UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

For the Quarterly Period Ended June 30, 2015

Or

Commission File No. 001-35049  

 

EARTHSTONE ENERGY, INC.

(Exact name of registrant as specified in its charter)

 

 

1400 Woodloch Forest Drive, Suite 300

The Woodlands, Texas 77380

(Address of principal executive offices)

Registrant’s telephone number, including area code:  (281) 298-4246

 

Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days.    Yes  þ    No  o

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

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

 

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

As of August 6, 2015, 13,835,128 shares of common stock, $0.001 par value per share, were outstanding.

 

 

 

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TABLE OF CONTENTS

 

 

 

 

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CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

Certain statements contained in this report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical facts contained in this report are forward-looking statements. These forward-looking statements can generally be identified by the use of words such as “may,” “will,” “could,” “should,” “project,” “intends,” “plans,” “pursue,” “target,” “continue,” “believes,” “anticipates,” “expects,” “estimates,” “predicts,” or “potential,” the negative of such terms or variations thereon, or other comparable terminology. Statements that describe our future plans, strategies, intentions, expectations, objectives, goals or prospects are also forward-looking statements. Actual results could differ materially from those anticipated in these forward-looking statements. Readers should consider carefully the risks described under the “Risk Factors” section included in our previously filed Annual Report on Form 10-K for the fiscal year ended December 31, 2014, and the other disclosures contained herein and therein, which describe factors that could cause our actual results to differ from those anticipated in forward-looking statements, including, but not limited to, the following factors:

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All forward-looking statements are expressly qualified in their entirety by the cautionary statements in this paragraph and elsewhere in this report. Other than as required under the securities laws, we do not assume a duty to update these forward-looking statements, whether as a result of new information, subsequent events or circumstances, changes in expectations or otherwise.

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PART I. FINANCIAL INFORMATION

 

 

Item 1.  Financial Statements (unaudited)

EARTHSTONE ENERGY, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited) 

 

 

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

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EARTHSTONE ENERGY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

 

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

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EARTHSTONE ENERGY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

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

 

 

 

 

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

 

Note 1. Basis of Presentation

Earthstone Energy, Inc., a Delaware corporation (“Earthstone” or the “Company”) is an independent oil and gas exploration and production company engaged in the acquisition, development, exploration and production of onshore, unconventional reserves, with a current focus on the Eagle Ford trend of South Texas and the Bakken trend of North Dakota and Montana. The Company also has conventional wells in East Texas, South Texas and Oklahoma.

The accompanying unaudited consolidated financial statements of Earthstone and our wholly-owned subsidiaries, which we refer to as “we,” “our” or “us,” have been prepared in accordance with Article 8-03 of Regulation S-X for interim financial statements required to be filed with the Securities and Exchange Commission (“SEC”).  The information furnished herein reflects all adjustments that are, in the opinion of management, necessary for the fair presentation of the Company's Consolidated Balance Sheets as of June 30, 2015, and December 31, 2014; the Consolidated Statements of Operations for the three and six months ended June 30, 2015 and 2014; and the Consolidated Statements of Cash Flows for the six months ended June 30, 2015 and 2014.  The Company’s balance sheet at December 31, 2014 is derived from the audited consolidated financial statements at that date.

The preparation of financial statements in conformity with the generally accepted accounting principles of the United States of America (“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 period. Actual results could differ from those estimates. For further information, see Note 2 in the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2014.

Interim period results are not necessarily indicative of results of operations or cash flows for the full year and accordingly, certain information normally included in financial statements and the accompanying notes prepared in accordance with GAAP, has been condensed or omitted. These financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, and the Company’s other filings with the SEC.  The Company has evaluated events or transactions through the date of issuance of these unaudited consolidated financial statements.

On December 19, 2014, the Company acquired three operating subsidiaries of Oak Valley Resources, LLC (“OVR”), in exchange for shares of Earthstone common stock (the “Exchange”), which resulted in a change of control of the Company. Pursuant to the Exchange Agreement, OVR contributed to Earthstone the membership interests of its three subsidiaries, Oak Valley Operating, LLC (“OVO”), EF Non-Op, LLC (“EF Non-Op”) and Sabine River Energy, LLC (“Sabine”), each a Texas limited liability company (collectively “Oak Valley”), in exchange for approximately 9.124 million shares, representing 84% of the Company’s common stock.  The transaction was accounted for as a reverse acquisition whereby Oak Valley is considered the acquirer for accounting purposes.  All historical financial information, prior to December 19, 2014, contained in this Quarterly Report on Form 10-Q is that of Oak Valley.

Immediately following the Exchange, the Company, through its acquired wholly owned subsidiary, Sabine, acquired an additional 20% undivided ownership interest in certain crude oil and gas properties located in Fayette and Gonzales Counties, Texas, in exchange for the issuance of approximately 2.957 million shares of common stock (the “Contribution Agreement”) to Flatonia Energy, LLC, increasing the Company’s ownership in these properties from a 30% undivided ownership to a 50% undivided ownership interest.  As a result of the share issuance to Flatonia, OVR’s ownership in the Company decreased from 84% to 66%.

Recently Issued Accounting Standards

Revenue Recognition - In May 2014, the Financial Accounting Standards Board (“FASB”) issued updated guidance for recognizing revenue from contracts with customers. The objective of this guidance is to establish principles for reporting information about the nature, timing, and uncertainty of revenue and cash flows arising from an entity’s contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and change in judgments, and assets recognized from the costs to obtain or fulfill a contract. In July 2015, the FASB deferred the effective date of the standards update for one year, to be effective for interim and annual period beginning after December 15, 2017; early adoption is allowed as of the original effective date of December 31, 2016. The Company will adopt this standards update, as required, beginning with the first quarter of 2018. The Company is in the process of evaluating the impact, if any, of the adoption of this guidance on its consolidated financial statements.

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Debt Issuance Costs – In April 2015, the FASB issued updated guidance which changes the presentation of debt issuance costs in the financial statements.  Under this updated guidance, debt issuance costs are presented on the balance sheet as a direct deduction from the related debt liability rather than as an asset.  Amortization of the costs is reported as interest expense.  The standards update is effective for interim and annual periods beginning after December 15, 2015.  The Company will adopt this standards update, as required, beginning with the first quarter of 2016 and will be retrospectively applied to all prior periods.  The Company does not expect the adoption of this new presentation guidance to have a material impact on its consolidated balance sheets.

Simplifying the Measurement of Inventory – In July 2015, the FASB issued updated guidance to simplify the measurement of inventory. Under this guidance, an entity should measure inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The standards update is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. This guidance should be applied prospectively and early adoption is permitted. We are in the process of evaluating the impact, if any, of the adoption of this guidance on our consolidated financial statements.

 

 

Note 2. Acquisitions and Divestitures

 

Earthstone Energy Reverse Acquisition

On December 19, 2014, the Company and OVR closed the Exchange. In this transaction, OVR contributed to the Company the membership interests of its three wholly-owned subsidiaries, which included producing assets, undeveloped acreage and cash.  OVR received approximately 9.124 million shares of newly issued common stock, $0.001 par value per share (the “Common Stock”), of the Company. The Exchange resulted in a change of control of the Company. The Exchange has been accounted in accordance with FASB Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”) as a reverse acquisition whereby Oak Valley is considered the acquirer for accounting purposes although Earthstone is the acquirer for legal purposes. ASC 805 also requires, that among other things, assets acquired and liabilities assumed to be measured at their acquisition date fair values. The results of operations from Earthstone’s legacy assets are reflected in the Company’s consolidated statement of operations beginning December 19, 2014.

An allocation of the purchase price was prepared using, among other things, the 2014 year-end reserve report prepared by Cawley, Gillespie and Associates, Inc. that was adjusted and re-priced by the Company’s reserve engineering staff back to the December 19, 2014 acquisition date. The following allocation is still preliminary with respect to final tax amounts, pending the completion of the 2014 Earthstone tax return and certain accruals and includes the use of estimates based on information that was available to management at the time these consolidated financial statements were prepared. Additional changes to the purchase price allocation may result in a corresponding change to goodwill in the period of the change.

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

The following table summarizes the consideration paid to acquire the legacy Earthstone net assets and the estimated values of those net assets (in thousands, except share and share price amounts):

 

 

2014 Eagle Ford Acquisition Properties

Also on December 19, 2014, immediately following the Exchange, Flatonia Energy, LLC (“Flatonia”), Parallel Resource Partners, LLC (“Parallel”), and Sabine, closed the transactions contemplated by the Contribution Agreement by and among the Company, OVR, Sabine, Oak Valley Operating, LLC, Parallel, and Flatonia,  whereby Parallel contributed 28.57% of the oil and natural gas property interests held by Flatonia, a wholly owned subsidiary of Parallel, in consideration for approximately 2.96 million shares of Common Stock (the “Contribution”). The assets subject to the Contribution Agreement were oil and natural gas property interests in producing wells and acreage in the Eagle Ford trend of Texas (the “2014 Eagle Ford Acquisition Properties”). One of the subsidiaries included in the Exchange is the operator of the 2014 Eagle Ford Acquisition Properties. The only relationship that Flatonia or Parallel

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

had with this subsidiary or the Company prior to the transaction was that the subsidiary is the operator of the 2014 Eagle Ford Acquisition Properties. The Contribution was accounted for as a business combination in accordance ASC 805 which among other things requires the assets acquired and liabilities assumed to be measured and recorded at their fair values as of the acquisition date. 

An allocation of the purchase price was prepared using, the 2014 year-end reserve report prepared by Cawley, Gillespie and Associates, Inc. that was adjusted and re-priced by the Company’s reserve engineering staff back to December 19, 2014. The following allocation is still preliminary with respect to final tax amounts, pending the completion of the 2014 Flatonia tax return and certain accruals and it includes the use of estimates based on information that was available to management at the time these audited consolidated financial statements were prepared. The Company’s final allocation of purchase price is dependent on the seller’s tax return since Earthstone received carryover basis on Flatonia’s assets and liabilities because the Contribution Agreement was not a taxable transaction under the United States Internal Revenue Code of 1986, as amended. Additional changes to the purchase price allocation may result in a corresponding change to goodwill in the period of the change.

The following table summarizes the consideration paid to acquire the 2014 Eagle Ford Acquisition Properties and the estimated values of those net assets (in thousands, except share and share price amounts):

 

 

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

 

The following unaudited supplemental pro forma combined condensed results of operations present consolidated information as though the Exchange and Contribution had been completed as of January 1, 2014. These unaudited supplemental pro forma results of operations are provided for illustrative purposes only and do not purport to be indicative of the actual results that would have been achieved by the combined company for the periods presented or that may be achieved by the combined company in the future. The pro forma results of operations do not include any cost savings or other synergies that resulted, or may result, from the Exchange or Contribution or any estimated costs that will be incurred to integrate the legacy Earthstone net assets and the 2014 Eagle Ford Acquisition Properties. Future results may vary significantly from the results reflected in this unaudited pro forma financial information (in thousands, except per share amounts).

 

 

For the three and six months ended June 30, 2015, the Company recognized $2.6 million and $5.3 million, respectively, of oil, natural gas and natural gas liquids sales related to the legacy Earthstone assets and operating expenses including depletion of $2.9 million and $5.9 million, respectively. There were no non-recurring transaction costs related to this acquisition incurred during the three and six months ended June 30, 2015.

 

For the three and six months ended June 30, 2015, the Company recognized $4.1 million and $6.6 million, respectively, of oil, natural gas and natural gas liquids related to the 2014 Eagle Ford Acquisition Properties and operating expenses including depletion of $3.1 million and $5.4 million, respectively. There were no non-recurring transaction costs related to this acquisition incurred during the three and six months ended June 30, 2015.

 

Other Acquisitions

 

In June 2015, the Company acquired a 50% operated interest in two gross Austin Chalk wells, which hold approximately 970 gross acres in southern Gonzales County, Texas. The acreage, acquired for future Eagle Ford development, is 100% held-by-production, with current gross production of 44 barrels of oil equivalent per day (“BOEPD”) all of which was oil.  Also during June 2015, the Company acquired additional acreage in northern Karnes County, Texas, increasing its total leasehold position to approximately 404 gross acres.  The Company currently has a 33% working interest in the Karnes acreage.  These two positions are adjacent to one another and will provide for 17 gross Eagle Ford locations with expected development beginning in the fourth quarter of 2015.

 

The following table summarizes the consideration paid to acquire the properties and the estimated fair values of the assets acquired and liabilities assumed (in thousands):

 

 

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Pro forma financial information, assuming the acquisition occurred at the beginning of each period presented, has not been presented because the effect on the Company’s results for each of those periods is not material.  The results of the above acquisitions have been included in the Company’s consolidated financials since the date of each acquisition.

In June 2015, the Company acquired additional acreage in existing Bakken spacing units primarily located in the Banks Field of McKenzie County, North Dakota, for $1.4 million.  The acquisition included 164 net acres which will allow us to increase our working interest in approximately 41 producing wells and 21 wells that are drilling or in the process of completing.

 

 

Divestitures

In April 2015, the Company sold its Louisiana properties located primarily in DeSoto and Caddo Parishes for cash consideration of $3.5 million.  The Company recorded a gain of $1.7 million on the sale.  The effective date of the transaction was March 1, 2015.

 

 

Note 3. Derivative Financial Instruments

The Company is exposed to certain risks relating to its ongoing business operations, such as commodity price risk. Derivative contracts are utilized to economically hedge the Company’s exposure to price fluctuations and reduce the variability in the Company’s cash flows associated with anticipated sales of future oil and natural gas production. The Company follows FASB ASC Topic 815 Derivatives and Hedging (“ASC Topic 815”), to account for its derivative financial instruments. The Company does not enter into derivative contracts for speculative trading purposes.

It is the Company’s policy to enter into derivative contracts only with counterparties that are creditworthy financial institutions deemed by management as competent and competitive. The counterparties to the Company’s current derivative contracts are lenders in the Company’s credit agreement, which is described in Note 6 Long-Term Debt below. The Company did not post collateral under any of these contracts as they are secured under the Company’s credit agreement with the same counterparties.

The Company’s crude oil and natural gas derivative positions consist of swaps. Swaps are designed so that the Company receives or makes payments based on a differential between fixed and variable prices for crude oil and natural gas. The Company has elected to not designate any of its derivative contracts for hedge accounting. Accordingly, the Company records the net change in the mark-to-market valuation of these derivative contracts, as well as all payments and receipts on settled derivative contracts, in “Net loss on derivative contracts” on the Consolidated Statements of Operations. All derivative contracts are recorded at their fair market value and are included in the Company’s Consolidated Balance Sheets as assets or liabilities.

With an individual derivative counterparty, the Company may have multiple hedge positions that expire at various points in the future and result in fair value asset and liability positions. At the end of each reporting period, those positions are offset to a single fair value asset or liability for each commodity per counter party, and the netted balance is reflected in the Company’s Consolidated Balance Sheets as an asset or a liability.

The Company nets its derivative instrument fair value amounts executed with the same counterparty pursuant to an International Swap Dealers Association Master Agreement (“ISDA”), which provides for net settlement over the term of the contract. The ISDA is a standard contract that governs all derivative contracts entered into between the Company and the respective counterparty. The ISDA allows for offsetting of amounts payable or receivable between the Company and the counterparty, at the election of both parties, for transactions that occur on the same date and in the same currency.

The Company had the following open crude oil derivative contracts as of June 30, 2015:

 

 

 

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

The following table summarizes the location and fair value amounts of all derivative instruments in the Consolidated Balance Sheets as well as the gross recognized derivative assets, liabilities, and amounts offset in the Consolidated Balance Sheets (in thousands):

 

 

The follow table summarizes the location and amounts of the Company’s realized and unrealized gains and losses on derivative instruments in the Company’s Consolidated Statements of Operations (in thousands):

 

 

 

Note 4. Fair Value Measurements

FASB ASC Topic 820, Fair Value Measurements and Disclosure (“ASC Topic 820”), defines 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. ASC Topic 820 provides a framework for measuring fair value, establishes a three level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date and requires consideration of the counterparty’s creditworthiness when valuing certain assets.

The three-level fair value hierarchy for disclosure of fair value measurements defined by ASC Topic 820 is as follows:

Level 1 – Unadjusted, quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. An active market is defined as a market where transactions for the financial instrument occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2 – Inputs, other than quoted prices within Level 1, that are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

Level 3 – Prices or valuations that require unobservable inputs that are both significant to the fair value measurement and unobservable. Valuation under Level 3 generally involves a significant degree of judgment from management.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instrument’s complexity. The Company reflects transfers between the three levels at the beginning of the reporting period in which the availability of observable inputs no longer justifies classification in the original level. There were no transfers between fair value hierarchy levels for the six months ended June 30, 2015.

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Fair Value on a Recurring Basis

Derivative financial instruments are carried at fair value and measured on a recurring basis. The derivative financial instruments consist of swaps for crude oil and natural gas. The Company’s swaps are valued based on a discounted future cash flow model. The primary input for the model is published forward commodity price curves. The Company’s model is validated by the counterparty’s marked-to-market statements. The swaps are also designated as Level 2 within the valuation hierarchy.

The fair values of commodity derivative instruments in an asset position include a measure of counterparty nonperformance risk, and the fair values of commodity derivative instruments in a liability position include a measure of the Company’s nonperformance risk. These measurements were not material to the consolidated financial statements.

The following table summarizes the fair value of the Company’s financial assets and liabilities, by level within the fair-value hierarchy (in thousands):

 

 

Other financial instruments include cash, accounts receivable and payable, and revenue royalties. The carrying amount of these instruments approximates fair value because of their short-term nature. The Company’s long-term debt obligation bears interest at floating market rates, therefore carrying amounts and fair value are approximately equal.

Fair Value on a Nonrecurring Basis

Asset Impairment

Oil and natural gas properties are measured at fair value on a nonrecurring basis. An impairment charge reduces the carrying values of oil and natural gas properties’ to their estimated fair values. These fair value measurements are classified as Level 3 measurements and include many unobservable inputs. Fair value is calculated as the estimated discounted future net cash flows attributable to the assets. The Company’s primary assumptions in preparing the estimated discounted future net cash flows to be recovered from oil and natural gas properties are based on (i) proved reserves, (ii) forward commodity prices and assumptions as to costs and expenses, and (iii) the estimated discount rate that would be used by potential purchasers to determine the fair value of the assets. The Company did not recognize any impairment write-downs with respect to its oil and natural gas properties during the six months ended June 30, 2015 or 2014.

Business Combinations

The Company records the identifiable assets acquired and liabilities assumed at fair value at the date of acquisition on a nonrecurring basis. Fair value may be estimated using comparable market data, a discounted cash flow method, or a combination of the two. In the discounted cash flow method, estimated future cash flows are based on management’s expectations for the future and include estimates of future oil and gas production, commodity prices based on NYMEX commodity futures price strips as of the date of the estimate, operating and development costs, and a risk-adjusted discount rate. The future oil and natural gas pricing used in the valuation is a Level 2 assumption.   Significant Level 3 assumptions associated with the calculation of discounted cash flows used in the determination of fair value of the acquisition include the Company’s estimate operating and development costs, anticipated production of proved reserves, appropriate risk-adjusted discount rates and other relevant data. The Company’s acquisitions are discussed in Note 2 Acquisitions.

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EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

 

Asset Retirement Obligations

The asset retirement obligation estimates are derived from historical costs and management’s expectation of future cost environments; and therefore, the Company has designated these liabilities as Level 3. The significant inputs to this fair value measurement include estimates of plugging, abandonment and remediation costs, well life, inflation and credit-adjusted risk free rate. See Note 7 Asset Retirement Obligations for a reconciliation of the beginning and ending balances of the liability for the Company’s asset retirement obligations.

 

 

Note 5. Earnings (Loss) Per Common Share

Basic earnings (loss) per share is computed by dividing net income (loss) attributable to shares of Common Stock by the basic weighted-average shares of Common Stock outstanding during the period. The calculation of diluted earnings per share is similar to basic, except the denominator includes the effect of dilutive common stock equivalents.

The following table is a reconciliation of net (loss) income and weighted-average shares of Common Stock outstanding for purposes of calculating basic and diluted (loss) income per share: