EARTHSTONE ENERGY INC - FORM 10-Q

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EX-32.2 - EX-32.2 - EARTHSTONE ENERGY INC	este-ex322_8.htm
EX-32.1 - EX-32.1 - EARTHSTONE ENERGY INC	este-ex321_9.htm
EX-31.2 - EX-31.2 - EARTHSTONE ENERGY INC	este-ex312_7.htm
EX-31.1 - EX-31.1 - EARTHSTONE ENERGY INC	este-ex311_6.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the Quarterly Period Ended September 30, 2016

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

Commission File No. 001-35049

EARTHSTONE ENERGY, INC.

(Exact name of registrant as specified in its charter)

Delaware		84-0592823
(State or other jurisdiction		(I.R.S Employer
of incorporation or organization)		Identification No.)

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 ☒ No ☐

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 ☒ No ☐

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.

Large accelerated filer	☐	Accelerated filer	☒

Non-accelerated filer	☐ (Do not check if a smaller reporting company)	Smaller reporting company	☐

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

As of November 4, 2016, 22,289,177 shares of common stock, $0.001 par value per share, were outstanding.

TABLE OF CONTENTS

		Page

	PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)	5
	Condensed Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015	5
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2016 and 2015	6
	Condensed Consolidated Statement of Equity for the Nine Months Ended September 30, 2016	7
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2016 and 2015	8
	Notes to Unaudited Condensed Consolidated Financial Statements	9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	33
Item 4.	Controls and Procedures	34

	PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	35
Item 1A.	Risk Factors	35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 3.	Defaults Upon Senior Securities	35
Item 4.	Mine Safety Disclosures	35
Item 5.	Other Information	35
Item 6.	Exhibits	35
	Signatures	36

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, 2015, 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:

•

volatility and weakness in commodity prices for oil and natural gas and the effect of prices set or influenced by action of the Organization of Petroleum Exporting Countries (“OPEC”);

•

substantial changes in estimates of our proved reserves;

•

substantial declines in the values of our oil and natural gas reserves;

•

our ability to replace our oil and natural gas reserves;

•

the potential for production decline rates for our wells to be greater than we expect;

•

the timing and extent of our success in discovering, acquiring, developing and producing oil and natural gas reserves;

•

the ability and willingness of our partners under our joint operating agreements to join in our future exploration, development and production activities;

•

our ability to acquire leases and quality services and supplies on a timely basis and at reasonable prices;

•

the cost and availability of high quality goods and services with fully trained and adequate personnel, such as drilling rigs and completion equipment;

•

risks in connection with potential acquisitions and the integration of significant acquisitions;

•

the possibility that acquisitions and divestitures may involve unexpected costs or delays, and that acquisitions may not achieve intended benefits and will divert management’s time and energy;

•

the possibility that anticipated divestitures may not occur or could be burdened with unforeseen costs;

•

reductions in the borrowing base under our credit facility;

•

risks incident to the drilling and operation of oil and natural gas wells including mechanical failures;

•

the presence or recoverability of estimated oil and natural gas reserves and the actual future production rates and associated costs;

•

the availability of sufficient pipeline and other transportation facilities to carry our production and the impact of these facilities on prices;

•

significant competition for acreage and acquisitions;

•

the effect of existing and future laws, governmental regulations and the political and economic climates of the United States;

•

our ability to retain key members of senior management and key technical and financial employees;

•

changes in environmental laws and the regulation and enforcement related to those laws;

•

the identification of and severity of environmental events and governmental responses to these or other environmental events;

•

legislative or regulatory changes, including retroactive royalty or production tax regimes, hydraulic-fracturing regulations, derivatives reform, and changes in state, and federal income taxes;

•

general economic conditions, whether internationally, nationally or in the regional and local market areas in which we conduct business, may be less favorable than expected, including the possibility that economic conditions in the United States will worsen and that capital markets will be disrupted or unavailable;

•

social unrest, political instability or armed conflict in major oil and natural gas producing regions outside the United States, such as Africa, the Middle East, and acts of terrorism or sabotage;

•

the insurance coverage maintained by us may not adequately cover all losses that may be sustained in connection with our business activities;

•

other economic, competitive, governmental, regulatory, legislative, including federal, state and tribal regulations and laws, geopolitical and technological factors that may negatively impact our business, operations or oil and natural gas prices;

•

the effect of our oil and natural gas derivative activities;

•

title to the properties in which we have an interest may be impaired by title defects; and

•

our dependency on the skill, ability and decisions of third party operators of oil and natural gas properties in which we have non-operated working interests.

All forward-looking statements are expressly qualified in their entirety by the cautionary statements in this section 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.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

EARTHSTONE ENERGY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

	September 30,			December 31,
ASSETS	2016			2015
Current assets:	(In thousands, except share amounts)
Cash and cash equivalents	$	23,809		$	23,264
Accounts receivable:
Oil, natural gas, and natural gas liquids revenues		9,205			13,529
Joint interest billings and other		2,108			4,924
Prepaid expenses and other current assets		2,376			498
Current derivative asset		185			3,694
Total current assets		37,683			45,909
Oil and gas properties, successful efforts method:
Proved properties		348,408			283,644
Unproved properties		59,942			34,609
Total oil and gas properties		408,350			318,253

Accumulated depreciation, depletion, and amortization		(135,823	)		(119,920	)
Net oil and gas properties		272,527			198,333
Other noncurrent assets:
Goodwill		20,549			17,532
Office and other equipment, less accumulated depreciation of $1,426 and $1,028 at September 30, 2016 and December 31, 2015		1,605			1,934
Other noncurrent assets		1,112			1,236
TOTAL ASSETS	$	333,476		$	264,944
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	12,529		$	11,580
Accrued expenses		10,445			12,975
Revenues and royalties payable		6,846			8,576
Advances		6,481			15,447
Current portion of long-term debt		1,591			—
Current derivative liability		1,237			—
Total current liabilities		39,129			48,578

Noncurrent liabilities:
Long-term debt		13,104			11,191
Asset retirement obligations		5,815			5,075
Noncurrent derivative liability		1,101			—
Deferred tax liability		1,051			—
Other noncurrent liabilities		183			227
Total noncurrent liabilities		21,254			16,493

Commitments and Contingencies (Note 10)

Equity:
Preferred stock, $0.001 par value, 20,000,000 shares authorized; none issued or outstanding		—			—
Common stock, $0.001 par value, 100,000,000 shares authorized; 22,289,177 and 13,835,128 shares issued and outstanding at September 30, 2016 and December 31, 2015		23			14
Additional paid-in capital		452,790			358,086
Accumulated deficit		(179,260	)		(157,767	)
Treasury stock, 15,357 shares at September 30, 2016 and December 31, 2015		(460	)		(460	)
Total equity		273,093			199,873

TOTAL LIABILITIES AND EQUITY	$	333,476		$	264,944

The accompanying notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

EARTHSTONE ENERGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
REVENUES	(In thousands, except share and per share amounts)
Oil, natural gas, and natural gas liquids revenues:
Oil	$	8,262		$	10,385		$	21,898		$	31,586
Natural gas		1,417			1,971			3,376			5,483
Natural gas liquids		851			677			1,843			2,164
Total oil, natural gas, and natural gas liquids revenues		10,530			13,033			27,117			39,233
Gathering income		55			60			142			233
Gain (loss) on sales of oil and gas properties, net		8			(13	)		8			1,667
Total revenues		10,593			13,080			27,267			41,133
OPERATING COSTS AND EXPENSES
Production costs:
Lease operating expense		3,981			4,138			10,248			12,751
Severance taxes		522			746			1,418			2,122
Rig idle and contract termination expense		—			—			5,059			—
Depreciation, depletion, and amortization		5,149			8,107			16,252			22,705
Re-engineering and workovers		798			234			1,379			520
Exploration expense		—			—			5			142
General and administrative expense		3,131			2,450			8,602			7,505
General and administrative expense - stock-based compensation		1,328			—			1,889			—
Total operating costs and expenses		14,909			15,675			44,852			45,745
Loss from operations		(4,316	)		(2,595	)		(17,585	)		(4,612	)
OTHER INCOME (EXPENSE)
Interest expense, net		(341	)		(169	)		(934	)		(507	)
Gain (loss) on derivative contracts, net		946			5,166			(2,517	)		4,522
Other income (expense), net		12			127			(70	)		384
Total other income (expense)		617			5,124			(3,521	)		4,399
(Loss) income before income taxes		(3,699	)		2,529			(21,106	)		(213	)
Income tax expense (benefit)		201			811			387			(69	)
Net (loss) income	$	(3,900	)	$	1,718		$	(21,493	)	$	(144	)
Net (loss) income per common share:
Basic	$	(0.17	)	$	0.12		$	(1.23	)	$	(0.01	)
Diluted	$	(0.17	)	$	0.12		$	(1.23	)	$	(0.01	)
Weighted average common shares outstanding:
Basic		22,289,177			13,835,128			17,433,079			13,835,128
Diluted		22,289,177			13,835,128			17,433,079			13,835,128

The accompanying notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

EARTHSTONE ENERGY, INC.

CONDENSED CONSOLIDATED STATEMENT OF EQUITY

(Unaudited)

					Additional
	Common Stock				Paid-in		Accumulated			Treasury Stock						Total
(In thousands, except share amounts)	Shares		Amount		Capital		Deficit			Shares			Amount			Equity
At December 31, 2015		13,835,128	$	14	$	358,086	$	(157,767	)		(15,357	)	$	(460	)	$	199,873

Common stock issued, net of offering costs of $2.7 million		4,753,770		5		47,120		—			—			—			47,125
Stock-based compensation expense		—		—		1,889		—			—			—			1,889
Shares issued in Lynden Arrangement		3,700,279		4		45,695		—			—			—			45,699
Net loss		—		—		—		(21,493	)		—			—			(21,493	)
At September 30, 2016		22,289,177	$	23	$	452,790	$	(179,260	)		(15,357	)	$	(460	)	$	273,093

The accompanying notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

EARTHSTONE ENERGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended September 30,
	2016			2015
Cash flows from operating activities:	(In thousands)
Net loss	$	(21,493	)	$	(144	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation, depletion, and amortization		16,252			22,705
Total loss (gain) on derivative contracts, net		2,517			(4,522	)
Operating portion of net cash received in settlement of derivative contracts		3,330			4,178
Rig idle and termination expense		5,059			—
Accretion of asset retirement obligations		404			425
Stock-based compensation		1,889			—
Deferred income taxes		387			(69	)
Amortization of deferred financing costs		220			195
Settlement of asset retirement obligations		(15	)		(65	)
Gain on sale of assets		(8	)		(1,667	)
Changes in assets and liabilities:
Decrease in accounts receivable		9,141			5,362
(Increase) decrease in prepaid expenses and other		(1,790	)		548
Decrease in accounts payable and accrued expenses		(3,462	)		(15,547	)
Decrease in revenue and royalties payable		(1,730	)		(7,318	)
(Decrease) increase in advances		(8,966	)		224
Net cash provided by operating activities		1,735			4,305
Cash flows from investing activities:
Lynden Arrangement, net of cash acquired		(31,334	)		—
Acquisitions of oil and gas property		—			(8,706	)
Additions to oil and gas property and equipment		(15,272	)		(57,705	)
Additions to other property and equipment		(63	)		(328	)
Proceeds from sales of oil and gas properties		—			3,441
Net cash used in investing activities		(46,669	)		(63,298	)
Cash flows from financing activities:
Proceeds from borrowings		36,597			—
Repayments of borrowings		(38,165	)		—
Issuance of common stock, net of offering costs of $2.7 million		47,125			—
Deferred financing costs		(78	)		(127	)
Net cash provided by (used in) financing activities		45,479			(127	)
Net increase (decrease) in cash and cash equivalents		545			(59,120	)
Cash and cash equivalents at beginning of period		23,264			100,447
Cash and cash equivalents at end of period	$	23,809		$	41,327
Supplemental disclosure of cash flow information
Cash paid for:
Interest	$	688		$	284
Non-cash investing and financing activities:
Common stock issued for Lynden Arrangement	$	45,698		$	—
Acquisitions of oil and gas property	$	—		$	2,130
Asset retirement obligations	$	101		$	128

The accompanying notes are an integral part of these Unaudited Condensed Consolidated Financial Statements.

EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation and Summary of Significant Accounting Policies

Earthstone Energy, Inc., a Delaware corporation (“Earthstone” or the “Company”) is an independent oil and gas exploration and production company focused on the acquisition, development, exploration and production of onshore, crude oil and natural gas reserves, with a current focus on the Eagle Ford trend and Midland Basin in Texas and the Williston Basin of North Dakota and Montana.

The accompanying Unaudited Condensed Consolidated Financial Statements of Earthstone and its wholly-owned subsidiaries, which we refer to as “we,” “our” or “us,” have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial statements. The information furnished herein reflects all adjustments that are, in the opinion of management, necessary for the fair presentation of the Company's financial position, results of operations and cash flows for the periods presented. The Company’s Condensed Consolidated Balance Sheet at December 31, 2015 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 periods. 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, 2015 (the “2015 Form 10-K”).

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 2015 Form 10-K, and the Company’s other filings with the SEC.

Certain prior-period amounts have been reclassified to conform to current-period presentation including amounts within the adjustments to reconcile net loss to net cash provided by from operating activities on the Condensed Consolidated Statements of Cash Flows. Specifically, the non-cash changes in fair value of the Company’s commodity swaps have been reclassified from the changes in the Unrealized loss (gain) on derivative contracts caption (which resulted in the caption being eliminated) with offsetting reclassifications to the captions, Total loss (gain) on derivative contracts, net and Operating portion of net cash received in settlement of derivative contracts. These reclassifications had no effect on Net cash provided by operating activities or any other subtotal in the Condensed Consolidated Statements of Cash Flows.

Recently Issued Accounting Standards

Standards adopted in 2016

Debt Issuance Costs – In April 2015, the Financial Accounting Standards Board (“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. In August 2015, the FASB subsequently issued a clarification as to the handling of debt issuance costs related to line-of-credit arrangements that allows the presentation of these costs as an asset. The standards update was effective for interim and annual periods beginning after December 15, 2015. The Company adopted this standards update, as required, effective January 1, 2016. The adoption of this standards update did not affect the Company’s method of amortizing debt issuance costs and did not have a material impact on its Condensed Consolidated Financial Statements.

Measurement-Period Adjustments – In September 2015, the FASB issued updated guidance that eliminates the requirement to restate prior periods to reflect adjustments made to provisional amounts recognized in a business combination. The updated guidance requires that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The standards update was effective prospectively for interim and annual periods beginning after December 15, 2015, with early adoption permitted. The Company adopted this standard update, as required, effective January 1, 2016, which did not have a material impact on its Condensed Consolidated Financial Statements.

EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Stock Compensation - In March 2016, the FASB issued updated guidance on share-based payment accounting. The standards update is intended to simplify several areas of accounting for share-based compensation arrangements, including the income tax impact, classification on the statement of cash flows and forfeitures. The standards update is effective for interim and annual periods beginning after December 15, 2016 with early adoption permitted. The Company elected to early-adopt this standards update as of April 1, 2016 in connection with its initial grant of awards under the Company’s 2014 Long Term Incentive Plan. The Company has elected to record the impact of forfeitures on compensation cost as they occur. The Company is also permitted to withhold income taxes upon settlement of equity-classified awards at up to the maximum statutory tax rates. There was no retrospective adjustment as the Company did not have any outstanding equity awards prior to adoption. See Note 6 Stock-Based Compensation.

Standards not yet adopted

Revenue Recognition - In May 2014, the 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 August 2015, the FASB issued guidance deferring the effective date of this standards update for one year, to be effective for interim and annual periods beginning after December 15, 2017. In March 2016, the FASB issued guidance which clarifies the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued further guidance on identifying performance obligations and clarification of the licensing implementation guidance. Early adoption of this updated guidance is permitted as of the original effective date of December 31, 2016. The Company expects to 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 Condensed Consolidated Financial Statements.

Leases – In February 2016, the FASB issued updated guidance on accounting for leases. The update requires that a lessee recognize in the statement of financial position a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. Similar to current guidance, the update continues to differentiate between finance leases and operating leases; however, this distinction now primarily relates to differences in the manner of expense recognition over time and in the classification of lease payments in the statement of cash flows. The standards update is effective for interim and annual periods beginning after December 15, 2018 with early adoption permitted. Entities are required to use a modified retrospective adoption, with certain relief provisions, for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements when adopted. The Company expects to adopt this standards update, as required, beginning with the first quarter of 2019. The Company is in the process of evaluating the impact, if any, of the adoption of this guidance on its Condensed Consolidated Financial Statements.

Statement of Cash Flows – In August 2016, the FASB issued updated guidance that clarifies how certain cash receipts and cash payments are presented in the statement of cash flows. This update provides guidance on eight specific cash flow issues. The standards update is effective for interim and annual periods beginning after December 15, 2017, and should be applied retrospectively to all periods presented. Early adoption is permitted. The Company expects to 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 Condensed Consolidated Financial Statements.

Note 2. Acquisitions and Divestitures

Lynden Arrangement

In May 2016, the Company acquired Lynden Energy Corp. (“Lynden”) in an all-stock transaction. The acquisition was made through an arrangement (the “Arrangement”) instead of a merger because Lynden is incorporated in British Columbia, Canada. The Company acquired all the outstanding shares of common stock of Lynden through a newly formed Company subsidiary, with Lynden surviving in the transaction as a wholly-owned subsidiary of the Company. The Company issued 3,700,279 shares of its common stock to the holders of Lynden common stock in the transaction. The Arrangement was accounted for as a business combination in accordance with FASB ASC Topic 805, Business Combinations, 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, among other things, a reserve report prepared by qualified reserve engineers and priced as of the acquisition date. The following allocation is still preliminary with respect to final tax amounts and certain accruals and includes the use of estimates based on information that was available to management at the time these condensed consolidated

EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

The following table summarizes the consideration transferred, fair value of assets acquired and liabilities assumed and resulting goodwill (in thousands, except share and share price amount):

Consideration:
Shares of Earthstone common stock issued in the Arrangement		3,700,279
Closing price of Earthstone common stock as of May 18, 2016	$	12.35
Total consideration to Lynden shareholders	$	45,698
Fair Value of Liabilities Assumed:
Credit facility ⁽⁴⁾	$	36,597
Current liabilities		1,895
Deferred tax liability⁽¹⁾		664
Asset retirement obligations		250
Total consideration plus liabilities assumed	$	85,104
Fair Value of Assets Acquired:
Cash and cash equivalents ⁽⁴⁾	$	5,263
Current assets		2,108
Proved oil and gas properties ⁽²⁾⁽³⁾		48,116
Unproved oil and gas properties		26,600
Amount attributable to assets acquired	$	82,087
Goodwill ⁽⁵⁾	$	3,017

1.	This amount represents the recorded book value to tax difference in the oil and natural gas properties as of the date of the Arrangement on a tax effected basis of approximately 34.5%.

The weighted average commodity prices utilized in the determination of the fair value of oil and natural gas properties was $64.73 per barrel of oil, $3.68 per Mcf of natural gas and $19.34 per barrel of oil equivalent for natural gas liquids, after adjustments for transportation fees and regional price differentials.

The market assumptions as to the future commodity prices, projections of estimated quantities of oil and natural gas reserves, expectations for timing and amount of the future development and operating costs, projecting of future rates of production, expected recovery rate and risk adjusted discount rates used by the Company to estimate the fair value of the oil and natural gas properties represent Level 3 inputs; see Note 4 Fair Value Measurements, below.

4.	Concurrent with closing the Arrangement, the Company paid off the outstanding balance of $36.6 million on the Lynden credit facility. The settlement of the debt and the cash acquired is equal to the $31.3 million net cash outflow associated with the Arrangement.

Goodwill was determined to be the excess consideration exchanged over the fair value of the net assets of Lynden on May 18, 2016. The goodwill resulted from the expected synergies of the management team and balance sheet of the Company combined with the key assets acquired in the Midland Basin area. The goodwill recognized will not be deductible for tax purposes.

EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The following unaudited supplemental pro forma condensed results of operations present consolidated information as though the Arrangement had been completed as of January 1, 2015. The unaudited supplemental pro forma financial information was derived from the historical consolidated and combined statements of operations for the Company and Lynden and adjusted to include: (i) depletion expense applied to the adjusted basis of the properties acquired, (ii) accretion expense associated with the asset retirement obligations recorded using the Company’s assumptions about the future liabilities and (iii) interest expense based on the combined debt of the Company post-acquisition. 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. Future results may vary significantly from the results reflected in this unaudited pro forma financial information (in thousands, except per share amounts).

	Three Months Ended September 30,		Nine Months Ended September 30,
	2015		2016			2015
(Unaudited)
Revenue	$	16,473	$	32,677		$	52,792
Income (loss) before taxes	$	1,698	$	(20,603	)	$	142
Income (loss) available to Earthstone common stockholders	$	1,165	$	(21,696	)	$	80
Pro Forma net income (loss) per common share:
Basic and diluted	$	0.07	$	(1.12	)	$	0.00

The results of operations attributable to Lynden are included in our Condensed Consolidated Statements of Operations beginning in May 2016. During the three and nine months ended September 30, 2016, the Company recognized $2.8 million and $4.3 million, respectively, of oil, natural gas and natural gas liquids sales related to the Lynden assets and $2.2 million and $3.1 million, respectively, of operating expenses, inclusive of depletion. During the three and nine months ended September 30, 2016, the Company recognized $0 and $0.7 million, respectively, of non-recurring transaction costs related to this acquisition.

Other Acquisitions

In June 2015, the Company acquired a 50% operated working interests in approximately 1,000 gross acres in southern Gonzales County, Texas. The acreage, acquired for future Eagle Ford development, is 100% held-by-production by two gross Austin Chalk wells with gross production of 44 barrels of oil equivalent per day as of the time of acquisition.

Also during June 2015, the Company acquired 400 gross acres in northern Karnes County, Texas, which is adjacent to the 1,000 gross acres in southern Gonzales County, Texas. Subsequent trades in Karnes County reduced the gross acreage from 400 to 350 gross acres (117 net acres).

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):

Purchase price	$	4,066
Estimated fair value of assets acquired:
Proved oil and natural gas properties	$	588
Unproved oil and natural gas properties		3,496
Total assets acquired	$	4,084
Estimated fair value of liabilities assumed:
Asset retirement obligations	$	13
Other liabilities		5
Total liabilities assumed	$	18
Consideration paid	$	4,066

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 Condensed Consolidated Financial Statements since the date of each acquisition.

EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Additionally, in June 2015, the Company acquired additional acreage and working interest in wells located within existing Bakken spacing units primarily located in the Banks Field of McKenzie County, North Dakota, for $1.4 million plus purchase price adjustments of $2.0 million for the revenues, net of production taxes and operating expenses and capital costs incurred for the existing wells. The acquisition included 164 net acres which allowed the Company to increase its working interest in approximately 41 producing wells and 21 wells that are in the drilling and completion phase.

In August 2015, the Company acquired a 33% working interest in approximately 1,650 gross acres, in southern Gonzales County, Texas for $3.3 million.

Divestitures

In April 2015, the Company sold substantially all of its Louisiana properties located primarily in DeSoto and Caddo Parishes for cash consideration of $3.4 million, recording a gain of $1.6 million. 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, 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 Company did not post collateral under any of these contracts.

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 “Gain (loss) on derivative contracts, net” on the Condensed Consolidated Statements of Operations. All derivative contracts are recorded at fair market value and are included in the Condensed 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 by counterparty, and the netted balance is reflected in the Condensed Consolidated Balance Sheets as an asset or a liability.

The Company nets its derivative instrument fair value amounts executed with each 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.

As of September 30, 2016, the Company had the following open crude oil derivative positions:

	Price Swaps
Period	Commodity	Volume (Bbls)		Weighted Average Price ($/Bbl)
Q4 2016	Crude Oil		135,000	$	49.35
Q1 - Q4 2017	Crude Oil		420,000	$	48.86
Q1 - Q4 2018	Crude Oil		270,000	$	50.70

EARTHSTONE ENERGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

As of September 30, 2016, the Company had the following open natural gas derivative positions:

	Price Swaps
Period	Commodity	Volume (MMBtu)		Weighted Average Price ($/MMBtu)
Q4 2016	Natural Gas		300,000	$	2.604
Q1 - Q4 2017	Natural Gas		1,560,000	$	2.946
Q1 - Q4 2018	Natural Gas		600,000	$	2.907

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

		September 30, 2016									December 31, 2015
Derivatives not designated as hedging contracts under ASC Topic 815	Balance Sheet Location	Gross Recognized Assets / Liabilities			Gross Amounts Offset			Net Recognized Assets / Liabilities			Gross Recognized Assets / Liabilities		Gross Amounts Offset		Net Recognized Assets / Liabilities
Commodity contracts	Current derivative assets	$	484		$	(299	)	$	185		$	3,694	$	—	$	3,694
Commodity contracts	Current derivative liabilities	$	(1,536	)	$	299		$	(1,237	)	$	—	$	—	$	—
Commodity contracts	Noncurrent derivative liabilities	$	(1,101	)	$	—		$	(1,101	)	$	—	$	—	$	—

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

Three Months Ended September 30,

Nine Months Ended September 30,

Derivatives not designated as hedging contracts under ASC Topic 815

EARTHSTONE ENERGY INC - FORM 10-Q - November 8, 2016

Attached files