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Table of Contents

 

 

 

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 September 30, 2011

 

OR

 

 

 

o

 

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

 

For the transition period from                to               

 

Commission File No. 000-33275

 

WARREN RESOURCES, INC.

(Exact Name of Registrant as Specified in its Charter.)

 

Maryland

 

11-3024080

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification Number)

 

1114 Avenue of the Americas,

 

 

New York, NY

 

10036

(Address of Principal Executive Offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code:

(212) 697-9660

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 and 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) 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 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 (as defined in Rule 12b-2 of the Exchange Act).

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

 

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

 

The aggregate number of Registrant’s outstanding shares on November 7, 2011 was 71,518,810 shares of Common Stock, $0.0001 par value.

 

 

 



Table of Contents

 

WARREN RESOURCES, INC.

 

TABLE OF CONTENTS

 

PART I—

FINANCIAL INFORMATION

 

 

 

 

 

Item 1. Financial Statements (Unaudited)

 

 

 

 

 

Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010

 

 

 

 

 

Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010

 

 

 

 

 

Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010

 

 

 

 

 

Notes to the Consolidated Financial Statements

 

 

 

 

 

Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operations

 

 

 

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

 

 

 

 

Item 4. Controls and Procedures

 

 

 

 

 PART II—

OTHER INFORMATION

 

 

 

 

 

Item 1. Legal Proceedings

 

 

 

 

 

Item 1A. Risk Factors

 

 

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

 

 

 

 

Item 3. Defaults upon Senior Securities

 

 

 

 

 

Item 4. Removed and Reserved

 

 

 

 

 

Item 5. Other Information

 

 

 

 

 

Item 6. Exhibits

 

 

 

 

 

Signatures

 

 

2



Table of Contents

 

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Warren Resources, Inc. and Subsidiaries

CONSOLIDATED BALANCE SHEETS

 

 

 

September 30,
2011
(Unaudited)

 

December 31,
2010

 

 

 

(in thousands, except share

 

 

 

and per share data)

 

ASSETS

 

 

 

 

 

Current Assets

 

 

 

 

 

Cash and cash equivalents

 

$

5,544

 

$

11,092

 

Accounts receivable — trade

 

12,483

 

12,512

 

Restricted investments in U.S. Treasury Bonds—available for sale, at fair value

 

133

 

110

 

Derivative financial instruments

 

377

 

 

Other current assets

 

1,036

 

1,040

 

 

 

 

 

 

 

Total current assets

 

19,573

 

24,754

 

 

 

 

 

 

 

Other Assets

 

 

 

 

 

Oil and gas properties—at cost, based on full cost method of accounting, net ofaccumulated depreciation, depletion and amortization (includes unproved properties excluded from amortization of $25,369 and $25,732 as of September 30, 2011 and December 31, 2010)

 

250,055

 

231,746

 

Property and equipment—at cost, net

 

16,764

 

10,817

 

Restricted investments in U.S. Treasury Bonds—available for sale, at fair value

 

1,194

 

987

 

Derivative financial instruments

 

716

 

392

 

Other assets

 

3,747

 

3,900

 

 

 

 

 

 

 

Total other assets

 

272,476

 

247,842

 

 

 

$

292,049

 

$

272,596

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Current maturities of debentures and other long-term liabilities

 

$

1,288

 

$

3,631

 

Accounts payable and accruals

 

34,868

 

24,414

 

Derivative financial instruments

 

893

 

9,625

 

 

 

 

 

 

 

Total current liabilities

 

37,049

 

37,670

 

 

 

 

 

 

 

Long-Term Liabilities

 

 

 

 

 

Debentures, less current portion

 

1,486

 

1,486

 

Other long-term liabilities, less current portion

 

13,323

 

12,663

 

Derivative financial instruments

 

 

603

 

Line of credit

 

69,500

 

69,500

 

 

 

 

 

 

 

 

 

84,309

 

84,252

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

8% convertible preferred stock, par value $.0001; authorized 10,000,000 shares,issued and outstanding, 10,703 shares and 10,703 in 2011 and 2010, respectively (aggregate liquidation preference $128 in 2011 and $128 in 2010)

 

128

 

128

 

Common stock - $.0001 par value; authorized, 100,000,000 shares;issued 71,518,810 shares in 2011 and 71,338,149 shares in 2010

 

7

 

7

 

Additional paid-in-capital

 

464,592

 

463,326

 

Accumulated deficit

 

(293,579

)

(312,217

)

Accumulated other comprehensive income, net of applicable income taxesof $179 in 2011 and $103 in 2010

 

271

 

158

 

 

 

171,419

 

151,402

 

Less common stock in Treasury—at cost; 632,250 shares in 2011 and 2010

 

728

 

728

 

Total stockholders’ equity

 

170,691

 

150,674

 

 

 

$

292,049

 

$

272,596

 

 

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

 

3



Table of Contents

 

Warren Resources, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, (Unaudited)

 

September 30, (Unaudited)

 

 

 

(in thousands, except share

 

(in thousands, except share

 

 

 

and per share data)

 

and per share data)

 

 

 

2011

 

2010

 

2011

 

2010

 

Operating revenues

 

 

 

 

 

 

 

 

 

Oil and gas sales

 

$

26,018

 

$

23,117

 

$

76,091

 

$

65,688

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Lease operating expense and taxes

 

7,894

 

7,666

 

24,335

 

21,632

 

Depreciation, depletion and amortization

 

7,604

 

5,608

 

20,582

 

15,531

 

General and administrative

 

3,684

 

4,003

 

10,847

 

11,617

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

19,182

 

17,277

 

55,764

 

48,780

 

 

 

 

 

 

 

 

 

 

 

Income from operations

 

6,836

 

5,840

 

20,327

 

16,908

 

 

 

 

 

 

 

 

 

 

 

Other income (expense)

 

 

 

 

 

 

 

 

 

Interest and other income

 

27

 

97

 

62

 

225

 

Interest expense

 

(749

)

(896

)

(2,093

)

(2,649

)

Gain (loss) on derivative financial instruments

 

4,001

 

(746

)

266

 

5,517

 

 

 

 

 

 

 

 

 

 

 

Total other income (expense)

 

3,279

 

(1,545

)

(1,765

)

3,093

 

 

 

 

 

 

 

 

 

 

 

Income before taxes

 

10,115

 

4,295

 

18,562

 

20,001

 

 

 

 

 

 

 

 

 

 

 

Deferred income tax benefit

 

(69

)

(25

)

(76

)

(68

)

 

 

 

 

 

 

 

 

 

 

Net income

 

10,184

 

4,320

 

18,638

 

20,069

 

 

 

 

 

 

 

 

 

 

 

Less dividends and accretion on preferred shares

 

3

 

3

 

8

 

16

 

 

 

 

 

 

 

 

 

 

 

Net income applicable to common stockholders

 

$

10,181

 

$

4,317

 

$

18,630

 

$

20,053

 

 

 

 

 

 

 

 

 

 

 

Earnings per share — Basic

 

$

0.14

 

$

0.06

 

$

0.26

 

$

0.29

 

Earnings per share — Diluted

 

0.14

 

0.06

 

0.26

 

0.28

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding — Basic

 

70,877,106

 

70,463,901

 

70,812,083

 

70,305,292

 

Weighted average common shares outstanding — Diluted

 

71,950,576

 

71,548,470

 

72,065,686

 

71,355,853

 

 

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

 

4



Table of Contents

 

Warren Resources, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

 

For the nine months ended
September 30, (Unaudited)

 

 

 

(in thousands)

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

18,638

 

$

20,069

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Accretion of discount on available-for-sale debt securities

 

(40

)

(38

)

Amortization of deferred offering costs

 

155

 

147

 

Depreciation, depletion and amortization

 

20,582

 

15,531

 

Change in fair value of derivative financial instruments

 

(10,037

)

(5,957

)

Stock option expense

 

1,151

 

1,925

 

Deferred tax benefit

 

(76

)

(68

)

Change in assets and liabilities:

 

 

 

 

 

Increase in accounts receivable—trade

 

(588

)

(406

)

(Increase) decrease in other assets

 

2

 

(9

)

Increase in accounts payable and accruals

 

2,690

 

3,167

 

Decrease in other long-term liabilities

 

(292

)

(565

)

 

 

 

 

 

 

Net cash provided by operating activities

 

32,185

 

33,796

 

Cash flows from investing activities:

 

 

 

 

 

Purchase, exploration and development of oil and gas properties

 

(28,918

)

(22,420

)

Purchase of property and equipment

 

(6,733

)

(3,556

)

 

 

 

 

 

 

Net cash used in investing activities

 

(35,651

)

(25,976

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Payments on long-term debt

 

(2,205

)

(7,728

)

Issuance of common stock, net

 

123

 

97

 

Repurchase of preferred stock, net

 

 

(1,051

)

 

 

 

 

 

 

Net cash used in financing activities

 

(2,082

)

(8,682

)

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(5,548

)

(862

)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

11,092

 

17,238

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

5,544

 

$

16,376

 

Supplemental disclosure of cash flow information

 

 

 

 

 

Cash paid for interest, net of amounts capitalized

 

$

1,948

 

$

2,454

 

Noncash investing and financing activities

 

 

 

 

 

Note payable on purchase of property and equipment

 

 

3,500

 

Accrued preferred stock dividend

 

8

 

16

 

 

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

 

5



Table of Contents

 

WARREN RESOURCES, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE A—ORGANIZATION

 

Warren Resources, Inc. (the “Company” or “Warren”), was originally formed on June 12, 1990 for the purpose of acquiring and developing oil and gas properties. The Company is incorporated under the laws of the state of Maryland. The Company’s properties are primarily located in Wyoming, California and New Mexico.

 

The accompanying unaudited financial statements and related notes present the Company’s consolidated financial position as of September 30, 2011 and December 31, 2010, the consolidated results of operations for the three and nine months ended September 30, 2011 and 2010 and consolidated cash flows for the nine months ended September 30, 2011 and 2010. The unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2011. The accounting policies followed by the Company are set forth in Note A to the Company’s financial statements included in Form 10-K for the year ended December 31, 2010. These interim financial statements and notes thereto should be read in conjunction with the consolidated financial statements presented in the Company’s 2010 Annual Report on Form 10-K.

 

NOTE BSTOCK BASED COMPENSATION

 

Stock Options

 

Compensation expense related to stock options and restricted stock awards recognized in operating results (general and administrative expenses) was approximately $0.4 and $0.4 million for the three months ended September 30, 2011 and September 30, 2010, respectively, and approximately $1.1 and $1.9 million for the nine months ending September 30, 2011 and September 30, 2010 respectively.

 

The following assumptions were used to value stock options calculated using the Black-Scholes options pricing model:

 

 

 

Nine months ended September 30,

 

 

 

2011

 

2010

 

Dividend yield

 

0

%

0

%

Expected volatility

 

74.5

%

77.8

%

Risk-free interest rate

 

1.2

%

1.6

%

Expected life

 

3.5 years

 

3.5 years

 

 

 

 

 

 

Weighted

 

Weighted

 

 

 

 

 

 

 

Average

 

Average

 

Aggregate

 

 

 

Number

 

Exercise

 

Remaining

 

Intrinsic Value

 

 

 

of Options

 

Price

 

Term (in years)

 

(in thousands)

 

Outstanding at December 31, 2010

 

3,541,703

 

$

4.80

 

 

 

 

 

Granted

 

143,000

 

3.92

 

 

 

 

 

Exercised

 

(155,935

)

0.79

 

 

 

 

 

Forfeited or expired

 

(380,199

)

12.48

 

 

 

 

 

Outstanding at September 30, 2011

 

3,148,569

 

$

4.03

 

2.46

 

$

2,143

 

 

 

 

 

 

 

 

 

 

 

Exercisable at September 30, 2011

 

1,817,399

 

$

5.60

 

2.01

 

$

1,216

 

 

6



Table of Contents

 

The total intrinsic value of options exercised during the nine months ended September 30, 2011 and 2010 were approximately $487,000 and $495,000 respectively.

 

As of September 30, 2011 total unrecognized stock-based compensation expense related to non-vested stock options was approximately $1.0 million, which we expect to recognize over a weighted average period of 1.6 years.

 

Restricted Shares

 

Restricted share activity as of September 30, 2011 was as follows:

 

 

 

Shares

 

Weighted
Average
Fair Value

 

 

 

 

 

 

 

Outstanding at December 31, 2010

 

28,373

 

$

11.15

 

Granted

 

662,562

 

4.22

 

Vested

 

(36,248

)

9.67

 

Forfeited

 

(38,558

)

4.22

 

Outstanding at September 30, 2011

 

616,129

 

$

4.22

 

 

Restricted stock awards for executive officers and employees vest ratably over three years. Fair value of our restricted shares is based on our closing stock price on the date of grant.  As of September 30, 2011, total unrecognized stock-based compensation expense related to non-vested restricted shares was $2.3 million, which is expected to be recognized over a weighted average period of approximately 2.4 years.

 

NOTE CSTOCKHOLDERS’ EQUITY

 

The preferred stock pays an 8% cumulative dividend which is treated as a deduction of additional paid in capital, due to insufficient retained earnings. The holders of the preferred stock are not entitled to vote except as defined by the agreement or as provided by applicable law.  The preferred stock may be voluntarily converted, at the election of the holder, into common stock of the Company based on a conversion rate of one share of preferred stock for 0.50 shares of common stock. The accrual of the dividend is deducted from earnings in the calculation of earnings attributable to common stockholders.

 

Additionally, commencing October 1, 2009, holders of the preferred stock can elect to require the Company to redeem their preferred stock at a redemption price equal to the liquidation value of $12.00 per share, plus accrued but unpaid dividends, if any, (“Redemption Price”).  Upon the receipt of a redemption election, the Company, at its option, shall either: (1) pay the holder cash in the amount equal to the Redemption Price or (2) issue to the holder shares of common stock in an amount equal to 125% of the redemption price and any accrued and unpaid dividends, based on the weighted average closing “bid” price of the Company’s common stock for the thirty trading days immediately preceding the date of the written redemption election by the holder up to a maximum of 1.5 shares of common stock for each one share of preferred stock redeemed. The Company has accreted the carrying value of its preferred stock to its redemption price using the effective interest method with changes recorded to additional paid in capital. The accretion of preferred stock results in a reduction of earnings applicable to common stockholders.

 

Notwithstanding the forgoing, if the closing “bid” price of the Company’s publicly traded common stock as reported by the NASDAQ stock market, or any exchange on which the shares of common stock are traded, exceeds 133% of the conversion price then in effect for the convertible preferred shares for at least 10 days during any 30-day trading period, the Company has the right to redeem in whole or in part the convertible preferred stock at a redemption price of $12 per share (plus any accrued unpaid dividends) or convert the convertible preferred shares (plus any accrued unpaid dividends) into common stock at the then applicable conversion rate.

 

7



Table of Contents

 

NOTE D—EARNINGS (LOSS) PER SHARE

 

Basic earnings (loss) per share is computed by dividing net earnings (loss) applicable to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted earnings (loss) per share is based on the assumption that stock options and warrants are converted into common shares using the treasury stock method and convertible bonds and preferred stock are converted using the if-converted method. Conversion is not assumed if the results are anti-dilutive.  Potential common shares for the nine months ended September 30, 2011 and September 30, 2010 of 52,522 and 52,522 respectively, relating to convertible bonds and preferred stock, were excluded from the computation of diluted earnings (loss) per share because they are anti-dilutive. Potential common shares of 1,519,795 and 2,402,963 respectively, relating to stock options and restricted stock were excluded from the computation of diluted earnings (loss) per share for the nine months ended September 30, 2011 and 2010, respectively, because they are anti-dilutive. Stock options have a weighted average exercise price of $4.03 and $4.78 at September 30, 2011 and September 31, 2010, respectively. At September 30, 2011, the convertible bonds may be converted from the date of issuance until maturity at 100% of principal amount into common stock of the Company at a price of $35 to $50.  The preferred stock may be converted at the discretion of the holder or upon meeting certain conditions at the discretion of the Company (see Note C).

 

Basic and diluted net earnings per share are computed based on the following information:

 

 

 

Three Months
Ended
September 30,
2011

 

Three Months
Ended
September 30, 2010

 

Nine Months
Ended
September 30,
2011

 

Nine Months
Ended
September 30,
2010

 

 

 

(in thousands, except for per
share data)

 

(in thousands, except for per
share data)

 

Net earnings available to common shareholders

 

$

10,181

 

$

4,317

 

$

18,630

 

$

20,053

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - basic

 

70,877,106

 

70,463,901

 

70,812,083

 

70,305,292

 

Effect of dilutive securities — stock options

 

1,073,470

 

1,084,569

 

1,253,603

 

1,050,561

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - diluted

 

71,950,576

 

71,548,470

 

72,065,686

 

71,355,853

 

 

 

 

 

 

 

 

 

 

 

Basic net earnings per share

 

$

0.14

 

$

0.06

 

$

0.26

 

$

0.29

 

Diluted net earnings per share

 

$

0.14

 

$

0.06

 

$

0.26

 

$

0.28

 

 

8



Table of Contents

 

NOTE E—LONG-TERM LIABILITIES

 

Long-term liabilities, excluding derivative financial instruments (see Note J), consisted of the following for the balance sheets dated:

 

 

 

September 30,

 

December 31,

 

 

 

2011

 

2010

 

 

 

(in thousands)

 

Line of Credit

 

$

69,500

 

$

69,500

 

Convertible debentures

 

1,651

 

1,651

 

Debt collateralized by treasury stock

 

139

 

245

 

Asset retirement obligations

 

10,740

 

10,217

 

Litigation allowance

 

3,100

 

3,100

 

Drilling rig note payable

 

467

 

2,567

 

 

 

85,597

 

87,280

 

Less current portion

 

1,288

 

3,631

 

Long-term portion

 

$

84,309

 

$

83,649

 

 

On November 19, 2007, the Company entered into a five year, $250 million credit agreement with Merrill Lynch Capital (now owned by GE Business Financial Services, Inc.). The Credit Facility provides for a revolving credit line up to the lesser of (i) the borrowing base, (ii) $250 million or (iii) the draw limit requested by the Company. The Credit Facility matures on November 19, 2012. It is secured by substantially all of our assets. The borrowing base will be determined by the lenders at least semi-annually on each April 1 and October 1 and is based in part on the proved reserves of the Company. The current borrowing base is $120 million. Interest payments are made in arrears. Credit line interest of approximately $0.1 million was accrued as of September 30, 2011. As of September 30, 2011, the Company has $69.5 million outstanding on its borrowing base.

 

The Company is subject to certain covenants under the terms of the Credit Facility which include, but are not limited to, the maintenance of the following financial ratios (1) minimum current ratio of current assets (including unused borrowing base in current assets) to current liabilities of 1.0 to 1.0 and (2) a minimum annualized consolidated EBITDAX (as defined by the Credit Facility) to net interest expense of 2.5 to 1.0. The Company is in compliance with these covenants as of September 30, 2011.

 

Depending on the current level of borrowing base usage, the annual interest rate on each base rate borrowing under the Credit Facility will be at our option either: (a) a “Base Rate Loan”, or any other Obligation other than a LIBOR Loan, which has an interest rate equal to the sum of the “Base Rate” plus the applicable “Base Rate Margin”, calculated to be the higher of (i) the Agent’s prime rate of interest announced from time to time, or (ii) the Federal Funds rate most recently determined by the Agent, plus 3.0% per annum, plus an applicable margin that ranges from 1.5% to 2.25%, or (b) a “LIBOR Loan”, which has an interest rate equal to the sum of the applicable LIBOR period plus the applicable “LIBOR Margin”, that ranges from 2.75% to 3.50%. As of September 30, 2011, the weighted average interest rate on the credit line was 3.2%.

 

The convertible bonds may be converted from the date of issuance until maturity at 100% of principal amount into common stock of the Company at prices ranging from $35 to $50. Each year the holders of the convertible bonds may tender to the Company up to 10% of the aggregate bonds issued and outstanding. During the nine months ended September 30, 2011, there were no bond redemptions.

 

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NOTE F—ASSET RETIREMENT OBLIGATION

 

The estimated fair value of the future costs associated with dismantlement, abandonment and restoration of oil and gas properties is recorded generally upon acquisition or completion of a well. The net estimated costs are discounted to present values using a risk adjusted rate over the estimated economic life of the oil and gas properties. Such costs are capitalized as part of the related asset. The asset is depleted on the units-of-production method. The associated liability is classified in other long-term liabilities, net of current portion, in the accompanying Consolidated Balance Sheets. The liability is periodically adjusted to reflect (1) new liabilities incurred, (2) liabilities settled during the period, (3) accretion expense, and (4) revisions to estimated future cash flow requirements. The accretion expense is recorded as a component of depreciation, depletion and amortization. The Company has cash held in escrow with a fair market value of $3.2 million that is legally restricted for potential plugging and abandonment liability in the Wilmington field which is recorded in other assets in the Consolidated Balance Sheets. A reconciliation of the Company’s asset retirement obligations is as follows:

 

 

 

September 30,

 

 

 

2011

 

 

 

(in thousands)

 

Balance at beginning of period

 

$

10,217

 

Liabilities incurred in current period

 

113

 

Liabilities settled in current period

 

(329

)

Accretion expense

 

739

 

Balance at end of period

 

$

10,740

 

 

NOTE G—CONTINGENCIES

 

In 2005, Warren recorded a provision for $1.8 million relating to a contingent liability that the Company may face as a result of a lawsuit originally filed in 1998 by Gotham Insurance Company in the 81st Judicial District Court of Frio County, Texas (Gotham Insurance Company v. Pedeco, Inc., et al.,) seeking a refund of approximately $1.8 million paid by Gotham and other insurers under an insurance policy issued for a well blow-out that occurred in 1997. After several appeals to the Texas Court of Appeals and the Texas Supreme Court, the case was remanded to the trial court for further proceedings. Both parties filed Motions for Summary Judgment in mid-2009, and on November 19, 2009, the trial court heard oral arguments on both Motions for Summary Judgment. On January 22, 2010, the court granted Gotham’s Motion for Summary Judgment for restitution in the amount of $1,823,156 and also awarded prejudgment interest at the rate of 5% per annum in the amount of $976,011. As a result of the January 2010 Summary Judgment, Warren recorded an additional provision of $1.3 million in the fourth quarter of 2009 relating to this contingent liability. On July 7, 2010, Warren E&P posted a supersedeas bond with the court and commenced to appeal the order of the trial court to the Texas Court of Appeals. The San Antonio Court of Appeals assigned and transferred this appeal to the El Paso Court of Appeals.  Based on extensions given by the El Paso Court of Appeals, the Frio County District Court Clerk certified and filed the Record on Appeal on October 26, 2010.  On March 14, 2011, Warren filed its appellate brief with the El Paso Court of Appeals. Gotham filed its response to Warren’s brief on May 31, 2011. Warren replied to Gotham’s response on June 23, 2011. The parties are waiting for a decision by the El Paso Court of Appeals. Although Warren believes that it has meritorious grounds for the appeal, if its appeal is unsuccessful, it will pay the amount of restitution to Gotham, as ordered by the trial court.

 

The Company is a party to various other matters of litigation arising in the normal course of business. Management believes that the ultimate outcome of the matters will not have a material effect on the Company’s financial condition or results of operations.

 

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NOTE H—COMPREHENSIVE INCOME

 

Other comprehensive income consists primarily of net unrealized investment gains and losses, net of income tax effect. Total comprehensive income for the periods is as follow:

 

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2011

 

2010

 

2011

 

2010

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

10,184

 

$

4,320

 

$

18,638

 

$

20,069

 

Holding gains on available for sale investments

 

102

 

39

 

113

 

103

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

10,286

 

$

4,359

 

$

18,751

 

$

20,172

 

 

NOTE I - FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The estimated fair values of financial instruments recognized in the Consolidated Balance Sheets or disclosed within these Notes to Consolidated Financial Statements have been determined using available market information, information from unrelated third party financial institutions and appropriate valuation methodologies, primarily discounted projected cash flows. However, considerable judgment is required when interpreting market information and other data to develop estimates of fair value.

 

Short-term Assets and Liabilities. The fair values of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses and other current liabilities approximate their carrying values because of their short-term nature.

 

U.S. Treasury Bonds - Trading and Available-For-Sale Securities.  The fair values are based upon quoted market prices for those or similar investments and are reported on the Consolidated Balance Sheets at fair value.

 

Collateral Security Agreement Account (included in other non-current assets). The balance sheet carrying amount approximates fair value, as it earns a market rate.

 

Convertible Debentures: Fair values of fixed rate convertible debentures were calculated using interest rates in effect as of period end for similar instruments with the other terms unchanged.

 

Other Long-Term Liabilities.  The carrying amount approximates fair value due the current rates offered to the Company for long-term liabilities of the same remaining maturities.

 

Line of Credit. The carrying amount approximates fair value due the current rates offered to the Company for lines of credit.

 

Derivatives. The fair values are based upon observable inputs based on market data obtained from independent sources and are considered Level 2 inputs (quoted prices for similar assets, liabilities (adjusted) and market-corroborated inputs) and are reported on the Consolidated Balance Sheets at fair value.

 

 

 

September 30, 2011

 

December 31, 2010

 

 

 

Fair

 

Carrying

 

Fair

 

Carrying

 

 

 

value

 

amount

 

value

 

amount

 

 

 

(in thousands)

 

Financial assets

 

 

 

 

 

 

 

 

 

Collateral security account

 

$

3,162

 

$

3,162

 

$

3,160

 

$

3,160

 

 

 

 

 

 

 

 

 

 

 

Financial liabilities

 

 

 

 

 

 

 

 

 

Fixed rate debentures

 

$

2,174

 

$

1,651

 

$

1,901

 

$

1,651

 

Other long-term liabilities

 

139

 

139

 

245

 

245

 

Line of credit

 

69,500

 

69,500

 

69,500

 

69,500

 

Drilling rig obligation

 

467

 

467

 

2,567

 

2,567

 

 

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FAIR VALUE MEASUREMENTS:

 

Fair value as defined by authoritative literature 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 and establishes a three level hierarchy for measuring fair value. The literature requires fair value measurements be classified and disclosed in one of the following categories:

 

Level 1:   Quoted prices (unadjusted) in active markets for identical assets and liabilities that we have the ability to access at the measurement date.

 

Level 2:  Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived from observable market data by correlation or other means. Instruments categorized in Level 2 include non-exchange traded derivatives such as over-the-counter forwards and swaps.

 

Level 3:  Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity for the asset or liability.

 

The following tables present for each hierarchy level our assets and liabilities, including both current and non-current portions, measured at fair value on a recurring basis.

 

September 30, 2011

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(in thousands)

 

Assets

 

 

 

 

 

 

 

 

 

Restricted investments in US Treasury Bonds — available for sale, at fair value

 

$

1,327

 

$

 

$

 

$

1,327

 

Commodity derivatives

 

$

 

$

1,093

 

$

 

$

1,093

 

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(in thousands)

 

Liabilities

 

 

 

 

 

 

 

 

 

Commodity derivatives

 

$

 

$

893

 

$

 

$

893

 

 

December 31, 2010

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(in thousands)

 

Assets

 

 

 

 

 

 

 

 

 

Restricted investments in US Treasury Bonds — available for sale, at fair value

 

$

1,097

 

$

 

$

 

$

1,097

 

Commodity derivatives

 

$

 

$

392

 

$

 

$

392

 

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(in thousands)

 

Liabilities

 

 

 

 

 

 

 

 

 

Commodity derivatives

 

$

 

$

10,228

 

$

 

$

10,228

 

 

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NOTE J — DERIVATIVE FINANCIAL INSTRUMENTS

 

To minimize the effect of a downturn in oil and gas prices and protect our profitability and the economics of our development plans, we enter into crude oil and natural gas hedge contracts. The terms of contracts depend on various factors, including management’s view of future crude oil and natural gas prices. This price hedging program is designed to moderate the effects of a crude oil and natural gas price downturn while allowing us to participate in some commodity price increases. Management regularly monitors the crude oil and natural gas markets and our financial commitments to determine if, when, and at what level some form of crude oil and/or natural gas hedging and/or basis adjustments or other price protection is appropriate. Currently, our derivatives are in the form of swaps, calls and costless collars.  However, we may use a variety of derivative instruments in the future to hedge. The Company has not designated these derivatives as hedges for accounting purposes.

 

The following table summarizes the open financial derivative positions as of September 30, 2011, related to oil and gas production. The Company will receive prices as noted in the table below and will pay a counterparty market price based on the NYMEX (for natural gas production) or WTI (for oil production) index price, settled monthly.

 

Product

 

Type

 

Contract Period

 

Volume

 

Price per
Mcf or Bbl

Oil

 

Swap

 

07/01/11 - 12/31/11

 

840 Bbl/d

 

$61.80

Oil

 

Call

 

01/01/12 - 01/31/12

 

200,000 Bbl

 

$110.00

Oil

 

Put

 

01/01/12 - 12/31/12

 

1,000 Bbl/d

 

$70.00

Natural Gas

 

Swap

 

09/01/11 - 10/31/11

 

4,000 Mcf/d

 

$4.56

Natural Gas

 

Collar

 

11/01/11 - 12/31/11

 

4,000 Mcf/d

 

$4.00 - $6.28

Natural Gas

 

Collar

 

07/01/11 - 12/31/11

 

3,000 Mcf/d

 

$4.25 - $5.03

Natural Gas Differentials

 

Swap

 

07/01/11 - 11/30/11

 

2,500 Mcf/d

 

–$0.71*

Natural Gas Differentials

 

Swap

 

07/01/11 - 12/31/11

 

6,500 Mcf/d

 

–$0.44*

Natural Gas Differentials

 

Swap

 

01/01/12 - 12/31/12

 

3,000 Mcf/d

 

–$0.51*

 


*                                         This represents a differential spread between NYMEX and CIG pricing.

 

The tables below summarize the amount of gains (losses) recognized in income from derivative instruments not designated as hedging instruments under authoritative guidance.

 

Derivatives not designated as

 

For the Three Months

 

For the Nine Months

 

Hedging Instrument under

 

Ended September 30,

 

Ended September 30,

 

authoritative guidance

 

2011

 

2010

 

2011

 

2010

 

(in thousands)

 

 

 

 

 

 

 

 

 

Realized cash settlements on hedges

 

$

(4,443

)

$

1,655

 

$

(9,664

)

$

1,636

 

Unrealized gain (loss) on hedges

 

8,444

 

(2,401

)

9,930

 

3,881

 

Total

 

$

4,001

 

$

(746

)

$

266

 

$

5,517

 

 

The table below reflects the line item in our Consolidated Balance Sheet where the fair value of our net derivatives, are included.

 

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Table of Contents

 

September 30, 2011

 

 

 

Derivative Assets

 

(in thousands)

 

Balance Sheet
Location

 

Fair Value

 

Commodity—Oil

 

current

 

377

 

Commodity—Natural Gas

 

Non-current

 

(62

)

Commodity—Oil

 

Non-current

 

778

 

Total derivatives not designated as hedging instruments

 

 

 

$

1,093

 

 

September 30, 2011

 

 

 

Derivative Liabilities

 

(in thousands)

 

Balance Sheet
Location

 

Fair Value

 

Commodity—Natural Gas

 

current

 

(147

)

Commodity—Oil

 

current

 

(746

)

Total derivatives not designated as hedging instruments

 

 

 

$

(893

)

 

December 31, 2010

 

 

 

Derivative Assets

 

(in thousands)

 

Balance Sheet
Location

 

Fair Value

 

Commodity—Natural Gas

 

Non-current

 

(92

)

Commodity—Oil

 

Non-current

 

484

 

Total derivatives not designated as hedging instruments

 

 

 

$

392

 

 

December 31, 2010

 

 

 

Derivative Liabilities

 

(in thousands)

 

Balance Sheet
Location

 

Fair Value

 

Commodity—Natural Gas

 

current

 

72

 

Commodity—Oil

 

current

 

(9,697

)

Commodity—Oil

 

Non-current

 

(603

)

Total derivatives not designated as hedging instruments

 

 

 

$

(10,228

)

 

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Table of Contents

 

Derivative’s Credit risk

 

The Company does not require collateral or other security from counterparties to support derivative instruments. However, the agreements with those counterparties typically contain netting provisions such that if a default occurs, the non-defaulting party can offset the amount payable to the defaulting party under the derivative contract with the amount due from the defaulting party. As a result of the netting provisions the Company’s maximum amount of loss due to credit risk is limited to the net amounts due to and from the counterparties under the derivative contracts.

 

As of September 30, 2011, the counterparties to the Company’s commodity derivative contracts consist of two financial institutions. The Company’s counterparties or their affiliates are also lenders under the Company’s Senior Credit Agreement. As a result, the counterparties to the Company’s derivative agreements share in the collateral supporting the Company’s Senior Credit Agreement. The Company is not generally required to post additional collateral under derivative agreements.

 

The Company’s derivative agreements contain provisions that require cross defaults and acceleration of those instruments to any material debt. If the Company were to default on any of its material debt agreements, it would be a violation of these provisions, and the counterparties to the derivative instruments could request immediate payment on derivative instruments that are in a net liability position at that time.

 

NOTE K — INCOME TAXES

 

The Company’s effective tax rate differs from the federal statutory tax rate due to changes in the valuation allowance on the Company’s net deferred tax asset.

 

NOTE L — RECENTLY ISSUED ACCOUNTING STANDARDS

 

In June 2011, guidance was issued that (i) will require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements and (ii) eliminates the option to present the components of other comprehensive income as part of the statement of equity. This guidance will become effective on January 1, 2012, can be adopted early, and is not expected to have a material impact on the Company’s consolidated financial statements.

 

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Table of Contents

 

Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operations

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

The Company has made in this report, and may from time to time otherwise make in other public filings, press releases and discussions with Company management, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 concerning the Company’s operations, economic performance and financial condition. These forward-looking statements include information concerning future production and reserves, schedules, plans, timing of development, contributions from oil and gas properties, and those statements preceded by, followed by or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “estimates,” “projects,” “target,” “goal,” “plans,” “objective,” “should” or similar expressions or variations on such expressions. For such statements, the Company claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from the Company’s expectations include, but are not limited to, the Company’s assumptions about energy markets, production levels, reserve levels, operating results, competitive conditions, technology, the availability of capital resources, capital expenditures and other contractual obligations, the supply and demand for and the price of oil, natural gas and other products or services, the weather, inflation, the availability of goods and services, drilling risks, future processing volumes and pipeline throughput, general economic conditions, either internationally or nationally or in the jurisdictions in which the Company or its subsidiaries are doing business, legislative or regulatory changes, including changes in environmental regulation, environmental risks and liability under federal, state and local environmental laws and regulations, potential environmental obligations, the securities or capital markets, our ability to repay debt and other factors discussed in “Risk Factors” and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in the Company’s 2010 Annual Report on Form 10-K, this Form 10-Q and in the Company’s other public filings, press releases and discussions with Company management. Warren undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, subsequent events or otherwise, unless otherwise required by law.

 

Overview

 

We are an independent energy company engaged in the exploration and development of domestic onshore oil and natural gas reserves. We focus our efforts primarily on our waterflood oil recovery programs and horizontal drilling in the Wilmington field within the Los Angeles Basin of California and on the exploration and development of coalbed methane (“CBM”) properties located in the Rocky Mountain region. As of September 30, 2011, we owned oil and natural gas leasehold interests in approximately 130,709 gross, 70,612 net acres, approximately 80% of which are undeveloped. Substantially all our undeveloped acreage is located in the Rocky Mountains.

 

Liquidity and Capital Resources

 

Our cash and cash equivalents decreased $5.5 million to $5.5 million during the nine months ended September 30, 2011.  This resulted from cash provided from operating activities of $32.2 million offset by cash used in investing activities of $35.7 million and cash used in financing activities of $2.1 million.

 

Cash provided by operating activities was primarily generated by oil and gas operations.  Cash used in investing activities was primarily spent on oil and gas properties and equipment.  Cash used in financing activities primarily represents paying down our outstanding debt on our recently acquired drilling rig.

 

On August 26, 2010, Warren purchased an oil drilling rig for $7 million. The Company paid $3.5 million at closing with the balance payable in fifteen equal monthly installments, commencing September 30, 2010. This rig was placed in operation during March 2011 to drill oil wells on our California properties.  As of September 30, 2011, the Company has paid an additional $9.2 million to assemble and equip the drilling rig.

 

On November 19, 2007, Warren entered into a five year, $250 million credit agreement with Merrill Lynch Capital (subsequently sold to GE Business Financial Services, Inc.) on behalf of itself and a syndicate of five participating banks (the “Credit Facility”).   The Credit Facility provides for a revolving loan up to the lesser of (i) the borrowing base (ii) $250 million or (iii) the draw limit requested by the Company.  The Credit Facility matures on November 19, 2012.  It is secured by substantially all of our assets.  The borrowing base will be determined by the lenders at least semi-annually on or about

 

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Table of Contents

 

April 1 and October 1 of each year, and is based in part on the proved reserves of the Company. The current borrowing base is $120 million, representing an immediate availability of $50.5 million as of September 30, 2011.  The Company has not repaid any amounts under the Credit Facility during the first nine months of 2011.  The Company is subject to certain covenants required by the Credit Facility which include, but are not limited to the maintenance of the following financial ratios (1) a minimum current ratio (including the unused borrowing base and excluding unrealized gains and losses on derivative financial instruments) of not less than 1.0 to 1.0 and (2) a minimum annualized consolidated EBITDAX (as defined by the Credit Facility) to net interest expense of not less than to of 2.5 to 1.0.  As of September 30, 2011, the Company had borrowed $69.5 million under the Credit Facility and was in compliance with all covenants.  If the Company fails to satisfy its Credit Facility covenants, it would be an event of default.  Under such event of default and upon notice, all borrowings would become immediately due and payable to the lending banks.

 

Depending on the current level of borrowing base usage, the annual interest rate on each base rate borrowing under the Credit Facility will be at our option either: (a) a “Base Rate Loan”, or any other Obligation other than a LIBOR Loan, which has an interest rate equal to the sum of the “Base Rate” plus the applicable “Base Rate Margin”, calculated to be the higher of (i) the Agent’s prime rate of interest announced from time to time, or (ii) the Federal Funds rate most recently determined by the Agent, plus 3.0% per annum, plus an applicable margin that ranges from 1.5% to 2.25%, or (b) a “LIBOR Loan”, which has an interest rate equal to the sum of the applicable LIBOR period plus the applicable “LIBOR Margin”, that ranges from 2.75% to 3.50%. During the first nine months of 2011, the Company incurred $2.0 million of interest expense, net of amounts capitalized, under the Credit Facility of which approximately $0.1 million was accrued for as of September 30, 2011. The weighted average interest rate as of September 30, 2011 was 3.2%.

 

If oil and gas commodity prices go lower, the Company may not generate sufficient cash flows to cover capital expenditures. In such case, the availability of funds under our Credit Facility is critical to our Company. The borrowing base is scheduled to be redetermined in November 2011. If the Credit Facility’s borrowing base is reduced to a level below current borrowings, the Company would be obligated to begin reducing the deficiency by 25% within 90 days after the deficiency occurs and the remaining 75% within 180 days after the deficiency occurs.

 

Our operations are affected by local, national and worldwide economic conditions. We have relied on the capital markets, particularly for equity securities, as well as the banking and debt markets, to meet financial commitments and liquidity needs if internally generated cash flow from operations is not adequate to fund our capital requirements. Capital markets in the United States and elsewhere have been experiencing extreme adverse volatility and disruption, due in part to the financial stresses affecting the liquidity of the banking system, the real estate mortgage industry and global financial markets generally.

 

Low commodity prices may restrict our ability to meet our current obligations. As a result, Management has taken several actions to ensure that the Company will have sufficient liquidity to meet its obligations through the next twelve months, including entering into price swap agreements, collars, puts, futures contracts and differential swap agreements for a portion of its 2011 and 2012 production to reduce price volatility and reductions in discretionary expenditures. As of September 30, 2011, approximately 50% of the Company’s estimated 2011 oil and natural gas production are covered by commodity derivatives. It is not anticipated that these percentages will change significantly during the remainder of 2011. If the liquidity of the Company should worsen, the Company would evaluate other measures to further improve its liquidity, including, the sale of equity or debt securities, the sale of certain assets, entering into joint ventures with third parties, volumetric production payments, additional commodity price hedging and other monetization of assets strategies. There is no assurance that the Company will be successful in these capital raising efforts that may be necessary to fund operations during the next twelve months.

 

During the first nine months of 2011, the Company had net income of $18.6 million (which included $9.9 million of unrealized gains on derivative financial instruments). This compares to the nine months of 2010 when the Company had net income of $20.1 million (which included a $3.9 million of unrealized gains on derivative financial instruments). At September 30, 2011, current assets were $17.5 million less than current liabilities. Currently, the Company has a borrowing base of $120 million and $69.5 million outstanding under the Credit Facility.

 

In the future, if natural gas inventories rise to levels such that no natural gas storage capacity exists, certain U.S. natural gas production will need to be reduced or shut in.  Additionally, if commodity prices decline to levels that make it uneconomic to produce oil and natural gas, the Company or its partners may elect to shut in or reduce production.  As a result, some or all of the Company’s oil and natural gas production may be shut in or curtailed during the next 12 months, which would have a material adverse effect on operations.

 

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Table of Contents

 

The Company’s proved reserves may decline in future years.  Due to commodity prices, compared to the cost of developing our undeveloped reserves and our estimated lease operating expenses, a portion of our future projects may become uneconomic.  The Company’s projects have material lease operating expenses.  Our oil operations include a secondary recovery waterflood with significant fixed costs.  During the first nine months of 2011, our oil lease operating expenses were $21.07 per net barrel of oil produced. Our natural gas operations include reinjecting the produced water into deep formations and compressing and transporting the gas with significant fixed costs. During the first nine months of 2011, our natural gas lease operating expenses were $2.78 per net mcf of gas produced.

 

At September 30, 2011, we had approximately 1.8 million vested outstanding stock options issued under our stock based equity compensation plans. Of the total outstanding vested options, 1.0 million had exercise prices above the closing market price $2.38 of our common stock on September 30, 2011.

 

Contractual Obligations

 

The contractual obligations table below assumes the maximum amount under contract is tendered each year. The table does not give effect to the conversion of any bonds to common stock which would reduce payments due. All bonds are secured at maturity by zero coupon U.S. treasury bonds deposited into an escrow account equaling the par value of the bonds maturing on or before the maturity of the bonds. Such U.S. treasury bonds had a fair market value of $1.3 million at September 30, 2011.  The table below does not reflect the release of escrowed U.S. treasury bonds to us upon redemption.

 

 

 

Payments due by period *

 

Contractual Obligations
As of September 30, 2011

 

Total

 

Less Than
1 Year

 

1-3
Years

 

3-5
Years

 

More Than
5 Years

 

 

 

(in thousands)

 

Line of credit

 

$

69,500

 

$

 

$

69,500

 

$

 

$

 

Bonds

 

1,651

 

165

 

282

 

229

 

975

 

Drilling rigs

 

1,032

 

1,032

 

 

 

 

Other Accounts Payable

 

147

 

147

 

 

 

 

Leases

 

1,358

 

635

 

601

 

122

 

 

Total

 

$

73,688

 

$

1,979

 

$

70,383

 

$

351

 

$

975

 

 


*                      Does not include estimated interest of $2.7 million less than one year, $0.8 million 1-3 years, $0.4 million 3-5 years and $1.0 million thereafter.

 

RESULTS OF OPERATIONS:

 

Three months Ended September 30, 2011 Compared to Three Months Ended September 30, 2010

 

Oil and gas sales. Revenue from oil and gas sales increased $2.9 million in the third quarter of 2011 to $26.0 million, a 13% increase compared to the same quarter in 2010.  This increase resulted from an increase in realized oil prices.  The average realized price per barrel of oil for the three months ended September 30, 2011 and 2010 was $88.79 and $68.87, respectively.  Additionally, the average realized price per Mcf of gas for the three months ended September 30, 2011 and 2010 was $4.18 and $3.87, respectively.  Net oil production for the three months ended September 30, 2011 and 2010 was 232 Mbbls and 265 Mbbls, respectively.  Net gas production for the three months ended September 30, 2011 and 2010 was 1.3 Bcf for both periods.

 

Lease operating expense. Lease operating expense increased 3% to $7.9 million ($17.59 per boe) for the third quarter of 2011 compared to $7.7 million ($16.18 per boe) in the comparable period of 2010. Primarily, this increase resulted from increased transportation costs in our Atlantic Rim project and higher California property taxes.

 

Depreciation, depletion and amortization. Depreciation, depletion and amortization expense increased $2.0 million for the third quarter of 2011 to $7.6 million, a 36% increase compared to the corresponding quarter last year.  The increase in depletion expense resulted from an increase in the 2011 depletion rate.  The 2011 depletion rate increased to $16.94 per boe compared to $11.83 per boe in 2010.  The increase in the 2011 depletion rate compared to the 2010 depletion rate on a boe

 

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basis reflects an increase in estimated future development costs.  Estimated future development costs were $84.6 million at September 30, 2011 compared to $21.3 million at September 30, 2010.  Additionally during the quarter, the Company recorded depreciation of $0.3 million related to its newly purchased drilling rig.

 

General and administrative expenses. General and administrative expenses decreased $0.3 million in the third quarter of 2011 to $3.7 million, an 8% decrease compared to the corresponding quarter last year.  This decrease resulted from a decrease of $0.4 million related to our incentive compensation accrual.  The Company anticipates paying year end incentive compensation amounts in March 2012 based upon reaching certain operational goals in our incentive compensation plan.  Additionally, stock option related expense and legal expense decreased $0.1 million and $0.2 million, respectively, during the quarter.  These decreases were offset by an increase in salary expense totaling $0.3 million.

 

Interest expense. Interest expense decreased 16% to $0.7 million in the third quarter of 2011 compared to the same quarter last year.  The decrease results from a decrease in borrowings under our Credit Facility from $82.5 million at September 30, 2010 to $69.5 million at September 30, 2011.

 

Interest and other income. Interest and other income decreased $70 thousand in the third quarter of 2011 to $27 thousand, compared to the same quarter in 2010.

 

Gain (loss) on derivative financial instruments.  Derivative gains of $4.0 million were recorded during the third quarter of 2011. This amount reflects $4.4 million of realized losses and $8.4 million of unrealized gains resulting from mark to market accounting of our oil and gas swaps, puts, futures contracts and costless collar positions.

 

Nine months Ended September 30, 2011 Compared to Nine Months Ended September 30, 2010

 

Oil and gas sales. Revenue from oil and gas sales increased $10.4 million in the first nine months of 2011 to $76.1 million, a 16% increase compared to the same period in 2010.  This increase resulted from an increase in realized oil prices.  The average realized price per barrel of oil for the nine months ended September 30, 2011 and 2010 was $91.21 and $69.65, respectively.  Additionally, the average realized price per Mcf of gas for the nine months ended September 30, 2011 and 2010 was $4.15 and $4.29, respectively.  Net oil production for the nine months ended September 30, 2011 and 2010 was 665 Mbbls and 729 Mbbls, respectively.  Net gas production for the nine months ended September 30, 2011 and 2010 was 3.7 Bcf and 3.5 Bcf, respectively.

 

Lease operating expense. Lease operating expense increased 12% to $24.3 million ($18.94 per boe) for the first nine months of 2011 compared to $21.6 million ($16.52 per boe) in the comparable period of 2010. Primarily, this increase resulted from increased transportation costs in our Atlantic Rim project, higher California property taxes and higher overall service costs.

 

Depreciation, depletion and amortization. Depreciation, depletion and amortization expense increased $5.1 million for the first nine months of 2011 to $20.6 million, a 33% increase compared to the corresponding period last year.  The increase in depletion expense resulted from an increase in the 2011 depletion rate.  The 2011 depletion rate increased to $16.02 per boe compared to $11.86 per boe in 2010.  The increase in the 2011 depletion rate compared to the 2010 depletion rate on a boe basis reflects an increase in estimated future development costs.  Estimated future development costs were $84.6 million at September 30, 2011 compared to $21.3 million at September 30, 2010.  Additionally during the first nine months of 2011, the Company recorded depreciation of $0.5 million related to its newly purchased drilling rig.

 

General and administrative expenses. General and administrative expenses decreased $0.8 million in the first nine months of 2011 to $10.8 million, a 7% decrease compared to the corresponding period last year.  This decrease resulted from a $0.8 million decrease in stock option expense, a $0.5 million decrease in legal fees and a $0.2 million decrease related to our incentive compensation accrual.  The Company anticipates paying year end incentive compensation amounts in March 2012 based upon reaching certain operational goals in our incentive compensation plan.  This was offset by an increase in salary expense of $0.5 million and other items.

 

Interest expense. Interest expense decreased 21% to $2.1 million in the first nine months of 2011 compared to the same period last year.  The decrease results from a decrease in borrowings under our Credit Facility and interest capitalized of $0.2 million relating to our drilling rig. Borrowings under our Credit Facility decreased from $82.5 million at September 30, 2010 to $69.5 million at September 30, 2011.

 

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Interest and other income. Interest and other income decreased $163 thousand in the first nine months of 2011 to $61 thousand, compared to the same period in 2010.

 

Gain (loss) on derivative financial instruments.  Derivative gains of $0.3 million were recorded during the first nine months of 2011. This amount reflects $9.6 million of realized losses and $9.9 million of unrealized gains resulting from mark to market accounting of our oil and gas swaps, puts, futures contracts and costless collar positions.

 

CRITICAL ACCOUNTING POLICIES

 

Our discussion and analysis of our financial condition and results of operations are based on consolidated financial statements that have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Our 2010 Form 10-K includes a discussion of our critical accounting policies.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

Energy Price Risk

 

The Company’s most significant market risk is the pricing for natural gas and crude oil. Management expects energy prices to remain volatile and unpredictable. If energy prices decline significantly, revenues and cash flow would significantly decline.

 

Commodity Risk

 

Our primary market risk exposure is in the price we receive for our natural gas and oil production. Realized pricing is primarily driven by the prevailing worldwide price for crude oil and spot regional market prices applicable to our U.S. natural gas production. Pricing for natural gas and oil production has been volatile and unpredictable for several years, and we expect this volatility to continue in the future. The prices we receive for production depend on many factors outside of our control, including volatility in the differences between product prices at sales points and the applicable index price.

 

Derivative Instruments and Hedging Activity

 

We have entered into several financial derivative swap contracts, calls and costless collars to hedge our exposure to commodity price risk associated with anticipated future oil and gas production. We believe we will have more predictability of our crude oil and gas revenues as a result of these financial derivative contracts. The total volumes which we hedge through the use of our derivative instruments varies from period to period, however, generally our objective is to hedge approximately 50% of our current and anticipated production for the next 12 to 24 months. Our hedge policies and objectives may change significantly as commodities prices or price futures change.

 

We are exposed to market risk on our open derivative contracts of non-performance by our counterparties. We do not expect such non-performance because our contracts are with major financial institutions with investment grade credit ratings. Each of the counterparties to our derivative contracts is a lender in our Senior Credit Agreement. We did not post collateral under any of these contracts as they are secured under the Senior Credit Agreement.

 

The following table summarizes our open financial derivative positions as of November 8, 2011 related to oil and gas production. The Company will receive prices as noted in the table below and will pay a counterparty market price based on the NYMEX (for natural gas production) or WTI (for oil production) index price, settled monthly.

 

Product

 

Type

 

Contract Period

 

Volume

 

Price per
Mcf or Bbl

Oil

 

Swap

 

07/01/11 - 12/31/11

 

840 Bbl/d

 

$61.80

Oil

 

Call

 

01/01/12 - 01/31/12

 

200,000 Bbl

 

$110.00

Oil

 

Put

 

01/01/12 - 12/31/12

 

1,000 Bbl/d

 

$70.00

Natural Gas

 

Swap

 

09/01/11 - 10/31/11

 

4,000 Mcf/d

 

$4.56

Natural Gas

 

Collar

 

11/01/11 - 12/31/11

 

4,000 Mcf/d

 

$4.00 - $6.28

Natural Gas

 

Collar

 

07/01/11 - 12/31/11

 

3,000 Mcf/d

 

$4.25 - $5.03

Natural Gas Differentials

 

Swap

 

07/01/11 - 11/30/11

 

2,500 Mcf/d

 

–$0.71*

Natural Gas Differentials

 

Swap

 

07/01/11 - 12/31/11

 

6,500 Mcf/d

 

–$0.44*

Natural Gas Differentials

 

Swap

 

01/01/12 - 12/31/12

 

3,000 Mcf/d

 

–$0.51*

 

20



*                                         This represents a differential spread between NYMEX and CIG pricing.

 

Interest Rate Risk

 

At September 30, 2011, we had debt outstanding under our Credit Facility of $69.5 million.  Depending on the current level of borrowing base usage, the annual interest rate on each base rate borrowing under the Credit Facility will be at our option either: (a) a “Base Rate Loan”, or any other Obligation other than a LIBOR Loan, which has an interest rate equal to the sum of the “Base Rate” plus the applicable “Base Rate Margin”, calculated to be the higher of (i) the Agent’s prime rate of interest announced from time to time, or (ii) the Federal Funds rate most recently determined by the Agent, plus 3.0% per annum, plus an applicable margin that ranges from 1.5% to 2.25%, or (b) a “LIBOR Loan”, which has an interest rate equal to the sum of the applicable LIBOR period plus the applicable “LIBOR Margin”, that ranges from 2.75% to 3.50%. We are exposed to interest rate risk on our variable interest rate debt. If interest rates increase, our interest expense would increase and our available cash flow would decrease.

 

Other Financial Instruments

 

Other financial instruments consist of the following: cash and cash equivalents, U.S. treasury bonds, collateral security accounts, line of credit and other long-term liabilities. The carrying amounts of these instruments approximate fair market value due to the highly liquid nature of these short-term instruments or they are reported at fair value.

 

Inflation and Changes in Prices

 

The general level of inflation affects our costs. Salaries and other general and administrative expenses are impacted by inflationary trends and the supply and demand of qualified professionals and professional services. Inflation and price fluctuations affect the costs associated with exploring for and producing natural gas and oil, which have a material impact on our financial performance.

 

Forward-Looking Statements and Risk

 

Certain statements in this report, including statements of the future plans, objectives, and expected performance of the company, are forward-looking statements that are dependent upon certain events, risks and uncertainties that may be outside the company’s control, and which could cause actual results to differ materially from those anticipated. Some of these include, but are not limited to, the market prices of oil and gas, economic and competitive conditions, exploration risks such as drilling unsuccessful wells, higher-than-expected costs, potential liability for remedial actions under existing or future environmental regulations and litigation, potential liability resulting from pending or future litigation,  environmental and regulatory uncertainties that could delay or prevent drilling, and not successfully completing, or any material delay of, any development of new or existing fields, expansion, or capital expenditure, legislative and regulatory changes, financial market conditions, political and economic uncertainties of foreign governments, future business decisions, and other uncertainties, all of which are difficult to predict. Forward-looking statements are generally accompanied by words such as “estimate”, “project”, “predict”, “will”, “anticipate”, “plan”, “intend”, “believe”, “expect” or similar expressions that convey the uncertainty of future events or outcomes. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. Unless legally required, Warren does not undertake any obligation to update any forward-looking statements, as a result of new information, future events or otherwise. Certain risks that may affect Warren’s results of operations and financial position appear in Part 1, Item 1A “Risk Factors” of Warren’s 2010 Annual Report on Form 10-K.

 

There are numerous uncertainties inherent in estimating quantities of proved oil and gas reserves and in projecting future rates of production and the timing of development expenditures. The total amount or timing of actual future production may vary significantly from reserves and production estimates. The drilling of exploratory wells can involve significant risks, including those related to timing, success rates and cost overruns. Lease and rig availability, complex geology and other

 

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factors can affect these risks. Fluctuations in oil and natural gas prices or a prolonged continuation of low prices may adversely affect the company’s financial position, results of operations and cash flows.

 

Item 4.  Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

Our management, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has evaluated the effectiveness of our disclosure controls and procedures as defined in Securities and Exchange Commission (“SEC”) Rule 13a-15(e) and 15d-15(e) as of the end of the period covered by this report.  Based upon that evaluation, management  has concluded that our  disclosure  controls  and  procedures  are  effective to ensure  that information  we are required to disclose in reports that we file or submit under the Securities Exchange Act is communicated to management, including the CEO and CFO, as appropriate to allow timely decisions  regarding required disclosure and is  recorded,  processed,  summarized  and  reported  within the time periods specified in the SEC’s rules and forms.

 

Changes in Internal Control over Financial Reporting

 

There have been no changes in our internal controls over financial reporting or in other factors during the quarter ended September 30, 2011, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II—OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Information with respect to this item may be found in Note G to the Consolidated Financial Statements (Part I, Item 1), which is incorporated herein by reference.

 

Item 1A. Risk Factors

 

Our business has many risks. In addition to the other information set forth in this report and our press releases and other reports and materials that we file with the Securities and Exchange Commission, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010, and in our Registration Statement on Form S-3, and the prospectus supplement thereto, in connection with our public offering on October 23, 2009, which could materially affect our business, financial condition, operating results or liquidity and the trading price of our common stock.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

a.               Not applicable

 

b.              Not applicable

 

c.               Not applicable

 

Item 3. Defaults upon Senior Securities

 

Not applicable.

 

Item 4. Removed and Reserved

 

Item 5. Other Information

 

Not applicable.

 

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Item 6. Exhibits

 

a)                                Exhibits

Exhibits not incorporated by reference to a prior filing are designated by an (*) and are filed herewith; all exhibits not so designated are incorporated herein by reference to a prior filing as indicated.

 

Exhibit

 

 

Number

 

Description

 

 

 

 

10.1*

 

Coalbed Natural Gas (CBNG) Unit Agreement for the Development and Operation of the Spyglass Hill (CBNG) Unit Area, County Of Carbon, State Of Wyoming.

 

10.2*

 

Unit Operating Agreement Spyglass Hill (CBNG) Unit Area

 

31.1*

 

Certification of Chief Executive Officer pursuant to Rule 13a-15(e)/15d-15(e)

 

31.2*

 

Certification of Chief Financial Officer pursuant to Rule 13a-15(e)/15d-15(e)

 

32.1*

 

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2*

 

Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002

 

101**

 

The following financial information from Warren Resources, Inc. Quarterly Report on Form 10-Q for the period ended September 30, 2011, filed with the SEC on November 8, 2011, formatted in Extensible Business Reporting Language (XBRL): (i) the Consolidated Statement of Operations for the three and nine-month month periods ended September 30, 2011 and 2010, (ii) the Consolidated Balance Sheet at September 30, 2011 and December 31, 2010, (iii) the Consolidated Statement of Cash Flows for the nine-month periods ended September 30, 2011 and 2010, and (iv) Notes to Consolidated Financial Statements.

 


 

*

 

Filed herewith.

 

**

 

Pursuant to Rule 406T of Regulation S-T that this interactive data file is deemed not filed or part of a registration statement or prospectus for the purposes of section 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities and Exchanges Act of 1934, as amended, and otherwise is not subject to liability under these sections.

 

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.

 

 

 

WARREN RESOURCES, INC.

 

 

(Registrant)

 

 

 

 

Date: November 8, 2011

 

By:

/s/ Timothy A. Larkin

 

 

 

Timothy A. Larkin

 

 

 

Executive Vice President, Chief Financial Officer and Principal Accounting Officer

 

23