---

 

Index

 

 

 

Quantities of natural gas are expressed in this report in terms of thousand cubic feet (mcf), million cubic feet (mmcf) or million British thermal unit (Mmbtu).  Oil, which includes natural gas liquids, is quantified in terms of barrels (bbls) and thousands of barrels (mbbls).  Natural gas and oil are compared in terms of barrels of oil equivalent (boe), thousand barrels of oil equivalent (mboe) or million barrels of oil equivalent (mmboe) or thousand cubic feet equivalent (mcfe) and million cubic feet equivalent (mmcfe).  Daily volumes are expressed as barrels of oil equivalent (boed) or million cubic feet (mmcfd).  One barrel of oil is the energy equivalent of six mcf of natural gas. This is a physical correlation and does not reflect a value or price relationship between the commodities.  With respect to information relating to our working interest in wells or acreage, “net” oil and natural gas wells or acreage is determined by multiplying gross wells or acreage by our working interest therein.  References to number of potential well locations are gross, unless otherwise indicated.

 

References to “GAAP” refer to U.S. generally accepted accounting principles.

 

 

---

 

 

 

 

 

 

 

 

 

 

 

---

 

 

 

 

 

 

 

 

 

 

 

---

 

 

 

 

 

---

 

 

 

 

 

 

 

 

---

 

 

 

 

Note 1 – General

 

Description of Business

 

Endeavour International Corporation is an independent oil and gas company engaged in the exploration, development, production and acquisition of energy reserves in the U.S. and U.K.  Endeavour was incorporated under the laws of the state of Nevada on January 13, 2000.  As used in these Notes to Condensed Consolidated Financial Statements, the terms “Endeavour,” “Company,” “we,” “us,” “our” and similar terms refer to Endeavour International Corporation and, unless the context indicates otherwise, its consolidated subsidiaries.  The accompanying financial statements should be read in conjunction with the audited consolidated financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2013.

 

Voluntary Reorganization under Chapter 11

 

On September 2, 2014, the Company announced that it had decided not to pay approximately $33.5 million in interest due on September 2, 2014 on its 12% First Priority Notes due March 2018 (“First Priority Notes”), 12% Second Priority Notes due June 2018 (“Second Priority Notes”) and 6.5% Convertible Senior Notes due November 2017 (“6.5% Convertible Senior Notes”).  Under the term of the indentures for the First Priority Notes, Second Priority Notes and 6.5% Convertible Senior Notes, there was a 30-day grace period during which the Company could elect to make the interest payment and cure any potential event of default for non-payment.

 

On September 30, 2014, the Company entered into forbearance agreements (the “Forbearance Agreements”) with holders of a majority of its debt as to which the interest payment was not made. Under the terms of the Forbearance Agreements, the holders agreed to forbear from exercising remedies against the Company arising from the failure by the Company to pay (following the passing of the 30-day grace period that ended on October 1, 2014) the September 2, 2014 interest payments due.  The forbearance period, initially scheduled to expire on October 7, 2014, was subsequently extended to October 10, 2014.

 

Subsequent to the close of the third quarter of 2014, on  October 10, 2014, the Company announced that it reached agreements with holders of more than two-thirds of its First Priority Notes, Second Priority Notes and 7.5% Convertible Bonds (see Note 6) and its 6.5% Convertible Senior Notes and 5.5% Convertible Senior Notes (see Note 6 and collectively, “Significant Debt Holders”), in the form of a consensual Restructuring Support Agreement (“RSA”) that, if implemented as proposed, would significantly reduce the Company’s outstanding debt.  The RSA contemplated that the recapitalization of the Company would occur pursuant to a pre-

---

 

arranged plan of reorganization.  On the same day (the “Petition Date”),  Endeavour and certain of its wholly owned U.S. subsidiaries - Endeavour Operating Corporation, Endeavour Colorado Corporation, Endeavour Energy New Ventures Inc., and END Management Company - and one of its foreign subsidiaries - Endeavour Energy Luxembourg S.a.r.l. (collectively, the “Debtors”) - filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”) in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”).  The Chapter 11 cases are being jointly administered by the Bankruptcy Court as Case No. 14-12308 (the “Bankruptcy Cases”).  

 

Since the Petition Date, the Debtors have operated their business as “debtors-in-possession" pursuant to Sections 1107(a) and 1108 of the Bankruptcy Code, which will allow the Company to continue operations during the reorganization proceedings.  Each Debtor will remain in possession of its assets and properties, and its business and affairs will continue to be managed by its directors and officers, subject in each case to the supervision of the Bankruptcy Court. 

 

None of the Company’s direct or indirect subsidiaries or affiliates incorporated in the U.K. has filed under Chapter 11 and none is expected to file for reorganization or protection from creditors under any insolvency or similar law in the U.S. or elsewhere.  Such non-filing subsidiaries and affiliates are called “non-Debtors.”

 

The RSA provides for several milestones for consummation and implementation of the consensual restructuring:

 

 

Pursuant to the agreed upon term sheet of the RSA, the Company’s existing debt and accrued interest will be reduced by approximately $568 million, including the cancellation of all of the Company’s First Priority Notes, Second Priority Notes, 7.5% Convertible Bonds, 5.5% Convertible Senior Notes and 6.5% Convertible Senior Notes.  As consideration for such cancellation, the reorganized Company would issue:

 

---

 

All of the Company’s existing equity securities, including its shares of common stock and preferred stock and warrants, will be cancelled without receiving any distribution.

 

On the Petition Date, the Company sought, and thereafter obtained, authority to take a broad range of actions, including, among others, authority to pay royalty interests and joint interest billings, certain employee obligations and pre-Petition contractor claims and taxes.  Additionally, other orders were obtained, including adequate assurance of payment to utility companies as well as continued use of cash management systems.

 

 

Note 2 – Summary of Significant Accounting Policies

 

Basis of Presentation and Use of Estimates

 

The accompanying unaudited condensed consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  On October 10, 2014, the Company filed a voluntary petition under Chapter 11 of the Bankruptcy Code.  The accompanying financial statements do not include any adjustments to reflect the possible future effects on the recoverability of assets or the amounts of liabilities that may result from the outcome of this uncertainty.

 

In the opinion of management, all normal recurring adjustments considered necessary for a fair presentation have been included in these financial statements.  Certain amounts for prior periods have been reclassified to conform to the current presentation.

 

US GAAP requires management to use estimates, judgments and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported herein.  While management regularly reviews its estimates, actual results could differ from those estimates.

 

Management believes that it is reasonably possible that the following material estimates affecting the financial statements could change in the current year:

 

 

---

 

Adoption of New Accounting Standards

 

In April 2014, the Financial Accounting Standards Board (“FASB”) issued an updated standard on reporting discontinued operations and disclosures of disposals of components of an entity.  The guidance applies prospectively to new disposals and new classifications of disposal groups as held for sale after the effective date.  The guidance is effective for interim and annual periods beginning on or after December 15, 2014.  We do not expect the adoption of this guidance to have a material impact on our financial position or results of operations.

 

In May 2014, the FASB issued a new standard on revenue recognition.  The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized.  The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  The new standard is effective for annual periods beginning after December 31, 2016 and can be adopted either retrospectively to each reporting period or retrospectively with a cumulative-effect adjustment as of the date of adoption.  We are currently evaluating the effect that adopting this guidance will have on our financial position, results of operations or cash flows.

 

 

Note 3 –  Property and Equipment

 

Property and equipment included the following at the dates indicated below:

 

 

 

---

 

The costs not subject to amortization include:

 

These costs are transferred to the amortization base when it is determined whether or not proved reserves can be assigned to such properties.  This analysis is dependent upon well performance, results of infill drilling, approval of development plans, drilling results and development of identified projects and periodic assessment of reserves.  We expect acquisition costs and exploration costs excluded from amortization to be transferred to the amortization base over the next three years due to a combination of well performance and results of infill drilling relating to currently producing assets and the drilling and development of identified projects.  Because of the nature of offshore oil and gas activities, development activities, including sanctioning and regulatory approvals, may take a significant amount of time to implement.  Even though our expectation is that most costs not subject to amortization are to be transferred to the amortization base over the next three years, it is not uncommon for the cycle times to be longer, particularly in the North Sea.  We have one U.K. field, Columbus, where costs have been excluded from amortization for greater than five years; however, we continue to work on the development planning for the field.

 

For the three months ended September 30, 2014 and 2013, we capitalized $2.4 million and $7.5 million, respectively, in interest related to exploration and development, primarily related to our U.K. activities.  For the nine months ended September 30, 2014 and 2013, we capitalized $7.4 million and $21.2 million, respectively, in interest related to exploration and development, primarily related to our U.K. activities.

 

For the three months ended September 30, 2014 and 2013, we capitalized $2.2 million and $3.1 million, respectively, in certain directly related employee costs.  For the nine months ended September 30, 2014, and 2013, we capitalized $8.2 million and $10.0 million, respectively, in certain directly related employee costs.

 

We did not have an impairment of oil and gas properties through the application of the full cost ceiling test for the three or nine months ended September 30, 2014.  For the three and nine months ended September 30, 2013, we recorded a pre-tax impairment of $6.0 million and $9.6 million, respectively, related to our U.S. oil and gas properties.

 

For the third quarter of 2014, the prices used for our U.S. impairment analysis were $99.08 per barrel for oil and $4.24 per mcf for gas and our U.K. impairment analysis utilized prices of $107.42 per barrel for oil and $8.90 per mcf for gas.  For the  third quarter of 2013, the prices used for our U.S. impairment analysis were $95.06 per barrel for oil and $3.61 per mcf for gas

---

 

and our U.K. impairment analysis utilized prices of $108.67 per barrel for oil and $10.51 per mcf for gas.

 

 

Note 4 – Goodwill

 

All of our goodwill is attributable to a single reporting unit.  Although the carrying amount of goodwill is tested annually for impairment, as  a result of a number of factors which occurred during and subsequent to the third quarter of 2013, including our filing under Chapter 11 of the United States Bankruptcy Code, we performed a preliminary goodwill impairment test as of September 30, 2014.

 

As a result of the preliminary goodwill impairment test, the entire amount of our goodwill, or $259.2 million, was charged to “Goodwill impairment loss” in cost of operations on our condensed consolidated statements of operations for the nine and three months ended September 30, 2014.

 

Fair value of the reporting unit was determined based on a combination of gross asset value, present value of future cash flows and comparison with comparable trading companies.  The impairment loss is an estimate that is not yet finalized.

 

 

Note 5 – Deferred Revenue

 

For certain of our U.K. fields, we sell production on a monthly basis; however, the production remains in the field’s storage tanks.  The inventory associated with these sales remains on our balance sheet and the revenue is deferred until the production is shipped out of our storage tanks.

 

In 2013 and 2014, we entered into three separate forward sale agreements with one of our established purchasers for payments of approximately $22.5 million each.  This effectively hedged a portion of production from our U.K. North Sea assets by locking in pricing for in excess of 200,000 barrels of oil, over a six month delivery period for each forward sale transaction.  Payment for two of these agreements was received in the first and third quarters of 2013.  Payment for the 2014 transaction was received in the second quarter of this year.

 

The 2013 forward sale commitments were fulfilled in June 2013 and March 2014.    The 2014 forward sale commitment is expected to be fulfilled during the fourth quarter of the current year.  The forward sale liabilities are included in deferred revenue until the purchaser takes possession of the product.

 

---

 

At September 30, 2014, our deferred revenue was attributable to our fields as follows:

 

 

 

 

 

Note 6 – Debt Obligations

 

At September 30, 2014, we had $1,230.2 million in outstanding debt.  Our debt consisted of the following at September 30, 2014 and December 31, 2013:

 

 

 

For discussion of the potential impact of our filing under Chapter 11 of the Bankruptcy Code on our debt obligations, see “Note 1 – General.”

 

Senior Notes

 

In February 2012, we closed the private placement of $350 million aggregate principal amount of 12% First Priority Notes due 2018 and $150 million aggregate principal amount of 12% Second Priority Notes due 2018.  In October 2012, we completed a private placement of an additional $54 million aggregate principal amount of 12% First Priority Notes due 2018 (collectively, the “2018 Notes”).

 

---

 

5.5% Convertible Senior Notes

 

In July 2011, we issued $135 million aggregate principal amount of our 5.5% Convertible Senior Notes due July 15, 2016.  Interest on these notes is payable semi-annually at a rate of 5.5% per annum.  The 5.5% Convertible Senior Notes are convertible into shares of our common stock at an initial conversion rate of 54.019 shares (equivalent to $18.51 per share) of common stock per $1,000 principal amount of the notes, subject to certain anti-dilution adjustments.

 

7.5% Convertible Bonds

 

Our 7.5% Convertible Bonds bore interest at a rate of 11.5% per annum until March 31, 2014, and at a rate of 7.5% thereafter.  Interest is compounded quarterly and added to the outstanding principal balance each quarter.  The bonds are convertible into shares of our common stock at an initial conversion price of $16.52 per $1,000 of principal, which represents a conversion rate of approximately 61 shares of our common stock per $1,000 of principal. 

 

Term Loan Facility

 

On January 24, 2014, we entered into a $255 million agreement consisting of a  $125 million senior secured first lien term loan facility (“Term Loan Facility”) and a $130 million Combined Procurement Agreement (see Note 16).  The Term Loan Facility bore quarterly interest of LIBOR plus 7.00% annually (provided LIBOR equals at least 1.25% annually).

 

The Term Loan Facility matured the earlier of:

 

The proceeds of the Term Loan Facility were used to repay the outstanding amounts under our Revolving Credit Facility.  The repayment included a prepayment fee and accrued interest of approximately $2.0 million.  Subsequent to the repayment, the Revolving Credit Facility was terminated, all of the associated liens on our collateral obligations were released, and we recorded a loss of $3.5 million on the early extinguishment of financing agreements.

 

On September 30, 2014, we repaid the balance outstanding under the Term Loan Facility with proceeds from the Amended Term Loan Facility.  See below.

 

Amended Term Loan Facility

 

On September 30, 2014, two wholly-owned subsidiaries, Endeavour International Holding B.V. (“EIH”) and End Finco LLC (“Finco” and collectively, “Borrowers”) entered into an amended and restated credit agreement (the “Amended Credit Agreement”) in respect of our Term Loan

---

 

Facility.  EIH and Finco are non-Debtors, and as such, the Amended Credit Agreement is not subject to the RSA and related Bankruptcy Cases.

 

Pursuant to the Amended Credit Agreement, the lenders advanced approximately $440 million in aggregate principal amount of term loans to the Borrowers (“Amended Term Loan Facility”).  The proceeds were used to:

 

 

We deferred financing costs of $10.3 million related to the Amended Term Loan Facility.  The repayments of the Term Loan Facility, Monetary Production Payments and Combined Procurement Agreement included prepayment fees of approximately $3.3 million, $7.8 million and $2.4 million, respectively, and accrued interest of $2.6 million, $3.7 million and $1.9 million, respectively.

 

Subsequent to the repayment, the Term Loan Facility, Monetary Production Payments and Combined Procurement Agreement were terminated, and all of the associated liens on our collateral obligations were released.  As a result, we wrote off deferred financing costs of $7.6 million and $6.7 million related to the Term Loan Facility and Monetary Production Payments, respectively.  Additionally, we wrote off a debt discount of $1.5 million related to the Term Loan Facility and charged $1.9 million to loss on foreign currency exchange related to the Combined Procurement Agreement.  All charges related to prepayment fees and write off of deferred financing costs, debt discount and loss on foreign currency exchange are included in other income as “Loss on early extinguishment of financing agreements” in our condensed consolidated statements of operations.

 

The Amended Term Loan Facility bears interest quarterly at a rate of LIBOR plus 10.00% per year (with a LIBOR floor of 1% per year) and matures on January 2, 2017.  The loans under the Amended Term Loan Facility were issued with original issue discount of 2.0%.  Borrowings under the Amended Term Loan Facility are guaranteed by the Company and certain of its current and future subsidiaries, including Endeavour Operating Corporation and Endeavour UK, subject to certain exceptions.  The Amended Term Loan Facility is secured by the same assets securing the Company’s Term Loan Facility other than cash and cash equivalents in the United States.

 

The Amended Credit Agreement contains covenants and provisions with respect to events of default that are substantially similar to the covenants in the Company’s Term Loan Facility

---

 

including, but not limited to, restrictions on the Company’s and its subsidiaries’ abilities to: (i) pay distributions or repurchase or redeem the Company’s capital stock or subordinated debt; (ii) make certain investments; (iii) incur additional indebtedness; (iv) create or incur certain liens; (v) sell assets; (vi) consolidate, merge or transfer all or substantially all of the Company’s assets; (vii) enter into agreements that restrict distributions from the Company’s subsidiaries to the Company; (viii) engage in transactions with affiliates; and (ix) allow EIH or any of its subsidiaries to make dividends, payments or other distributions of any kind to the Debtors, other than pursuant to specific limited amounts and for specified purposes.

 

The Amended Credit Agreement contains customary events of default, subject to certain exceptions.  In particular, the following events do not constitute events of default under the Amended Credit Agreement: (a) payment defaults or other defaults to the Company’s existing notes or to certain intercompany indebtedness or (b) a bankruptcy filing by the Company or its domestic subsidiaries and one foreign subsidiary.

 

In addition, the Amended Credit Agreement contains various financial covenants as defined in the agreement, including:

 

Revolving Credit Facility

 

On April 12, 2012, we entered into a Revolving Credit Facility, with Cyan Partners, LP, as administrative agent, under which we ultimately borrowed $115 million.

 

On January 24, 2014, we repaid the balance outstanding under the Revolving Credit Facility with proceeds from the Term Loan Facility.  Following the repayment, the Revolving Credit Facility was terminated and all of the associated liens on the collateral securing our obligations were released.

 

6.5% Convertible Senior Notes

 

On February 28, 2014, we entered into a securities purchase agreement  (the “Securities Purchase Agreement”) relating to the issuance of up to $55 million in common stock, warrants and convertible notes.  We closed on an initial $30 million in late February and early March 2014, comprised of:

---

 

The 6.5% Convertible Senior Notes have a maturity date the same as the Term Loan Facility.  Interest is payable on the 6.5% Convertible Senior Notes quarterly.

 

The 6.5% Convertible Senior Notes are:

 

Fair Value

 

The fair value of our outstanding debt obligations was $791.6 million and $868.4 million at September 30, 2014 and December 31, 2013, respectively.  The fair values of our 2018 Notes and 5.5% Convertible Senior Notes were determined based upon external market quotes and the 6.5% Convertible Senior Notes and 7.5% Convertible Bonds were determined based upon implied valuations in the RSA.  The fair value of our Amended Term Loan Facility was determined based upon a discounted cash flow model.  As a result, all fair value measures related to our debt are considered Level 3.

 

 

Note 7 – Income Taxes 

 

Our U.S. operations are taxed at a statutory rate of 35%.  However, we currently do not record tax benefits due to losses in the U.S. as there is no assurance that we will generate any U.S. taxable earnings, resulting in a full valuation allowance of all deferred tax assets generated.

 

Our income tax expense relates primarily to our operations in the U.K. which are taxed at a statutory rate of 62% plus an additional Petroleum Revenue Tax on our Alba field.  With the utilization of our tax attributes in the U.K., we have not paid any corporate taxes in the U.K.  Because of our accumulated tax attributes, we do not expect to pay U.K. corporate taxes until after 2016.  The current tax expense is related to Petroleum Revenue Tax (“PRT”) on our Alba field.  We have no other producing fields subject to PRT.

 

 

---

 

Note 8 – Monetary Production Payments

 

Our production payment liability, net of repayments, consisted of the following at September 30, 2014 and December 31, 2013:

 

 

 

During 2013, we entered into various monetary production payment arrangements (collectively, the “Monetary Production Payments”) covering the proceeds of sale from a portion of EEUK’s entitlement to production from its interests in the certain fields located in the U.K. sector of the North Sea.  We issued the Monetary Production Payments in the following manner:

 

 

We made principal payments of $5.0 million in January 2014 and $5.8 million each in April 2014 and July 2014. 

 

On September 30, 2014, we repaid the balance of the Monetary Production Payments outstanding with proceeds from the Amended Term Loan Facility.  Following the repayment, the Monetary Production Payments were terminated and all of the associated liens on the collateral securing our obligations were released (see Note 6).

 

 

---

 

Note 9 – Other Long-Term Liabilities

 

At September 30, 2014 and December 31, 2013, our other liabilities included the following:

 

 

 

Asset Retirement Obligations

 

Our asset retirement obligations relate to our obligation for the plugging and abandonment of oil and gas properties.  The asset retirement obligations are recorded at fair value and accretion expense, recognized over the life of the property, increases the liability to its expected settlement value.  If the fair value of the estimated asset retirement obligation changes, an adjustment is recorded for both the asset retirement obligation and the asset retirement cost.    The following table provides a rollforward of our asset retirement obligations for the nine months ended September 30, 2014 and 2013:

 

 

 

 

 

 

 

Note 10 – Equity Transactions

 

In February 2014, we entered into the Securities Purchase Agreement whereby we issued 2.9 million shares of our common stock and warrants to purchase 0.7 million shares of our common stock for a total of $12.5 million in cash.  The warrants have an exercise price of $5.292 per share and expire on February 28, 2019 and are subject to customary anti-dilution provisions.

---

 

In April 2014, we issued the warrants to purchase 2,130,680 shares of our common stock, with an exercise price of $5.29 per share, in connection with our litigation settlement.  The Warrants expire on April 16, 2019 and are subject to customary anti-dilution provisions.  See Note 16 for additional information.

 

For discussion of the potential impact of our filing under Chapter 11 of the Bankruptcy Code on our equity, see “Note 1 – General.”

 

 

 

 

Note 11 – Stock-Based Compensation Arrangements

 

We grant restricted stock and stock options to employees and directors as incentive compensation.  The restricted stock and options generally vest over three years.  Non-cash stock-based compensation is recorded in general and administrative (“G&A”) expenses or capitalized G&A as follows:

 

 

 

 

 

At September 30, 2014, total compensation cost related to awards not yet recognized was approximately $7.7 million and is expected to be recognized over a weighted average period of less than three years.

 

Stock Options

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. We did not grant any stock options during 2013 or 2014. 

---

 

Information relating to outstanding stock options is summarized as follows:

 

 

 

Restricted Stock

 

Restricted stock awards are valued based on the closing price of our common stock on the measurement date, which is typically the date of grant.

 

The status of the restricted shares outstanding as of September 30, 2014 is presented below:

 

 

Performance-Based Share Awards

 

Certain of our executive officers were granted a target number of performance shares under individual Performance Unit Award Agreements.  The performance shares will be earned as the relative total shareholder return ranking is measured among a designated peer group at the end of a three-year performance period.  Payouts will be based on a predetermined schedule at the end of the performance period. The shares issued may range from 0% to 200% of the number of Performance Units specified in the agreements.  The fair value of each performance-based award is estimated on the date of grant using a Monte Carlo simulation model. 

 

---

 

The status of the performance-based share awards as of September 30, 2014 is presented below:

 

 

 

For discussion of the potential impact of our filing under Chapter 11 of the Bankruptcy Code on our equity, see “Note 1 – General.”

 

 

 

 

Note 12 – Loss per Share

 

Basic loss per common share is computed by dividing net loss to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted loss per share includes the effect of our outstanding stock options, warrants and shares issuable pursuant to convertible debt, convertible preferred stock and certain stock incentive plans under the treasury stock method, if including such instruments would be dilutive.

 

For each of the periods presented, shares associated with stock options, warrants, convertible debt, convertible preferred stock and certain stock incentive plans were not included because their inclusion would be anti-dilutive.

 

The common shares potentially issuable arising from these instruments, which were outstanding during the periods presented in the financial statements consisted of:

 

 

 

 

 

 

---

 

 

Note 13 – Fair Value Measurements

 

We measure the fair value of financial assets and liabilities on a recurring basis, defining fair value as 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.  The fair value is based on assumptions that market participants would use when pricing an asset or liability, including assumptions about risk and the risks inherent in valuation techniques and the inputs to valuations.  This includes not only the credit standing of counterparties involved and the impact of credit enhancements but also the impact of our own nonperformance risk on our liabilities.  Fair value measurements are classified and disclosed in one of the following categories:

 

Level  1:Fair value is based on actively-quoted market prices, if available.

 

Level  2:In the absence of actively-quoted market prices, we seek price information from external sources, including broker quotes and industry publications.  Substantially all of these inputs are observable in the marketplace during the entire term of the instrument, derived from observable data, or supported by observable levels at which transactions are executed in the marketplace.

 

Level  3:If valuations require inputs that are both significant to the fair value measurement and less observable from objective sources, we must estimate prices based on available historical and near-term future price information and certain statistical methods that reflect our market assumptions.

 

We apply fair value measurements to certain assets and liabilities including embedded derivatives relating to conversion and change in control features in certain of our debt instruments and three-way collars related to our U.K. gas production.  We seek to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. 

---

 

The following table summarizes the valuation of our financial instruments by pricing levels as of September 30, 2014 and December 31, 2013:

 

 

 

For the Company’s three-way collars, which are classified as Level 2, we used a closed option model to derive the value of our derivatives.  The key inputs into this valuation model are quoted forward prices for natural gas,  volatility factors and interest rates for a similar length of time as the derivative contract term as applicable.

 

For the Company’s embedded derivatives, the key inputs into this valuation model are our current stock price, risk-free interest rates, the stock volatility and our implied credit spread.  The first two aforementioned inputs are based on observable market data and are considered Level 2 inputs while the last two aforementioned inputs are unobservable and thus require management’s judgment and are considered Level 3 inputs.  The following is a reconciliation of changes in fair value of derivative liabilities classified as Level 3:

 

 

 

 

Note 14 – Derivative Instruments

 

During the three months ended September 30, 2014, the Company entered into three-way collars to mitigate commodity pricing risks related to a portion of its U.K. gas production.  These three-

---

 

way collars expire on December 31, 2014.  As of September 30, 2014, the Company had the following outstanding three-way collars, all which settle monthly based on the U.K. National Balancing Point (“NBP”) index:

 

 

 

During the three and nine months ended September 30, 2014, we  also had recognized embedded derivative liabilities related to debt and equity instruments.  Based on our filing under Chapter 11 of the Bankruptcy Code as discussed in “Note 1 – General” and the related probable cancellation of the underlying debt and equity instruments, we wrote off the entire amount of the embedded derivatives and recorded a gain of $6.2 million during the third quarter of 2014.    None of the Company’s derivatives are designated as hedges for accounting purposes. 

 

The fair market value of these derivative instruments is included in our balance sheets as follows for the periods indicated:

 

 

 

The effect of derivatives on our condensed consolidated statements of operations was as follows:

 

 

 

 

 

 

---

 

Note 15 – Supplemental Cash Flow Information

 

Cash paid (refunded) during the period for interest and income taxes was as follows:

 

 

 

 

 

 

Note 16 – Commitments and Contingencies

 

Commitments Related to Asset Retirement Obligations

 

We have entered into decommissioning security agreements related to abandonment liabilities for certain of our U.K. oil and gas properties.  Under these agreements, we are required to post security from time to time in the form of letters of credit, cash or other agreed-upon consideration.    Prior to entry into the LC Issuance Agreement on September 30, 2014 (see below), the commitments under these agreements were not recorded as liabilities, and fees and expenses related to these agreements were included in “Letter of credit fees” in other expenses on our condensed consolidated statements of operations.

 

Decommissioning Security Agreements

 

LC Issuance Agreement

 

On September 30, 2014, in conjunction with the Amended Term Loan Facility, the Company entered into an LC Issuance Agreement (the “LC Issuance Agreement”), pursuant to which Credit Suisse agreed to issue letters of credit for Endeavour UK’s account in the amount of approximately $89.5 million as of September 30, 2014.

 

The letters of credit secure decommissioning obligations in connection with certain of Endeavour’s  U.K. Continental Shelf petroleum production.  The Company has collateralized its obligations under the LC Issuance Agreement and all letters of credit issued thereunder by posting cash collateral, which has been funded with the proceeds from the Amended Term Loan Facility.

 

The posted cash collateral balance of $89.5 million related to the LC Issuance Agreement as of September 30, 2014 is reflected as “Restricted cash, long-term portion” in our condensed consolidated balance sheets.  The liability related to the posted cash collateral is included as part

---

 

of the $440 million Amended Term Loan Facility long-term debt obligation.  The LC Issuance Agreement was entered into to replace the Combined Procurement Agreement.

 

As of September 30, 2014, we do not expect to begin decommissioning activities for the Alba field for many years.  The timing of decommissioning activities will be determined by the ultimate performance and life of the reservoir, which is not expected to occur until 2029 or later.

 

Combined Procurement Agreement

 

On January 24, 2014, we entered into a letter of credit procurement agreement (the “Combined Procurement Agreement”) with an unaffiliated third party (“Payee”), where we agreed to reimburse the Payee for any expense incurred by it in connection with the posting of cash collateral to secure letters of credit issued for our account in the amount of approximately £78 million (approximately $130 million as of January 24, 2014, subsequently reduced as discussed below).  The letters of credit secured decommissioning obligations in connection with certain of our U.K. licenses.  The Combined Procurement Agreement was entered into to replace the LOC Procurement Agreement (see below) and a previous agreement related to the Alba field.

 

Due to a change in the U.K. tax treatment for decommissioning, we amended our Decommissioning Securities Agreement for the Alba field.  The new tax law, which allows companies to treat decommissioning on an after-tax basis (including PRT), enabled us to reduce our current letter of credit amount.  Prior to entry into the LC Issuance Agreement, we had approximately $90 million in outstanding letters of credit securing decommissioning obligations under the Combined Procurement Agreement.

 

Under the Combined Procurement Agreement, we paid a quarterly fee computed at a rate of LIBOR plus 7.00% per year (provided that LIBOR shall equal at least 1.25% per year) on the aggregate balance of posted cash collateral.

 

Concurrent with our entry into the LC Issuance Agreement on September 30, 2014, the Combined Procurement Agreement was terminated, and we paid all outstanding interest and fees of $1.9 million and $2.4 million, respectively.

 

LOC Procurement Agreement

 

On January 9, 2013, we entered into an LOC Procurement agreement (the “LOC Procurement Agreement”) with an unaffiliated third party entity, which matured on July 9, 2014.  The LOC Procurement Agreement was entered into in connection with the unaffiliated third party’s entry into a credit support arrangement with a providing bank.  Pursuant to this credit support arrangement, the third party pledged cash, contributed by one of our shareholders, to secure letters of credit in the amount of $33.0 million for the support of decommissioning obligations in connection with certain of our U.K. license agreements.

---

 

Concurrent with our entry into the Combined Procurement Agreement on January 24, 2014, the LOC Procurement Agreement was terminated, and we paid all outstanding and accrued fees totaling approximately $0.2 million. 

 

Terminated Acquisition of Marcellus Assets

 

On July 17, 2011, we entered into agreements with SM Energy Company and certain other sellers named therein (“SM Energy”) for the purchase of oil and gas leases, producing properties, geophysical data, a pipeline and related assets in the Marcellus shale play in Pennsylvania for aggregate consideration of approximately $110 million (the “SM Purchase Agreements”).  We terminated the agreements on December 14, 2011, based on our conclusion that (i) the title defects we identified, after analyzing SM Energy’s responses to the notice of defects and valuation of the defects; and (ii) the condition of the pipeline was not in compliance with applicable regulatory standards.

 

SM Energy filed a lawsuit against us in Texas state court on December 20, 2011 alleging that we breached the SM Purchase Agreements by terminating them and refusing to close on the transactions.

 

On April 16, 2014, we reached an agreement with SM Energy to settle and dismiss the litigation.  In accordance with the settlement agreement, we:

 

As a result of this settlement, we recorded $19 million in total settlement expense during the first quarter of 2014.

 

Legal Proceedings

 

Refer to “Note 1 — General” for information concerning the Bankruptcy Cases.

 

 

Note 17 – Guarantor Subsidiaries

 

Certain of our wholly-owned domestic subsidiaries have, jointly and severally, fully and unconditionally guaranteed the 2018 Notes.  Pursuant to Securities and Exchange Commission (“SEC”) regulations, we have presented in columnar format the condensed consolidating

---

 

financial information for Endeavour International Corporation, the guarantor subsidiaries on a combined basis, and all non-guarantor subsidiaries on a combined basis.

 

The subsidiary guarantees are unsecured obligations of each subsidiary guarantor and rank equally in right of payment with all senior indebtedness of that subsidiary guarantor and senior in right of payment to all subordinated indebtedness of that subsidiary guarantor.  The subsidiary guarantees are effectively subordinated to any secured indebtedness of the subsidiary guarantor with respect to the assets securing the indebtedness.  In addition, the subsidiary guarantees may be released in certain customary circumstances, including (i) the sale of all or substantially all of the properties or assets or a guarantor, (ii) the sale of the capital stock of a guarantor, (iii) the designation of a guarantor as an “Unrestricted Subsidiary,” (iv) upon legal defeasance of the 2018 Notes or satisfaction and discharge of the indentures governing the 2018 Notes, (v) upon the liquidation or dissolution of the guarantor or (vi) if the guarantor ceases to guarantee other of our indebtedness and ceases to be a material subsidiary, each of which is subject to important limitations in the indentures governing the 2018 Notes.

 

During 2014, we executed an intercompany loan agreement, effective May 2012, between Endeavour International Corporation and one of its wholly-owned subsidiaries that is a guarantor of the 2018 Notes.  As the intercompany loan is effective for prior periods, the revisions for this loan and related interest to the applicable prior periods are reflected in the financial information herein.  The intercompany loan has no effect on our condensed consolidated results of operations or financial statement positions.

 

---

 

Condensed consolidating financial statements for our guarantor subsidiaries and non-guarantor subsidiaries are presented in the following tables:

 

 

 

---

 

 

 

---

 

 

 

---

 

 

 

---

 

 

 

---

 

 

 

 

 

 

---

 

---