ZAZA ZaZa Energy Corporation (CE)

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended: March 31, 2014

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

Commission file number 001-35432

ZaZa Energy Corporation

(Exact name of registrant as specified in its charter)

ZaZa Energy Corporation
1301 McKinney St Suite 2800
Houston, Texas 77010

(Address of principal executive office)

Registrant’s telephone number, including area code: 713-595-1900

Indicate by check mark whether the Registrant (i) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (ii) has been subject to such filing requirements for the past 90 days.  Yes x   No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x   No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No x

As of April 30, 2014, there were 107,148,103 shares of common stock, par value $0.01 per share, outstanding.

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ZAZA ENERGY CORPORATION

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The accompanying notes are an integral part of these financial statements.

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The accompanying notes are an integral part of these financial statements.

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The accompanying notes are an integral part of these financial statements.

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ZAZA ENERGY CORPORATION

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·                   Exchange of Leases and Wells.  Our counterparty has acquired approximately 19,000 additional net acres and interests in related wells in the parties’ Area of Mutual Interest, and has assigned to ZaZa a 25% working interest in these leases and wells. In consideration for ZaZa’s participation in our counterparty’s leases and producing wells, ZaZa assigned to our counterparty approximately 13,875 additional net acres and paid approximately $700,000 in cash.

On March 7, 2014, ZaZa entered into a further amendment to JEDA pursuant to which we agreed to assign to the counterparty approximately 9,600 net acres, which represents a 75% working interest in our remaining Phase III acreage, in exchange for cash consideration of approximately $4.7 million and the carry by the counterparty of our share of future drilling and completion costs in an aggregate amount up to approximately $9.2 million.  Additionally, the counterparty committed to drill two additional test wells, with drilling on the first of such wells to commence by July 1, 2014.

Also pursuant to the amendment and effective March 7, 2014, we and our counterparty agreed to terminate that certain Participation Agreement, effective as of March 1, 2012, by and between the Company and Range Texas Production, LLC (“Range”) (such agreement, as amended, the “Range Agreement”).  Range’s rights and obligations under the Range Agreement were assigned to, and assumed by, the counterparty pursuant to that certain Quitclaim Assignment and Bill of Sale, effective as of December 1, 2013, by and between Range and the counterparty.  The Range Agreement provided for the joint development by Range and the Company of oil and gas leases in the Eaglebine trend.  The joint development of such leases will now be governed by the JEDA.

Sale of Moulton Properties

On April 5, 2013 the Company closed a purchase and sale agreement and sold certain of its properties in the Eagle Ford trend located in Fayette, Gonzalez and Lavaca Counties, Texas, which we refer to as our Moulton properties, for approximately $9.2 million. Net proceeds from the sale, after closing purchase price adjustments and expenses were approximately $8.8 million. We used approximately $4.6 million of the proceeds to pay down our Senior Secured Notes.

We also entered into an agreement on June 27, 2013 to sell approximately 10,000 net acres of our properties in the Eagle Ford trend located in Fayette, Gonzalez and Lavaca Counties, Texas, including seven producing wells located on the Moulton properties, for approximately $28.8 million.  We closed this transaction on July 26, 2013 and received cash proceeds of $29.3 million. We used $1.8 million to pay down our Senior Secured Notes reducing the principal balance to $26.8 million.

South Texas Joint Venture with Sabine

On September 17, 2013, ZaZa entered into an agreement with Sabine South Texas LLC (“Sabine”), a subsidiary of Sabine Oil & Gas LLC, for the joint development of a prospect in the Eagle Ford shale formation located in Lavaca and DeWitt Counties, Texas.  Under this agreement, Sabine agreed to jointly develop with us up to approximately 7,600 net acres that we owned and that comprised a portion of our interest in South Texas.  Sabine agreed to bear 100% of the drilling and completion costs of two commitment wells and up to $750,000 of construction costs related to gathering and infrastructure in order to earn a 75% working interest in 7,600 acres in the “Sweet Home Prospect,” which is in DeWitt and Lavaca Counties, and a well that we refer to as the “Boening well.”  Sabine also has agreed to carry up to $300,000 of ZaZa’s expenses related to the extension and renewal of certain leases in the Sweet Home Prospect.

Sabine completed the first commitment well on February 14, 2014 and ZaZa transferred to Sabine a 75% working interest in approximately 3,200 net acres and the Boening well.  Sabine completed the second commitment well on March 11, 2014, and ZaZa transferred to Sabine a 75% working interest in the remaining net acres.  Participating interests in any additional wells drilled or lease acreage acquired in the Sweet Home prospect will be shared 75% by Sabine and 25% by ZaZa under an area of mutual interest that will expire on September 15, 2015 (assuming affirmative elections to participate in such lease acreage acquisition(s)).

NOTE 2 — GOING CONCERN

In connection with the audit of our financial statements for the year ended December 31, 2013, our independent registered public accounting firm issued their report dated March 31, 2014, that included an explanatory paragraph describing the existence of conditions that raise substantial doubt about our ability to continue as a going concern due to our dependency on the success of our 2014 drilling program with our joint-venture partners to generate sufficient cash flows to maintain positive liquidity.

Our future crude oil and natural gas reserves and production, and therefore our cash flow and results of operations, are highly dependent on our success in efficiently developing and exploiting our current reserves and economically finding or acquiring additional recoverable reserves.  We intend to grow our reserves and production by further exploiting our existing property base through our joint-ventures in South and East Texas, with activity in any particular area to be a function of market and field economics.

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Without considering new production from our 2014 drilling program, we do not currently generate sufficient cash flows to maintain positive liquidity to fund debt service requirements throughout 2014.  We currently plan to initially limit our 2014 capital expenditures to our available cash on hand; however; we are carried for the costs to drill and complete approximately 10 gross (2.5 net) wells in South and East Texas. Approximately 2 gross (0.5 net) wells have been drilled and completed as of March 31, 2014. The remaining 8 gross (2.0 net) wells are expected to be drilled and completed by December 31, 2014.

The Company’s Board of Directors and management team have taken and continue to take proactive steps to streamline and strengthen the Company’s balance sheet.  Over the next year, we expect to access the capital markets by issuing equity and debt securities, among others, to fund our cash needs and to accomplish the balance sheet initiative described in the section “Management’s discussion and analysis of financial condition and results of operations - liquidity and capital resources”. Any decision regarding a financing transaction, and our ability to complete such a transaction, will depend on prevailing market conditions and other factors.

Over the next nine months, we intend to fund approximately $7.7 million in cash general and administrative expenses and $6.7 million in cash interest payments from cash currently on hand and net cash flows from operations. Our planned capital expenditures for the remainder of the year are limited to $2.0 million as we are carried for an additional 8 gross wells and approximately $9.2 million (including costs for 2 of the 8 additional gross carried wells) in additional miscellaneous expenses. Also, on February 6, 2014, we reduced the outstanding principal amount of our Senior Secured Notes by $11.8 million to $15.0 million with previously restricted cash from the Hess escrow and $1.1 million in cash on hand. We classified $13.5 million of our Senior Secured Notes as current as of March 31, 2014 consisting of principal of $15.0 million and discount of $1.5 million pursuant to the Securities and Purchase Agreement which gives the holders of the Senior Secured Notes the right to require us to purchase all or a portion of the Senior Secured Notes beginning February 21, 2015.

NOTE 3 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

The preparation of financial statements in conformity with United States generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers investments in all highly liquid instruments with original maturities of three months or less at date of purchase to be cash equivalents.

Restricted Cash

Restricted cash primarily consisted of funds held in escrow accounts relating to our Hess joint venture dissolution.

Revenue Recognition

The Company derives its oil and gas revenue primarily from the sale of produced oil and gas. The Company uses the sales method of accounting for the recognition of gas revenue whereby revenues, net of royalties are recognized as the production is sold to the purchaser. The amount of gas sold may differ from the amount to which the Company is entitled based on its working interest or net revenue interest in the properties. Revenue is recorded when title is transferred based on our nominations and net revenue interests. Pipeline imbalances occur when production delivered into the pipeline varies from the gas we nominated for sale. Pipeline imbalances are settled with cash approximately 30 days from date of production and are recorded as a reduction of revenue or increase of revenue depending upon whether we are over-delivered or under-delivered. Settlements of oil and gas sales occur after the month in which the product was produced. We estimate and accrue for the value of these sales using information available at the time financial statements are generated. Differences are reflected in the accounting period during which payments are received from the purchaser.

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Accounts Receivable

Accounts receivable include oil and gas revenues, joint interest billing, and related parties’ receivables. Management periodically assesses the Company’s accounts receivable and establishes an allowance for estimated uncollectible amounts. Accounts determined to be uncollectible are charged to operations when that determination is made. The Company usually does not require collateral.

Concentration of Credit Risk

The Company maintains its cash balances at several financial institutions, which are insured by the Federal Deposit Insurance Corporation. The Company’s cash balances typically are in excess of the insured limit. This concentration may impact the Company’s overall credit risk, either positively or negatively, in that this entity may be similarly affected by changes in economic or other conditions. The Company has incurred no losses related to these accounts.

Successful Efforts Method of Accounting for Oil and Gas Activities

The Company accounts for its natural gas and crude oil exploration and production activities under the successful efforts method of accounting. Oil and gas lease acquisition costs are capitalized when incurred. Lease rentals are expensed as incurred. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether they have discovered proved reserves. Exploratory drilling costs are capitalized when drilling is complete if it is determined that there is economic producibility supported by either actual production or a conclusive formation test. If proved reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved reserves have been found when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of natural gas and crude oil, are capitalized. Unproved properties with individually significant acquisition costs are analyzed on a property-by-property basis for any impairment in value. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties.

The Company’s third party engineers estimate proved oil and gas reserves, which directly impact financial accounting estimates, including depreciation, depletion, and amortization. Our proved reserves represent estimated quantities of oil and condensate, natural gas liquids and gas that geological and engineering data demonstrate, with reasonable certainty, to be recovered in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is very complex requiring significant subjective decisions in the evaluation of all available geological, engineering, and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving producing history, and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time.

Depreciation, depletion, and amortization of the cost of proved oil and gas properties are calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion, and amortization for leasehold acquisition costs is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration, and abandonment costs, net of salvage values are taken into account.

Unit-of-production rates are revised whenever there is an indication of a need, but at least annually. When circumstances indicate that an asset may be impaired, the Company compares expected undiscounted future cash flows at a producing field level to the amortized capitalized cost of the asset. If the future undiscounted cash flows, based on the Company’s estimate of future natural gas and crude oil prices, operating costs, anticipated production from proved reserves, and other relevant data, are lower than the amortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is calculated by discounting the future cash flows at an appropriate risk-adjusted discount rate.

Asset Retirement Obligations

We follow ASC 410-20 which applies to obligations associated with the retirement of tangible long-lived assets that result from the acquisition, construction and development of the assets. ASC 410-20 requires that we record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset.

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Furniture and Fixtures

Furniture and fixtures are stated at cost. Depreciation is calculated using the straight-line method over the assets’ estimated useful lives as follows:

Other Assets

Other assets consist of long term restricted deposits related to letters of credit with the Railroad Commission and other vendors, carrying values associated with our joint venture carried wells, and debt issuance costs.  At March 31, 2014 and December 31, 2013, debt issuance costs were $2.5 million and $2.5 million, and accumulated amortization was $0.5 million and $0.5 million, respectively. The costs are being amortized over the life of the associated debt.

Income Taxes

The Company follows the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recorded for the estimated future tax consequences attributable to the differences between the financial carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the tax rate in effect for the year in which those temporary differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the year of the enacted rate change.

The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Management periodically assesses, by tax jurisdiction, the probability of recovery of recorded deferred tax assets based on its assessment of future earnings estimates. The Company considers estimates of future production, commodity prices and expenditures, future taxable income in determining the need for a valuation allowance.  Such estimates are inherently imprecise since many assumptions utilized in the assessments are subject to revision in the future. A valuation allowance is established to reduce deferred tax assets if it is more likely than not that the related tax benefits will not be realized.  In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the tax jurisdictions in which the deferred tax assets are located.

The Company is required to make judgments, including estimating reserves for potential adverse outcomes regarding tax positions that the Company has taken. The Company accounts for uncertainty in income taxes using a recognition and measurement threshold for tax positions taken or expected to be taken in a tax return. Determining the income tax expense for potential assessments and recording the related effects requires management judgments and estimates. The amounts ultimately paid upon resolution of audits could be materially different from the amounts previously included in our income tax expense and, therefore, could have a material impact on our tax provision, net income and cash flows.

The Company recognizes accrued interest related to uncertain tax positions in Interest expense and other and accrued penalties related to such positions in General and administrative expense in the Consolidated Statement of Operations.

Foreign Currency Translation

The United States dollar is the functional currency for all of ZaZa’s consolidated subsidiaries except for certain of its French subsidiaries, for which the functional currency is the Euro. Our French subsidiaries hold an immaterial amount of cash and no other assets.  For subsidiaries whose functional currency is deemed to be other than the United States dollar, asset and liability accounts are translated using the period-end exchange rates and revenues and expenses are translated at average exchange rates prevailing during the period. Translation adjustments are included in Accumulated Other Comprehensive Income (“AOCI”) on the Consolidated Balance Sheets. Any gains or losses on transactions or monetary assets or liabilities in currencies other than the functional currency are included in net income (loss) in the current period.

Stock-based Compensation

Stock-based compensation cost is measured at the date of grant, based on the fair value of the award, and is recognized as expense, generally on a straight line basis over the vesting period of the award.  Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods to reflect actual forfeitures. Awards subject to vesting requirements for non-employees are fair valued each reporting period, final fair value being determined at the vesting date.

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Our policy is to issue new shares for the exercise of stock options, when restricted stock awards are granted, and at vesting of restricted stock units.  Stock grants are approved by the Compensation Committee. To date only restricted stock awards have been granted under the Long Term Incentive Plan (the “Plan”). Restricted stock awards granted under the Plan vest 33% per year. Stock awards granted as Short term Incentive awards can vest anywhere between immediately and one year.

Earnings (loss) Per Common Share

Basic earnings (loss) per share is calculated by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding for the period.

Diluted earnings (loss) per share reflect the potential dilutive effect of unvested share-based payments, warrants and debt instruments that can be converted into common stock. We use the treasury stock method to compute potential common shares from unvested share-based payments and warrants and the if-converted method to compute potential common shares from convertible notes. When a net loss occurs, potential common shares have an anti-dilutive effect on loss per share and are excluded from the diluted loss per share calculations.

Recent Accounting Standards

In March 2013, the FASB issued ASU 2013-05 to clarify the accounting for the release of cumulative translation adjustment into net income when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity.  We adopted the new standard for our fiscal years, and interim periods within those fiscal years, beginning on or after January 1, 2014. The adoption of this had no impact on our financial position, results of operations or cash flows.

In April 2014, the FASB issued ASU 2014-08 that raised the threshold for a disposal to qualify as a discontinued operation and requires new disclosures of both discontinued operations and certain other material disposal transactions that do not meet the revised definition of discontinued operations. Under the updated standard, a disposal of a component or group of components of an entity is required to be reported as discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results when the component or group of components of the entity (1) has been disposed of by a sale, (2) has been disposed of other than by sale or (3) is classified as held for sale. This accounting standards update is effective for annual periods beginning on or after December 15, 2014 and is applied prospectively. Early adoption is permitted but only for disposals (or classifications that are held for sale) that have not been reported in financial statements previously issued or available for use. We adopted the new standard for our fiscal years, and interim periods within those fiscal years, beginning on or after January 1, 2014. The adoption of this had no impact on our financial position, results of operations or cash flows.

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(a)          For the three months ended March 31, 2014 and 2013, the average ZaZa share price was lower than the exercise price of the warrants and therefore the anti-dilutive effect was not considered.

(b)          For the three months ended March 31, 2014 and 2013, the number of shares used in the calculation of diluted income per share did not include 16.0 million common equivalent shares from the embedded convertible options associated with the Convertible Senior Notes due to their anti-dilutive effect.

(c)           For the three months ended March 31, 2014, and 2013, the number of shares used in the calculation of diluted income per share did not include 1.9 million and 0.2 million shares respectively, unvested restricted common stock awards due to their anti-dilutive effect.

NOTE 5 —INCOME TAXES

We are subject to income taxes primarily in the United States. The provision for taxes on income consists primarily of income taxes based on the tax laws and rates of the countries in which operations were conducted during the periods presented. We did not pay any income taxes in the first quarter of 2014. We paid approximately $2.4 million in the second quarter of 2013 related to capital gains taxes from the wind up of our foreign subsidiaries that had been previously accrued.

We have approximately $24.3 million gross net operating losses. As a result of the lack of positive evidence at the consolidated level, we recorded a valuation allowance to offset a portion of the deferred tax assets.

We are subject to income taxes primarily in the United States. The current provision for taxes on income consists primarily of income taxes based on the tax laws and rates of the countries in which operations were conducted during the periods presented. All interest and penalties related to income tax is charged to general and administrative expense. We compute our provision for deferred income taxes using the liability method. Under the liability method, deferred income tax assets and liabilities are determined based on differences between financial reporting and income tax basis of assets and liabilities and are measured using the enacted tax rates and laws. The measurement of deferred tax assets is adjusted by a valuation allowance, if necessary, to reduce the future tax benefits to the amount, based on available evidence it is more likely than not deferred tax assets will be realized.

The following table reconciles income tax expense/(benefit) at the U.S. federal statutory rate to the expense/(benefit) for income taxes (in thousands):

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Income tax benefit for the three months ended March 31, 2014 and 2013 was $1.2 million and $4.7 million, respectively. The income tax benefit for the three months ended March 31, 2014 of $1.2 million is different from the statutory tax benefit (at a rate of 35%) of $0.9 million due to permanent differences related to the gain on the warrants. The income tax benefit for the three months ended March 31, 2013 of $4.7 million is different from the statutory tax benefit (at a rate of 35%) of $2.4 million due to a reduction in the valuation allowance.

As of March 31, 2014, the difference between the gross unrecognized tax benefits of $16.4 million and $13.2 million recorded on the balance sheet in long-term accrued liabilities (of which $13.1 million is related to unrecognized tax benefits) is due to $3.3 million available NOL that is netted against the uncertain tax position. As of December 31, 2013, the difference between the gross unrecognized tax benefits of $16.4 million and $14.7 million recorded on the balance sheet in long-term accrued liabilities (of which $14.3 million is related to unrecognized tax benefits) is due to $2.1 million available NOL that is netted against the uncertain tax position. The uncertain tax position is available to support recognition of a $3.3 million deferred tax asset as of March 31, 2014, an increase of $1.2 million, equal to the tax benefit for the quarter, from December 31, 2013.

The total amounts of interest and penalties recognized in the statement of operations and the total amounts of interest and penalties recognized in the statement of financial position are not material for the three month periods ended March 31, 2014 and 2013. Amounts of income tax expense or benefit related to components of other comprehensive income, including reclassifications within other comprehensive income, are not material for the three month periods ended March 31, 2014 and 2013.

NOTE 6 — FAIR VALUE MEASUREMENTS

Authoritative literature establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three levels. The fair value hierarchy gives the highest priority to quoted market prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). Level 2 inputs are inputs, other than quoted prices included within Level 1, which are observable for the asset or liability, either directly or indirectly.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The guidance requires disclosure that establishes a framework for measuring fair value expands disclosure about fair value measurements and requires that fair value measurements be classified and disclosed in one of the following categories:

Level 1:         Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. We consider active markets as those in which transactions for the assets or liabilities occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2:         Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability. This category includes those derivative instruments that we value using observable market data. Substantially all of these inputs are observable in the marketplace throughout the full term of the derivative instrument, can be derived from observable data or supported by observable levels at which transactions are executed in the market place.

Level 3:           Measured based on prices or valuation models that require inputs that are both significant to the fair value measurement and less observable from objective sources (i.e., supported by little or no market activity). Our valuation models for derivative contracts are primarily industry-standard models that consider various inputs including: (a) quoted forward prices for commodities, (b) time value, (c) volatility factors, (d) counterparty credit risk and (e) current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Level 3 instruments primarily include warrants, embedded conversion options and debt. Although we utilize third-party broker quotes to assess the reasonableness of our prices and valuation techniques, we do not have sufficient corroborating market evidence to support classifying these assets and liabilities as Level 2.

The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value at March 31, 2014 and December 31, 2013, due to the short-term nature or maturity of the instruments.

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The Senior Secured Notes and Subordinated Notes were valued under the income approach using discounted cash flows.  The Convertible Senior Notes and embedded conversion option were valued using a Binomial Lattice Model designed to capture incremental value attributed to the conversion option in addition to the value of the note. The warrants associated with the Senior Notes were valued as written call options using a Binomial Lattice Model.

Cash flows were discounted utilizing the US Treasury rate and our credit spread to estimate the appropriate risk adjusted rate.  A Binomial Lattice Model was used to estimate our credit spread by solving for a premium to the US Treasury rate that produces a value of the Convertible Senior Note as of the issuance date that equates to proceeds received. The current stock price, US Treasury rate and stock price volatility are based on observable market data and are considered Level 2 inputs.  Our credit spread is unobservable and considered a Level 3 input.  The fair value measurements are considered Level 3 measurements within the fair value hierarchy.

The following tables summarize the valuation of our liabilities measured on a recurring basis at levels of fair value at March 31, 2014 and December 31, 2013 (in thousands):

The following is a reconciliation of changes in fair value of our liabilities classified as Level 3 during the three months ended March 31, 2014 and 2013 (in thousands):

On March 31, 2014, the Senior Secured Notes, which had a book value of $13.5 million (net of unamortized discount of $1.5 million), had a fair value of approximately $14.3 million.  An increase in the credit spread by 500 basis points results in a $0.5 million decrease in the fair value of the note.

On March 31, 2014, the Convertible Senior Notes, which had a book value of $28.7 million (net of unamortized discount of $11.3 million), had a fair value of approximately $32.4 million.  An increase in the credit spread by 500 basis points results in a $3.1 million decrease in the fair value of the note.

On March 31, 2014, Subordinated Notes, which had a book value of $47.3 million, had a fair value of approximately $31.1 million.  An increase in the credit spread by 500 basis points results in a $3.3 million decrease in the fair value of the note.

As of March 31, 2014, an increase in the volatility by 5% results in a $0.9 million and $0.3 million increase in the fair values of the warrants and embedded conversion option, respectively.

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NOTE 7 — IMPAIRMENT OF ASSETS

The Company reviews non-producing leasehold costs and proved oil and gas properties on a field-by-field basis for impairment when events or circumstances indicate a possible decline in the recoverability of the carrying value of such property. We compare the carrying value of the property to its estimated undiscounted future cash flows. If the carrying value of the property exceeds its estimated undiscounted future cash flows, the carrying value is reduced to its estimated fair value and any impairment is charged to expense in the period incurred. Fair value is estimated using comparable market data, a discounted future cash flow method, or a combination of the two. Significant Level 3 assumptions are used in the fair value determination and include management’s expectations of future production, commodity prices, operating and development costs, risk-adjusted discount rate and other relevant data.

In the first quarter of 2014, non-producing leasehold costs in South Texas with carrying values of $2.4 million were written down to their fair values of $0.8 million, resulting in pretax impairment charges of $1.6 million. The decline in fair value of these non-producing leases is driven by shorter remaining lease terms.  There were no impairments in the first quarter of 2013.

NOTE 9 — LONG-TERM DEBT

As described in more detail in our 2013 annual report on Form 10-K, our long-term debt includes 8.00% Senior Secured Notes due 2017 (10% as of March 1, 2014) (“Senior Secured Notes”), 9.00% Convertible Senior Notes due 2017 (“Convertible Notes”), and 8.00% Subordinated Notes due 2017 (“Subordinated Notes”). The fair market values of debt, warrants associated with the Senior Secured Notes and embedded conversion option associated with Convertible Notes are disclosed in “Note 6 — Fair Value Measurement”.

Our long-term debt consisted of the following (in thousands):

(1)                       The Senior Secured Notes original issuance discount is amortized to the principal amount through the date of the first put right on February 21, 2015 using the effective interest rate method and rate of 21.2%.

(2)                       The Convertible Notes original issuance discount is amortized to the principal amount through maturity on August 1, 2017 using the effective interest rate method and rate of 17.5%.

(3)                       We classified $13.5 million of our Senior Secured Notes as current as of March 31, 2014 consisting of principal of $15.0 million and discount of $1.5 million pursuant to the Securities Purchase Agreement described below, which gives the holders of the Senior Secured Notes the right to require us to purchase all or a portion of the Senior Secured Notes beginning February 21, 2015. We classified $10.2 million of our Senior Secured Notes as current as of December 31, 2013 consisting of principal of $11.8 million and discount of $1.6 million pursuant to Amendment No. 5 to the Securities and Purchase Agreement, which required the principal balance to be reduced to $15 million by February 28, 2014.

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8.00% Senior Secured Notes due 2017 (10% as of March 1, 2014) and Warrants

The Senior Secured Notes were issued under the Securities Purchase Agreement, dated February 21, 2012 (as amended, the “Securities Purchase Agreement”), and will mature on February 21, 2017.  On February 6, 2014, we received $11.5 million from an escrow account as a result of a settlement of disputes with the Hess Corporation and these proceeds, combined with approximately $1.1 million of cash on hand, were used to reduce the outstanding aggregate principal amount of our Senior Secured Notes from $26.8 million to $15.0 million.  Subject to certain adjustments set forth in the Securities Purchase Agreement, interest on the Senior Notes accrues at 10% per annum as of March 1, 2014, payable quarterly in cash. Amendment No. 5 to the Securities Purchase Agreement, dated March 28, 2013 (“Amendment No. 5”), stated that the interest rate would increase from 8% per annum to 10% per annum effective March 1, 2014 if the Senior Notes were not prepaid to zero by February 28, 2014. The balance outstanding on the Senior Notes was $15 million as of February 28, 2014 and therefore the interest rate increased to 10% per annum.

Beginning on February 21, 2015, the holders of the Senior Secured Notes may require us to purchase all or a portion of the Senior Secured Notes at a price equal to the principal amount of the Senior Secured Notes to be purchased, plus any accrued and unpaid interest on such notes. Accordingly, we reclassified the outstanding amount of Senior Secured Notes as current as of February 21, 2014.

Pursuant to the Securities Purchase Agreement, the purchasers of our Senior Secured Notes were also issued warrants (the “Warrants”) to purchase 26,315,789 shares of our common stock at an exercise price of $3.15 per share.  Due to various transactions in prior periods having triggered anti-dilution adjustments in the Warrants, as of March 31, 2014, the number of outstanding shares of Common Stock represented by the Warrants had increased to 27,433,244 and the exercise price had been reduced to $1.98 per share.

At March 31, 2014 and December 31, 2013, the unamortized issuance discount related to Senior Secured Notes was $1.5 million and $3.6 million, respectively.  The outstanding principal of the Senior Secured Notes was $15.0 million and $26.8 million at March 31, 2014 and December 31, 2013, respectively.

Amendment No.5 was considered an extinguishment of debt. Accordingly, in the first quarter of 2013, for accounting purposes we extinguished the Senior Secured Notes and associated discounts and debt issuance costs of $33.2 million, $9.1 million and $1.2 million, respectively.  We recognized a loss on extinguishment of debt of $15.1 million consisting of a loss from the modification of the terms of the warrants of $10.9 million and a difference between the fair value and book value of debt of $4.2 million.  We recorded the modified debt at its fair market value of $27.1 million, consisting of a principal amount of $33.2 million and discount of $6.1 million.

In anticipation our independent registered public accounting firm including in their report an explanatory paragraph describing the existence of conditions that raise substantial doubt about our ability to continue as a going concern as described in Note 2 — Going concern, on March 14, 2014, the Company entered into Amendment No. 6 to the Securities Purchase Agreement, which amended the Securities Purchase Agreement to obtain relief from the “going concern” requirements for the Company’s fiscal year 2013 financial statements consistent with the relief obtained for the 2012 financial statements.

9.00% Convertible Senior Notes due 2017

The Company has $40,000,000 aggregate principal amount of 9% Convertible Senior Notes due 2017 (the “Convertible Notes”).  The Convertible Notes are the senior, unsecured obligations of the Company, bear interest at a fixed rate of 9.0% per year, payable semiannually in arrears and mature August 1, 2017 unless earlier converted, redeemed or repurchased.  The Convertible Notes are convertible, at the option of the holder, at any time prior to the third trading day immediately preceding the maturity date, into shares of the Company’s common stock, par value $0.01 per share (the “Conversion Shares”), and cash in lieu of fractional shares of common stock.  The initial conversion rate will be 400 shares per $1,000 Convertible Note, reflecting a conversion premium of approximately 32.28% of the closing price of the Company’s common stock on the pricing date of the offering, which equates to an initial conversion price of $2.50 per share.

At March 31, 2014 and December 31, 2013, the unamortized issuance discount related to Convertible Notes was $11.3 million and $12.0 million, respectively.  The outstanding principal on the Convertible Notes was $40.0 million at both March 31, 2014 and December 31, 2013.

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8.00% Subordinated Notes due 2017

In February 2012, we issued Subordinated Notes in an aggregate amount of $47.33 million to Todd A. Brooks (President and Chief Executive Officer of the Company) and Blackstone Oil & Gas, LLC (an entity controlled by Mr. Brooks) (together, the “Brooks Note Holders”), (b) John E. Hearn, Jr. (a Director of the Company) and Lara Energy, Inc. (an entity controlled by Mr. Hearn) (together, the “Hearn Note Holders”) and (c) Gaston L. Kearby (a Director of the Company) and Omega Energy Corp. (an entity controlled by Mr. Kearby) (together, the “Kearby Note Holders,” and collectively with the Brooks Note Holders and the Hearn Note Holders, the “Subordinated Note Holders”). The Subordinated Notes accrue interest at a rate of 8% per annum payable monthly in cash, and mature on August 17, 2017.

On February 24, 2014, ZaZa entered into agreements (the “Subordinated Notes Exchange Agreements”) with the Subordinated Note Holders to exchange all $47.3 million in outstanding Subordinated Notes for a combination of shares of our common stock and a new series of perpetual preferred stock.  Under the terms of the Subordinated Notes Exchange Agreements, in exchange for the $15.8 million in Subordinated Notes held collectively by each individual and the entity that he controls, the Company will issue (i) approximately 3.16 million shares of ZaZa common stock (the “Exchange Common Shares”) valued at $0.9495 per share based on the volume weighted average price per share for the ten trading days prior to February 24, 2014 and (ii) a new series of perpetual preferred stock with a liquidation preference of $12.8 million.  The new series of perpetual preferred stock will be issued in the form of Series A Cumulative Redeemable Preferred Stock with a cash dividend rate of 13% per annum based on a liquidation preference of $25 per share.  The exchange of the Subordinated Notes is conditional on extinguishing our Senior Secured Notes as the Senior Secured Notes prevent us from executing the exchange.

Interest expense

For the three months ended March 31, 2014 and 2013, interest expense consisted of the following (in thousands):

NOTE 10 — STOCK-BASED COMPENSATION

Long Term Incentive Plan (the “Plan”)

We currently have 9.1 million shares authorized for issuance under the Plan adopted in March 2012.  At March 31, 2014, approximately 3.8 million shares were available for future grants under the Plan.

Stock-based compensation costs for the three months ended March 31, 2014 and 2013 were $0.5 million and $0.1 million, respectively.

The following table presents the changes in restricted stock awards pursuant to the Plan (in thousands except per share data):

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At March 31, 2014 and 2013, we had $2.1 million and $0.4 million, respectively, of total unrecognized compensation costs related to unvested awards which are expected to be recognized over a weighted average period of 1.57 years and 1.11 years, respectively.

NOTE 11 — SEVERANCE COSTS

In April 2013, ZaZa announced a significant reduction in workforce and terminated approximately 37 employees and contractors, and closed offices in Corpus Christi and Dallas. In the second quarter of 2013, we recognized $3.9 million in severance expense and $0.7 million in onerous contracts for a total expense of $4.6 million included in general and administrative expenses. As of March 31, 2014, we have a remaining liability of $1.2 million of which $1.0 million is recorded in current accrued liabilities and $0.2 million is recorded in non-current accrued liabilities.

NOTE 12 — COMMITMENTS AND CONTINGENCIES

FLMK/Emerald Leasing Claims

On August 9, 2012, ZaZa LLC filed a lawsuit in Harris County District Court against certain lease brokers, consultants and law firms who were involved in the leasing of acreage for the company in DeWitt and Lavaca Counties.  ZaZa paid certain of these brokers for approximately 3,924 acres of leases which the brokers have not delivered to the company. Additionally, there are net lease acreage shortages for which ZaZa has made a claim. The relief sought by ZaZa includes economic damages, exemplary damages, and reasonable attorney’s fees.  Certain of the defendants have settled, and ZaZa continues to pursue its claims against the remaining defendants, which include Emerald Leasing LLC, FLMK Acquisition, LLC, John T. Lewis, Billy Marcum, Brad Massey, Max Smith, Heroux & Helton PLLC, W&L Holdings, LLC, Rock Leasing, LLC, Nwk Resources, LLC, and Hlk Acquisitions, LLC.

Sankalp Americas, Inc. Casing Collar Failure

On March 13, 2013, ZaZa LLC filed a lawsuit in Harris County District Court against Sankalp Americas, Inc. (“Sankalp”). The dispute arose due to the catastrophic loss of a 17,000 plus foot horizontal well, the Stingray A-1H, drilled by ZaZa LLC in Walker County, Texas.  While ZaZa LLC worked to complete the sixteenth stage of its hydraulic fracturing operations, a casing collar manufactured by Sankalp failed, separating completely, and causing a downhole restriction.  This restriction, which could not be remediated, ultimately resulted in the loss of the entire horizontal portion of the well.  ZaZa LLC seeks to recover its economic damages and court costs from Sankalp for its substantial losses caused by such failure.  The case is set for trial in the fourth quarter of 2014.

Other

From time to time, we are named as a defendant in other legal proceedings arising in the normal course of business. In our opinion, the final judgment or settlement, if any, which may be awarded with any such suit or claim would not have a material adverse effect on our financial position, results of operations or cash flows.

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Our strategy is to enhance shareholder value through consistent growth in cash flows by focusing on the organic development of our existing assets within our core areas.  We also look for opportunities to diversify and build upon our current portfolio through the acquisition of additional unconventional assets with a focus on Texas.

ZaZa owns producing and non-producing oil and gas acreage in proven or prospective basins that are located in South Texas and East Texas.  Almost all of our assets, including long-lived assets, are located within the United States.  Except for an immaterial amount of cash held by our two foreign subsidiaries, which we are in the process of dissolving, we have no assets or operations outside of the United States.  In this Quarterly Report, our use of “East Texas” refers to Madison, Grimes, Walker, Trinity and Montgomery counties and the surrounding region; and our use of “South Texas” refers to DeWitt and Lavaca counties and the surrounding region.

Additionally, we have converted our natural gas reserves or production into barrel of oil equivalents in this Quarterly Report. For this purpose, six thousand cubic feet of natural gas is equal to one barrel of oil, which is based on the relative energy content of natural gas and oil. Natural gas liquids are aggregated with oil in this Quarterly Report.

Recent Developments

East Texas Joint Venture with EOG

On March 7, 2014, we entered into the Fourth Amendment (the “Fourth Amendment”) to our Joint Exploration and Development Agreement (as amended, the “JEDA”) with EOG Resources, Inc. (“our counterparty”) with respect to the joint development of certain of our East Texas properties.  Under the Fourth Amendment, we agreed to assign to our counterparty approximately 9,600 net acres in East Texas representing a 75% working interest in the acreage remaining in the third and final phase of the joint development program under the JEDA.  As consideration for this transfer, we received approximately $4.7 million in cash and the carry by our counterparty of our share of future drilling and completion costs in an aggregate amount up to approximately $9.2 million.  Additionally, our counterparty committed to drill two additional test wells, with drilling on the first of such wells to commence by July 1, 2014.

Also pursuant to the Fourth Amendment and effective March 7, 2014, we and our counterparty agreed to terminate that certain Participation Agreement, effective as of March 1, 2012, by and between the Company and Range Texas Production, LLC (“Range”) (such agreement, as amended, the “Range Agreement”).  Range’s rights and obligations under the Range Agreement were assigned to, and assumed by, our counterparty pursuant to that certain Quitclaim Assignment and Bill of Sale, effective as of December 1, 2013, by and between Range and our counterparty.  The Range Agreement provided for the joint development by Range and the Company of oil and gas leases in the Eaglebine trend in East Texas.  The joint development of such leases will now be governed by the JEDA.

South Texas Joint Venture with Sabine

In South Texas, our joint venture partner — Sabine South Texas LLC (“Sabine”), a subsidiary of Sabine Oil & Gas LLC — completed two fully carried commitment wells as of March 31, 2014.  In exchange for Sabine fulfilling its obligations with respect to our South Texas joint venture, ZaZa transferred a 75% working interest in approximately 5,724 net acres and a well known as the Boening well.  Participating interests in any additional wells drilled or lease acreage acquired under an area of mutual interest will be shared 75% by Sabine and 25% by ZaZa (assuming affirmative elections to participate in such lease acreage acquisition(s)).  The area of mutual interest expires on September 15, 2015.

Balance Sheet Initiative

Beginning with the filing on November 12, 2013 of a universal shelf registration statement on Form S-3, which became effective on February 14, 2014, we initiated several efforts to improve the balance sheet and capital structure of the Company.  On February 24, 2014, ZaZa entered into agreements (the “Subordinated Notes Exchange Agreements”) with Todd A. Brooks (President and Chief Executive Officer of the Company) and Blackstone Oil & Gas, LLC (an entity controlled by Mr. Brooks) (together, the “Brooks Note Holders”), (b) John E. Hearn, Jr. (a Director of the Company) and Lara Energy, Inc. (an entity controlled by Mr. Hearn) (together, the “Hearn Note Holders”) and (c) Gaston L. Kearby (a Director of the Company) and Omega Energy Corp. (an entity controlled by Mr. Kearby) (together, the “Kearby Note Holders,” and collectively with the Brooks Note Holders and the Hearn Note Holders, the “Subordinated Note Holders”).  Under the Subordinated Notes Exchange Agreements, we agreed to exchange all $47.3

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million in outstanding Subordinated Notes for a combination of shares of our common stock and a new series of perpetual preferred stock.  Under the terms of the Subordinated Notes Exchange Agreements, in exchange for the $15.8 million in Subordinated Notes held collectively by each individual and the entity that he controls, the Company will issue (i) approximately 3.16 million shares of ZaZa common stock (the “Exchange Common Shares”) valued at $0.9495 per share based on the volume weighted average price per share for the ten trading days prior to February 24, 2014 and (ii) a new series of perpetual preferred stock with a liquidation preference of $12.8 million.  The new series of perpetual preferred stock will be issued in the form of Series A Cumulative Redeemable Preferred Stock with a cash dividend rate of 13% per annum based on a liquidation preference of $25 per share.  The exchange of the Subordinated Notes is conditional on extinguishing our Senior Secured Notes due 2017 (the “Senior Secured Notes”) as the Senior Secured Notes prevent us from executing the exchange.

Early Release of Hess Escrow

On February 6, 2014, we agreed with the Hess Corporation (“Hess”) to an early release of $15.0 million that was being held in escrow pursuant to certain agreements relating to the dissolution of earlier joint ventures between ZaZa and Hess.  This release was part of a broader transaction that also included:  (i) termination of the Company’s overriding royalty interests in certain assets in the Paris Basin in France; (ii) Hess’s release of an interest in the Company’s litigation against certain third parties; and (iii) the payment of $3.5 million of the escrowed funds to Hess.  The remaining $11.5 million was released to ZaZa, and these proceeds, combined with approximately $1.1 million of cash on hand, were used to reduce outstanding aggregate principal amount of our Senior Secured Notes from $26.8 million to $15.0 million.

At March 31, 2014, we had:

·                   Cash and cash equivalents of $10.7 million.

·                   Current ratio (current assets/current liabilities) of 0.62 to 1.

RESULTS OF OPERATIONS

The following is a discussion of our consolidated results of operations, financial condition and capital resources. This discussion should be read in conjunction with our consolidated financial statements and the notes thereto included in this Quarterly Report on Form 10-Q.

The following table presents our production, average prices obtained for our production and average production cost for the three months ended March 31, 2014 and 2013: