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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 June 30, 2012

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: 001-35539

 

 

New Source Energy Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   45-2735455

(State or other jurisdiction of

incorporation or organization)

  (IRS Employer Identification No.)

914 North Broadway Avenue,

Suite 230

Oklahoma City, OK 73102

(Address of principal executive offices,

including Zip Code)

(405) 272-3028

Registrant’s telephone number,

including area code

 

 

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.    Yes  ¨    No  x

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

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

 

Large accelerated filer   ¨   Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)   Smaller reporting company   x

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

As of July 31, 2012, the registrant had 24,257,500 outstanding shares of common stock, par value $0.001 per share.

We are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012. For implications of our status as an emerging growth company, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2 of this Quarterly Report.

 

 

 


Table of Contents

NEW SOURCE ENERGY CORPORATION

FORM 10-Q

Table of Contents

 

          Page  

PART I – FINANCIAL INFORMATION

     1   

Item 1.

   Financial Statements      1   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      13   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      22   

Item 4.

   Controls and Procedures      22   

PART II – OTHER INFORMATION

     22   

Item 1.

   Legal Proceedings      22   

Item 1A.

   Risk Factors      22   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      22   

Item 3.

   Defaults Upon Senior Securities      23   

Item 4.

   Mine Safety Disclosures      23   

Item 5.

   Other Information      23   

Item 6.

   Exhibits      23   

SIGNATURES

     24   

 

-i-


Table of Contents

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

New Source Energy Corporation

Condensed Balance Sheets

(in thousands, except share amounts)

 

     June 30, 2012     December 31, 2011  
     (unaudited)        

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 36      $ 738   

Oil and natural gas sales receivables

     2,559        6,644   

Oil and natural gas sales receivables – related parties

     2,170        452   

Other receivables

     345        12   

Prepaid expenses and deposits

     169        244   

Derivative assets

     4,242        1,241   

Deferred tax asset

     2,887        2,067   
  

 

 

   

 

 

 

Total current assets

     12,408        11,398   
  

 

 

   

 

 

 

Property and equipment:

    

Oil and natural gas properties, at cost, using full cost method (including $4,088 and $3,390 of unevaluated properties at June 30, 2012 and December 31, 2011)

     237,255        220,749   

Prepaid drilling and completion costs

     1,509        4,384   

Other property and equipment

     555        241   

Accumulated depreciation, depletion and amortization

     (108,296     (100,028
  

 

 

   

 

 

 

Total property and equipment, net

     131,023        125,346   
  

 

 

   

 

 

 

Goodwill

     4,228        4,228   

Loan fees, net

     1,773        2,046   

Deferred offering costs

     —          1,266   

Derivative assets

     2,164        687   
  

 

 

   

 

 

 

Total assets

   $ 151,596      $ 144,971   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable – trade

   $ 726      $ 561   

Accounts payable – related parties

     5,397        3,876   

Accrued liabilities

     95        322   

Derivative obligations

     —          1,610   

Income taxes payable

     —          98   
  

 

 

   

 

 

 

Total current liabilities

     6,218        6,467   
  

 

 

   

 

 

 

Credit facility

     68,500        68,500   

Accounts payable – related parties

     1,205        2,001   

Derivative obligations

     —          1,629   

Deferred tax liability

     17,608        16,212   

Asset retirement obligation

     1,648        1,534   
  

 

 

   

 

 

 

Total liabilities

     95,179        96,343   
  

 

 

   

 

 

 

Commitments and contingencies (See Note 9)

    

Stockholders’ equity:

    

Preferred stock ($0.001 par, 20,000,000 shares authorized, none issued and outstanding at June 30, 2012 and December 31, 2011)

     —          —     

Common stock ($0.001 par, 180,000,000 shares authorized, 24,257,500 shares issued and 21,357,500 shares outstanding at June 30, 2012 and December 31, 2011)

     21        21   

Additional paid-in capital

     66,115        59,398   

Accumulated deficit

     (9,719     (10,791
  

 

 

   

 

 

 

Total stockholders’ equity

     56,417        48,628   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 151,596      $ 144,971   
  

 

 

   

 

 

 

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

 

1


Table of Contents

New Source Energy Corporation

Condensed Statements of Operations

(in thousands, except per share amounts)

(unaudited)

 

     Three Months ended June 30,     Six Months ended June 30,  
     2012     2011     2012     2011  

REVENUES

        

Oil sales

   $ 1,588      $ 1,255      $ 3,117      $ 2,331   

Natural gas sales

     1,274        2,593        2,828        4,879   

Natural gas liquids sales

     5,757        9,162        13,286        17,141   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     8,619        13,010        19,231        24,351   
  

 

 

   

 

 

   

 

 

   

 

 

 

OPERATING COSTS AND EXPENSES

        

Oil and natural gas production expenses

     2,233        2,554        4,326        4,710   

Oil and natural gas production taxes

     315        932        670        1,235   

General and administrative (including stock-based compensation expense of $3,358 and $6,717 for the three and six months ended June 30, 2012)

     7,006        613        11,619        785   

Depreciation, depletion and amortization

     3,988        3,887        8,268        7,110   

Accretion expense

     32        14        62        28   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating costs and expenses

     13,574        8,000        24,945        13,868   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (loss)

     (4,955     5,010        (5,714     10,483   

OTHER INCOME (EXPENSE)

        

Interest expense

     (786     (788     (1,598     (1,444

Realized and unrealized gain (loss) from derivatives, net

     7,996        768        9,005        (2,758
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     2,255        4,990        1,693        6,281   

Income tax expense

     948        —          621        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 1,307      $ 4,990      $ 1,072      $ 6,281   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income per common share (See Note 1)

        

Basic and diluted

   $ 0.05        $ 0.04     
  

 

 

     

 

 

   

Weighted average shares outstanding used in computing net income per common share

        

Basic and diluted

     21,358          21,358     
  

 

 

     

 

 

   

Pro forma net income reflecting change in tax status (See Note 1)

        

Income before income taxes

     $ 4,990        $ 6,281   

Pro forma income tax expense

       (1,941       (2,443
    

 

 

     

 

 

 

Pro forma net income

     $ 3,049        $ 3,838   
    

 

 

     

 

 

 

Pro forma net income per common share – basic and diluted (See Note 1)

        

Pro forma net income per common share

     $ 0.15        $ 0.19   
    

 

 

     

 

 

 

Shares used in computing pro forma net income per common share

       20,000          20,000   
    

 

 

     

 

 

 

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

 

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Table of Contents

New Source Energy Corporation

Condensed Statements of Cash Flows

(in thousands)

(unaudited)

 

     Six months ended June 30,  
     2012     2011  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 1,072      $ 6,281   

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

    

Depreciation, depletion and amortization

     8,268        7,110   

Stock-based compensation

     6,717        —     

Unrealized net derivatives loss (gain)

     (7,718     1,819   

Deferred income tax expense

     576        —     

Write off abandoned offering costs

     2,604        —     

Amortization of loan fees

     303        239   

Accretion expense

     62        28   

Changes in operating assets and liabilities:

    

Oil and natural gas sales receivables

     4,085        (310

Oil and natural gas sales receivables – related parties

     (1,718     —     

Other current assets

     (251     —     

Accounts payable – trade

     165        (133

Accounts payable – related parties

     3        —     

Current income taxes

     (105     —     

Accrued liabilities

     (227     —     
  

 

 

   

 

 

 

Net cash provided by operating activities

     13,836        15,034   
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

    

Payments for oil and natural gas properties

     (12,856     (16,734

Payments for other property and equipment

     (314     —     
  

 

 

   

 

 

 

Net cash used in investing activities

     (13,170     (16,734
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

    

Payments for deferred loan costs

     (30     —     

Payments for offering costs

     (1,338     (544

Contribution from parent

     —          2,244   
  

 

 

   

 

 

 

Net cash provided by (used in) financing activities

     (1,368     1,700   
  

 

 

   

 

 

 

Net change in cash and cash equivalents

     (702     —     

Cash and cash equivalents, beginning of period

     738        —     
  

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 36      $ —     
  

 

 

   

 

 

 

SUPPLEMENTAL CASH FLOW INFORMATION

    

Cash paid for interest expense

   $ 1,434      $ 1,204   

Cash paid for income taxes

   $ 150      $ —     

NON-CASH INVESTING AND FINANCING ACTIVITIES

    

Capitalized asset retirement obligation

   $ 52      $ 6   

Increase (decrease) in accrued capital expenditures

   $ 722      $ (1,214

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

 

3


Table of Contents

New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

1. Summary of Significant Accounting Policies

Organization

New Source Energy Corporation (the “Company”) is a Delaware corporation that was formed on July 12, 2011 to acquire and develop oil and natural gas properties. On August 12, 2011, the Company acquired (i) certain oil and natural gas properties from Scintilla, LLC (“Scintilla”), an affiliated entity, in exchange for 20.0 million shares of the Company’s common stock and $60.0 million cash, and (ii) additional working interests from other contributing parties in exchange for 1.2 million shares of the Company’s common stock and the assumption of deferred income tax liabilities.

The properties acquired on August 12, 2011 include interests in wells producing oil, natural gas, and natural gas liquids from the Misener-Hunton (the “Hunton”) formation in east-central Oklahoma. The properties acquired represent an undivided 90% of Scintilla’s working interest in certain Hunton formation producing wells located in Pottawatomie, Seminole and Okfuskee Counties, Oklahoma (“Golden Lane Area”), which equates to approximately a 38% weighted average working interest in the Golden Lane Area, and approximately an undivided 60% working interest in certain Hunton formation producing wells located in Oklahoma and Lincoln Counties, Oklahoma (“Luther Area”).

Basis of Presentation

The accompanying unaudited condensed financial statements present the financial position of the Company at June 30, 2012 and December 31, 2011 and the Company’s results of operations for the three and six months ended June 30, 2012 and its cash flows for the six months ended June 30, 2012 and 2011. These condensed financial statements include all adjustments, consisting of normal and recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the indicated interim periods in accordance with accounting principles generally accepted in the United States of America, or “GAAP,” for interim financial reporting. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted. Therefore, these unaudited condensed financial statements should be read along with the Company’s financial statements for the year ended December 31, 2011 included in the Company’s Registration Statement on Form S-1 (File No. 333-176548) for an expanded discussion of the Company’s financial disclosures and accounting policies. The results of operations for the three and six months ended June 30, 2012 are not necessarily indicative of the results to be expected for the full year ending December 31, 2012.

Nature of Operations

The transaction between the Company and Scintilla discussed above was a transaction between businesses under common control. The accounts relating to the properties acquired have been reflected retroactively in the Company’s financial statements at carryover basis. Therefore, for periods prior to August 12, 2011, the accompanying financial statements may not be indicative of the Company’s future performance and may not reflect what its financial position, results of operations, and cash flows would have been had it been operated as an independent company.

Prior to August 12, 2011, Scintilla performed certain corporate functions on behalf of the properties acquired, and the financial statements reflect an allocation of the costs Scintilla incurred. These functions included executive management, information technology, tax, insurance, accounting, legal and treasury services. The costs of such services were allocated based on the most relevant allocation method to the service provided, primarily based on relative book value of assets, among other factors. Management believes such allocations are reasonable; however, they may not be indicative of the actual expense that would have been incurred had the Company been operated as an independent company for the periods prior to August 12, 2011 presented. The charges for these functions are included primarily in general and administrative expenses.

Reclassification

Reclassifications were made to the prior period financial statements to conform to the current period presentation. These reclassifications did not have an impact on the Company’s previously reported results of operations or earnings per share amounts. Additionally, these reclassifications did not impact compliance with any applicable debt covenants in the Company’s credit agreement.

 

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Table of Contents

New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

Use of Estimates in the Preparation of Financial Statements

Preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates. Depletion of oil and natural gas properties is determined using estimates of proved oil and natural gas reserves. There are numerous uncertainties inherent in the estimation of quantities of proved reserves and in the projection of future rates of production and the timing of development expenditures. Similarly, evaluations for impairment of proved and unproved oil and natural gas properties are subject to numerous uncertainties including, among others, estimates of future recoverable reserves. Other significant estimates include, but are not limited to, the valuation of commodity derivatives and the Company’s common stock issued in a business combination and as compensation for services, the allocation of general and administrative expenses, and asset retirement obligations.

Oil and Natural Gas Properties

The Company utilizes the full cost method of accounting for oil and natural gas properties whereby productive and nonproductive costs incurred in connection with the acquisition, exploration, and development of oil and natural gas reserves are capitalized. All capitalized costs of oil and natural gas properties and equipment, including the estimated future costs to develop proved reserves, are amortized using the units-of-production method based on total proved reserves. No gains or losses are recognized upon the sale or other disposition of oil and natural gas properties except in transactions that would significantly alter the relationship between capitalized costs and proved reserves. Under the full cost method, the net book value of oil and natural gas properties, less related deferred income taxes, may not exceed the estimated after-tax future net revenues from proved oil and natural gas properties, discounted at 10% (the ceiling limitation). In arriving at estimated after-tax future net revenues, estimated lease operating expenses, development costs, and certain production-related and ad valorem taxes are deducted. In calculating future net revenues, prices and costs in effect at the time of the calculation are held constant indefinitely, except for changes that are fixed and determinable by existing contracts. The net book value is compared to the ceiling limitation on a quarterly basis. The excess, if any, of the net book value above the ceiling limitation is charged to expense in the period in which it occurs and is not subsequently reinstated. Reserve estimates used in determining estimated after-tax future net revenues have been prepared by an independent petroleum engineer. Future net revenues were computed based on reserves using prices calculated as the unweighted arithmetical average oil and natural gas prices on the first day of each month within the latest twelve-month period. Prior to August 12, 2011, the ceiling limitation computation was determined without regard to income taxes. There were no full cost ceiling write-downs recorded in the six months ended June 30, 2012 or 2011.

Earnings per Share

Subsequent to the acquisition of the properties from Scintilla on August 12, 2011, the Company presents earnings per share information in accordance with ASC Topic 260, “Earnings per Share.”

The Company’s restricted shares of common stock are participating securities under ASC 260, because they may participate in undistributed earnings with common stock.

As a result of issuing restricted shares of common stock that are deemed participating securities, we calculate earnings per share using the two-class method. The two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common stockholders. Under the two-class method, earnings for the period are allocated between the common stockholders and the participating security holders based on their respective rights to receive dividends as if all undistributed booked earnings for the period were distributed. Accordingly, earnings attributable to unvested equity awards, along with the corresponding share counts, are excluded from earnings per share as reflected in our statement of operations. In calculating basic net income per common share, we deduct any dividends and undistributed earnings allocated to unvested equity awards from net income and then divide the result by the weighted-average number of common shares outstanding for the period.

 

5


Table of Contents

New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

     Three Months
Ended
June 30, 2012
    Six Months
Ended
June 30, 2012
 
     (in thousands, except per share
data)
 

Basic and diluted net income per common share

    

Numerator:

    

Net income

   $ 1,307      $ 1,072   

Net income attributable to restricted participating securities

     (156     (128
  

 

 

   

 

 

 

Net income attributable to common stockholders - basic and diluted

   $ 1,151      $ 944   
  

 

 

   

 

 

 

Denominator:

    

Weighted average common shares used to compute basic and diluted net income per common share

     21,358        21,358   
  

 

 

   

 

 

 

Basic and diluted net income per common share attributable to common stockholders

   $ 0.05      $ 0.04   
  

 

 

   

 

 

 

Pro Forma Earnings per Share

Pro forma net earnings per common share for periods through August 11, 2011 were determined by dividing pro forma net income by the weighted average number of shares of common stock outstanding, which was the 20 million shares issued to Scintilla in exchange for oil and natural gas properties.

2. Related Party Transactions

The Company is affiliated by common ownership and has a working relationship with New Dominion, LLC (“New Dominion”), an exploration and production operator based in Tulsa, Oklahoma. New Dominion is currently contracted to operate the Company’s existing wells in the Hunton formation in east-central Oklahoma. New Dominion has historically performed this service for Scintilla. As a result, all historical accounts payable related to the Company’s properties are presented as accounts payable – related party in the accompanying balance sheets.

New Dominion acquires leasehold acreage on behalf of the Company for which the Company is obligated to pay in varying amounts according to agreements applicable to particular areas of mutual interest. The leasehold cost for which the Company is obligated is approximately $4.6 million as of June 30, 2012, of which $3.4 million is reflected as a current liability and $1.2 million is reflected as a long-term liability. The Company classifies these amounts as current or long-term liabilities based on the estimated dates of future development of the leasehold, which is customarily when New Dominion invoices the Company for these costs.

3. Credit Facility

On August 12, 2011, the Company entered into a $150.0 million four-year credit facility with Bank of Montreal as administrative agent and KeyBank as syndication agent. Although the credit facility has a $150.0 million borrowing limit, the Company is only entitled to borrow an amount equal to the Company’s borrowing base, which is re-determined on a semiannual basis and at other times as directed by the Company or the administrative agent. The initial borrowing base was $72.5 million. The borrowing base is re-determined based on reserve reports prepared by engineers acceptable to the administrative agent, which the Company must deliver to the administrative agent on April 1 and October 1 of each year. At June 30, 2012, the borrowing base was $72.5 million.

As of June 30, 2012, the Company had $68.5 million outstanding under the Company’s credit facility and, as a result, the Company had $4.0 million of available borrowing capacity under the credit facility. The borrowing base was re-determined on August 2, 2012, in connection with derivative transactions occurring in July 2012. As a result, the Company’s borrowing base was reduced to $70 million. (See Note 10.) The credit facility matures on August 12, 2015 and bears interest at a variable rate, which was approximately 3.75% per annum at June 30, 2012. Amounts borrowed and repaid under the credit facility may be re-borrowed. The credit facility is available for general corporate purposes, including working capital for the Company’s operations. The Company’s obligations under the credit facility are secured by substantially all of the Company’s assets.

 

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Table of Contents

New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

4. Fair Value Measurements

Measurements of fair value of derivative instruments are classified according to the fair value hierarchy, which prioritizes the inputs to the valuation techniques used to measure fair value. Fair value is the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are classified and disclosed in one of the following categories:

Level 1: Measured based on unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. Active markets are considered those in which transactions for the assets or liabilities occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

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

Level 3: Measured based on prices or valuation models that require inputs that are both significant to the fair value measurement and less observable from objective sources (i.e. supported by little or no market activity). The valuation models used to value derivatives associated with the Company’s oil and natural gas production are primarily industry standard models that consider various inputs including: (a) quoted forward prices for oil and gas, (b) discount rates, (c) volatility factors and (d) current market and contractual prices, as well as other relevant economic measures. Although third party quotes are utilized to assess the reasonableness of the prices and valuation techniques, there is not sufficient corroborating evidence to support classifying these assets and liabilities as Level 2.

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. Management’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels.

Fair Value on a Recurring Basis

The following table sets forth by level within the fair value hierarchy the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of June 30, 2012 (in thousands):

 

Description

   Active Market for
Identical Assets
(Level 1)
     Observable
Inputs
(Level 2)
     Unobservable
Inputs
(Level 3)
     Total
Carrying
Value
 

Natural gas liquids swaps

   $ —         $ —         $ 4,148       $ 4,148   

Oil and natural gas collars

     —           —           2,259         2,259   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total net financial assets

   $ —         $ —         $ 6,407       $ 6,407   
  

 

 

    

 

 

    

 

 

    

 

 

 

The Company’s commodity derivative contracts are accounted for at fair value on a recurring basis. The net fair values at June 30, 2012 and December 31, 2011 of $6.4 million and $(1.3) million, respectively, were classified as Level 3. The fair values of derivative instruments are based on a third-party pricing model which utilizes inputs that include (a) quoted forward prices for oil and gas, (b) discount rates, (c) volatility factors and (d) current market and contractual prices, as well as other relevant economic measures. The estimates of fair value are compared to the values provided by the counterparty for reasonableness. Derivative instruments are subject to the risk that counterparties will be unable to meet their obligations. Such non-performance risk is considered in the valuation of the Company’s derivative instruments but to date has not had a material impact on estimates of fair values. Significant changes in the quoted forward prices for commodities and changes in market volatility generally leads to corresponding changes in the fair value measurement of the Company’s derivative contracts.

 

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New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

Fair Value on a Non-Recurring Basis

The Company follows the provisions of ASC 820-10 for nonfinancial assets and liabilities measured at fair value on a non-recurring basis. As it relates to the Company, the statement applies to certain nonfinancial assets and liabilities as may be acquired in a business combination and thereby measured at fair value; common stock issued for compensation purposes; goodwill impairment assessments; and the initial recognition of asset retirement obligations for which fair value is used.

The Company utilizes ASC 805-10 to identify and record the fair value of assets and liabilities acquired in a business combination. New assets measured at fair value during the year ended December 31, 2011 relate to the purchase of certain oil and natural gas properties in exchange for 1.2 million shares, equal to $11.9 million based upon discounted cash flows associated with the properties’ estimated proved reserves (using various analyses with discount factors ranging from 8% to 15%). The inputs used by management for the fair value measurements of these acquired oil and gas properties include significant unobservable inputs, and therefore, the fair value measurements employed are classified as Level 3 for these types of assets.

The Company utilizes ASC Topic 718, “Compensation—Stock Compensation,” to value shares issued for compensation purposes. Measurement of share-based payment transactions with employees is generally based on the grant date fair value of the equity instruments issued.

The Company utilizes ASC Topic 350, “Intangibles—Goodwill and Other,” to perform an annual impairment test of goodwill. As required by ASC Topic 350, the impairment test is accomplished using a two-step approach. The first step screens for impairment, by comparing the fair value of the carrying amount, and when impairment is indicated, a second step is employed to measure the impairment. The inputs used by management for the fair value measurements utilized in this review include significant unobservable inputs, and therefore, the fair value measurements employed are classified as Level 3 for these types of assets.

Asset retirement cost estimates are derived from historical costs as well as management’s expectation of future cost environments. As there is no corroborating market activity to support the assumptions used, the Company has designated these liabilities as Level 3.

The carrying amount of the revolving long-term debt of $68.5 million as of June 30, 2012 approximates fair value because the Company’s current borrowing rate does not materially differ from market rates for similar bank borrowings. The Company has classified the revolving long-term debt as a Level 2 item within the fair value hierarchy.

The following table sets forth a reconciliation of changes in the fair value of the Company’s derivative contracts classified as Level 3 in the fair value hierarchy (in thousands):

 

     Significant Unobservable Inputs (Level 3)
Six Months Ended June 30,
 
     2012     2011  

Beginning balance

   $ (1,311   $ (1,174

Realized gains (losses)

     1,287        (743

Unrealized gains (losses)

     7,718        (1,908

Settlements paid (received)

     (1,288     743   
  

 

 

   

 

 

 

Ending balance

   $ 6,406      $ (3,082
  

 

 

   

 

 

 

Change in unrealized gains (losses) included in earnings related to derivates still held as of June 30, 2012 and 2011

   $ 7,718      $ (1,908

5. Derivative Instruments

To reduce the impact of fluctuations in oil and natural gas prices on the Company’s revenues, or to protect the economics of property acquisitions, the Company periodically enters into derivative contracts with respect to a portion of its projected oil, natural gas and natural gas liquids production through various transactions that fix or, through options, modify the future prices to be realized. These transactions may include price swaps whereby the Company will receive a fixed price for its production and pay a variable market

 

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New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

price to the contract counterparty. Additionally, the Company may enter into collars, whereby it receives the excess, if any, of the fixed floor price over the floating rate or pays the excess, if any, of the floating rate over the fixed ceiling price. In addition, the Company enters into option transactions, such as puts or put spreads, as a way to manage its exposure to fluctuating prices. These hedging activities are intended to support oil and natural gas prices at targeted levels and to manage exposure to oil, natural gas and natural gas liquids price fluctuations. It is never the Company’s intention to enter into derivative contracts for speculative trading purposes.

Under ASC Topic 815, “Derivatives and Hedging,” all derivative instruments are recorded on the condensed consolidated balance sheets at fair value as either short-term or long-term assets or liabilities based on their anticipated settlement date. The Company will net derivative assets and liabilities for counterparties where it has a legal right of offset. Changes in the derivatives’ fair values are recognized currently in earnings unless specific hedge accounting criteria are met. The Company has elected not to designate its current derivative contracts as hedges. Therefore, changes in the fair value of these instruments are recognized in earnings and included as realized and unrealized gains (losses) on derivative instruments in the condensed statements of operations.

Commodity derivative positions at June 30, 2012 were as follows:

 

Oil collars:                     

Year

   Volumes (Bbls)      Floor Price      Ceiling Price  

July 1 – December 31, 2012

     63,508       $ 72.15       $ 112.02   

2013

     91,145       $ 72.00       $ 118.76   

2014

     34,645       $ 86.01       $ 116.97   
Natural gas liquid swaps:                     

Year

   Volumes (Gals)      Avg Price per Gal      Range per Gal  

July 1 – December 31, 2012

     5,613,609       $ 1.249       $ 0.399 - $2.381   

2013

     8,173,304       $ 1.062       $ 0.376 - $2.300   

2014

     3,148,316       $ 1.133       $ 0.410 - $2.300   
Natural gas collars:                     

Year

   Volumes (MMBtu)      Floor Price      Ceiling Price  

July 1 – December 31, 2012

     687,510       $ 4.00       $ 4.72   

2013

     950,004       $ 4.25       $ 5.43   

Balance Sheet Presentation

The following information summarizes the presentation of the fair value of the Company’s derivative instruments on the condensed balance sheets as of June 30, 2012 and December 31, 2011 (in thousands):

 

     June 30, 2012      December 31, 2011  

Current asset

   $ 4,242       $ 1,241   

Long-term asset

     2,164         687   

Current liability

     —           (1,610

Long-term liability

     —           (1,629
  

 

 

    

 

 

 

Total fair value net asset (liability)

   $ 6,406       $ (1,311
  

 

 

    

 

 

 

Gain (Loss) on Derivatives

Gains and losses on derivatives are reported on the condensed statements of operations as “Realized and unrealized derivatives gain (loss) from derivatives, net.” Realized gains (losses) represent amounts related to the settlement of derivative instruments or the expiration of contracts. Unrealized gains (losses) represent the change in fair value of the derivative instruments to be settled in the future and are non-cash items which fluctuate in value as commodity prices change. The following summarizes the Company’s realized and unrealized gains (losses) from derivative instruments for the three and six months ended June 30, 2012 and 2011 (in thousands):

 

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New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2012      2011     2012      2011  

Realized gains (losses) on derivative instruments

   $ 1,100       $ (636   $ 1,287       $ (939

Unrealized gains (losses) on derivative instruments

     6,896         1,404        7,718         (1,819
  

 

 

    

 

 

   

 

 

    

 

 

 

Total realized and unrealized gains (losses) on derivative instruments

   $ 7,996       $ 768      $ 9,005       $ (2,758
  

 

 

    

 

 

   

 

 

    

 

 

 

6. Income Taxes

Subsequent to the acquisition of oil and gas properties from Scintilla on August 12, 2011, the Company accounts for income taxes using the asset and liability method and applies the provisions of ASC Topic 740, “Income Taxes.” The provision (benefit) for income taxes for the three and six months ended June 30, 2012 is comprised of (in thousands):

 

     Three Months Ended
June 30, 2012
    Six Months Ended
June 30, 2012
 

Current

   $ (18   $ 45   

Deferred

     966        576   
  

 

 

   

 

 

 

Provision for income tax expense

   $ 948      $ 621   
  

 

 

   

 

 

 

The provision (benefit) for income taxes differs from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The significant differences between pre-tax book income and taxable book income relate to non-deductible expenses.

The Company’s income tax expense was computed based on the federal statutory rate and the average state statutory rates, net of the related federal benefit. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

Significant components of the Company’s deferred tax assets and liabilities are as follows at June 30, 2012 (in thousands):

 

Deferred tax liabilities:

  

Current:

  

Derivative assets

   $ 1,650   
  

 

 

 

Total current deferred tax liability

     1,650   
  

 

 

 

Noncurrent:

  

Derivative assets

     842   

Depreciable and depletable property, plant and equipment

     24,129   
  

 

 

 

Total noncurrent deferred tax liabilities

     24,971   
  

 

 

 

Total deferred tax liabilities

   $ 26,621   
  

 

 

 

Deferred tax assets:

  

Current:

  

Stock compensation

   $ (4,537
  

 

 

 

Total current deferred tax asset

     (4,537
  

 

 

 

Noncurrent:

  

Asset retirement obligation

     (641

Net operating loss carryforward and alternative minimum tax credit

     (6,722
  

 

 

 

Total noncurrent deferred tax assets

     (7,363

Total deferred tax assets

     (11,900
  

 

 

 

Net deferred tax liability

   $ 14,721   
  

 

 

 

 

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New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

7. Stock-based Compensation

On August 18, 2011, the Company granted 2,900,000 shares of restricted common stock, with 1,000,000 shares vesting upon the first anniversary of the date of grant, 700,000 shares vesting on the second anniversary of the date of grant, and the remaining 1,200,000 shares vesting on the completion of an initial public offering of the Company’s common stock pursuant to a filed prospectus provided that the employees remain employed by the Company on the applicable vesting dates subject to limited exceptions.

The Company amortizes the value to general and administrative expense over the vesting periods for which there are fixed vesting terms of the awards. Accordingly, the Company recorded $6.7 million of stock-based compensation for the six months ended June 30, 2012, as compared to no stock-based compensation expense recorded for the six months ended June 30, 2011. As of June 30, 2012, unamortized stock compensation expense is $5.3 million.

An additional $11.9 million may be charged to expense in the event that the Company completes an initial public offering of common stock.

8. Abandoned Initial Public Offering

The Company had accumulated and deferred certain costs on the balance sheet in 2011 and 2012 related to efforts to complete an initial public offering of its common stock. The Company abandoned the plan for this public offering in May 2012. As a result, deferred offering costs previously capitalized in the amount of $2.6 million were charged against earnings and recorded within general and administrative expenses in the quarter ending June 30, 2012. The company retained no costs associated with this attempted offering on its balance sheet as of June 30, 2012.

9. Commitments and Contingencies

Commitments

As part of the transactions described in Notes 1 and 2, the Company acquired rights to participate in the development of undeveloped properties held and to be acquired by Scintilla and New Dominion. These properties will be held by New Dominion for the benefit of the Company pending development of the properties. The Company is required by its underlying agreements with New Dominion to pay certain acreage fees to reimburse New Dominion for the cost of the acreage attributable to the Company’s working interest when invoiced by New Dominion. The Company recognizes an asset and corresponding liability as the acreage costs are incurred by New Dominion, as set forth in Note 2, Related Party Transactions.

New Dominion controls the acquisition and development of these properties. The Company is obligated to reimburse New Dominion for its proportionate share of the cost of additional acreage New Dominion purchases. To the extent the Company elects to participate in developing future wells on this acreage as proposed by New Dominion, it will be obligated to pay its proportionate share of the development costs, including paying connection charges to New Dominion for connection and access to its saltwater disposal infrastructure and maintenance and operating costs of New Dominion’s saltwater disposal wells. The Company does not become obligated to fund development costs until (i) wells are proposed by New Dominion for drilling, and (ii) the Company’s consent to participate in the drilling activity is formalized. The Company estimates that at June 30, 2012 it has committed to fund future development costs of approximately $6.4 million.

Legal Matters

New Dominion is a defendant in a legal proceeding arising in the normal course of its business which may impact the Company as described below.

In the case of Mattingly v. Equal Energy, LLC, New Dominion is a named defendant. In this case, the plaintiffs assert claims on behalf of a class of royalty owners in wells operated by New Dominion and others from which natural gas is sold by New Dominion to Scissortail Energy, LLC. The plaintiffs assert that royalties to the class should be paid based upon the price received by Scissortail for the gas and its components at the tailgate of the plant, rather than the price paid by Scissortail at the wellhead where the gas is purchased. The plaintiffs assert a variety of breach of contract and tort claims. The case was originally filed in the District Court of Creek County, Oklahoma was removed by the defendants to the federal court but was remanded to state court on August 1, 2011.

 

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New Source Energy Corporation

Notes to Unaudited Condensed Financial Statements

 

If a liability does attach to New Dominion as operator, New Dominion would look to the working interest owners to pay their proportionate share of any liability. While the outcome and impact on the Company of this proceeding cannot be predicted with certainty, management believes a range of loss from $10,000 to $250,000 may be reasonably possible.

The Company may be involved in other various routine legal proceedings incidental to its business from time to time. However, there were no other material pending legal proceedings to which the Company is a party or to which any of its assets are subject.

10. Subsequent Events

On July 12, 2012, the Company liquidated all of the oil, natural gas and natural gas liquids swap and collar derivative positions that it held as of June 30, 2012 and received proceeds of approximately $4.9 million. On July 19, 2012, the Company entered into new fixed price derivative swap contracts for oil, natural gas and natural gas liquids for approximately 50% of the volumes that were previously hedged at current prices. The commodity derivative positions that were entered into on July 19, 2012 are as follows:

 

Oil fixed price swaps:                     

Contract Period

        Volume (bbl)      Fixed Price         

August – December 2012

     26,111       $ 92.60      

January – December 2013

     45,576       $ 93.05      

January – July 2014

     17,324       $ 90.20      
Natural gas fixed price swaps:                     

Contract Period

        Volume (mmbtu)      Fixed Price         

August – December 2012

     286,465       $ 3.08      

January – December 2013

     475,008       $ 3.60      
Natural gas liquids fixed price swaps:                     

Contract Period

        Volume (gallons)      Average Price      Price Range  

August – December 2012

     2,311,013       $ 1.013       $ 0.401 - $1.970   

January – December 2013

     4,086,668       $ 1.032       $ 0.394 - $1.943   

January – July 2014

     1,574,163       $ 1.066       $ 0.379 - $1.895   

As a result of the derivative commodity transactions in July 2012 described above, the Company’s credit facility borrowing base was re-determined by the administrative agent and, on August 2, 2012, the Company’s borrowing base was reduced to $70 million.

The Company has evaluated subsequent events through the date the financial statements were issued, and determined that no events, other than those disclosed within the footnotes hereto, have occurred subsequent to June 30, 2012 that warrant additional disclosure or accounting considerations.

 

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

Background

New Source Energy Corporation (the “Company” or “we,” and correlative terms) is an independent energy company engaged in the development and production of onshore oil and liquids-rich natural gas projects in the United States. Our primary business strategy is to utilize specialized processes and low cost access to existing infrastructure to develop and produce hydrocarbons consistently and economically from known reservoirs previously deemed not prospective by others. Our current properties consist of non-operated working interests in the Misener-Hunton (the “Hunton”) formation, a conventional resource reservoir in east-central Oklahoma. This formation has a 90-year history of exploration and development and thousands of wellbore penetrations that have led to more accurate geologic mapping. We believe our position as non-operator and our strategic relationship as an affiliate of our contract operator, New Dominion, LLC (“New Dominion” or our “contract operator”), allow us to maintain low fixed operating expenses by utilizing a limited in-house employee base aside from our management team. We are committed to pursuing conventional resource plays in proximity to our existing asset base that are similar in profile and that carry what we believe is minimal exploration risk.

We were formed on July 12, 2011, to acquire and develop oil and natural gas properties. On August 12, 2011, we acquired certain oil and natural gas assets from Scintilla, LLC (“Scintilla”), an affiliated entity, and certain other parties for 21.2 million shares of our common stock and $60 million in cash, as described in the notes to our financial statements included in this Quarterly Report. At the time of our acquisition of these assets, we became a party to agreements by which New Dominion will continue as the contract operator of those properties. We subsequently acquired additional undeveloped interests in our Golden Lane field from Scintilla. Both Scintilla and New Dominion are owned and controlled by our principal stockholder, chairman and senior geologist, David J. Chernicky. Scintilla serves as Mr. Chernicky’s holding company for his working interests, while New Dominion acts as the operator of those assets and related infrastructure.

On August 30, 2011, we filed a registration statement with the Securities and Exchange Commission (the “Commission”) on Form S-1 for an initial public offering of our common stock. This registration statement was declared effective by the Commission on May 8, 2012. However, due to adverse general market conditions, we elected not to complete this offering and filed a request to withdraw our registration statement with the Commission on May 11, 2012. If general market conditions improve, we may again attempt an offering of debt or equity securities and/or other capital-raising activities, but we can offer no assurance that we will do so or, if we do, that we will be successful in such activities. As a result of our decision to abandon this offering, we charged deferred offering costs in the amount of $2.6 million against our earnings in the second quarter of 2012.

Implications of Being an Emerging Growth Company

We qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). An emerging growth company may take advantage of specified reduced reporting and other burdens that are applicable to other public companies that are not “emerging growth companies” including, but not limited to:

 

   

Reduced disclosure about our executive compensation arrangements;

 

   

Exemption from holding non-binding advisory votes on executive compensation or golden parachute arrangements; and

 

   

Exemption from the auditor attestation requirement in the assessment of our internal control over financial reporting.

We expect to take advantage of one or more of these reduced reporting burdens in our future filings. If we do, the information that we provide stockholders may be different than what is available with respect to other public companies.

 

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In addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period for complying with new or revised accounting standards under the JOBS Act. We have elected to take advantage of the benefits of this extended transition period. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies.

We may remain an emerging growth company for up to five years following an initial public offering of our common stock, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period.

Overview and Basis of Presentation

Until the closing of our acquisition of the assets we acquired from Scintilla and certain other parties on August 12, 2011, as described in the notes to our financial statements included in this Quarterly Report, we were a newly formed corporation with only nominal assets and no active business operations. Since Scintilla is under common control with us, we recorded the assets we acquired from Scintilla retrospectively at their historical carrying values, and no goodwill or other intangible assets were recognized. Approximately 7% of the assets we acquired on August 12, 2011 (based on PV-10 reserve value as of December 31, 2010) were acquired from parties other than Scintilla not under common control with us, and accordingly, those assets have not been included in our historical financial statements as of dates and for periods ended prior to August 12, 2011 but are included in our financial statements prospectively from that date. Likewise, our historical operations data for periods prior to August 12, 2011 provided in this Quarterly Report reflect only the assets acquired from Scintilla but reflect and will reflect historical operations data of all of our assets for periods after that date.

Our historical financial statements as of and for periods prior to August 12, 2011 were prepared on a “carve out” basis. As such, they reflect historical accounts attributable to the assets we acquired from Scintilla for such periods, including allocation of expenses of Scintilla. Due to the change from a non-taxable entity to a taxable one on August 12, 2011, our financial statements also include substantial deferred income taxes attributable to the differences between the book and tax bases of the assets we acquired from Scintilla and the assets we acquired from other parties. These book and tax basis differences primarily result from prior income tax deductions taken with respect to these assets by Scintilla and the other parties from which the assets were acquired. The deferred income taxes that we recorded in the third quarter ended September 30, 2011, relate to the acquisition of these assets, and are non-recurring in nature.

Our historical financial statements may not be indicative of our future performance and may not reflect what our results of operations, financial position and cash flows would have been if we had operated as an independent company during all of the periods presented. We expect to incur additional annual costs associated with outstanding stock-based compensation awards that will vest in the future as well as our compliance and disclosure obligations as a public company, which will require us to implement additional financial and management controls, reporting systems and procedures and hire additional accounting, financial and legal staff. Our general and administrative expenses are subject to change as our operations change over time.

 

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Summary Operating Data

The following table presents summary operating data:

 

     Three months ended June 30,      Six months ended June 30,  
           2012                  2011            2012      2011  

Net Sales Data:

           

Oil sales (Bbls)

     17,532         12,537         32,827         24,334   

Natural gas (Mcf)(1)

     600,442         649,270         1,228,241         1,288,319   

Natural gas liquids (Bbls)

     190,958         184,093         379,222         372,924   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total crude oil equivalent (Boe)(2)

     308,564         304,842         616,756         611,978   

Average daily volumes (Boe/d)

     3,391         3,350         3,389         3,381   

Average Sales Price (Excluding Derivatives):

           

Crude oil (per Bbl)

   $ 90.58       $ 100.10       $ 94.95       $ 95.79   

Natural gas (per Mcf)

   $ 2.12       $ 3.99       $ 2.30       $ 3.79   

Natural gas liquids (per Bbl)

   $ 30.15       $ 49.77       $ 35.03       $ 45.96   

Average equivalent price (per Boe)

   $ 27.93       $ 42.68       $ 31.18       $ 39.79   

Expenses (per Boe):

           

Lease operating expenses

   $ 5.66       $ 5.39       $ 5.56       $ 4.78   

Workover expenses

   $ 1.58       $ 2.99       $ 1.45       $ 2.92   

Production taxes

   $ 1.02       $ 3.06       $ 1.09       $ 2.02   

General and administrative

   $ 22.71       $ 2.01       $ 18.84       $ 1.28   

Depreciation, depletion and amortization

   $ 12.92       $ 12.75       $ 13.41       $ 11.62   

 

(1) Natural gas volumes presented in the second quarter of 2012 are presented on an after processed basis. Reclassifications were made to volumes for the first quarter of 2012 and the first and second quarters of 2011 to provide comparable volumetric comparisons.
(2) Determined using the ratio of 6 Mcf of natural gas to 1 Bbl of crude oil.

Three Months Ended June 30, 2012 and 2011

Oil & Natural Gas Revenues

Revenues from oil and natural gas operations were approximately $8.6 million for the three months ended June 30, 2012, a decrease of $4.4 million, or 34%, compared to the three months ended June 30, 2011. Of the total revenues generated during the three months ended June 30, 2012, approximately 67% were generated through natural gas liquids sales, approximately 15% were generated through natural gas sales and approximately 18% were generated through oil sales. The decrease in revenues was largely the result of generally lower average prices.

The following were specifically related to the impact of production and price levels on revenues recorded during the periods:

 

   

the average realized oil price was $90.58 per Bbl during the three months ended June 30, 2012, a decrease of 10% from $100.10 per Bbl during the three months ended June 30, 2011;

 

   

total oil production was 17,532 Bbls during the three months ended June 30, 2012, an increase of 40% from 12,537 Bbls during the three months ended June 30, 2011;

 

   

the average realized natural gas price was $2.12 per Mcf during the three months ended June 30, 2012, a decrease of 47% from $3.99 per Mcf during the three months ended June 30, 2011;

 

   

total natural gas production was 600,442 Mcf for the three months ended June 30, 2012, a decrease of 8% from 649,270 Mcf for the three months ended June 30, 2011;

 

   

the average realized natural gas liquids price was $30.15 per Bbl during the three months ended June 30, 2012, a decrease of 39% from $49.77 per Bbl during the three months ended June 30, 2011; and

 

   

total natural gas liquids production was 190,958 Bbls for the three months ended June 30, 2012, an increase of 4% from 184,093 Bbls for the three months ended June 30, 2011.

For the three months ended June 30, 2012, production of oil and natural gas liquids increased and production of natural gas decreased as compared to the second quarter of 2012 primarily because the Company has increased its development and production activities since the first quarter of 2011 in areas of the Hunton reservoir containing a higher concentration of oil and natural gas liquids and a relatively lower concentration of natural gas.

 

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Operating Expenses

Lease operating expenses. Lease operating expenses increased $0.1 million, or 6%, to $1.7 million during the three months ended June 30, 2012 from $1.6 million during the three months ended June 30, 2011. Significant components of lease operating expenses were power & fuel, treating & chemicals, salt water disposal and overhead charges.

Workover expenses. Workover expenses decreased $0.4 million, or 46%, to $0.5 million during the three months ended June 30, 2012 from $0.9 million during the three months ended June 30, 2011. Workovers decreased due to fewer required workover operations.

Total production costs decreased on an equivalent basis from $8.38 per Boe to $7.24 per Boe.

Production taxes. Production taxes decreased $0.6 million or 66%, to $0.3 million during the three months ended June 30, 2012 from $0.9 million during the three months ended June 30, 2011. The decrease was due to tax incentives on new wells and tax refunds received in 2012.

General and administrative. General and administrative expense increased $6.4 million, or 1043%, to $7.0 million during the three months ended June 30, 2012 from $0.6 million during the three months ended June 30, 2011. The increase in general and administrative expense was related to operations of the Company outside of Scintilla subsequent to the acquisition of assets from this related party primarily related to executive, accounting and legal fees, the write off of $2.6 million of abandoned offering costs and $3.4 million of stock based compensation expense recognized during the three months ended June 30, 2012.

Depreciation, depletion and amortization. Depreciation, depletion and amortization expense increased $0.1 million, or 3%, to $4.0 million during the three months ended June 30, 2012 from $3.9 million during the three months ended June 30, 2011. This increase was consistent with the increase in production.

Other Income/Expense

Interest expense. Interest expense decreased less than 1%, to $786,000 during the three months ended June 30, 2012 from $788,000 during the three months ended June 30, 2011.

Realized and unrealized gains from derivatives. Realized and unrealized gains from derivatives increased $7.2 million, or 941%, to $8.0 million during the three months ended June 30, 2012 from $0.8 million during the three months ended June 30, 2011. This was primarily the result of energy commodity prices falling significantly during the second quarter of 2012.

Net Income

The Company recorded a net income of $1.3 million during the three months ended June 30, 2012 compared to net income of $5.0 million during the three months ended June 30, 2011. The decrease in net income is primarily due to increased general and administrative expenses related to stock based compensation and the write off of abandoned offering costs offset by gains from derivatives.

Six Months Ended June 30, 2012 and 2011

Oil & Natural Gas Revenues

Revenues from oil and natural gas operations were approximately $19.2 million for the six months ended June 30, 2012, a decrease of $5.1 million, or 21%, compared to the six months ended June 30, 2011. Of the total revenues generated during the six months ended June 30, 2012, approximately 69% were generated through natural gas liquids sales, approximately 15% were generated through natural gas sales and approximately 16% were generated through oil sales. The decrease in revenues was largely the result of generally lower average prices.

The following were specifically related to the impact of production and price levels on revenues recorded during the periods:

 

   

the average realized oil price was $94.95 per Bbl during the six months ended June 30, 2012, a decrease of 1% from $95.79 per Bbl during the six months ended June 30, 2011;

 

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total oil production was 32,827 Bbls during the six months ended June 30, 2012, an increase of 35% from 24,334 Bbls during the six months ended June 30, 2011;

 

   

the average realized natural gas price was $2.30 per Mcf during the six months ended June 30, 2012, a decrease of 39% from $3.79 per Mcf during the six months ended June 30, 2011;

 

   

total natural gas production was 1,228,241 Mcf for the six months ended June 30, 2012, a decrease of 5% from 1,288,319 Mcf for the six months ended June 30, 2011;

 

   

the average realized natural gas liquids price was $35.03 per Bbl during the six months ended June 30, 2012, a decrease of 24% from $45.96 per Bbl during the six months ended June 30, 2011; and

 

   

total natural gas liquids production was 379,222 Bbls for the six months ended June 30, 2012, an increase of 2% from 372,924 Bbls for the six months ended June 30, 2011.

For the six months ended June 30, 2012, production of oil and natural gas liquids increased and production of natural gas decreased as compared to the first half of 2012 primarily because the Company has increased its development and production activities since the first half of 2011 in areas of the Hunton reservoir containing a higher concentration of oil and natural gas liquids and a relatively lower concentration of natural gas.

Operating Expenses

Lease operating expenses. Lease operating expenses increased $0.5 million, or 17%, to $3.4 million during the six months ended June 30, 2012 from $2.9 million during the six months ended June 30, 2011. Significant components of lease operating expenses were power & fuel, treating & chemicals, salt water disposal and overhead charges.

Workover expenses. Workover expenses decreased $0.9 million, or 50%, to $0.9 million during the six months ended June 30, 2012 from $1.8 million during the six months ended June 30, 2011. Workovers decreased due to focus on capitalized lateral extensions and new drilling and fewer required workover operations.

Total production costs decreased on an equivalent basis from $7.70 per Boe to $7.01 per Boe.

Production taxes. Production taxes decreased $0.5 million, or 46%, to $0.7 million during the six months ended June 30, 2012 from $1.2 million during the six months ended June 30, 2011. The decrease was due to tax incentives on new wells and tax refunds received in 2012.

General and administrative. General and administrative expense increased $10.8 million, or 1380%, to $11.6 million during the six months ended June 30, 2012 from $0.8 million during the six months ended June 30, 2011. The increase in general and administrative expense was related to operations of the Company outside of Scintilla subsequent to the acquisition of assets from this related party primarily related to executive, accounting and legal fees, the write off of $2.6 million of abandoned offering costs and $6.7 million of stock based compensation expense recognized during the six months ended June 30, 2012.

Depreciation, depletion and amortization. Depreciation, depletion and amortization expense increased $1.2 million, or 16%, to $8.3 million during the six months ended June 30, 2012 from $7.1 million during the six months ended June 30, 2011. This increase was the result of increased future development cost estimated in connection with the Company’s oil and natural gas reserves at March 31, 2012.

Other Income/Expense

Interest expense. Interest expense increased $0.2 million, or 11%, to $1.6 million during the six months ended June 30, 2012 from $1.4 million during the six months ended June 30, 2011. The increase was primarily due to higher debt balances outstanding on the credit agreement during the six months ended June 30, 2012 than was outstanding in the first half of 2011.

Realized and unrealized gains and losses from derivatives. Realized and unrealized gains from derivatives were $9.0 million during the six months ended June 30, 2012 compared to losses of $2.8 million during the six months ended June 30, 2012. This was primarily the result of energy commodity prices falling significantly during the first half of 2012.

 

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Net Income

The Company recorded net income of $1.1 million during the six months ended June 30, 2012 compared to net income of $6.3 million during the six months ended June 30, 2011. The decrease in net income is primarily due to increased general and administrative expenses related to stock based compensation and the write off of abandoned offering costs offset by gains from derivatives.

Cash Flow –Six Months Ended June 30, 2012 and 2011

The Company recorded cash flows provided by operations of $13.8 million during the six months ended June 30, 2012 compared to 15.0 million during the six months ended June 30, 2011. Cash flows provided by operations decreased in the first six months of 2012 compared to the first six months of 2011 primarily due to higher general and administrative costs as discussed above in the results of operations. Cash flows used in investing activities were $13.2 million during the six months ended June 30, 2012 compared to $16.7 million during the six months ended June 30, 2011. Cash flows used in financing activities were $1.4 million during the six months ended June 30, 2012 compared to cash flows provided by financing activities of $1.7 million during the six months ended June 30, 2011.

Capital Resources and Liquidity

Our primary needs for cash are to fund (i) our share of development costs associated with well development within our leasehold properties, (ii) the further acquisition of and payment for additional leasehold assets, and (iii) the payment of contractual obligations and working capital obligations. We believe that funding for these cash needs will likely be provided by a combination of internally-generated cash flows from operations and additional capital raised through future debt and equity financings, and supplemented by additional borrowings under our credit facility.

On August 12, 2011, in conjunction with closing on the assets we acquired from Scintilla and certain other parties, we:

 

   

closed a private placement of our common stock and raised approximately $1.6 million; and

 

   

borrowed $62.5 million under a new credit facility, of which $60.0 million was paid to acquire the assets we acquired from Scintilla and approximately $2.5 million was used to pay certain fees incurred to enter into the credit facility (including professional costs and financing fees). As of June 30, 2012, approximately $4.0 million remained available to us under our credit facility to use for general working capital purposes. The borrowing base was reduced by $2.5 million on August 2, 2012, in connection with a re-determination as a result of derivative transactions occurring in July 2012.

We are subject to restrictive covenants under our credit facility. The ability to maintain this facility and borrow additional funds is dependent on a number of variables, including our proved reserves, and assumptions regarding the price at which oil and natural gas can be sold. For more information regarding the terms of our credit facility, see “—Credit Facility,” below.

Our capital expenditures budget for 2012 is approximately $35 million. We expect to be able to fund our 2012 capital budget with our operating cash flows, in conjunction with potential additional draws from our credit facility. Our capital budget is partially discretionary, and if we experience sustained oil and natural gas prices significantly below their current levels or substantial increases in our drilling and completion costs, we may reduce our capital spending program to remain substantially within our operating cash flows or budgetary constraints.

Other than the development of existing leasehold acreage and other miscellaneous property interests, our 2012 capital budget is exclusive of acquisitions, as the timing and size of acquisitions are difficult to forecast. However, we expect to actively seek to acquire oil and natural gas properties in conventional resource reservoirs that we believe are not subject to significant risk and that provide opportunities for the addition of new reserves and production in Oklahoma and, possibly, elsewhere.

 

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We are also required by our agreements with our contract operator to pay for leasehold held or acquired by our contract operator for our benefit pursuant to such agreements when invoiced by our contract operator, which typically occurs when development of this leasehold commences but may occur prior to that time in the discretion of our contract operator. We estimate that this obligation as of June 30, 2012 was $4.6 million and have recorded a liability in this amount. Although the exact amount we will be required to pay for leasehold in the future is difficult to predict with certainty due to the unknown timing and quantity of acquisitions of leasehold by our contract operator, based on current trends we expect that we will be required to pay approximately $3.4 million during 2012 and approximately $1.2 million in 2013 and 2014 in respect of these leasehold acquisition costs.

While we believe that our available cash and cash flows will partially fund our 2012 capital expenditures, as adjusted from time to time, we cannot provide any assurances that we will be successful in securing additional funding for all of our planned expenditures. The actual amount and timing of our expenditures may differ materially from our estimates as a result of, among other things, actual drilling results, the timing of expenditures by our contract operator or third parties for leasehold acquisition or relating to projects that we do not operate, the availability of drilling rigs and other services and equipment, regulatory, technological and competitive developments and market conditions. In addition, we would consider increasing, decreasing, or reallocating our 2012 capital budget under certain circumstances.

Credit Facility

On August 12, 2011, we entered into a $150.0 million four-year credit facility with Bank of Montreal as administrative agent and KeyBank as syndication agent. Although the credit facility has a $150.0 million borrowing limit, we are only entitled to borrow an amount equal to our borrowing base, which will be redetermined on a semiannual basis and at other times as directed by us or the administrative agent. The initial borrowing base was $72.5 million. The borrowing base will be redetermined based on reserve reports prepared by engineers acceptable to the administrative agent, which we must deliver to the administrative agent on April 1 and October 1 of each year. At June 30, 2012, the borrowing base was $72.5 million, and we had approximately $68.5 million outstanding under our credit facility, resulting in $4.0 million of available borrowing capacity under the credit facility. The borrowing base was reduced by $2.5 million on August 2, 2012, in connection with a re-determination as a result of derivative transactions occurring in July 2012.

Our credit facility matures on August 12, 2015 and bears interest at a variable rate, which was approximately 3.75% per annum at June 30, 2012. Amounts borrowed and repaid under the credit facility may be reborrowed. The credit facility is available for general corporate purposes, including working capital for our operations.

The obligations of the lenders under our credit facility are several, not joint, meaning that if one lender fails to meet its lending obligations, the other lenders do not have to make us whole. As a result, the total amount that we may borrow might be substantially less than the borrowing base.

Our obligations under the credit facility are secured at all times by substantially all of our assets. We may prepay all advances at any time without penalty, subject to the reimbursement of lender breakage costs in the case of prepayment of LIBOR borrowings.

Indebtedness under the credit facility bears interest, at our option, at either:

 

   

the higher of the administrative agent’s prime rate or the federal funds rate plus 0.50%, plus an applicable margin that ranges from 1.50% to 2.25%, depending on the percentage of the borrowing base being utilized; or

 

   

LIBOR plus an applicable margin that ranges from 2.50% to 3.25%, depending on the percentage of borrowing base being utilized.

In addition, the credit facility contains various covenants that limit, among other things, our ability to:

 

   

grant liens on our assets;

 

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incur additional indebtedness;

 

   

engage in a merger, consolidation or dissolution;

 

   

sell or otherwise dispose of our assets, businesses and operations;

 

   

materially alter the character of our business;

 

   

make acquisitions, investments and capital expenditures;

 

   

enter into any transactions with affiliated parties except as specifically contemplated in the credit facility; and

 

   

pay cash dividends or make certain other distributions to stockholders.

The credit facility also contains covenants requiring us to maintain:

 

   

a current ratio (the ratio of our consolidated current assets to our consolidated current liabilities) of not less than 1.0 to 1.0;

 

   

a leverage ratio (the ratio of our consolidated funded indebtedness under the credit facility and all other sources to our consolidated adjusted EBITDAX, as defined in the credit agreement) of not more than 3.5 to 1.0; and

 

   

an interest coverage ratio (the ratio of our consolidated EBITDAX to our consolidated interest expense, as defined in the credit agreement) of not less than 2.5 to 1.0 determined as of the last day of each quarter for the four-quarter period ending on the date of determination.

As of June 30, 2012, we were in compliance with these covenants.

If an event of default exists under the credit facility, the lenders will be able to accelerate the maturity of the credit facility and exercise other rights and remedies. Each of the following could be an event of default under the credit facility:

 

   

failure to pay any principal when due or any interest or fees within three business days of the due date;

 

   

failure to perform or otherwise comply with the covenants in the credit facility;

 

   

failure of any representation or warranty to be true and correct in any material respect;

 

   

failure to pay debt;

 

   

a change of control of us; and

 

   

other customary defaults, including specified bankruptcy or insolvency events, violations of the Employee Retirement Income Security Act of 1974, and material judgment defaults.

Contractual Obligations

In addition to our contractual obligations to service our credit facility and to pay our proportionate shares of acreage and other costs in existing and new wells in the Golden Lane field and the Luther field, we currently lease 6,595 square feet as our principal executive offices at the rate of $7,100 per month (which we believe reflects current market rates). This lease has a current term through July, 2013 with a one-year option on the same terms and conditions. We have also entered into employment agreements with four of our executive officers, Messrs. Kos, Chernicky,

 

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Finley and Thompson, providing for the payment of their salaries and certain initial grants of restricted stock. We generally may terminate the employment of these individuals at any time without liability to us under these agreements, except that if we terminate any of these officers without cause, all of the terminated officer’s remaining unvested shares of restricted stock will immediately vest.

Off Balance Sheet Arrangements

As of June 30, 2012, we had no material off-balance sheet arrangements. We have no plans to enter into any off-balance sheet arrangements in the foreseeable future.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make a variety of estimates and assumptions that affect (i) the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and (ii) the reported amounts of expenses during the reporting periods covered by the financial statements. Our management routinely makes judgments and estimates about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the future resolution of the uncertainties increase, these judgments become even more subjective and complex. Although we believe that our estimates and assumptions are reasonable, actual results may differ significantly from these estimates. Changes in estimates and assumptions based upon actual results may have a material impact on results of operations and/or financial condition.

As an “emerging growth company” we have elected to use the extended transition period for complying with new or revised accounting standards under the JOBS Act. This election allows us to delay the adoption of new or revised accounting standards that have different effective dates for public and private companies until those standards apply to private companies. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates for such new or revised accounting standards.

Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if we choose to rely on such exemptions as an “emerging growth company,” we may not be required, among other things, (i) to provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, (ii) to provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) to disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the chief executive officer’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we no longer meet the criteria for an “emerging growth company,” whichever is earlier.

Our significant accounting policies are disclosed in Note 1 to our Financial Statements included in Part I, Item 1 of this Quarterly Report and also in our registration statement on Form S-1 (File No. 333-176548) originally filed with the Commission on August 30, 2011, as amended.

Forward-Looking Statements

Statements that we make in this Form 10-Q that are not historical or current facts are “forward-looking statements” made pursuant to the safe harbor provisions in the federal securities laws and judicial interpretations thereof. These statements often can be identified by the use of terms such as “may,” “will,” “expect,” “anticipate,” “estimate,” or “continue,” or the negative thereof. Such forward-looking statements speak only as of the date made. Any forward-looking statements represent management’s best judgment as to what may occur in the future. However, forward-looking statements are subject to many risks, uncertainties and important facts beyond our control that could cause actual results and events to differ materially from historical results of operations and events and those presently anticipated or projected. We disclaim any obligation to revise any forward-looking statements to reflect events or circumstances after the date of such statement or to reflect the occurrence of anticipated or unanticipated events.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not required.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures as of June 30, 2012

As required by Rule 15d-15 under the Exchange Act, our management carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered in this Quarterly Report. “Disclosure controls and procedures” are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. These include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive and financial officer, as appropriate to allow timely decisions regarding required disclosure.

This evaluation was carried out under the supervision and with the participation of our principal executive officer and our principal financial officer, who concluded that our disclosure controls and procedures were effective as of June 30, 2012.

Our principal executive officer and our principal financial officer do not expect that our disclosure controls will prevent all error and all fraud. The design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be considered relative to their cost. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that we have detected all of our control issues and all instances of fraud, if any. The design of any system of controls also is based partly on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving our stated goals under all potential future conditions.

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

We are not a party to any legal proceedings. Other than the litigation described in Note 8 to our Financial Statements included in Part I, Item 1 of this Quarterly Report, we are not aware of any material legal proceedings against our Company or involving any of our assets that are contemplated.

 

Item 1A. Risk Factors

Not required.

 

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

Sales of Unregistered Equity Securities

There were no unregistered sales of equity securities during the quarter ended June 30, 2012.

Repurchases of Equity Securities

We did not repurchase any of our equity securities during the second quarter of 2012.

 

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Item 3. Defaults Upon Senior Securities

None.

 

Item 4. Mine Safety Disclosures

Not applicable.

 

Item 5. Other Information

None.

 

Item 6. Exhibits

For a list of documents filed as exhibits to this Quarterly Report, see the Exhibit Index immediately preceding the exhibits filed with this Quarterly Report.

 

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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.

 

 

NEW SOURCE ENERGY CORPORATION

 

/s/ Richard D. Finley

August 14, 2012  

Richard D. Finley

Chief Financial Officer

 

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EXHIBIT INDEX

 

     Incorporated by Reference  

Exhibit

No.

  

Exhibit Description

  

Form

    

SEC

File No.

    

Exhibit

    

Filing

Date

    

Filed
Herewith

    

Furnished

Herewith

 
3.1    Certificate of Incorporation of New Source Energy Corporation      S-1         333-176548         3.1         08/30/2011         
3.2    Bylaws of New Source Energy Corporation      S-1         333-176548         3.2         08/30/2011         
4.1    Registration Rights Agreement, dated as of August 12, 2011, among New Source Energy Corporation, the David J. Chernicky Trust, Deylau, LLC, Timothy R. and Robin L. Cargile, W.K. Chernicky, L.L.C., Okeanos, Inc., Tony McKaig, and Red Dragon, L.L.C.      S-1         333-176548         10.8         08/30/2011         
31.1    Rule 15d-14(a) Certification of Chief Executive Officer                  X      
31.2    Rule 15d-14(a) Certification of Chief Financial Officer                  X      
32.1    Certification of Chief Executive Officer pursuant to 18 U.S.C. § 1350                     X   
32.2    Certification of Chief Financial Officer pursuant to 18 U.S.C. § 1350                     X   

 

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