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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 June 30, 2004
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
------------- -------------
Commission file number: 001-13781
KCS ENERGY, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 22-2889587
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
5555 SAN FELIPE, SUITE 1200, HOUSTON, TEXAS 77056
(Address of principal executive offices) (Zip Code)
(713) 877-8006
(Registrant's telephone number, including area code)
NOT APPLICABLE
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). [X] Yes [ ] No
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.[ ] Yes [ ] No
Not applicable. Although the registrant was involved in bankruptcy
proceedings during the preceding five years, the registrant did not distribute
securities under its plan of reorganization.
Number of shares of common stock, par value $0.01 per share, outstanding
as of July 30, 2004: 48,933,154.
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
KCS ENERGY, INC. AND SUBSIDIARIES
CONDENSED STATEMENTS OF CONSOLIDATED INCOME
Three Months Ended Six Months Ended
(Amounts in thousands, except June 30, June 30,
-------------------- ---------------------
per share data) Unaudited 2004 2003 2004 2003
-------- -------- --------- --------
Oil and gas revenue $ 50,982 $ 38,422 $ 101,296 $ 78,069
Other, net (341) 4,310 (211) 5,103
-------- -------- --------- --------
Total revenue and other 50,641 42,732 101,085 83,172
-------- -------- --------- --------
Operating costs and expenses
Lease operating expenses 7,194 6,139 14,628 11,733
Production and other taxes 3,316 2,022 6,211 5,052
General and administrative expenses 2,189 1,862 4,472 3,662
Stock compensation 1,225 257 1,567 411
Accretion of asset retirement obligation 258 279 515 558
Depreciation, depletion and amortization 13,219 11,441 26,008 22,083
-------- -------- --------- --------
Total operating costs and expenses 27,401 22,000 53,401 43,499
-------- -------- --------- --------
Operating income 23,240 20,732 47,684 39,673
-------- -------- --------- --------
Interest and other income, net 224 75 228 102
Redemption premium on early extinguishment of debt (3,698) - (3,698) -
Interest expense (4,376) (4,588) (7,397) (9,202)
-------- -------- --------- --------
Income before income taxes and cumulative effect of accounting change 15,390 16,219 36,817 30,573
Federal and state income (taxes) benefit (893) 11,082 (2,875) 11,564
-------- -------- --------- --------
Net income before cumulative effect of accounting change 14,497 27,301 33,942 42,137
Cumulative effect of accounting change, net of tax - - - (934)
-------- -------- --------- --------
Net income 14,497 27,301 33,942 41,203
Dividends and accretion of issuance costs on preferred stock - (132) - (442)
-------- -------- --------- --------
Income available to common stockholders $ 14,497 $ 27,169 $ 33,942 $ 40,761
======== ======== ========= ========
Earnings per share of common stock - basic
Before cumulative effect of accounting change $ 0.30 $ 0.71 $ 0.70 $ 1.10
Cumulative effect of accounting change - - - (0.02)
-------- -------- --------- --------
Earnings per share of common stock - basic $ 0.30 $ 0.71 $ 0.70 $ 1.08
======== ======== ========= ========
Earnings per share of common stock - diluted
Before cumulative effect of accounting change $ 0.29 $ 0.66 $ 0.69 $ 1.02
Cumulative effect of accounting change - - - (0.02)
-------- -------- --------- --------
Earnings per share of common stock - diluted $ 0.29 $ 0.66 $ 0.69 $ 1.00
======== ======== ========= ========
Average shares outstanding for computation of earnings per share
Basic 48,912 38,227 48,779 37,833
Diluted 49,704 41,531 49,537 41,295
======== ======== ========= ========
The accompanying notes to the unaudited condensed consolidated financial
statements are an integral part of these financial statements.
1
KCS ENERGY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, June 30, December 31,
except share and per share data) Unaudited 2004 2003
- ------------------------------------------------------------- --------- ------------
Assets
Current assets
Cash and cash equivalents $ 9,753 $ 2,178
Trade accounts receivable, less allowance
for doubtful accounts-2004 $4,907; 2003 $4,896 29,873 23,911
Prepaid drilling 1,412 1,014
Other current assets 1,960 3,706
--------- ---------
Current assets 42,998 30,809
--------- ---------
Oil and gas properties, full cost method, less accumulated
DD&A-2004 $959,109; 2003 $933,572 332,679 283,791
Other property , plant and equipment at cost less accumulated
depreciation-2004 $12,069; 2003 $11,598 7,987 8,214
--------- ---------
Property, plant and equipment, net 340,666 292,005
--------- ---------
Deferred charges and other assets
Deferred taxes 17,935 18,818
Other 8,853 1,334
--------- ---------
Deferred charges and other assets 26,788 20,152
--------- ---------
Total Assets $ 410,452 $ 342,966
========= =========
Liabilities and stockholders' equity
Current liabilities
Accounts payable $ 30,657 $ 27,834
Accrued interest 3,119 5,100
Accrued drilling cost 13,650 9,596
Other accrued liabilities 9,087 9,071
Derivative liabilities 4,898 -
--------- ---------
Current liabilities 61,411 51,601
--------- ---------
Deferred credits and other non-current liabilities
Deferred revenue 27,370 38,696
Asset retirement obligations 12,221 11,918
Other 995 720
--------- ---------
Deferred credits and other non-current liabilities 40,586 51,334
--------- ---------
Long-term debt
Credit facility - 17,000
Senior notes 175,000 -
Senior subordinated notes - 125,000
--------- ---------
Long-term debt 175,000 142,000
--------- ---------
Stockholders' equity
Common stock, par value $0.01 per share,
authorized 75,000,000 shares, issued 51,099,167
and 50,532,373, respectively 511 505
Additional paid-in capital 240,504 236,204
Accumulated deficit (94,690) (128,632)
Unearned compensation (1,706) (725)
Accumulated other comprehensive income (6,423) (4,580)
Less treasury stock, 2,167,096 shares, at cost (4,741) (4,741)
--------- ---------
Total stockholders' equity 133,455 98,031
--------- ---------
Total liabilities and stockholders' equity $ 410,452 $ 342,966
========= =========
The accompanying notes to the unaudited condensed consolidated financial
statements are an integral part of these financial statements.
2
KCS ENERGY, INC. AND SUBSIDIARIES
CONDENSED STATEMENTS OF CONSOLIDATED INCOME
Six Months Ended
June 30,
------------------
(Amounts in thousands) Unaudited 2004 2003
- -------------------------------- ---- ----
Cash flows from operating activities:
Net income $ 33,942 $ 41,203
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation, depletion and amortization 26,008 22,083
Amortization of deferred revenue (11,326) (15,197)
Non-cash losses on derivative instruments 2,270 2,756
Redemption premium on early extinguishment of debt 3,698 -
Deferred income tax expense (benefit) 1,876 (11,965)
Cumulative effect of accounting change, net of tax - 934
Asset retirement obligation accretion 515 558
Other non-cash charges and credits, net 2,158 917
Changes in operating assets and liabilities:
Trade accounts receivable (6,104) (7,328)
Accounts payable and accrued liabilities 2,839 11,793
Accrued interest (1,981) (1,886)
Other, net (651) (261)
--------- --------
Net cash provided by operating activities 53,244 43,607
--------- --------
Cash flows from investing activities:
Investments in oil and gas properties (70,760) (36,845)
Proceeds from sales of oil and gas properties 135 (130)
Other capital expenditures (244) (292)
--------- --------
Net cash used in investing activities (70,869) (37,267)
--------- --------
Cash flows from financing activities:
Proceeds from borrowings 175,000 69,295
Repayments of debt (142,000) (77,069)
Proceeds from issuance of common stock 1,395 10
Redemption premium on early extinguishment of debt (3,698) -
Deferred financing costs (5,497) (3,210)
--------- --------
Net cash provided by (used in) financing activities 25,200 (10,974)
--------- --------
Increase (decrease) in cash and cash equivalents 7,575 (4,634)
Cash and cash equivalents at beginning of period 2,178 6,935
--------- --------
Cash and cash equivalents at end of period $ 9,753 $ 2,301
========= ========
The accompanying notes to the unaudited condensed consolidated financial
statements are an integral part of these financial statements.
3
KCS ENERGY, INC. AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED STOCKHOLDERS' EQUITY (UNAUDITED)
(Dollars in thousands)
Accumulated
Additional Other
Common Paid- in Accumulated Unearned Comprehensive
Stock Capital Deficit Compensation Income
------- ---------- ----------- ------------ -------------
Balance at December 31, 2003 $ 505 $ 236,204 $ (128,632) $ (725) $(4,580)
Comprehensive income
Net income - - 33,942 - -
Commodity hedges, net of tax - - - - (1,843)
Comprehensive income
Stock issuances - exercise of warrants 2 798 - - -
Stock issuances - costs incurred - (221) - - -
Stock issuances - benefit plans and
awards of restricted stock 4 2,642 - (1,467) -
Stock compensation expense - 1,081 - 486 -
------- --------- ---------- ------- -------
Balance at June 30, 2004 $ 511 $ 240,504 $ (94,690) $(1,706) $(6,423)
======= ========= ========== ======= =======
Treasury Comprehensive Stockholder
Stock Income Equity
-------- ------------- -----------
Balance at December 31, 2003 $ (4,741) $ 98,031
Comprehensive income
Net income - $ 33,942 33,942
Commodity hedges, net of tax - (1,843) (1,843)
--------
Comprehensive income $ 32,099
========
Stock issuances - exercise of warrants - 800
Stock issuances - costs incurred - (221)
Stock issuances - benefit plans and
awards of restricted stock - 1,179
Stock compensation expense - 1,567
-------- --------
Balance at June 30, 2004 $ (4,741) $133,455
======== ========
The accompanying notes to the unaudited condensed consolidated financial
statements are an integral part of these financial statements.
4
KCS ENERGY, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. Basis of Presentation
The condensed consolidated interim financial statements included herein
have been prepared by KCS Energy, Inc. ("KCS" or the "Company"), without audit,
pursuant to the rules and regulations of the Securities and Exchange Commission
("SEC") for quarterly reports on Form 10-Q and reflect all adjustments which are
of a normal recurring nature and which are, in the opinion of management,
necessary for a fair presentation of the interim results. Certain information
and footnote disclosures have been condensed or omitted pursuant to such rules
and regulations. Although the Company believes that the disclosures are adequate
to make the information presented herein not misleading, it is suggested that
these condensed consolidated financial statements be read in conjunction with
the financial statements and the notes thereto included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2003. Certain previously
reported amounts have been reclassified to conform with current period
presentations. The results of operations for the three and six months ended June
30, 2004 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2004.
2. Stock Compensation
The cost of awards of restricted stock, determined as the market value of
the shares as of the date of grant, is expensed ratably over the restricted
period. Stock options issued under the Company's 2001 stock plan within six
months of the cancellation of options in connection with the Company's plan of
reorganization are subject to variable accounting in accordance with Financial
Accounting Standards Board ("FASB") Interpretation No. 44, "Accounting for
Certain Transactions Involving Stock Compensation." Under variable accounting
for stock options, the amount of expense recognized during a reporting period is
directly related to the movement in the market price of the Company's common
stock during that period. For the three months ended June 30, 2004, stock
compensation was $1.2 million compared to $0.3 million for the three months
ended June 30, 2003. For the six months ended June 30, 2004, stock compensation
was $1.6 million compared to $0.4 million for the six months ended June 30,
2003. The increases in the 2004 three and six-month periods reflect the
significant increase in the market price of the Company's common stock.
As permitted under Statement of Financial Accounting Standards ("SFAS")
No. 123 "Accounting for Stock-Based Compensation," as amended ("SFAS 123"), the
Company has elected to continue to account for stock options under the
provisions of Accounting Principles Board Opinion No. 25 "Accounting for Stock
Issued to Employees." Under this method, the Company does not record any
compensation expense for stock options granted if the exercise price of those
options is equal to or greater than the market price of the Company's common
stock on the date of grant, unless the awards are subsequently modified. The
following table illustrates the effect on income available to common
stockholders and earnings per share if the Company had applied the fair value
recognition provision of SFAS No. 123.
5
For the Three Months Ended For the Six Months Ended
June 30, June 30,
(amounts in thousands, except -------------------------- ------------------------
per share data) 2004 2003 2004 2003
---------- ------------ ---------- ----------
Income available to common
stockholders, as reported $ 14,497 $ 27,169 $ 33,942 $ 40,761
Add: Stock-based compensation expense
included in reported net income 1,226 257 1,567 411
Deduct: Total stock-based employee
compensation expense determined
under fair value-based method for
all awards (502) (532) (1,056) (943)
Pro forma income available to ---------- ---------- ---------- ----------
common stockholders $ 15,221 $ 26,894 $ 34,453 $ 40,229
========== ========== ========== ==========
Earnings per share:
Basic - as reported $ 0.30 $ 0.71 $ 0.70 $ 1.08
Basic - pro forma $ 0.31 $ 0.70 $ 0.71 $ 1.06
Diluted - as reported $ 0.29 $ 0.66 $ 0.69 $ 1.00
Diluted - pro forma $ 0.31 $ 0.65 $ 0.70 $ 0.98
3. Income Taxes
The Company records deferred tax assets and liabilities to account for
temporary differences arising from events that have been recognized in its
financial statements and will result in future taxable or deductible items in
its tax returns. To the extent deferred tax assets exceed deferred tax
liabilities, at least annually and more frequently if events or circumstances
change materially, the Company assesses the realizability of its net deferred
tax assets. A valuation allowance is recognized if, at the time, it is
anticipated that some or all of the net deferred tax assets may not be realized.
In making this assessment, management performs an extensive analysis of
the operations of the Company to determine the sources of future taxable income.
Such an analysis consists of a detailed review of all available data, including
the Company's budget for the ensuing year, forecasts based on current as well as
historical prices, and the Company's oil and gas reserves.
The determination to establish and adjust a valuation allowance requires
significant judgment as the estimates used in preparing budgets, forecasts and
reserve reports are inherently imprecise and subject to substantial revision as
a result of changes in the outlook for prices, production volumes and costs,
among other factors. It is difficult to predict with precision the timing and
amount of taxable income the Company will generate in the future. Accordingly,
while the Company's current net operating loss carryforwards (approximately $173
million as of December 31, 2003) have remaining lives ranging from 9 to 19 years
(with the majority having a life in excess of 15 years), management examines a
much shorter time horizon (usually two to three years), when projecting
estimates of future taxable income and making the determination as to whether
the valuation allowance should be adjusted.
The Company currently estimates an annual effective tax rate for the year
ending December 31, 2004 of approximately 7.8%. The primary item affecting the
Company's annual effective tax rate determination, as compared to the U.S.
corporate statutory rate of 35%, is the anticipated reduction of the Company's
valuation allowance that is currently applied against the deferred tax asset
associated with the Company's net operating losses ("NOLs"). Management believes
that the increased taxable income the Company expects to generate during 2004,
in light of the favorable commodity pricing environment and other factors, will
more likely than not result in the Company's utilization of an additional
portion of its unbenefited NOLs.
6
Based upon the applicable provisions of SFAS No. 109, "Accounting for
Income Taxes," the Company has included the benefit associated with the
realization of its NOLs in its estimated annual effective tax rate because the
realization relates to additional estimated ordinary income in the current year.
The Company estimates that it will make alternative minimum tax payments
of 1 to 2% of pretax income in 2004.
4. Deferred Revenue
In February 2001, the Company entered into a production payment
transaction whereby it sold 43.1 Bcfe (38.3 Bcf of gas and 797,000 barrels of
oil) to be delivered over 60 months (the "Production Payment"). Net proceeds
from the Production Payment of approximately $175 million were recorded as
deferred revenue on the Company's balance sheet. Deliveries under the Production
Payment are recorded as oil and gas revenue with a corresponding reduction of
deferred revenue at the average discounted price per Mcf of natural gas and per
barrel of oil received when the Production Payment was sold. The Company also
reflects the production volumes and depletion expense as deliveries are made.
However, the associated oil and gas reserves are excluded from the Company's
reserve data. For the six months ended June 30, 2004, the Company delivered 2.7
Bcfe and recorded $11.3 million of oil and gas revenue. This compares to
Production Payment deliveries of 3.7 Bcfe and $15.2 million of oil and gas
revenue for the six months ended June 30, 2003. From the sale of the Production
Payment in February 2001 to June 30, 2004, the Company had delivered 36.5 Bcfe,
or 85% of the total quantity to be delivered.
5. Earnings Per Share
The following table sets forth the computation of basic and diluted
earnings per share:
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
(amounts in thousands,
except per share data) 2004 2003 2004 2003
------- ------- ------- -------
Basic earnings per share:
Income available to common stockholders $14,497 $27,169 $33,942 $40,761
------- ------- ------- -------
Average shares of common stock outstanding 48,912 38,227 48,779 37,833
------- ------- ------- -------
Basic earnings per share $ 0.30 $ 0.71 $ 0.70 $ 1.08
------- ------- ------- -------
Diluted earnings per share:
Income available to common stockholders $14,497 $27,169 $33,942 $40,761
Dividends and accretion of issuance costs
on preferred stock - 132 - 442
------- ------- ------- -------
Diluted earnings $14,497 $27,301 $33,942 $41,203
------- ------- ------- -------
Average shares of common stock outstanding 48,912 38,227 48,779 37,833
Assumed conversion of convertible
preferred stock - 3,129 - 3,346
Stock options and warrants 792 175 758 116
------- ------- ------- -------
Average diluted shares of common stock outstanding 49,704 41,531 49,537 41,295
------- ------- ------- -------
Diluted earnings per share $ 0.29 $ 0.66 $ 0.69 $ 1.00
======= ======= ======= =======
7
6. Derivatives
Oil and natural gas prices have historically been volatile. The Company
has at times utilized derivative contracts, including commodity price swaps,
futures contracts, option contracts and price collars, to manage this price
risk.
Commodity Price Swaps. Commodity price swap agreements require the Company
to make payments to, or entitle it to receive payments from, the counter parties
based upon the differential between a specified fixed price and a price related
to those quoted on the New York Mercantile Exchange for the period involved.
Futures Contracts. Oil or natural gas futures contracts require the
Company to sell and the counter party to buy oil or natural gas at a future time
at a fixed price.
Option Contracts. Option contracts provide the right, not the obligation,
to buy or sell a commodity at a fixed price. By buying a "put" option, the
Company is able to set a floor price for a specified quantity of its oil or
natural gas production. By selling a "call" option, the Company receives an
upfront premium from selling the right for a counter party to buy a specified
quantity of oil or natural gas production at a fixed price.
Price Collars. Selling a call option and buying a put option creates a
"collar" whereby the Company establishes a floor and ceiling price for a
specified quantity of future production. Buying a call option with a strike
price above the sold call strike price establishes a "3-way collar" that
entitles the Company to capture the benefit of price increases above that call
price.
As of June 30, 2004, the Company had outstanding derivative instruments
covering 7.5 million MMBtu of 2004 natural gas production, 2.7 million MMbtu of
2005 natural gas production, 0.1 million barrels of 2004 oil production and 0.2
million barrels of 2005 oil production. The Company does not have any
outstanding derivative instruments related to future production that extend
beyond 2005. The following table sets forth the Company's open derivative
contracts as of June 30, 2004.
8
Expected Maturity
-------------------------------------------------
2004 2005 Fair Value as of
----------------------------------- ----------- June 30,
3rd 4th 2004
Quarter Quarter Total Total ---------------
--------- --------- ---------- ----------- (In thousands)
Swaps:
Oil
Volumes (bbl) 92,000 46,000 138,000 182,500 $ (434)
Weighted average price ($/bbl) $ 35.40 $ 30.30 $ 33.70 $ 34.98
Natural Gas
Volumes (MMbtu) 2,610,000 920,000 3,530,000 1,820,000 $ (2,833)
Weighted average price ($/MMbtu) $ 5.71 $ 5.90 $ 5.76 $ 5.44
Collars:
Natural Gas
Volumes (MMbtu) 1,840,000 1,840,000 3,680,000 450,000 $ (1,260)
Weighted average price ($/MMbtu)
Floor $ 4.42 $ 4.00 $ 4.21 $ 5.00
Cap $ 6.04 $ 7.52 $ 6.78 $ 7.42
Sold calls:
Natural Gas
Volumes (MMbtu) - 305,000 305,000 450,000 $ (454)
Weighted average price ($/MMbtu) - $ 7.10 $ 7.10 $ 7.10
Fair value of derivatives at June 30, 2004 $ (4,981)
The fair value of the Company's derivative instruments are reflected as
assets or liabilities in the Company's financial statements as presented in the
following table.
June 30, 2004
-------------
(in thousands)
Other current assets $ 222
Derivative liabilities (4,898)
Other non-current liabilities (305)
----------
Fair value of derivatives at June 30, 2004 $ (4,981)
==========
In addition to the information set forth in the first table above, the
Company will deliver 2.4 Bcfe during the remainder of 2004, 3.9 Bcfe in 2005 and
0.2 Bcfe in 2006 under the Production Payment sold in February 2001 and amortize
deferred revenue at a weighted average price of $4.05 per Mcfe.
Reflected in the first table above are natural gas call options that were
sold for proceeds of $343,525. These options are not being accounted for as
hedges under SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" (SFAS No. 133) and therefore, all unrealized gains and losses
related to changes in fair value and realized gains and losses are being
reported in other, net on the Condensed Statements of Consolidated Income.
As of June 30, 2004, the Company had approximately $6.4 million of
derivative loss, net of tax, recorded in Accumulated Other Comprehensive Income
(Loss) ("AOCI") which included losses associated with terminated commodity
derivatives and other commodity derivatives. The following table recaps the
balance of AOCI at June 30, 2004 on both a pre-tax and after tax basis.
9
Pre-tax After-tax
---------- ----------
(In thousands)
Terminated commodity derivatives(a) $ (5,296) $ (3,442)
Other commodity derivatives(b) (4,586) (2,981)
---------- ----------
AOCI at June 30, 2004 $ (9,882) $ (6,423)
========== ==========
(a) During 2001, the Company terminated certain commodity derivative
instruments and recognized a charge to AOCI. As the original forecasted
transaction occurs, this loss is reclassified as a charge against earnings. The
following table details the activity of these terminated commodity instruments
on both a pre-tax and after-tax basis.
Pre-tax After-tax
---------- ---------
(In thousands)
Balance included in AOCI, December 31, 2003 $(7,566) $(4,918)
Reclassified as a charge against earnings 2,270 1,476
------- -------
Balance included in AOCI, June 30, 2004 $(5,296) $(3,442)
======= =======
Of the $3.4 million loss remaining in AOCI at June 30, 2004 related to the
terminated commodity derivatives, $1.4 million and $2.0 million will be
reclassified as a charge against earnings during the remainder of 2004 and 2005,
respectively.
(b) The Company also has other commodity derivatives, which were accounted
for as hedges under SFAS No. 133. The following table details the activity of
those commodity derivatives on both a pre-tax and after-tax basis.
Pre-tax After-tax
--------- ---------
(In thousands)
Balance included in AOCI, December 31, 2003 $ 520 $ 338
Reclassified into earnings (439) (285)
Change in fair market value (4,709) (3,061)
Ineffective portion of hedges 42 27
---------- ----------
Balance included in AOCI, June 30, 2004 $ (4,586) $ (2,981)
========== ==========
7. Debt
The following table sets forth information regarding the Company's
outstanding debt.
June 30, December 31,
2004 2003
-------- -----------
(Amounts in thousands)
Bank Credit Facility $ - $ 17,000
8-7/8% Senior Subordinated Notes - 125,000
7-1/8% Senior Notes 175,000 -
175,000 142,000
-------- --------
Classified as short-term debt - -
Long-term debt $175,000 $ 142,000
======== =========
Bank Credit Facility. The Company has a bank credit facility that provides
up to $100 million of revolving borrowing capacity and matures on November 20,
2006. Borrowing capacity under the bank credit facility is subject to a
borrowing base initially set at $100 million and is reviewed at least
semi-annually and may be adjusted based on the lenders' valuation of the
Company's oil and natural gas reserves and other factors. Substantially all of
the Company's assets, including the stock of all of its subsidiaries, are
pledged to secure the bank credit facility. Further, each of the Company's
subsidiaries has guaranteed its obligations
10
under the bank credit facility.
Borrowings under the bank credit facility bear interest, at the Company's
option, at an interest rate of LIBOR plus 2.25% to 3.0% or the greater of (1)
the Federal Funds Rate plus 0.5% or (2) the Base Rate, plus 0.5% to 1.25%,
depending on utilization. These rates will decrease by 0.5% after the final
deliveries are made in connection with the Production Payment discussed in Note
4 above and the lien on the subject property is released. A commitment fee of
0.5% per year is paid on the unused availability under the bank credit facility.
Financing fees pertaining to the bank credit facility are being amortized over
the life of the facility.
The bank credit facility contains various restrictive covenants, including
minimum levels of liquidity and interest coverage. The bank credit facility also
contains other usual and customary terms and conditions of a conventional
borrowing base facility, including requirements for hedging a portion of the
Company's 2004 oil and natural gas production, prohibitions on a change of
control, prohibitions on the payment of cash dividends, restrictions on certain
other distributions and restricted payments, and limitations on the incurrence
of additional debt and the sale of assets.
As of June 30, 2004, we did not have any outstanding amounts under the
bank credit facility and had $100 million of unused borrowing capacity available
for future financing needs. The Company was in compliance with all covenants
under the bank credit facility as of that date.
Senior Notes. On April 1, 2004, the Company issued $175 million of 7-1/8%
senior notes due April 1, 2012 (the "Senior Notes"). The Senior Notes bear
interest at a rate of 7-1/8% per annum with interest payable semi-annually on
April 1 and October 1, beginning on October 1, 2004. The Company may redeem the
Senior Notes at its option, in whole or in part, at any time on or after April
1, 2008 at a price equal to 100% of the principal amount plus accrued and unpaid
interest, if any, plus a specified premium which decreases yearly from 3.563% in
2008 to 0% in 2010 and thereafter. In addition, at any time prior to April 1,
2007, the Company may redeem up to a maximum of 35% of the aggregate principal
amount with the net cash proceeds of one or more equity offerings at a price
equal to 107.125% of the principal amount, plus accrued and unpaid interest. The
Senior Notes are senior unsecured obligations and rank subordinate in right of
payment to all existing and future secured debt, including secured debt under
the Company's bank credit facility, and will rank equal in right of payment to
all existing and future senior indebtedness.
The Senior Notes are jointly and severally and fully and unconditionally
guaranteed on a senior unsecured basis by all of the Company's current
subsidiaries. KCS Energy, Inc., the issuer of the Senior Notes, has no
independent assets or operations apart from the assets and operations of its
subsidiaries.
The indenture governing the Senior Notes contains covenants that, among
other things, restricts or limits the ability of the Company and the subsidiary
guarantors to: (i) borrow money; (ii) pay dividends on stock; (iii) purchase or
redeem stock or subordinated indebtedness; (iv) make investments; (v) create
liens; (vi) enter into transactions with affiliates; (vii) sell assets; and
(viii) merge with or into other companies or transfer all or substantially all
of the Company's assets.
In addition, upon the occurrence of a change of control (as defined in the
indenture governing the Senior Notes), the holders of the Senior Notes will have
the right to require the Company to repurchase all or any part of the Senior
Notes at a purchase price equal to 101% of the aggregate principal amount, plus
accrued and unpaid interest, if any.
11
The Company received $171.1 million in net proceeds from the issuance of
the Senior Notes. Net proceeds of the issuance were used to redeem the aggregate
principal of the Company's $125 million 8-7/8% senior subordinated notes due
2006 (the "Senior Subordinated Notes") together with an early redemption premium
of 2.958%, or $3.7 million, and to repay the $22 million outstanding under the
Company's bank credit facility. The remainder of the proceeds will be used for
general corporate purposes.
The Senior Subordinated Notes were redeemed on May 1, 2004 and the early
redemption premium of $3.7 million was charged against earnings in the second
quarter of 2004. In addition, the Company incurred an additional $0.9 million of
interest expense as both the Senior Subordinated Notes and the Senior Notes were
outstanding during the month of April 2004.
8. Supplemental Cash Flow Information
The Company considers all highly liquid financial instruments with a
maturity of three months or less when purchased to be cash equivalents. Interest
payments were $9.0 million for the six months ended June 30, 2004 compared to
$10.5 million for the six months ended June 30, 2003. Income tax payments were
$1.0 million for the six months ended June 30, 2004 compared to income tax
payments of $0.4 million during the six months ended June 30, 2003.
In connection with the adoption of SFAS No. 143 in 2003, the Company
recorded a non-cash increase to oil and gas properties of $10.2 million, a
non-cash increase in liabilities of $11.1 million and a non-cash charge of $0.9
million as a cumulative effect of accounting change.
Additions to oil and gas properties for the six months ended June 30, 2004
were $74.6 million. Of this amount, $70.8 million were cash expenditures and are
reflected as investments in oil and gas properties on the Company's Condensed
Statements of Consolidated Cash Flows. The remaining $3.8 million was made up of
increases in accrued drilling cost of $4.1 million and capitalized asset
retirement obligation of $0.1 million, offset by increased drilling prepayments
of $0.4 million.
Additions to oil and gas properties for the six months ended June 30, 2003
were $38.9 million. Of this amount, $36.8 million were cash expenditures and are
reflected as investments in oil and gas properties on the Company's Condensed
Statements of Consolidated Cash Flows. The remaining $2.1 million was made up of
increases in accrued drilling cost of $6.1 million and capitalized asset
retirement obligation of $0.3 million, offset by increased drilling prepayments
of $4.3 million.
9. Comprehensive Income
The following table presents the components of comprehensive income for
the three months and six months ended June 30, 2004 and 2003:
Three Months Ended Six Months Ended
June 30, June 30,
------------------- --------------------
(Amounts in thousands) 2004 2003 2004 2003
-------- -------- -------- --------
Net income $ 14,497 $ 27,301 $ 33,942 $ 41,203
Commodity hedges,
net of tax 730 700 (1,843) 1,495
-------- -------- -------- --------
Comprehensive income $ 15,227 $ 28,001 $ 32,099 $ 42,698
======== ======== ======== ========
12
10. New Accounting Principles
In March 2004, the FASB issued an exposure draft that would amend SFAS No.
123 "Accounting for Stock Based Compensation" and SFAS No. 95 "Statement of Cash
Flows." This exposure draft was issued to improve existing accounting rules and
to provide more complete, higher quality information for investors on employee
stock compensation matters. The comment period for the exposure draft ended on
June 30, 2004. The exposure draft covers a wide range of equity-based
arrangements including stock options. Under the FASB's proposal, share-based
payments to employees, including stock options, would be treated the same as
other forms of compensation by recognizing the related costs in the income
statement. The expense of the award would generally be measured at fair value at
the grant date. The Company is evaluating the effects that could result should
this exposure draft be ratified.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following is a discussion and analysis of our financial condition and
results of operations and should be read in conjunction with our unaudited
condensed consolidated financial statements and related notes included elsewhere
in this quarterly report on Form 10-Q. Unless the context otherwise requires,
the terms "KCS," "we," "our," or "us" refer to KCS Energy, Inc. and subsidiaries
on a consolidated basis.
FORWARD-LOOKING STATEMENTS
The information discussed in this quarterly report on Form 10-Q includes
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. All statements, other than statements of historical facts, included
herein concerning, among other things, planned capital expenditures, increases
in oil and natural gas production, the number of anticipated wells to be drilled
in the future, our financial position, business strategy and other plans and
objectives for future operations are forward-looking statements. These
forward-looking statements are identified by their use of terms and phrases such
as "expect," "estimate," "project," "plan," "believe," "achievable,"
"anticipate" and similar terms and phrases. Although we believe that the
expectations reflected in any forward-looking statements are reasonable, they do
involve certain assumptions, risks and uncertainties. Our actual results could
differ materially from those anticipated in these forward-looking statements as
a result of certain factors, including:
- the timing and success of our drilling activities;
- the volatility of prices and supply of, and demand for, oil and
natural gas;
- the numerous uncertainties inherent in estimating quantities of oil
and natural gas reserves and actual future production rates and
associated costs;
- our ability to successfully identify, execute or effectively
integrate future acquisitions;
- the usual hazards associated with the oil and gas industry
(including fires, well blowouts, pipe failure, spills, explosions
and other unforeseen hazards);
- our ability to effectively market our oil and natural gas;
- the results of our hedging transactions;
- the availability of rigs, equipment, supplies and personnel;
- our ability to acquire or discover additional reserves;
- our ability to satisfy future capital requirements;
- changes in regulatory requirements;
- the credit risks associated with our customers;
- economic and competitive conditions;
- our ability to retain key members of senior management and key
employees;
- uninsured judgments or a rise in insurance premiums;
14
- continued hostilities in the Middle East and other sustained
military campaigns and acts of terrorism or sabotage; and
- if underlying assumptions prove incorrect.
These and other risks are described in greater detail in "Business - Risk
Factors" included in our annual report on Form 10-K for the year ended December
31, 2003. All forward-looking statements attributable to us or persons acting on
our behalf are expressly qualified in their entirety by these factors. Other
than as required under the securities laws, we do not assume a duty to update
these forward-looking statements, whether as a result of new information,
subsequent events or circumstances, changes in expectations or otherwise.
OVERVIEW
In 2004, our plan is to continue to execute the strategies that were
successful for us in 2003. Our focus is on low-risk development and exploitation
drilling in our core operating areas and to commit about 12 to 15% of our
capital expenditure budget to moderate-risk, higher-potential exploration
prospects in the onshore Gulf Coast region. We intend to stay focused on natural
gas, which we believe offers more upside potential than oil or liquids. We plan
to maintain a conservative capital structure and continue to reduce debt per
Mcfe by increasing our oil and gas reserve base. We will continue our
disciplined hedging program designed to protect against price declines while
participating to a large extent in future price increases. In this way, we
endeavor to ensure that we generate a sufficient level of cash flow to carry out
a capital expenditure program sufficient to at least replace our expected
production and still benefit if prices rise. In June 2004, we announced an
increase in our capital budget from $105 million to $125 million due to the
success of our drilling program and the continued strength of natural gas and
oil prices resulting in increased cash flow. We believe that these factors
present us with a unique opportunity to accelerate the drilling of our prospect
inventory and to increase our oil and gas production and reserves. During the
first half of 2004, we incurred $74.6 million and drilled 65 wells, of which 64
were completed resulting in a 98% success rate. We plan on drilling between 45
and 65 wells during the second half of the year.
During the first half of 2004, we further strengthened our financial
condition and provided additional financial flexibility by completing a $175
million senior notes offering. The new senior notes bear interest at an annual
rate of 7-1/8% and mature in 2012. The proceeds of this issuance were used to
redeem the $125 million 8-7/8% senior subordinated notes due 2006 and to repay
the $22 million outstanding under our bank credit facility. As of June 30, 2004,
we had $9.8 million of cash on hand and $100 million of unused committed
borrowing capacity under our bank credit facility. Please read Note 7 to our
Condensed Consolidated Financial Statements for more information regarding our
senior notes.
In the Mid-Continent region, we concentrate our drilling programs
primarily in north Louisiana, east Texas, Oklahoma (Anadarko and Arkoma basins)
and west Texas. Our Mid-Continent operations provide us with a solid base for
production and reserve growth. We plan to continue to exploit areas within the
various basins that require low-risk exploitation wells for additional reservoir
drainage. Our exploitation wells are generally step-out and extension type wells
with moderate reserve potential. We have a multi-year inventory of locations in
the Mid-Continent region and have increased the level of drilling in our Elm
Grove, Talihina and Joaquin fields and continued the development program in our
Sawyer Canyon Field. During the first half of 2004, we drilled 48 wells in this
region with a success rate of 98%.
15
In the Gulf Coast region, we concentrate our drilling programs primarily
in south Texas. We also have working interests in several minor non-operated
offshore and Mississippi salt basin properties. We conduct development programs
and pursue moderate-risk, higher potential exploration drilling programs in this
region. Our Gulf Coast operations have numerous exploration prospects that are
expected to provide us additional growth. During the first half of 2004, we
drilled 8 exploratory and 9 development wells in this region with a success rate
of 100%.
RESULTS OF OPERATIONS
For the three months ended June 30, 2004, operating income was $23.2
million compared to $20.7 million for the three months ended June 30, 2003 due
to a 16% increase in natural gas and oil production as a result of our
successful drilling program and a 15% increase in average realized prices,
partially offset by lower non-oil and gas revenue and higher operating expenses.
Income before income taxes and cumulative effect of accounting change was $15.4
million for the three months ended June 30, 2004 compared to $16.2 million for
the three months ended June 30, 2003 as a result of a $3.7 million redemption
premium and $0.9 million of additional interest expense associated with the
early redemption of our 8-7/8% senior subordinated notes due 2006. Income tax
expense was $0.9 million (primarily non-cash) for the three months ended June
30, 2004 compared to a non-cash income tax benefit of $11.1 million for the
three months ended June 30, 2003 due to changes in our valuation allowance
against our net deferred tax asset. Income available to common stockholders for
the three months ended June 30, 2004 was $14.5 million, or $0.30 per basic share
and $0.29 per diluted share, compared to $27.2 million, or $0.71 per basic share
and $0.66 per diluted share, for the three months ended June 30, 2003.
For the six months ended June 30, 2004, operating income was $47.7 million
compared to $39.7 million for the six months ended June 30, 2003. This increase
was primarily attributable to a 20% increase in natural gas and oil production
and a 9% increase in average realized prices as a result of less production
dedicated to production payment obligations, partially offset by lower non-oil
and gas revenue and higher operating expenses. The $3.7 million redemption
premium and interest expense of $7.4 million brought income before income taxes
and cumulative effect of accounting change to $36.8 million for the six months
ended June 30, 2004 compared to $30.6 million for the six months ended June 30,
2003. The significant decrease in interest expense for the six months ended June
30, 2004 to $7.4 million (including the $0.9 million additional interest expense
associated with the early redemption of the senior subordinated notes) compared
to $9.2 million for the six months ended June 30, 2003 reflects both
substantially lower average outstanding borrowings and lower interest rates.
Income tax expense was $2.9 million (primarily non-cash) for the six months
ended June 30, 2004, compared to a non-cash income tax benefit of $11.6 million
for the six months ended June 30, 2003 due to changes in the valuation allowance
against our net deferred tax asset. During the six months ended June 30, 2003,
we recorded a cumulative effect of accounting change of $0.9 million, or $0.02
per basic and diluted share, as a result of the adoption of Statement of
Financial Accounting Standards No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS No. 143"). Net income for the six months ended June 30, 2004
was $33.9 million, or $0.70 per basic share and $0.69 per diluted share,
compared to $41.2 million, or $1.08 per basic share and $1.00 per diluted share,
for the six months ended June 30, 2003.
The following table sets forth: (i) our gross natural gas and oil
production; (ii) our production net of obligations under a production payment
(net production); (iii) the average realized prices received for our production;
and (iv) our associated revenue for the three and six months ended June 30, 2004
and 2003.
16
Three Months Ended Six Months Ended
June 30, June 30,
2004 2003 2004 2003
--------- --------- --------- ---------
Production (a):
Gas (MMcf) 8,189 6,758 16,056 12,733
Oil (Mbbl) 197 213 390 428
Natural Gas Liquids (Mbbl) 52 58 110 105
--------- --------- --------- ---------
Total (MMcfe) 9,686 8,381 19,056 15,933
Dedicated to Production
Payment (1,332) (1,702) (2,745) (3,720)
--------- --------- --------- ---------
Net production (MMcfe) 8,354 6,679 16,311 12,213
========= ========= ========= =========
Average Price:
Gas (per Mcf) $ 5.44 $ 4.81 $ 5.52 $ 5.14
Oil (per bbl) 28.16 23.97 27.63 25.73
Natural Gas Liquids (bbl) 17.23 14.15 17.09 15.56
Total (per Mcfe) (b) 5.26 4.58 5.32 4.90
Revenue (in thousands):
Gas $ 44,520 $ 32,504 $ 88,633 $ 65,415
Oil 5,562 5,103 10,786 11,014
Natural Gas Liquids 900 815 1,877 1,640
--------- --------- --------- ---------
Total $ 50,982 $ 38,422 $ 101,296 $ 78,069
========= ========= ========= =========
- --------
(a) Includes delivery obligations dedicated to a production payment transaction
whereby in February 2001 we sold 43.1 Bcfe (38.3 Bcf of natural gas and 797 Mbbl
of oil) to be delivered over 60 months (the "Production Payment"). Production
includes 1,332 and 2,745 MMcfe, respectively, for the three and six months ended
June 30, 2004 compared to 1,702 and 3,720 MMcfe, respectively, for the three and
six months ended June 30, 2003 dedicated to the Production Payment. Please read
Note 4 to our Condensed Consolidated Financial Statements.
(b) The average realized prices reported above include the non-cash effects of
volumes delivered under the Production Payment sold in 2001 as well as the
unwinding of various derivative contracts terminated in 2001. These items do not
generate cash to fund our operations. Excluding these items, the average
realized price per Mcfe was $5.67 and $5.71 for the three and six months ended
June 30, 2004, respectively, compared to $5.03 and $5.52 for the three and six
months ended June 30, 2003.
Natural gas revenue
For the three months ended June 30, 2004, natural gas revenue increased
$12.0 million to $44.5 compared to $32.5 million for the same period in 2003 due
to a 21% increase in production and a 13% increase in average realized prices.
The production increase was primarily due to our successful drilling program.
17
For the six months ended June 30, 2004, natural gas revenue increased
$23.2 million to $88.6 compared to $65.4 million for the same period in 2003 due
to a 26% increase in production and a 7% increase in average realized prices.
Oil and natural gas liquids revenue
For the three months ended June 30, 2004, oil and natural gas liquids
revenue increased $0.5 million to $6.5 million due to a 19% increase in the
average realized price, partially offset by an 8% decrease in production.
For the six months ended June 30, 2004 and 2003, oil and natural gas
liquids revenue was $12.7 million. Average realized prices increased 7% in 2004
offset by a 6% decline in oil and natural gas liquids production.
The decrease in oil and natural gas liquids production reflected the
natural decline of our oil and natural gas liquids properties as our drilling
program over the last two years has been focused almost entirely on natural gas
prospects.
Other, net
For the three months ended June 30, 2004, other, net was a loss of $0.3
million compared to other, net revenue of $4.3 million for the three months
ended June 30, 2003. The $4.6 million change was primarily related to the sale
of emission reduction credits in 2003. For the six months ended June 30, 2004,
other, net was a loss of $0.2 million compared to other, net revenue of $5.1
million. We do not anticipate that there will be any significant sales of
emission credits in the second half of 2004.
Lease operating expenses
For the three months ended June 30, 2004, lease operating expenses
increased $1.1 million to $7.2 million compared to $6.1 million for the three
months ended June 30, 2003. For the six months ended June 30, 2004, lease
operating expenses increased $2.9 million, to $14.6 million, compared to $11.7
million for the six months ended June 30, 2003. The increases in the 2004 three
and six-month periods were attributable to the increase in the number of
producing wells as a result of our expanded drilling program, higher salt water
disposal costs associated with our properties, and increased workover activity.
Production and other taxes
For the three months ended June 30, 2004, production and other taxes
increased $1.3 million to $3.3 million compared to $2.0 million for the three
months ended June 30, 2003. For the six months ended June 30, 2004, production
and other taxes increased $1.2 million to $6.2 million compared to $5.1 million
for the six months ended June 30, 2003. The increases in the 2004 three and
six-month periods were primarily due to increased severance taxes due to higher
oil and gas revenues.
General and administrative expenses
For the three months ended June 30, 2004, general and administrative
expenses increased $0.3 million to $2.2 million compared to $1.9 million for the
three months ended June 30, 2003. For the six months ended June 30, 2004,
general and administrative expenses increased $0.8 million to $4.5 million
compared to $3.7 million for the six months ended June 30, 2003. The increases
in the 2004 three and six-month periods were primarily attributable to higher
workforce costs as a result of our expanded drilling program.
18
Stock compensation
Stock compensation reflects the non-cash expense associated with stock
options issued in 2001 that are subject to variable accounting in accordance
with FASB Interpretation No. 44, "Accounting for Certain Transactions Involving
Stock Compensation" ("FIN 44"), and the non-cash expense associated with the
amortization of restricted stock grants. Under variable accounting for stock
options, the amount of expense recognized during a reporting period is directly
related to the movement in the market price of our common stock during that
period.
For the three months ended June 30, 2004, stock compensation was $1.2
million compared to $0.3 million for the three months ended June 30, 2003. For
the six months ended June 30, 2004, stock compensation was $1.6 million compared
to $0.4 million. The increases in the 2004 three and six-month periods reflect
the significant increase in the market price of our common stock.
Depreciation, depletion and amortization
We amortize our oil and gas properties using the unit-of-production method
based on proved reserves. For the three months ended June 30, 2004,
depreciation, depletion and amortization ("DD&A") increased $1.8 million to
$13.2 million compared to $11.4 million for the three months ended June 30,
2003. For the six months ended June 30, 2004, DD&A increased $3.9 million to
$26.0 million compared to $22.1 million for the six months ended June 30, 2003.
The increases in the 2004 three and six-month periods reflect the higher
production associated with our expanded drilling program.
Redemption premium on early extinguishment of debt
On May 1, 2004, we redeemed our $125 million 8-7/8% senior subordinated
notes due 2006. Pursuant to the indenture, we paid an early redemption premium
of 2.958%, or $3.7 million, which was charged against earnings during the three
months ended June 30, 2004.
Interest expense
For the three months ended June 30, 2004, interest expense was $4.4
million compared to $4.6 million for the three months ended June 30, 2003. The
2004 three-month period included an additional $0.9 million of interest expense
as both our 8-7/8% senior subordinated notes due 2006 and our new 7-1/8% senior
notes due 2012 were outstanding during the month of April 2004. Our 8-7/8%
senior subordinated notes were redeemed on May 1, 2004.
For the six months ended June 30, 2004, interest expense was $7.4 million
compared to $9.2 million for the six months ended June 30, 2003. The decrease
reflects lower amounts of outstanding debt and lower borrowing costs.
Income taxes
For the three months ended June 30, 2004, the income tax provision was
$0.9 million (primarily non-cash) compared to a non-cash income tax benefit of
$11.1 million for the three months ended June 30, 2003. The income tax benefit
in the 2003 three-month period reflects an adjustment to our valuation allowance
against our net deferred tax asset as a result of the substantial improvement in
our financial condition and other factors. Please read Note 3 to our Condensed
Consolidated Financial Statements. For the six months ended June 30, 2004, the
income tax provision was $2.9 million compared to an income tax benefit of $11.6
million for the six months ended June 30, 2003.
We currently estimate that our annual effective tax rate for the year
ending December 31, 2004 will be approximately 7.8%. The primary item affecting
our annual effective tax rate determination, as compared to
19
the U.S. corporate statutory rate of 35%, is the anticipated reduction of our
valuation allowance that is currently applied against the deferred tax asset
associated with our net operating losses ("NOLs"). We believe that the increased
taxable income expected to be generated during 2004, in light of the favorable
commodity pricing environment and other factors, will more likely than not
result in the utilization of an additional portion of our unbenefited NOLs.
Based upon the applicable provisions of SFAS No. 109, "Accounting for
Income Taxes," we included the benefit associated with the realization of our
NOLs in the estimated annual effective tax rate because the realization relates
to additional estimated ordinary income in the current year.
We also believe that if the current pricing environment continues, the
valuation allowance on our deferred tax assets for NOLs may be further reduced.
We estimate that we will make alternative minimum tax payments of 1 to 2%
of pre-tax income in 2004.
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity and capital resources improved significantly during 2003. In
January 2003, we amended and restated our bank credit facility to increase our
borrowing availability and paid off our maturing senior note obligations. We
also accelerated our drilling program, resulting in increased production and oil
and natural gas reserves. The increase in production coupled with a strong
natural gas and oil price environment resulted in a substantial increase in cash
flow.
We took several major steps during 2003 to further strengthen our
financial condition, lower interest costs and provide increased financial
flexibility. The balance of our outstanding Series A Convertible Preferred Stock
was converted into shares of our common stock. This conversion simplified our
overall capital structure and eliminated the 5% dividend obligation associated
with the preferred stock. In the first quarter, we paid off our maturing senior
note obligations. In the fourth quarter of 2003, we amended and restated our
bank credit facility, which increased our revolving credit capacity to $100
million and significantly reduced our borrowing costs. We also completed a
public offering of 6.9 million shares of our common stock and used the net
proceeds of approximately $52 million to repay a portion of the borrowings under
our bank credit facility and to accelerate our drilling program in certain core
areas. Our successful drilling program, along with strong oil and natural gas
prices and proceeds from our public common stock offering, allowed us to reduce
debt during 2003 from $186.8 million, or $0.95 per Mcfe of reserves, at the
beginning of the year to $142.0 million, or $0.53 per Mcfe of reserves, at the
end of the year.
In April 2004, we completed a private placement of $175 million of 7-1/8%
senior notes due 2012. The proceeds of this issuance were used to redeem our
$125 million 8-7/8% senior subordinated notes due 2006 and to repay the $22
million outstanding under our bank credit facility. The remainder of the
proceeds will be used for general corporate purposes. On May 1, 2004, we
redeemed our $125 million 8-7/8% senior subordinated notes due 2006. Pursuant to
the indenture, we paid an early redemption premium of 2.958%, or $3.7 million.
Please read Note 7 to our Condensed Consolidated Financial Statements for more
information regarding our senior notes, including a discussion of restrictive
covenants, and our bank credit facility.
With the completion of the steps outlined above, we believe that we are
positioned to capitalize on the current strong natural gas and oil price
environment, to focus on developing our multi-year prospect inventory, to
increase reserves and production in our core areas and to further reduce debt
per Mcfe.
20
Our primary cash requirements are for the exploration, development and
acquisition of oil and gas properties, operating expenses and debt service.
In June 2004, we increased our capital budget from $105 million to $125
million due to the success of our drilling program and the continued strength of
natural gas and oil prices resulting in increased cash flow. During the first
half of 2004, we spent $74.6 million and drilled 65 wells, of which 64 were
completed resulting in a 98% success rate. We plan on drilling between 45 and 65
wells during the second half of the year. We believe that this program will be
funded primarily through internally generated cash flows. The amount and
allocation of our capital budget is subject to change based on operational
developments, commodity prices, service costs, acquisitions and numerous other
factors. Generally, we do not budget for acquisitions.
Our net working capital position at June 30, 2004 was a deficit of $18.4
million. On that date, we had $100.0 million of availability under our bank
credit facility. Working capital deficits are not unusual in our industry. We,
like many other oil and gas companies, typically maintain relatively low cash
reserves and use any excess cash to fund our capital expenditure program or pay
down borrowings under our bank credit facility.
We believe that cash on hand, net cash generated from operations and unused
committed borrowing capacity under our bank credit facility will be adequate to
fund our capital budget and satisfy our liquidity needs. As of June 30, 2004, we
had $9.8 million of cash on hand and $100 million of unused committed borrowing
capacity under our bank credit facility available for future financing needs. In
the future, we may also utilize various financing sources available to us,
including the issuance of debt or equity securities under our shelf registration
statement or through private placements. Our ability to complete future debt and
equity offerings and the timing of these offerings will depend upon various
factors including prevailing market conditions, interest rates and our financial
condition.
Cash flow provided by operating activities
For the six months ended June 30, 2004, net cash provided by operating
activities was $53.2 million compared to $43.6 million for the six months ended
June 30, 2003. The improvement in our cash flow during the six months ended June
30, 2004 was primarily due to a 34% increase in net production, lower interest
expense and the timing of our cash receipts and disbursements.
Cash used in investing activities
For the six months ended June 30, 2004, net cash used in investing
activities was $70.9 million, substantially all of which was invested in oil and
gas properties, compared to net cash used in investing activities of $37.3
million during the same period in 2003, substantially all of which was invested
in oil and gas properties.
Cash from financing activities
For the six months ended June 30, 2004, net cash provided by financing
activities was $25.2 million due to the refinancing of our debt as discussed
above and in Note 7 to our Condensed Consolidated Financial Statements. For the
six months ended June 30, 2003, net cash used in financing activities was $11.0
million due to the net reduction in our debt during that period.
CONTRACTUAL CASH OBLIGATIONS
The following table summarizes our future contractual cash obligations
related to long-term debt as of June 30, 2004 after taking into account the
issuance of the $175.0 million of 7-1/8% senior notes due 2012 as
21
further described in Note 7 to our Condensed Consolidated Financial Statements
(in thousands).
Payments due by period
Less Than 1-3 3-5 More Than
Total 1 Year Years Years 5 Years
- ----------------------------------------------------------------------------------------
Long-term debt $175,000 - - - $175,000
There were no other material changes outside the ordinary course of our
business during the three months ended June 30, 2004 to the other items listed
in the Contractual Cash Obligations table included in our annual report on Form
10-K for the year ended December 31, 2003.
NEW ACCOUNTING PRINCIPLES
In March 2004, the FASB issued an exposure draft that would amend SFAS No.
123 "Accounting for Stock Based Compensation" and SFAS No. 95 "Statement of Cash
Flows." This exposure draft was issued to improve existing accounting rules and
to provide more complete, higher quality information for investors on employee
stock compensation matters. The comment period for the exposure draft ended on
June 30, 2004. The exposure draft covers a wide range of equity-based
arrangements including stock options. Under the FASB's proposal, share-based
payments to employees, including stock options, would be treated the same as
other forms of compensation by recognizing the related costs in the income
statement. The expense of the award would generally be measured at fair value at
the grant date. We are evaluating the effects that could result should this
exposure draft be ratified.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
All information and statements included in this section, other than
historical information and statements, are "forward-looking statements." Please
read "Management's Discussion and Analysis of Financial Condition and Results of
Operations - Forward-Looking Statements."
COMMODITY PRICE RISK
Our major market risk exposure is to oil and natural gas prices, which
have historically been volatile. Realized prices are primarily driven by the
prevailing worldwide price for crude oil and regional spot prices for natural
gas production. We have utilized, and may continue to utilize, derivative
contracts, including commodity price swaps, futures contracts, options contracts
and price collars to manage this price risk. We do not enter into derivative or
other financial instruments for trading or speculative purposes. Effective
January 1, 2001, we adopted SFAS No. 133 "Accounting for Derivative Instruments
and Hedging Activities". While these derivative contracts are structured to
reduce our exposure to decreases in the price associated with the underlying
commodity, they also limit the benefit we might otherwise receive from price
increases. We maintain a system of controls that includes a policy covering
authorization, reporting and monitoring of derivative activity. Please read Note
6 to our Condensed Consolidated Financial Statements for more information on our
derivative contracts.
As of June 30, 2004, we had outstanding derivative instruments covering
7.5 million MMBtu of 2004 natural gas production, 2.7 million MMbtu of 2005
natural gas production, 0.1 million barrels of 2004 oil production and 0.2
million barrels of 2005 oil production. We do not have any outstanding
derivative instruments related to future production that extend beyond 2005. The
following table sets forth information with respect to our open derivative
contracts as of June 30, 2004.
22
Expected Maturity
-----------------------------------
2004 2005
----------------------------------- ---------- Fair Value as of
3rd 4th June 30,
Quarter Quarter Total Total 2004
-------------
(In thousands)
Swaps:
Oil
Volumes (bbl) 92,000 46,000 138,000 182,500 $ (434)
Weighted average price ($/bbl) $ 35.40 $ 30.30 $ 33.70 $ 34.98
Natural Gas
Volumes (MMbtu) 2,610,000 920,000 3,530,000 1,820,000 $ (2,833)
Weighted average price ($/MMbtu) $ 5.71 $ 5.90 $ 5.76 $ 5.44
Collars:
Natural Gas
Volumes (MMbtu) 1,840,000 1,840,000 3,680,000 450,000 $ (1,260)
Weighted average price ($/MMbtu)
Floor $ 4.42 $ 4.00 $ 4.21 $ 5.00
Cap $ 6.04 $ 7.52 $ 6.78 $ 7.42
Sold calls:
Natural Gas
Volumes (MMbtu) - 305,000 305,000 450,000 $ (454)
Weighted average price ($/MMbtu) - $ 7.10 $ 7.10 $ 7.10
Fair value of derivatives at June 30, 2004 $ (4,981)
In addition to the information set forth in the table above, we will
deliver 2.4 Bcfe during the remainder of 2004, 3.9 Bcfe in 2005 and 0.2 Bcfe in
2006 under the Production Payment and amortize deferred revenue at a weighted
average price of $4.05 per Mcfe.
In March 2004, we sold natural gas call options for proceeds of $343,525.
These options are not being accounted for as hedges under SFAS No. 133 and
therefore, all unrealized gains and losses related to changes in fair value and
realized gains and losses are being reported in other, net on the Condensed
Statements of Consolidated Income.
Commodity Price Swaps. Commodity price swap agreements require us to make
payments to, or entitle us to receive payments from, the counter parties based
upon the differential between a specified fixed price and a price related to
those quoted on the New York Mercantile Exchange for the period involved.
Futures Contracts. Oil or natural gas futures contracts require us to sell
and the counter party to buy oil or natural gas at a future time at a fixed
price.
Option Contracts. Option contracts provide the right, not the obligation,
to buy or sell a commodity at a fixed price. By buying a "put" option, we are
able to set a floor price for a specified quantity of our oil or natural gas
production. By selling a "call" option, we receive an upfront premium from
selling the right for a counter party to buy a specified quantity of oil or
natural gas production at a fixed price.
Price Collars. Selling a call option and buying a put option creates a
"collar" whereby we establish a floor and ceiling price for a specified quantity
of future production. Buying a call option with a strike price above the sold
call strike establishes a "3-way collar" that entitles us to capture the benefit
of price increases above that call price
23
INTEREST RATE RISK
We use fixed and variable rate long-term debt to finance our capital
spending program and for general corporate purposes. Our variable rate debt
instruments expose us to market risk related to changes in interest rates. Our
fixed rate debt and the associated weighted average interest rate was $175.0
million at 7.1% on June 30, 2004 and $125.0 million at 8.9% on December 31,
2003 and June 30, 2003. Our variable rate debt and weighted average interest
rate was $17.0 million at 3.6% on December 31, 2003 and $54.0 million at 7.8% on
June 30, 2003. We did not have any outstanding variable rate debt as of June 30,
2004.
On April 1, 2004, we issued $175.0 million of 7-1/8% senior notes due
April 1, 2012. Please read Note 7 to our Condensed Consolidated Financial
Statements (Unaudited) for more information on the senior notes. The table below
presents our debt obligations and related average interest rates expected by
maturity date as of June 30, 2004 (dollars in millions).
AS OF JUNE 30, 2004
-----------------------------------------------------------------------------------
EXPECTED MATURITY DATE FAIR VALUE
--------------------------------------------------------- ----- ----------
2004 2005 2006 2007 2008 THEREAFTER TOTAL
---- ---- ---- ---- ---- ---------- -----
Long-term debt
Fixed rate - - - - - $ 175.0 $ 175.0 $172.6
Average interest rate - - - - - 7.125% 7.125% -
Variable rate - - - - - - - -
Average interest rate - - - - - - - -
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of disclosure controls and procedures. Based on their
evaluation of our disclosure controls and procedures as of the end of the period
covered by this report, our Chief Executive Officer and Chief Financial Officer
have concluded that our disclosure controls and procedures are effective in
ensuring that the information required to be disclosed by us (including our
consolidated subsidiaries) in the reports that we file or submit under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported, within the time periods specified in the Securities and Exchange
Commission's rules and forms.
Changes in internal control over financial reporting. There were no
changes in our internal control over financial reporting that occurred during
our last fiscal quarter that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting.
24
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Note 11 (Litigation) to our Condensed Consolidated Financial Statements
included in our annual report on Form 10-K for the year ended December 31, 2003
is incorporated herein by reference.
ITEM 2. CHANGE IN SECURITIES.
On April 1, 2004, we issued $175 million of 7-1/8% senior notes due April
1, 2012 (the "Senior Notes"). The Senior Notes were initially sold in a private
placement in reliance upon the exemptions from registration in Rule 144A and
Regulation S of the Securities Act of 1933. We received $171.1 million in net
proceeds from the issuance of the Senior Notes. Net proceeds of the issuance
were used to redeem the aggregate principal of our $125 million 8-7/8% senior
subordinated notes due 2006 together with an early redemption premium of 2.958%,
or $3.7 million, and to repay the $22 million outstanding under our bank credit
facility. The remainder of the proceeds will be used for general corporate
purposes.
The Senior Notes bear interest at a rate of 7-1/8% per annum with interest
payable semi-annually on April 1 and October 1, beginning on October 1, 2004. We
may redeem the Senior Notes at our option, in whole or in part, at any time on
or after April 1, 2008 at a price equal to 100% of the principal amount plus
accrued and unpaid interest, if any, plus a specified premium which decreases
yearly from 3.563% in 2008 to 0% in 2010 and thereafter. In addition, at any
time prior to April 1, 2007, we may redeem up to a maximum of 35% of the
aggregate principal amount with the net cash proceeds of one or more equity
offerings at a price equal to 107.125% of the principal amount, plus accrued and
unpaid interest. The Senior Notes are senior unsecured obligations and rank
subordinate in right of payment to all existing and future secured debt,
including secured debt under our bank credit facility, and will rank equal in
right of payment to all existing and future senior indebtedness.
The Senior Notes are jointly and severally and fully and unconditionally
guaranteed on a senior unsecured basis by all of our current subsidiaries. KCS
Energy, Inc., the issuer of the Senior Notes, has no independent assets or
operations apart from the assets and operations of its subsidiaries.
The indenture governing the Senior Notes contains covenants that, among
other things, restricts or limits our ability and the ability of our subsidiary
guarantors to: (i) borrow money; (ii) pay dividends on stock; (iii) purchase or
redeem stock or subordinated indebtedness; (iv) make investments; (v) create
liens; (vi) enter into transactions with affiliates; (vii) sell assets; and
(viii) merge with or into other companies or transfer all or substantially all
of our assets.
In addition, upon the occurrence of a change of control (as defined in the
indenture governing the Senior Notes), the holders of the Senior Notes will have
the right to require us to repurchase all or any part of the Senior Notes at a
purchase price equal to 101% of the aggregate principal amount, plus accrued and
unpaid interest, if any.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
We held our Annual Meeting of Stockholders on May 27, 2004 in
Houston, Texas to elect two directors. Both nominated directors were elected and
will serve a three-year term expiring in 2007.
25
(a) Directors elected at the Annual Meeting:
Votes in Favor Votes Withheld
-------------- --------------
G. Stanton Geary 43,438,626 1,082,579
Robert G. Raynolds 43,324,386 1,196,819
(b) Directors with terms of office continuing after the Annual
Meeting:
Directors with terms expiring in 2005
James W. Christmas
Joel D. Siegel
Christopher A. Viggiano
Directors with terms expiring in 2006
William N. Hahne
James L. Bowles
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
4.1 Indenture, dated as of April 1, 2004, among KCS Energy, Inc.,
certain of its subsidiaries and U.S. Bank National Association
(incorporated by reference to Exhibit 4.1 to the quarterly
report on Form 10-Q (File No. 001-13781) filed with the SEC on
May 10, 2004).*
4.2 Form of 7-1/8% Senior Note due 2012 (included in Exhibit
4.1).*
10.1 Registration Rights Agreement, dated April 1, 2004, by and
among KCS Energy, Inc., KCS Resources, Inc., Medallion
California Properties Company, KCS Energy Services, Inc.,
Proliq, Inc., Credit Suisse First Boston LLC, Merill Lynch,
Pierce, Fenner & Smith, Incorporated, Jefferies & Company,
Inc., Harris Nesbitt Corp., Banc One Capital Markets, Inc.,
and BNB Paribas Securities Corp. (incorporated by reference to
Exhibit 10.2 to the quarterly report on Form 10-Q (File No.
001-13781) filed with the SEC on May 10, 2004).*
31.1 Certification of James W. Christmas, Chairman and Chief
Executive Officer, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.+
31.2 Certification of Joseph T. Leary, Vice President and Chief
Financial Officer, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.+
26
32.1 Certification of James W. Christmas, Chairman and Chief
Executive Officer, pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.+
32.2 Certification of Joseph T. Leary, Chief Financial Officer,
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.+
- ---------------------------
+ Filed herewith.
* Incorporated by reference.
(b) Reports on Form 8-K.
On April 1, 2004, we filed a report on Form 8-K under Item 5, Other
Events, announcing the closing of a private placement $175 million
of our 7-1/8% senior notes due 2012.
On May 10, 2004, we furnished a report on Form 8-K under Item 12,
Results of Operations and Financial Condition, reporting the
issuance of a press release announcing our financial and operating
results for the three months ended March 31, 2004.
On June 8, 2004, we filed a report on Form 8-K under Item 5, Other
Events, announcing an increase in our 2004 capital budget.
27
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
KCS ENERGY, INC.
Date: August 9, 2004 /s/ Frederick Dwyer
-----------------------------------------------
Frederick Dwyer
Vice President, Controller and Secretary
(Signing on behalf of the registrant and
as Principal Accounting Officer)
28
EXHIBIT INDEX
Exhibit
No. Description
- ------ -----------
4.1 Indenture, dated as of April 1, 2004, among KCS Energy, Inc., certain
of its subsidiaries and U.S. Bank National Association (incorporated by
reference to Exhibit 4.1 to the quarterly report on Form 10-Q (File No.
001-13781) filed with the SEC on May 10, 2004).*
4.2 Form of 7-1/8% Senior Note due 2012 (included in Exhibit 4.1).*
10.1 Registration Rights Agreement, dated April 1, 2004, by and among KCS
Energy, Inc., KCS Resources, Inc., Medallion California Properties
Company, KCS Energy Services, Inc., Proliq, Inc., Credit Suisse First
Boston LLC, Merill Lynch, Pierce, Fenner & Smith, Incorporated,
Jefferies & Company, Inc., Harris Nesbitt Corp., Banc One Capital
Markets, Inc., and BNB Paribas Securities Corp. (incorporated by
reference to Exhibit 10.2 to the quarterly report on Form 10-Q (File
No. 001-13781) filed with the SEC on May 10, 2004).*
31.1 Certification of James W. Christmas, Chairman and Chief Executive
Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.+
31.2 Certification of Joseph T. Leary, Vice President and Chief Financial
Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.+
32.1 Certification of James W. Christmas, Chairman and Chief Executive
Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.+
32.2 Certification of Joseph T. Leary, Chief Financial Officer, pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.+
- ------------------
+ Filed herewith.
* Incorporated by reference.