our business; (xi) change our 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 basket amounts and acceptable transaction levels. In addition, (i) the Senior Revolving Notes require Carbon California’s compliance with (A) a maximum Debt/EBITDA ratio of 4.0 to 1.0 (B) a maximum Senior Revolving Notes/EBITDA ratio of 2.5 to 1.0, (C) a minimum interest coverage ratio of 2.0 to 1.0 and (D) a minimum current ratio of 1.0 to 1.0 and (ii) the Subordinated Notes require Carbon California’s compliance with (A) a maximum Debt/EBITDA ratio of 4.75 to 1.0, (B) a maximum Senior Revolving Notes/EBITDA ratio of 3.0 to 1.0, (C) a minimum interest coverage ratio of 1.6 to 1.0, (D) an asset coverage test whereby indebtedness may not exceed the product of 0.65 times Adjusted PV-10 set forth in the most recent reserve report, (E) maintenance of a minimum borrowing base of $10.0 million under the Senior Revolving Notes and (F) a minimum current ratio of 0.85 to 1.00.

As of September 30, 2019, Carbon California was not in compliance with its Senior Revolving Notes/EBITDA ratio. We are currently negotiating an amendment to the covenant requirements with Prudential, a 46.08% owner of Carbon California, and are confident we will be successful in amending the covenants. While we have historically been successful in renegotiating covenant requirements with our lenders, there can be no assurance that we will be able to do so successfully in the future.

NOTE 8 – LEASES

On January 1, 2019, we adopted Topic 842. Results for reporting periods beginning January 1, 2019 are presented in accordance with Topic 842, while prior period amounts are reported in accordance with Topic 840 – Leases. On January 1, 2019, we recognized approximately $7.7 million in right-of-use assets and approximately $7.7 million in lease liabilities, representing the present value of minimum payment obligations associated with compressor, vehicle, and office space operating leases with non-cancellable lease terms in excess of one year. We do not have any finance leases, nor are we the lessor in any leasing arrangements. We have elected certain practical expedients available under Topic 842 including those that permit us to (i) account for lease and non-lease components in our contracts as a single lease component for all asset classes; (ii) not evaluate existing and expired land easements; (iii) not apply the recognition requirements of Topic 842 to leases with a lease term of twelve months or less; and (iv) retain our existing lease assessment and classification. As such, there was no cumulative-effect adjustment to retained earnings required at January 1, 2019.

The lease amounts disclosed herein are presented on a gross basis. A portion of these costs may have been or will be billed to other working interest owners, and our net share of these costs, once paid, are included in lease operating expenses, pipeline operating expenses or general and administrative expenses, as applicable.

Our right-of-use assets and lease liabilities are recognized at their discounted present value on the balance sheet. All leases recognized on our unaudited condensed consolidated balance sheet are classified as operating leases, which include leases related to the asset classes reflected in the table below:

We recognize lease expense on a straight-line basis excluding short-term and variable lease payments which are recognized as incurred. Short-term lease cost represents payments for leases with a lease term of twelve months or less, excluding leases with a term of one month or less. Short-term leases include certain compressors and vehicles that have a non-cancellable lease term of less than one year.

The following table summarizes the components of our gross operating lease costs incurred during the three and nine months ended September 30, 2019:

We do not have any leases with an implicit interest rate that can be readily determined. As a result, we calculate collateralized incremental borrowing rates to use as discount rates. We utilize the benchmark rates defined in our credit facilities, and adjust for facility utilization and term considerations, to establish collateralized incremental borrowing rates. See Note 7 for additional information on our credit facilities.

Our weighted-average lease term and discount rate used are as follows:

The following table summarizes supplemental cash flow information related to operating leases: 

Minimum future commitments by year for our long-term operating leases as of September 30, 2019 are presented in the table below. Such commitments are reflected at undiscounted values and are reconciled to the discounted present value recognized on the balance sheet as follows:

NOTE 9 – REVENUE

The following tables present our disaggregated revenue by primary region within the United States and major product line:

For the three months ended September 30, 2019 and 2018 (in thousands):

For the nine months ended September 30, 2019 and 2018 (in thousands):

We record revenue in the month production is delivered to the purchaser, but settlement statements may not be received until 30 to 90 days after the month of production. As such, we estimate the production delivered and the related pricing. The estimated revenue is recorded within Accounts receivable – Revenue on the unaudited condensed consolidated balance sheets. Any differences between our initial estimates and actuals are recorded in the month payment is received from the customer. These differences have not historically been material. Revenue recognized for the nine months ended September 30, 2019, that related to performance obligations satisfied in prior reporting periods was immaterial.

NOTE 10 – STOCK-BASED COMPENSATION PLANS

We have three stock plans, the Carbon 2011 Stock Incentive Plan, the Carbon 2015 Stock Incentive Plan and the Carbon 2019 Long Term Incentive Plan (collectively the “Carbon Plans”). The Carbon 2019 Long Term Incentive Plan was approved by the Company’s stockholders in May 2019. The Carbon Plans provide for the issuance of approximately 1.6 million shares of common stock to our officers, directors, employees or consultants eligible to receive the awards under the Carbon Plans.

The Carbon Plans provide for the granting of incentive stock options, non-qualified stock options, restricted stock awards, performance awards and phantom stock awards, or a combination of the foregoing, to employees, officers, directors or consultants, provided that only employees may be granted incentive stock options and directors may only be granted restricted stock awards and phantom stock awards.

Restricted Stock

As of September 30, 2019, approximately 748,000 shares of restricted stock have been granted under the terms of the Carbon Plans. Restricted stock awards for employees vest ratably over a three-year service period or cliff vest at the end of a three-year service period. For non-employee directors, the awards vest upon the earlier of a change in control of us or the date their membership on the Board of Directors is terminated other than for cause. During the nine months ended September 30, 2019, approximately 105,000 restricted stock units vested.

Compensation costs recognized for these restricted stock grants were approximately $204,000 and $607,000 for the three and nine months ended September 30, 2019, respectively, and approximately $187,000 and $537,000 for the three and nine months ended September 30, 2018, respectively. As of September 30, 2019, there was approximately $1.5 million unrecognized compensation costs related to these restricted stock grants which we expect to be recognized over the next 6.5 years.

Restricted Performance Units

As of September 30, 2019, approximately 699,000 shares of performance units have been granted under the terms of the Carbon Plans. Performance units represent a contractual right to receive one share of our 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 as well as, in some cases, continued service requirements. During the nine months ended September 30, 2019, approximately 95,000 performance units vested.

We account for the performance units granted during 2017 through 2019 at their fair value determined at the date of grant, which were $7.20, $9.80 and $10.00 per share, respectively. The final measurement of compensation cost will be based on the number of performance units that ultimately vest. At September 30, 2019, we estimated that none of the performance units granted in 2017 through 2019 would vest, and, accordingly, no compensation cost has been recorded for these performance units. We estimated that it was probable that the performance units granted in 2015 and 2016 would vest and therefore compensation costs of approximately $43,000 and $135,000 related to these performance units were recognized for the nine months ended September 30, 2019 and 2018, respectively. As of September 30, 2019, compensation costs related to the performance units granted in 2015 and 2016 have been fully recognized. As of September 30, 2019, if change in control and other performance provisions pursuant to the terms and conditions of these award agreements are met in full, the estimated unrecognized compensation cost related to outstanding performance units would be approximately $3.8 million.

NOTE 11 – EARNINGS (LOSS) PER COMMON SHARE

Basic earnings (loss) per common share is computed by dividing the net income (loss) attributable to common stockholders for the period by the basic weighted average number of common shares outstanding during the period. Diluted earnings (loss) per common share includes potentially issuable shares consisting primarily of non-vested restricted stock and contingent restricted performance units, using the treasury stock method. In periods when we report a net loss, all common stock equivalents are excluded from the calculation of diluted weighted average shares outstanding because they would have an anti-dilutive effect, meaning the loss per share would be reduced.

For the three months ended September 30, 2019 and 2018, approximately 275,000 and 497,000 shares, respectively, and for the nine months ended September 30, 2019 and 2018, approximately 275,000 and 280,000 shares, respectively, were considered anti-dilutive and were excluded from the computation of diluted earnings per share.

The following table sets forth the calculation of basic and diluted income (loss) per share:

Series B Convertible Preferred Stock - Related Party

In connection with the closing of the Seneca Acquisition, we raised $5.0 million through the issuance of 50,000 shares of Series B Convertible Preferred Stock, par value $0.01 per share (“Preferred Stock”) to Yorktown. The Preferred Stock converts into common stock at the election of the holder or will automatically convert into shares of our common stock upon completion of a qualifying equity financing event. The number of shares of common stock issuable upon conversion is dependent upon the price per share of common stock issued in connection with any such qualifying equity financing but has a floor conversion price equal to $8.00 per share. The conversion ratio at which the Preferred Stock will convert into common stock is equal to an amount per share of $100 plus all accrued but unpaid dividends payable in respect thereof divided by the greater of (i) $8.00 per share or (ii) the price that is 15.0% less than the lowest price per share of shares sold to the public in the next equity financing. Using the floor of $8.00 per share would yield 12.5 shares of common stock for every unit of Preferred Stock. The conversion price will be proportionately increased or decreased to reflect changes to the outstanding shares of common stock, such as the result of a combination, reclassification, subdivision, stock split, stock dividend or other similar transaction involving the common stock. Additionally, after the third anniversary of the issuance of the Preferred Stock, we have the option to redeem the shares for cash.

The Preferred Stock accrues cash dividends at a rate of 6.0% of the initial issue price of $100 per share per annum. The holders of the Preferred Stock are entitled to the same number of votes of common stock that such share of Preferred Stock would represent on an as converted basis. The holders of the Preferred Stock receive liquidation preference based on the initial issue price of $100 per share plus a preferred return over common stockholders and the holders of any junior ranking stock. The preferred return was approximately $449,000 as of September 30, 2019 and increased by $225,000 during the nine months ended September 30, 2019.

NOTE 12 – INCOME TAXES

We recognize 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. We have net operating loss carryforwards available in certain jurisdictions to reduce future taxable income. Future tax benefits from 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, 2019, the Company has established a full valuation allowance against the balance of net deferred tax assets.

Commodity Derivative

As of September 30, 2019, our commodity derivative financial instruments are comprised of natural gas and oil swaps and costless collars. The fair values of these agreements are determined under an income valuation technique. The valuation model requires a variety of inputs, including contractual terms, published forward prices, volatilities for options and discount rates, as appropriate. Our estimates of fair value of derivatives include consideration of the counterparty’s credit worthiness, our credit worthiness and the time value of money. The consideration of these factors results 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, our derivative instruments are included within the Level 2 fair value hierarchy.

Assets and Liabilities Measured and Recorded at Fair Value on a Non-Recurring Basis

The fair value of each of the following assets and 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 fair value of the non-controlling interests in the partnerships we are required to consolidate was determined based on the net discounted cash flows of the proved developed producing properties attributable to the non-controlling interests in these partnerships.

We assume, at times, certain firm transportation contracts as part of our acquisitions of oil and natural gas properties. The fair value of the firm transportation contract obligations was determined based upon the contractual obligations assumed by us and discounted based upon our effective borrowing rate.

The fair value measurements associated with the assets acquired and liabilities assumed in the business combination for the OIE Membership Acquisition of Carbon Appalachia are outlined within Note 3.

Debt Discount

The fair value of the debt discount from the 1,425 and 585 additional Class A Units issued in connection with the Subordinated Notes and 2018 Subordinated Notes was $1.3 million and $490,000, respectively. The debt discount was a Level 3 fair value assessment and was based on the relative fair value of Class A Units. Class A Units were issued contemporaneously at $1,000 per Class A Unit.

Asset Retirement Obligation

The fair value of our asset retirement obligation liability is recorded in the period in which it is incurred or assumed by taking into account the cost of abandoning oil and gas wells ranging from $20,000 to $45,000, which is based on our historical experience and industry expectations for similar work; the estimated timing of reclamation ranging from one to 75 years based on estimates from reserve engineers; an inflation rate between 1.52% to 2.79%; and a credit adjusted risk-free rate between 3.28% to 8.27%, which takes into account our credit risk and the time value of money. Given the unobservable nature of the inputs, the initial measurement of the asset retirement obligation liability is deemed to use Level 3 inputs. During the nine months ended September 30, 2019, we did not record any additions to asset retirement obligations. We use 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. 

Class B Units

We received Class B units from Carbon California and Carbon Appalachia as part of the entry into the Carbon California LLC Agreement and Carbon Appalachia LLC Agreement, respectively. We estimated the fair value of the Class B units, in each case, by utilizing the assistance of third-party valuation specialists. The fair values were based upon enterprise values derived from inputs including estimated future production rates, future commodity prices including price differentials as of the dates of closing, future operating and development costs and comparable market participants.

NOTE 14 – COMMODITY DERIVATIVES

We historically use commodity-based derivative contracts to manage exposures to commodity price on a portion of our oil and natural gas production. We do not hold or issue derivative financial instruments for speculative or trading purposes. We also have entered 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. These contracts are not recorded at fair value in the unaudited condensed consolidated financial statements.

We have entered into swap and costless collar derivative agreements to hedge a portion of our oil and natural gas production through 2022. As of September 30, 2019, these derivative agreements consisted of the following: