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EX-32.2 - EXHIBIT 32.2 - EARTHSTONE ENERGY INCa63018ex322.htm
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EX-31.2 - EXHIBIT 31.2 - EARTHSTONE ENERGY INCa63018ex312.htm
EX-31.1 - EXHIBIT 31.1 - EARTHSTONE ENERGY INCa63018ex311.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 June 30, 2018
Or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File No. 001-35049  
earthstone_logoa01.jpg
_________________________________________________________ 
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 files).    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 definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth 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
 
Emerging growth company  
 
 
 
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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      No  ☒
As of July 30, 2018, 28,163,239 shares of Class A Common Stock, $0.001 par value per share, and 35,815,153 shares of Class B Common Stock, $0.001 par value per share, were outstanding.



TABLE OF CONTENTS
 
 
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
EARTHSTONE ENERGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(In thousands, except share and per share amounts)
 
 
June 30,
 
December 31,
ASSETS
 
2018
 
2017
Current assets:
 
 
 
 
Cash
 
$
4,196

 
$
22,955

Accounts receivable:
 
 
 
 
Oil, natural gas, and natural gas liquids revenues
 
13,564

 
14,978

Joint interest billings and other, net of allowance of $116 and $138 at June 30, 2018 and December 31, 2017, respectively
 
5,011

 
7,778

Derivative asset
 

 
184

Prepaid expenses and other current assets
 
2,059

 
1,178

Total current assets
 
24,830

 
47,073

 
 
 
 
 
Oil and gas properties, successful efforts method:
 
 
 
 
Proved properties
 
681,960

 
605,039

Unproved properties
 
272,260

 
275,025

Land
 
5,382

 
5,534

Total oil and gas properties
 
959,602

 
885,598

 
 
 
 
 
Accumulated depreciation, depletion and amortization
 
(138,313
)
 
(118,028
)
Net oil and gas properties
 
821,289

 
767,570

 
 
 
 
 
Other noncurrent assets:
 
 
 
 
Goodwill
 
17,620

 
17,620

Office and other equipment, net of accumulated depreciation of $2,272 and $2,093 at June 30, 2018 and December 31, 2017, respectively
 
764

 
947

Other noncurrent assets
 
1,277

 
1,207

TOTAL ASSETS
 
$
865,780

 
$
834,417

LIABILITIES AND EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
12,307

 
$
33,472

Revenues and royalties payable
 
18,725

 
10,288

Accrued expenses
 
18,499

 
8,707

Advances
 
18,746

 
4,587

Derivative liability
 
14,803

 
11,805

Total current liabilities
 
83,080

 
68,859

 
 
 
 
 
Noncurrent liabilities:
 
 
 
 
Long-term debt
 
22,500

 
25,000

Deferred tax liability
 
10,461

 
10,515

Asset retirement obligation
 
1,834

 
2,354

Derivative liability
 
5,502

 
1,826

Other noncurrent liabilities
 
109

 
131

Total noncurrent liabilities
 
40,406

 
39,826

 
 
 
 
 
Commitments and Contingencies (Note 13)
 


 


 
 
 
 
 
Equity:
 
 
 
 
Preferred stock, $0.001 par value, 20,000,000 shares authorized; none issued or outstanding
 

 

Class A Common stock, $0.001 par value, 200,000,000 shares authorized; 28,131,464 issued and outstanding at June 30, 2018 and 27,584,638 issued and outstanding at December 31, 2017
 
28

 
28


3


Class B Common Stock, $0.001 par value, 50,000,000 shares authorized; 35,846,928 shares issued and outstanding at June 30, 2018; 36,052,169 issued and outstanding at December 31, 2017
 
36

 
36

Additional paid-in capital
 
509,381

 
503,932

Accumulated deficit
 
(218,851
)
 
(224,822
)
Total Earthstone Energy, Inc. equity
 
290,594

 
279,174

Noncontrolling interest
 
451,700

 
446,558

Total equity
 
742,294

 
725,732

 
 
 
 
 
TOTAL LIABILITIES AND EQUITY
 
$
865,780

 
$
834,417

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

4


EARTHSTONE ENERGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except share and per share amounts)
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
REVENUES
 
 
 
 
Oil
 
$
31,903

 
$
21,563

 
$
66,320

 
$
34,082

Natural gas
 
1,783

 
2,131

 
4,467

 
3,825

Natural gas liquids
 
3,464

 
2,083

 
7,258

 
3,213

Total revenues
 
37,150

 
25,777

 
78,045

 
41,120

 
 
 
 
 
 
 
 
 
OPERATING COSTS AND EXPENSES
 
 
 
 
 
 
 
 
Lease operating expense
 
5,009

 
5,243

 
9,666

 
9,582

Severance taxes
 
1,824

 
1,327

 
3,861

 
2,117

Impairment expense
 

 
66,648

 

 
66,648

Depreciation, depletion and amortization
 
10,812

 
10,039

 
20,520

 
17,928

General and administrative expense
 
7,286

 
7,385

 
13,865

 
12,188

Transaction costs
 

 
3,764

 

 
4,567

Accretion of asset retirement obligation
 
43

 
154

 
84

 
306

Exploration expense
 

 
1

 

 
1

Total operating costs and expenses
 
24,974

 
94,561

 
47,996

 
113,337

 
 
 
 
 
 
 
 
 
Gain on sale of oil and gas properties
 
63

 
1,691

 
512

 
1,691

 
 
 
 
 
 
 
 
 
Income (loss) from operations
 
12,239

 
(67,093
)
 
30,561

 
(70,526
)
 
 
 
 
 
 
 
 
 
OTHER INCOME (EXPENSE)
 
 
 
 
 
 
 
 
Interest expense, net
 
(610
)
 
(633
)
 
(1,223
)
 
(970
)
Write-off of deferred financing costs
 

 
(526
)
 

 
(526
)
(Loss) gain on derivative contracts, net
 
(10,850
)
 
3,340

 
(16,125
)
 
7,800

Other income, net
 
391

 
31

 
397

 
32

Total other income (expense)
 
(11,069
)
 
2,212

 
(16,951
)
 
6,336

 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
 
1,170

 
(64,881
)
 
13,610

 
(64,190
)
Income tax benefit
 
302

 
9,914

 
53

 
9,952

Net income (loss)
 
1,472

 
(54,967
)
 
13,663

 
(54,238
)
 
 
 
 
 
 
 
 
 
Less: Net income (loss) attributable to noncontrolling interest
 
822

 
(37,844
)
 
7,692

 
(37,844
)
 
 
 
 
 
 
 
 
 
Net income (loss) attributable to Earthstone Energy, Inc.
 
$
650

 
$
(17,123
)
 
$
5,971

 
$
(16,394
)
 
 
 
 
 
 
 
 
 
Net income (loss) per common share attributable to Earthstone Energy, Inc.:
 
 
 
 
 
 
 
 
Basic
 
$
0.02

 
$
(0.75
)
 
$
0.21

 
$
(0.73
)
Diluted
 
$
0.02

 
$
(0.75
)
 
$
0.21

 
$
(0.73
)
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding:
 
 
 
 
 
 
 
 
Basic
 
27,987,509

 
22,728,011

 
27,886,220

 
22,503,750

Diluted
 
28,036,052

 
22,728,011

 
27,967,421

 
22,503,750

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

5


EARTHSTONE ENERGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands) 
 
 
 
For the Six Months Ended
June 30,
 
 
2018
 
2017
Cash flows from operating activities:
 
 
Net income (loss)
 
$
13,663

 
$
(54,238
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
 
Impairment of proved and unproved oil and gas properties
 

 
66,648

Depreciation, depletion and amortization
 
20,520

 
17,928

Accretion of asset retirement obligations
 
84

 
306

Settlement of asset retirement obligations
 
(79
)
 

Gain on sale of oil and gas properties
 
(512
)
 
(1,691
)
Total loss (gain) on derivative contracts, net
 
16,125

 
(7,800
)
Operating portion of net cash paid in settlement of derivative contracts
 
(9,267
)
 
(267
)
Stock-based compensation
 
4,013

 
2,958

Deferred income taxes
 
(54
)
 
(9,952
)
Write-off of deferred financing costs
 

 
526

Amortization of deferred financing costs
 
143

 
137

Changes in assets and liabilities:
 
 
 
 
Decrease in accounts receivable
 
4,475

 
3,233

Increase in prepaid expenses and other current assets
 
(992
)
 
(522
)
Decrease in accounts payable and accrued expenses
 
(17,286
)
 
(3,148
)
Increase (decrease) in revenues and royalties payable
 
8,437

 
(1,905
)
Increase (decrease) in advances
 
14,159

 
(535
)
Net cash provided by operating activities
 
53,429

 
11,678

Cash flows from investing activities:
 
 
 
 
Bold Contribution Agreement, net of cash acquired
 

 
(55,609
)
Additions to oil and gas properties
 
(68,516
)
 
(10,048
)
Additions to office and other equipment
 
(53
)
 
(103
)
Proceeds from sales of oil and gas properties
 
210

 
2,416

Net cash used in investing activities
 
(68,359
)
 
(63,344
)
Cash flows from financing activities:
 
 
 
 
Proceeds from borrowings
 
25,000

 
70,000

Repayments of borrowings
 
(27,500
)
 
(10,792
)
Cash paid related to the exchange and cancellation of Class A Common Stock
 
(1,116
)
 

Deferred financing costs
 
(213
)
 
(1,071
)
Net cash (used in) provided by financing activities
 
(3,829
)
 
58,137

Net (decrease) increase in cash
 
(18,759
)
 
6,471

Cash at beginning of period
 
22,955

 
10,200

Cash at end of period
 
$
4,196

 
$
16,671

Supplemental disclosure of cash flow information
 
 
 
 
Cash paid for:
 
 
 
 
Interest
 
$
986

 
$
740

Non-cash investing and financing activities:
 
 
 
 
Accrued capital expenditures
 
$
25,791

 
$
27,054

Asset retirement obligations
 
$
(141
)
 
$
21

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

6


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" and together with its consolidated subsidiaries, the "Company"), is a growth-oriented independent oil and natural gas development and production company. In addition, the Company is active in corporate mergers and the acquisition of oil and natural gas properties that have production and future development opportunities. The Company's operations are all in the upstream segment of the oil and natural gas industry and all its properties are onshore in the United States.
Earthstone is the sole managing member of Earthstone Energy Holdings, LLC, a Delaware limited liability company (together with its wholly-owned consolidated subsidiaries, “EEH”), with a controlling interest in EEH. Earthstone, together with its wholly-owned subsidiary, Lynden Energy Corp., a corporation organized under the laws of British Columbia (“Lynden Corp”), and Lynden Corp’s wholly-owned consolidated subsidiary, Lynden USA Inc., a Utah corporation (“Lynden US”) and also a member of EEH, consolidates the financial results of EEH and records a noncontrolling interest in the Condensed Consolidated Financial Statements representing the economic interests of EEH's members other than Earthstone and Lynden US.
The accompanying unaudited Condensed Consolidated Financial Statements and notes thereto have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial statements. Pursuant to such rules and regulations, certain disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been omitted. The accompanying unaudited Condensed Consolidated Financial Statements and notes should be read in conjunction with the financial statements and notes included in Earthstone’s 2017 Annual Report on Form 10-K.
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, 2017 is derived from the audited Consolidated Financial Statements at that date.
Prior-period Stock-based compensation in the Condensed Consolidated Statements of Operations has been reclassified from its own line item and included in General and administrative expense, within Operating Costs and Expenses, to conform to current-period presentation. This reclassification had no effect on Income (loss) from operations, Income (loss) before income taxes, or Net income (loss) for the three and six months ended June 30, 2018 and 2017.
Bold Contribution Agreement
On May 9, 2017, Earthstone completed a contribution agreement dated as of November 7, 2016 and as amended on March 21, 2017 (the “Bold Contribution Agreement”), by and among Earthstone, EEH, Lynden US, Lynden USA Operating, LLC, a Texas limited liability company (“Lynden Op”), Bold Energy Holdings, LLC, a Texas limited liability company (“Bold Holdings”), and Bold Energy III LLC, a Texas limited liability company (“Bold”). The purpose of the Bold Contribution Agreement was to provide for, among other things described below, the business combination between Earthstone and Bold, which owned significant developed and undeveloped oil and natural gas properties in the Midland Basin of Texas (the “Bold Transaction”).
The Bold Transaction was structured in a manner commonly known as an “Up-C.” Under this structure and the Bold Contribution Agreement, (i) Earthstone recapitalized its common stock, $0.001 par value per share (the “Common Stock”), into two classes – Class A common stock, $0.001 par value per share (the “Class A Common Stock”), and Class B common stock, $0.001 par value per share (the “Class B Common Stock”), and all of the Common Stock, was recapitalized on a one-for-one basis for Class A Common Stock (the “Recapitalization”); (ii) Earthstone transferred all of its membership interests in Earthstone Operating, LLC, Sabine River Energy, LLC, EF Non-Op, LLC and Earthstone Legacy Properties, LLC (formerly Earthstone GP, LLC) and $36,071 in cash from the sale of Class B Common Stock to Bold Holdings (collectively, the “Earthstone Assets”) to EEH, in exchange for 16,791,296 membership units of EEH (the “EEH Units”); (iii) Lynden US transferred all of its membership interests in Lynden Op to EEH in exchange for 5,865,328 EEH Units; (iv) Bold Holdings transferred all of its membership interests in Bold to EEH in exchange for 36,070,828 EEH Units and purchased 36,070,828 shares of Class B Common Stock issued by Earthstone for $36,071; and (v) Earthstone granted an aggregate of 150,000 fully vested shares of Class A Common Stock under Earthstone’s 2014 Long-Term Incentive Plan, as amended and restated (the “2014 Plan”), to certain employees of Bold. Each EEH Unit, together with one share of Class B Common Stock, are convertible into one share of Class A Common Stock. 
Upon closing of the Bold Transaction on May 9, 2017, Bold Holdings owned approximately 61.4% of the outstanding shares of Class A Common Stock, on a fully diluted, as converted basis. The EEH Units and the shares of Class B Common Stock issued to Bold Holdings were not registered under the Securities Act of 1933, as amended (the “Securities Act”), but were issued by EEH and Earthstone in reliance on the exemption provided under Section 4(a)(2) of the Securities Act.  

7

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

On May 9, 2017, the closing sale price of the Class A Common Stock was $13.58 per share. On May 10, 2017, the Class A Common Stock was uplisted from the NYSE American, LLC (formerly the NYSE MKT) (the “NYSE American”) to the New York Stock Exchange (the “NYSE”) where it is listed under the symbol “ESTE.”
On May 9, 2017, in connection with the closing of the Bold Transaction, Earthstone, EnCap Investments L.P. (“EnCap”), Oak Valley Resources, LLC (“Oak Valley”), and Bold Holdings entered into a voting agreement (the “Voting Agreement”), pursuant to which EnCap, Oak Valley, and Bold Holdings agreed not to vote any shares of Class A Common Stock or Class B Common Stock held by them in favor of any action, or take any action that would in any way alter the composition of the board of directors of Earthstone (the “Board”) from its composition immediately following the closing of the Bold Transaction as long as the Voting Agreement is in effect.
Pursuant to the terms of the Bold Contribution Agreement, at the closing of the Bold Transaction, Earthstone, Bold Holdings, and the unitholders of Bold Holdings entered into a registration rights agreement (the “Registration Rights Agreement”) relating to the shares of Class A Common Stock issuable upon the exchange of the EEH Units and Class B Common Stock held by Bold Holdings or its unitholders. In accordance with the Registration Rights Agreement, Earthstone filed a registration statement (the “Registration Statement”) with the SEC to permit the public resale of the shares of Class A Common Stock issued by Earthstone to Bold Holdings or its unitholders in connection with the exchange of Class B Common Stock and EEH Units in accordance with the terms of the First Amended and Restated Limited Liability Company Agreement of EEH. On October 18, 2017, the Registration Statement was declared effective by the SEC.
The Bold Transaction was recorded in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations, and is consolidated in these financial statements in accordance with FASB ASC Topic 810, Consolidation, which requires the recording of a noncontrolling interest component of net income (loss), as well as a noncontrolling interest component within equity, including changes to additional paid-in capital to reflect the noncontrolling interest within equity in the Condensed Consolidated Balance Sheet as of June 30, 2018 at the noncontrolling interest’s respective membership interest in EEH.
Recently Issued Accounting Standards
Revenue Recognition  On January 1, 2018, we adopted the FASB accounting standards update for “Revenue from Contracts with Customers,” which superseded the revenue recognition requirements in “Topic 605, Revenue Recognition,” using the modified retrospective method. Adoption of this standard did not have a significant impact on our consolidated statements of operations or cash flows. We implemented processes to ensure new contracts are reviewed for the appropriate accounting treatment and generate the disclosures required under the new standard. Revenues for the sale of oil, natural gas and natural gas liquids are recognized as the product is delivered to our customers’ custody transfer points and collectability is reasonably assured. We fulfill the performance obligations under our customer contracts through daily delivery of oil, natural gas and natural gas liquids to our customers’ custody transfer points and revenues are recorded on a monthly basis. The prices received for oil, natural gas and natural gas liquids sales under our contracts are generally derived from stated market prices which are then adjusted to reflect deductions including transportation, fractionation and processing. As a result, our revenues from the sale of oil, natural gas and natural gas liquids will decrease if market prices decline. The sales of oil, natural gas and natural gas liquids as presented on the Consolidated Statements of Operations represent the Company’s share of revenues net of royalties and excluding revenue interests owned by others. When selling oil, natural gas and natural gas liquids on behalf of royalty owners or working interest owners, the Company is acting as an agent and thus reports the revenue on a net basis. To the extent actual volumes and prices of oil and natural gas sales are unavailable for a given reporting period because of timing or information not received from third parties, the expected sales volumes and prices for those properties are estimated and recorded.  
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 adopted the new standard, as required, beginning with the first quarter of 2018, with no material impact on its Consolidated Financial Statements.
Business Combinations – In January 2017, the FASB issued updated guidance that clarifies the definition of a business, which amends the guidance used in evaluating whether a set of acquired assets and activities represents a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets; if so, the set of transferred assets and activities is not considered a business. As a result, acquisition fees and expenses will be capitalized to the cost basis of the property acquired, and the tangible and intangible components acquired will be recorded based on their relative fair values as of the acquisition date. The standard is effective for all public business entities for annual periods beginning after December 15, 2017, including interim periods within those fiscal years, with

8

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

early adoption permitted for periods for which financial statements have not yet been issued. The Company adopted the new standard, as required, beginning with the first quarter of 2018, with no material impact on its Consolidated Financial Statements.
Compensation – Stock Compensation – In May 2017, the FASB issued updated guidance that provides clarity about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The update is effective for annual periods beginning after December 15, 2017, and early adoption is permitted, including adoption in any interim period. The Company adopted the new standard, as required, beginning with the first quarter of 2018, with no material impact on its 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 update, as required, beginning with the first quarter of 2019. The Company is in the process of evaluating the impact of this guidance, if any, of the adoption of this guidance on its Consolidated Financial Statements.
Intangibles - Goodwill and Other – In January 2017, the FASB issued updated guidance simplifying the test for goodwill impairment. The update eliminates Step 2 of the goodwill impairment test. Instead, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The update is effective for annual and interim periods beginning after December 15, 2019 and early adoption is permitted for interim or annual goodwill impairment tests performed after January 1, 2017. The Company is in the process of evaluating the impact of this guidance, if any, on its Consolidated Financial Statements.
Compensation – Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting In June 2018, the FASB issued updated guidance simplifying the guidance on nonemployee share-based payments. The update is effective for annual and interim periods beginning after December 15, 2018 and early adoption is permitted. The Company is in the process of evaluating the impact of this guidance, if any, on its Consolidated Financial Statements.
Codification Improvements – In July 2018, the FASB issued an update which does not prescribe any new accounting guidance, but instead makes minor improvements and clarifications of several different FASB Accounting Standards Codification areas based on comments and suggestions made by various stakeholders. Certain updates are applicable immediately while others provide for a transition period to adopt as part of the next fiscal year beginning after December 15, 2018. The Company is in the process of evaluating the impact of this update, if any, on its Consolidated Financial Statements.
Note 2. Acquisitions and Divestitures
The Company accounts for its acquisitions that qualify as business combinations, under the acquisition method of accounting 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. The initial accounting for acquisitions may not be complete and adjustments to provisional amounts, or recognition of additional assets acquired or liabilities assumed, may occur as additional information is obtained about the facts and circumstances that existed as of the acquisition dates.
Bold Transaction
On May 9, 2017, Earthstone completed the Bold Transaction described in Note 1. Basis of Presentation and Summary of Significant Accounting Policies.
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.

9

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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

Shares of Class A Common Stock issued pursuant to the Bold Contribution Agreement to certain employees of Bold
150,000

EEH Units issued to Bold Holdings
36,070,828

Total equity interest issued in the Bold Transaction
36,220,828

Closing per share price of Class A Common Stock as of May 9, 2017
$
13.58

Total consideration transferred (1)(2)
$
491,879

 
 
Fair value of assets acquired:
 
Cash and cash equivalents
$
2,355

Other current assets
10,078

Oil and gas properties (3)
557,704

Amount attributable to assets acquired
$
570,137

 
 
Fair value of liabilities assumed:
 
Long-term debt (4)
$
58,000

Current liabilities
17,042

Deferred tax liability
2,857

Noncurrent asset retirement obligations
359

Amount attributable to liabilities assumed
$
78,258

 
 
 
(1)
Consideration included 150,000 shares of Class A Common Stock recorded above based upon its fair value which was determined using its closing price of $13.58 per share on May 9, 2017.
(2)
Consideration was 36,070,828 EEH Units. Additionally, Bold Holdings purchased 36,070,828 shares of Class B Common Stock for $36,071. Each EEH Unit, together with one share of Class B Common Stock, is convertible into one share of Class A Common Stock. The fair value of the consideration was determined using the closing price of the Company’s Class A Common Stock of $13.58 per share on May 9, 2017.
(3)
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 3. Fair Value Measurements, below.
(4)
Concurrent with the closing of the Bold Transaction, EEH assumed Bold’s outstanding borrowings of $58 million under its credit agreement.


10

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 Bold Transaction and the Bakken Sale (discussed below) had been completed as of January 1, 2017. The unaudited supplemental pro forma financial information was derived from the historical consolidated and combined statements of operations for Bold and Earthstone and adjusted to include: (i) depletion expense applied to the adjusted basis of the properties acquired and (ii) to eliminate non-recurring transaction costs directly related to the Bold Transaction that do not have a continuing impact on the Company’s operating results. 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
June 30,
 
Six Months Ended
June 30,
 
 
2017
 
2017
Revenue
 
$
33,176

 
$
62,755

Loss before taxes
 
$
(55,939
)
 
$
(45,854
)
Net loss
 
$
(46,025
)
 
$
(35,902
)
Less: Net loss available to noncontrolling interest
 
$
(28,557
)
 
$
(22,056
)
Net loss attributable to Earthstone Energy, Inc.
 
$
(17,468
)
 
$
(13,846
)
Pro forma net loss per common share attributable to Earthstone Energy, Inc.:
 
 
 
 
Basic
 
$
(0.77
)
 
$
(0.59
)
Diluted
 
$
(0.77
)
 
$
(0.59
)
The Company has included in its Condensed Consolidated Statements of Operations, revenues of $24.3 million and $51.6 million, respectively and direct operating expenses of $12.3 million and $22.6 million, respectively for the three and six months ended June 30, 2018 related to the properties acquired in the Bold Transaction.
On December 20, 2017, the Company sold all of its oil and natural gas leases, oil and natural gas wells and associated assets located in the Williston Basin in North Dakota (the "Bakken Sale") for a net cash consideration of approximately $27.3 million after normal and customary purchase price adjustments of $0.3 million to account for net cash flows from the effective date to the closing date. The effective date of the sale was December 1, 2017.
Note 3. Fair Value Measurements
FASB 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 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 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

11

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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, 2018.
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 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 Condensed 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):
 
June 30, 2018
 
Level 1
 
Level 2
 
Level 3
 
Total
Financial assets
 
 
 
 
 
 
 
 
Derivative asset - current
 
$

 
$

 
$

 
$

Derivative asset - noncurrent
 

 

 

 

Total financial assets
 
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
Financial liabilities
 
 
 
 
 
 
 
 
Derivative liability - current
 
$

 
$
14,803

 
$

 
$
14,803

Derivative liability - noncurrent
 

 
5,502

 

 
5,502

Total financial liabilities
 
$

 
$
20,305

 
$

 
$
20,305

 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
Financial assets
 
 
 
 
 
 
 
 
Derivative asset - current
 
$

 
$
184

 
$

 
$
184

Derivative asset - noncurrent
 

 

 

 

Total financial assets
 
$

 
$
184

 
$

 
$
184

 
 
 
 
 
 
 
 
 
Financial liabilities
 
 
 
 
 
 
 
 
Derivative liability - current
 
$

 
$
11,805

 
$

 
$
11,805

Derivative liability - noncurrent
 

 
1,826

 

 
1,826

Total financial assets
 
$

 
$
13,631

 
$

 
$
13,631

 
 
 
 
 
 
 
 
 
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
The Company applies the provisions of the fair value measurement standard on a non-recurring basis to its non-financial assets and liabilities, including oil and gas properties and goodwill. These assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances. 
Proved Oil and Natural Gas Properties
Proved oil and natural gas properties are measured at fair value on a nonrecurring basis in order to review for impairment. The impairment charge reduces the carrying values 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

12

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

recovered from oil and 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.
Goodwill
Goodwill represents the excess of the purchase price of assets acquired over the fair value of those assets and is tested for impairment annually, or more frequently if events or changes in circumstances dictate that the fair value of goodwill may be less than its carrying amount. Such test includes an assessment of qualitative and quantitative factors.
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 described in Note 2. Acquisitions and Divestitures.
Asset Retirement Obligations
The estimated fair value of the Company's asset retirement obligation at inception is determined by utilizing the income approach by applying a credit-adjusted risk-free rate, which takes into account the Company's credit risk, and the time value of money to the undiscounted expected abandonment cash flows, including estimates of plugging, abandonment and remediation costs and well life. Given the unobservable nature of the inputs, the measurement of the asset retirement obligations was classified as Level 3 in the fair value hierarchy. See Note 11. Asset Retirement Obligations for a reconciliation of the beginning and ending balances of the liability for the Company’s asset retirement obligations.
Performance Units
Stock-based compensation related to performance is estimated utilizing the Monte Carlo Simulation pricing model, which calculates multiple potential outcomes for an award and establishes fair value based on the most likely outcome, and has been classified as Level 3 in the fair value hierarchy. Stock-based compensation related to performance units is described in Note 9. Stock-Based Compensation.
Note 4. Derivative Financial Instruments
The Company’s hedging activities consist of derivative instruments entered into in order to hedge against changes in oil and natural gas prices through the use of fixed price swap agreements. Swaps exchange floating price risk in the future for a fixed price at the time of the hedge. Consistent with its hedging policy, the Company has entered into a series of derivative instruments to hedge a significant portion of its expected oil and natural gas production through December 31, 2020. Typically, these derivative instruments require payments to (receipts from) counterparties based on specific indices as required by the derivative agreements. Although not risk free, the Company believes these instruments reduce its exposure to oil and natural gas price fluctuations and, thereby, allow the Company to achieve a more predictable cash flow.
The Company’s derivative instruments are cash flow hedge transactions in which it is hedging the variability of cash flow related to a forecasted transaction. The Company does not enter into derivative instruments for trading or other speculative purposes. These transactions are recorded in the Condensed Consolidated Financial Statements in accordance with FASB ASC Topic 815. The Company has accounted for these transactions using the mark-to-market accounting method. Generally, the Company incurs accounting losses on derivatives during periods where prices are rising and gains during periods where prices are falling which may cause significant fluctuations in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Operations.
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

13

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 and natural gas derivative contracts as of June 30, 2018:    
 
 
Price Swaps
Period
 
Commodity
 
Volume
(Bbls / MMBtu)
 
Weighted Average Price
($/Bbl / $/MMBtu)
Q3 - Q4 2018
 
Crude Oil
 
873,400

 
$
54.31

Q1 - Q4 2019
 
Crude Oil
 
1,259,100

 
$
57.15

Q3 - Q4 2018
 
Crude Oil (Basis Swap)(1)
 
303,600

 
$
(0.15
)
Q1 - Q4 2019
 
Crude Oil (Basis Swap)(1)
 
365,000

 
$
(5.95
)
Q1 - Q4 2020
 
Crude Oil (Basis Swap)(1)
 
366,000

 
$
(5.95
)
Q3 - Q4 2018
 
Crude Oil (Basis Swap)(2)
 
184,000

 
$
6.35

Q1 - Q4 2019
 
Crude Oil (Basis Swap)(2)
 
365,000

 
$
4.50

Q3 - Q4 2018
 
Natural Gas
 
1,220,000

 
$
2.95

(1)
The basis differential price is between WTI Midland Argus Crude and the WTI NYMEX.
(2)
The basis differential price is between LLS Argus Crude and the WTI NYMEX.
Additionally, on July 9, 2018, the Company entered into additional crude oil basis swap agreements, limiting the basis differential between WTI Midland Argus Crude and the WTI NYMEX to a weighted average price differential of -$7.75/Bbl for 547,500 Bbls of its 2019 crude oil production.

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)
 
 
 
 
June 30, 2018
 
December 31, 2017
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
 
Derivative asset - current
 
$

 
$

 
$

 
$
184

 
$

 
$
184

Commodity contracts
 
Derivative liability - current
 
$
20,044

 
$
(5,241
)
 
$
14,803

 
$
11,805

 
$

 
$
11,805

Commodity contracts
 
Derivative liability - noncurrent
 
$
6,052

 
$
(550
)
 
$
5,502

 
$
1,826

 
$

 
$
1,826

The following table summarizes the location and amounts of the Company’s realized and unrealized gains and losses on derivatives instruments in the Condensed Consolidated Statements of Operations (in thousands)
 
 
 
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
Derivatives not designated as hedging contracts under ASC Topic 815
 
Statement of Operations Location
 
2018
 
2017
 
2018
 
2017
Total (loss) gain on commodity contracts
 
(Loss) gain on derivative contracts, net
 
$
(5,858
)
 
$
3,021

 
$
(6,858
)
 
$
8,067

Cash (paid) received in settlements on commodity contracts
 
(Loss) gain on derivative contracts, net
 
(4,992
)
 
319

 
(9,267
)
 
(267
)
(Loss) gain on commodity contracts, net
 
 
 
$
(10,850
)
 
$
3,340

 
$
(16,125
)
 
$
7,800

 
 
 
 
 
 
 
 
 
 
 
Note 5. Oil and Natural Gas Properties

14

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company follows the successful efforts method of accounting for its oil and natural gas properties. Under this method, costs to acquire oil and natural gas properties, drill and equip exploratory wells that find proved reserves, and drill and equip development wells are capitalized. Exploration costs, including unsuccessful exploratory wells and geological and geophysical costs, are charged to operations as incurred. Upon sale or retirement of oil and natural gas properties, the costs and related accumulated depreciation, depletion and amortization are eliminated from the accounts and the resulting gain or loss is recognized.
Costs incurred to maintain wells and related equipment, lease and well operating costs, and other exploration costs are charged to expense as incurred. Gains and losses arising from the sale of properties are included in Income (loss) from operations in the Condensed Consolidated Statements of Operations.
The Company’s lease acquisition costs and development costs of proved oil and natural gas properties are amortized using the units-of-production method, at the field level, based on total proved reserves and proved developed reserves, respectively. For the three months ended June 30, 2018 and 2017, depletion expense for oil and gas producing property and related equipment was $10.7 million and $9.9 million, respectively. For the six months ended June 30, 2018 and 2017, depletion expense for oil and gas producing property and related equipment was $20.3 million and $17.7 million, respectively.
Proved Properties
Proved oil and natural gas properties are measured at fair value on a nonrecurring basis in order to review for impairment. The impairment charge reduces the carrying values 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 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.
Unproved Properties
Unproved properties consist of costs incurred to acquire undeveloped leases as well as the cost to acquire unproved reserves. Undeveloped lease costs and unproved reserve acquisition costs are capitalized. Unproved oil and gas leases are generally for a primary term of three to five years. In most cases, the term of the unproved leases can be extended by paying delay rentals, meeting contractual drilling obligations, or by the presence of producing wells on the leases. Unproved costs related to successful exploratory drilling are reclassified to proved properties and depleted on a units-of-production basis.
The Company reviews its unproved properties periodically for impairment. In determining whether an unproved property is impaired, the Company considers numerous factors including, but not limited to, current exploration and development plans, favorable or unfavorable exploration activity on the property being evaluated and/or adjacent properties, the Company’s geologists' evaluation of the property, and the remaining months in the lease term for the property.
Impairments to Oil and Natural Gas Properties
The Company did not record any impairments to its oil and natural gas properties for the three and six months ended June 30, 2018.
During the three and six months ended June 30, 2017, the Company recorded impairments consisting of $63.0 million to its proved oil and natural gas properties and $3.6 million to its unproved oil and natural gas properties, primarily to its properties located in the Eagle Ford Trend of south Texas.

Note 6. Noncontrolling Interest
Earthstone consolidates the financial results of EEH and its subsidiaries and records a noncontrolling interest for the economic interest in Earthstone held by the members of EEH other than Earthstone and Lynden US. Net income attributable to noncontrolling interest in the Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2018 represents the portion of net income or loss attributable to the economic interest in the Company held by the members of EEH other than Earthstone and Lynden US. Noncontrolling interest in the Condensed Consolidated Balance Sheet as of June 30, 2018 and December 31, 2017 represents the portion of net assets of the Company attributable to the members of EEH other than Earthstone and Lynden US.

15

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The following table presents the changes in noncontrolling interest for the six months ended June 30, 2018
 
 
EEH Units Held
By Earthstone
and Lynden US
 
%
 
EEH Units Held
By Others
 
%
 
Total EEH
Units
Outstanding
As of December 31, 2017
 
27,584,638

 
43.3
%
 
36,052,169

 
56.7
%
 
63,636,807

EEH Units and Class B Common Stock converted to Class A Common Stock
 
205,241

 
 
 
(205,241
)
 
 
 

EEH Units issued in connection with the vesting of restricted stock units
 
341,585

 
 
 

 
 
 
341,585

As of June 30, 2018
 
28,131,464

 
44.0
%
 
35,846,928

 
56.0
%
 
63,978,392

The following table summarizes the activity for the equity attributable to the noncontrolling interest for the six months ended June 30, 2018 (in thousands):
 
2018
As of December 31, 2017
$
446,558

EEH Units and Class B Common Stock converted to Class A Common Stock
(2,550
)
Net income attributable to noncontrolling interest
7,692

 
 
As of June 30, 2018
$
451,700

Note 7. Net Income (Loss) Per Common Share
Net income (loss) per common share—basic is calculated by dividing Net income (loss) by the weighted average number of shares of common stock outstanding during the period (Common Stock for the period from January 1, 2017 through May 8, 2017 and Class A Common Stock thereafter). Net income (loss) per common share—diluted assumes the conversion of all potentially dilutive securities and is calculated by dividing Net income (loss) by the sum of the weighted average number of shares of common stock, as defined above, outstanding plus potentially dilutive securities. Net income (loss) per common share—diluted considers the impact of potentially dilutive securities except in periods in which there is a loss because the inclusion of the potential common shares, as defined above, would have an anti-dilutive effect.
A reconciliation of Net income (loss) per common share is as follows:
 
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
(In thousands, except per share amounts)
 
2018
 
2017
 
2018
 
2017
Net income (loss) attributable to Earthstone Energy, Inc.
 
$
650

 
$
(17,123
)
 
$
5,971

 
$
(16,394
)
 
 
 
 
 
 
 
 
 
Net income (loss) per common share attributable to Earthstone Energy, Inc.:
 
 
 
 
 
 
 
 
Basic
 
$
0.02

 
$
(0.75
)
 
$
0.21

 
$
(0.73
)
Diluted
 
$
0.02

 
$
(0.75
)
 
$
0.21

 
$
(0.73
)
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding
 
 
 
 
 
 
 
 
Basic
 
27,987,509

 
22,728,011

 
27,886,220

 
22,503,750

Add potentially dilutive securities:
 
 
 
 
 
 
 
 
Unvested restricted stock units
 
48,543

 

 
81,201

 

Diluted weighted average common shares outstanding
 
28,036,052

 
22,728,011

 
27,967,421

 
22,503,750

Class B Common Stock has been excluded, as its conversion would eliminate noncontrolling interest and Net income (loss) attributable to noncontrolling interest of $0.8 million and $7.7 million for the three and six months ended June 30, 2018, respectively,

16

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

would be added back to Net income (loss) attributable to Earthstone Energy, Inc., having no dilutive effect on Net income (loss) per common share attributable to Earthstone Energy, Inc.

Note 8. Common Stock
On May 9, 2017, and in connection with the completion of the Bold Transaction, Earthstone recapitalized its Common Stock into two classes, as described in Note 1. – Basis of Presentation and Summary of Significant Accounting Policies, Class A Common Stock and Class B Common Stock. At that time, all of Earthstone’s existing outstanding Common Stock was automatically converted on a one-for-one basis into Class A Common Stock.
Class A Common Stock
At June 30, 2018 and December 31, 2017, there were 28,131,464 and 27,584,638 shares of Class A Common Stock issued and outstanding, respectively. During the three and six months ended June 30, 2018, Earthstone issued 255,313 and 341,585 shares, respectively, of Class A Common Stock as a result of the vesting and settlement of restricted stock units under the 2014 Plan. During the period January 1, 2017 through May 8, 2017, Earthstone issued 382,804 shares of Common Stock as a result of the vesting and settlement of restricted stock units under the 2014 Plan. During the period May 9, 2017 through June 30, 2017, Earthstone issued 84,825 shares of Class A Common Stock as a result of the vesting and settlement of restricted stock units under the 2014 Plan. Additionally, on May 9, 2017, under the Bold Contribution Agreement, Earthstone issued 150,000 shares of Class A Common Stock valued at approximately $2.0 million on that date. For additional information, see Note 2. Acquisitions and Divestitures.
Class B Common Stock
At June 30, 2018 and December 31, 2017, there were 35,846,928 and 36,052,169 shares of Class B Common Stock issued and outstanding, respectively. Each share of Class B Common Stock, together with one EEH Unit, is convertible into one share of Class A Common Stock. During the three and six months ended June 30, 2018, 11,195 shares and 205,241 shares, respectively, of Class B Common Stock and EEH Units were exchanged for an equal number of shares of Class A Common Stock. In July 2018, an additional 135,621 shares of Class B Common Stock and EEH Units were exchanged for an equal number of shares of Class A Common Stock.
Note 9. Stock-Based Compensation
Restricted Stock Units
The 2014 Plan, allows, among other things, for the grant of restricted stock units ("RSUs"). On June 6, 2018, at the annual meeting of stockholders, Earthstone's stockholders approved an amendment and restatement of the 2014 Plan, including increasing the shares of Class A Common Stock that may be issued under the Plan by 600,000 shares, to a total of 6.4 million shares.
On May 9, 2017, and in connection with the completion of the Bold Contribution Agreement, and upon approval by the stockholders of Earthstone, the 2014 Plan was amended to increase the number of shares of Class A Common Stock authorized to be issued under the 2014 Plan by 4.3 million shares, to a total of 5.8 million shares. Each RSU represents the contingent right to receive one share of Class A Common Stock. The holders of outstanding RSUs do not receive dividends or have voting rights prior to vesting and settlement. Prior to May 9, 2017, the Company determined the fair value of granted RSUs based on the market price of the Common Stock on the date of the grant. Beginning on May 9, 2017, the Company began determining the fair value of granted RSUs based on the market price of the Class A Common Stock on the date of the grant. Compensation expense for granted RSUs is recognized on a straight-line basis over the vesting and is net of forfeitures, as incurred. Stock-based compensation is included in General and administrative expense in the Condensed Consolidated Statements of Operations and is recorded with a corresponding increase in Additional paid-in capital within the Condensed Consolidated Balance Sheet.

17

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The table below summarizes unvested RSU award activity for the six months ended June 30, 2018:
 
 
Shares
 
Weighted-Average Grant Date Fair Value
Unvested RSUs at December 31, 2017
 
969,245

 
$
9.89

Granted
 
344,000

 
$
9.35

Forfeited
 
(44,165
)
 
$
10.87

Vested
 
(454,011
)
 
$
9.93

Unvested RSUs at June 30, 2018
 
815,069

 
$
9.59

For the three and six months ended June 30, 2018, Stock-based compensation related to RSUs was $1.8 million and $3.6 million, respectively. The unrecognized compensation expense related to the RSU awards at June 30, 2018 was $7.5 million which will be amortized over the remaining vesting period. The weighted average remaining vesting period of the unrecognized compensation expense is 1.02 years.
The table below summarizes unvested RSU award activity for the six months ended June 30, 2017:
 
 
Shares
 
Weighted-Average Grant Date Fair Value
Unvested RSUs at December 31, 2016
 
781,500

 
$
12.53

Granted
 
214,500

 
$
12.22

Forfeited
 
(36,000
)
 
$
13.30

Vested
 
(467,629
)
 
$
12.44

Unvested RSUs at June 30, 2017
 
492,371

 
$
12.42

For the three and six months ended June 30, 2017, Stock-based compensation related to RSUs was $1.6 million and $3.0 million, respectively.
Performance Units
On February 28, 2018, the Board granted 252,500 performance units (“PSUs”) to certain named executive officers pursuant to the 2014 Plan. The PSUs are payable in shares of Class A Common Stock based upon the achievement by the Company over a period commencing on February 28, 2018 and ending on February 28, 2021 (the “Performance Period”) of performance criteria established by the Board.  
The number of shares of Class A Common Stock that may be issued will be determined by multiplying the number of PSUs granted by the Relative Total Shareholder Return ("TSR") Percentage (0% to 200%).  The “Relative TSR Percentage” is the percentage, if any, achieved by attainment of a certain predetermined range of targets for the Performance Period. Accordingly, the potential aggregate number of shares of Class A Common Stock issuable under the outstanding PSU awards range from zero to 505,000.
TSR for the Company and each of the peer companies is generally determined by dividing (A) the volume weighted average price of a share of stock for the trading days during the thirty calendar days ending on and including the last calendar day of the Performance Period minus the volume weighted average price of a share of stock for the trading days during the thirty calendar days ending on and including the first day of the Performance Period plus cash dividends paid over the Performance Period by (B) the volume weighted average price of a share of stock for the trading days during the thirty calendar days ending on and including the first day of the Performance Period.
As of June 30, 2018, there were 252,500 PSUs outstanding. There were no PSUs outstanding as of December 31, 2017. The unrecognized compensation expense related to the PSU awards at June 30, 2018 was $3.1 million which will be amortized over the remaining vesting period. The weighted average remaining vesting period of the unrecognized compensation expense is 1.36 years.
The Company is accounting for this award as a market-based award which was valued utilizing the Monte Carlo Simulation pricing model, which calculates multiple potential outcomes for an award and establishes fair value based on the most likely outcome. Under the Monte Carlo Simulation pricing model, the Company calculated the weighted average fair value per PSU to be $13.75. For the three and six months ended June 30, 2018, Stock-based compensation related to the PSUs was approximately $0.3 million and $0.4 million, respectively. There was no Stock-based compensation related to the PSUs for the three and six months ended June 30, 2017.

18

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Note 10. Long-Term Debt
Credit Agreement
On May 23, 2018, Earthstone Energy Holdings, LLC (“EEH” or the “Borrower”), a subsidiary of Earthstone, each of Earthstone Operating, LLC, EF Non-Op, LLC, Sabine River Energy, LLC, Earthstone Legacy Properties, LLC, Lynden USA Operating, LLC, Bold Energy III LLC, Bold Operating, LLC, as guarantors (the “Guarantors”), BOKF, NA dba Bank Of Texas, as Administrative Agent, and the lenders party thereto (the “Lenders”), entered into an amendment (the “Amendment”) to the Credit Agreement dated May 9, 2017, by and among EEH, as Borrower, the Guarantors, BOKF, NA dba Bank Of Texas, as Agent and Lead Arranger, Wells Fargo Bank, National Association, as Syndication Agent, and the Lenders (together with all amendments or other modifications, the “EEH Credit Agreement”). Among other things, the Amendment increased the borrowing base from $185.0 million to $225.0 million, provided for a 50-basis point decrease in the interest rate on outstanding loans, increased flexibility related to hedging limitations and provided the ability to obtain short-term borrowings via a swingline as a part of the borrowing base.
On May 9, 2017, in connection with the closing of the Bold Transaction, the Company exited its credit agreement dated December 19, 2014, by and among Earthstone and its subsidiaries, BOKF, NA dba Bank of Texas, and the Lenders party thereto (as amended, modified or restated from time to time, the “ESTE Credit Agreement”). At that time, all outstanding borrowings of $10.0 million under the ESTE Credit Agreement were repaid and $0.5 million of remaining unamortized deferred financing costs were expensed.  
The borrowing base under the EEH Credit Agreement is subject to redetermination on or about November 1st and May 1st of each year. The amounts borrowed under the EEH Credit Agreement bear annual interest rates at either (a) the London Interbank Offered Rate (“LIBOR”) plus 1.75% to 2.75% or (b) the prime lending rate of Bank of Texas plus 0.75% to 1.75%, depending on the amounts borrowed under the EEH Credit Agreement. Principal amounts outstanding under the EEH Credit Agreement are due and payable in full at maturity on May 9, 2022. All of the obligations under the EEH Credit Agreement, and the guarantees of those obligations, are secured by substantially all of EEH’s assets. Additional payments due under the EEH Credit Agreement include paying a commitment fee of 0.375% or 0.50%, depending on borrowing base utilization, per year to the Lenders in respect of the unutilized commitments thereunder, as well as certain other customary fees.
The EEH Credit Agreement contains a number of covenants that, among other things, restrict, subject to certain exceptions, EEH’s ability to incur additional indebtedness, create liens on assets, make investments, enter into sale and leaseback transactions, pay dividends and make distributions or repurchase its limited liability interests, engage in mergers or consolidations, sell certain assets, sell or discount any notes receivable or accounts receivable and engage in certain transactions with affiliates.
In addition, the EEH Credit Agreement requires EEH to maintain the following financial covenants: a current ratio, as defined, of not less than 1.0 to 1.0 and a leverage ratio of not greater than 4.0 to 1.0. Leverage ratio means the ratio of (i) the aggregate debt of EEH and its consolidated subsidiaries as at the last day of the fiscal quarter (excluding any debt from obligations relating to non-cash losses under FASB ASC 815 as a result of changes in the fair market value of derivatives) to (ii) the product of EBITDAX for such fiscal quarter multiplied by four. The term “EBITDAX” means, for any period, the sum of consolidated net income for such period plus (a) the following expenses or charges to the extent deducted from consolidated net income in such period: (i) interest, (ii) taxes, (iii) depreciation, (iv) depletion, (v) amortization, (vi) non-cash losses under FASB ASC 815 as a result of changes in the fair market value of derivatives, (vii) exploration expenses, (viii) impairment expenses, and (ix) non-cash compensation expenses and minus (b) to the extent included in consolidated net income in such period, non-cash gains under FASB ASC 815 as a result of changes in the fair market value of derivatives.
The EEH Credit Agreement contains customary affirmative covenants and defines events of default to include failure to pay principal or interest, breach of covenants, breach of representations and warranties, insolvency, judgment default, and if Frank A. Lodzinski ceases to serve and function as Chief Executive Officer of EEH and the majority of the Lenders do not approve of Mr. Lodzinski’s successor. Upon the occurrence and continuance of an event of default, the Lenders have the right to accelerate repayment of the loans and exercise their remedies with respect to the collateral. As of June 30, 2018, EEH was in compliance with the covenants under the EEH Credit Agreement.       
As of June 30, 2018, the Company had a $225.0 million borrowing base under the EEH Credit Agreement, of which $22.5 million was outstanding, bearing annual interest of 3.838%, resulting in an additional $202.5 million of borrowing base availability under the EEH Credit Agreement. At December 31, 2017, there were $25.0 million of borrowings outstanding under the EEH Credit Agreement.
For the six months ended June 30, 2018, the Company had borrowings of $25.0 million and $27.5 million in repayments of borrowings.
For the three and six months ended June 30, 2018, interest on borrowings averaged 3.66% and 3.64% per annum, respectively, which excluded commitment fees of $0.3 million and $0.5 million, respectively, and amortization of deferred financing costs of

19

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

$0.1 million and $0.1 million, respectively. For the three and six months ended June 30, 2017, interest on borrowings averaged 4.32% and 4.45% per annum, respectively, of which both excluded commitment fees of $0.1 million and amortization of deferred financing costs of $0.1 million.  
The Company capitalized $0.2 million of costs associated with the EEH Credit Agreement for both the three and six months ended June 30, 2018. The Company capitalized $1.1 million of costs associated with the ESTE Credit Agreement for both the three and six months ended June 30, 2017. These capitalized costs are included in Other noncurrent assets in the Condensed Consolidated Balance Sheets. The Company’s policy is to capitalize the financing costs associated with its debt and amortize those costs on a straight-line basis over the term of the associated debt.  
Note 11. Asset Retirement Obligations
The Company has asset retirement obligations associated with the future plugging and abandonment of oil and gas properties and related facilities. Revisions to the liability typically occur due to changes in the estimated abandonment costs, well economic lives, and the discount rate.
The following table summarizes the Company’s asset retirement obligation transactions recorded during the six months ended June 30, (in thousands)
 
 
2018
 
2017
Beginning asset retirement obligations
 
$
2,354

 
$
6,013

Liabilities incurred
 
42

 
2

Liabilities settled
 
(79
)
 

Acquisitions
 

 
359

Accretion expense
 
84

 
306

Divestitures
 
(385
)
 
(7
)
Revision of estimates
 
(182
)
 
19

Ending asset retirement obligations
 
$
1,834

 
$
6,692

 
Note 12. Related Party Transactions
 FASB ASC Topic 850, Related Party Disclosures, requires that information about transactions with related parties that would make a difference in decision making shall be disclosed so that users of the financial statements can evaluate their significance.
 Flatonia Energy, LLC (“Flatonia”), which owns approximately 10.5% of the outstanding Class A Common Stock and 4.7% of our Class A Common Stock and Class B Common Stock combined together as a single class as of June 30, 2018, is a party to a joint operating agreement (the “Operating Agreement”) with the Company. The Operating Agreement covers certain jointly owned oil and natural gas properties located in the Eagle Ford Trend in Texas. In connection with the Operating Agreement, the Company made payments to Flatonia of $6.1 million and $12.4 million and received payments from Flatonia of $2.0 million and $4.1 million for the three and six months ended June 30, 2018, respectively. For the three and six months ended June 30, 2017, the Company made payments to Flatonia of $7.2 million and $14.4 million and received payments from Flatonia of $0.8 million and $2.4 million, respectively. At June 30, 2018 and December 31, 2017, amounts receivable from Flatonia in connection with the Operating Agreement were $0.3 million and $1.3 million, respectively. There were no payables outstanding and due to Flatonia as of June 30, 2018 or December 31, 2017.
Our majority shareholder consists of various investment funds managed by a venture capital firm who may manage other investments in entities with which we interact in the normal course of business.
Note 13. Commitments and Contingencies  
Legal
From time to time, the Company and its subsidiaries may be involved in various legal proceedings and claims in the ordinary course of business.

20

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Olenik v. Lodzinksi et al.: On June 2, 2017, Nicholas Olenik filed a purported shareholder class and derivative action in the Delaware Court of Chancery against Earthstone’s Chief Executive Officer, along with other members of the Board, EnCap, Bold, Bold Holdings and OVR. The complaint alleges that Earthstone’s directors breached their fiduciary duties in connection with the Bold Contribution Agreement. The Plaintiff asserts that the directors negotiated the Bold Transaction to benefit EnCap and its affiliates, failed to obtain adequate consideration for the Earthstone shareholders who were not affiliated with EnCap or Earthstone management, did not follow an adequate process in negotiating and approving the Bold Transaction and made materially misleading or incomplete proxy disclosures in connection with the Bold Transaction. The suit seeks unspecified damages and purports to assert claims derivatively on behalf of Earthstone and as a class action on behalf of all persons who held Common Stock up to March 13, 2017, excluding defendants and their affiliates. On July 20, 2018, the Delaware Court of Chancery granted the defendants' motion to dismiss and entered an order dismissing the action in its entirety with prejudice.  Plaintiff may appeal to the Delaware Supreme Court. Earthstone and each of the other defendants believe the claims are entirely without merit and they intend to mount a vigorous defense. The outcome of this suit is uncertain, and while Earthstone is confident in its position, any potential monetary recovery or loss to Earthstone cannot be estimated at this time.
On August 18, 2017, litigation captioned Trinity Royal Partners, LP v. Bold Energy III LLC, et al. was filed with the 142nd Judicial District of the District Court in Midland County, Texas, asserting breach of contract and indemnity claims for alleged damages from loss of property relating to two oil and natural gas wells in which Bold was the operator. Trinity Royalty Partners, LP (“Trinity”) alleges that Bold is required to indemnify Trinity under the terms of an Assignment and a Participation and Joint Development Agreement between Bold and Trinity. Damages are alleged to include costs incurred in attempting to repair and restore an oil and natural gas well and for the loss of future reserves attributable to both wells. Trinity is seeking approximately $7.2 million in damages and attorneys’ fees. Earthstone and Bold believe the suit is without any merit and Bold intends to mount a vigorous defense. The outcome of this suit is uncertain, and while the Company is confident in its position, any potential monetary recovery or loss to the Company cannot be estimated at this time.
Environmental and Regulatory
As of June 30, 2018, there were no known environmental or other regulatory matters related to the Company’s operations that are reasonably expected to result in a material liability to the Company.
Note 14. Income Taxes
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act ("TCJA") that significantly changes the federal income taxation of business entities. The TCJA, among other things, reduces the corporate income tax rate to 21%, partially limits the deductibility of business interest expense and net operating losses, imposes a one-time tax on unrepatriated earnings from certain foreign subsidiaries, taxes offshore earnings at reduced rates regardless of whether they are repatriated and allows the immediate deduction of certain capital expenditures instead of deductions for depreciation expense over time. Consistent with Staff Accounting Bulletin No. 118 issued by the SEC, which provides for a measurement period of one year from the enactment date to finalize the accounting for effects of the TCJA, the Company provisionally recorded income tax expense of $7.8 million related to the TCJA in the fourth quarter of 2017. As of June 30, 2018, the Company has not yet completed its accounting for the tax effects of the enactment of the TCJA. The Internal Revenue Service is expected to issue additional guidance clarifying provisions of the TCJA. As additional guidance is issued one or more of the provisional amounts may change.
The Company’s corporate structure requires the filing of two separate consolidated U.S. Federal income tax returns and one Canadian income tax return which include Lynden US, Earthstone, and Lynden Corp. As such, taxable income of Earthstone cannot be offset by tax attributes, including net operating losses, of Lynden US, nor can taxable income of Lynden US be offset by tax attributes of Earthstone. Earthstone and Lynden US record a tax provision, respectively, for their share of the book income or loss of EEH, net of the non-controlling interest. As EEH is treated as a partnership for U.S. Federal income tax purposes, it is not subject to income tax at the federal level and only recognizes the Texas Margin Tax.
During the six months ended June 30, 2018, the Company recorded a net income tax benefit of approximately $0.1 million which included (1) income tax expense for Lynden US of $0.2 million as a result of its share of the distributable income from EEH, offset by a $0.5 million discrete income tax benefit related to refundable AMT tax credits resulting from the TCJA, (2) income tax expense for Earthstone of $0.9 million as a result of its share of the distributable income from EEH, which was used to reduce the valuation recorded against its deferred tax asset as future realization of the net deferred tax asset cannot be assured and (3) deferred income tax expense of $0.2 million related to the Texas Margin Tax. Lynden Corp incurred no material income or loss, or related income tax expense or benefit, for the six months ended June 30, 2018.
During the six months ended June 30, 2017, the Company (1) recorded an income tax benefit for Lynden US of $2.9 million as a result of its standalone pre-tax incurred before the Bold Transaction and its share of the distributable loss from EEH after the Bold

21

EARTHSTONE ENERGY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Transaction, (2) recorded a $7.5 million income tax benefit for Earthstone as a discrete item during the current reporting period, which resulted from a change in assessment of the realization of its net deferred tax assets due to the deferred tax liability that was recorded with respect to its investment in EEH as part of the Bold Transaction as an adjustment to Additional paid-in capital in the Condensed Consolidated Statement of Equity and (3) recorded deferred income tax expense of $0.5 million related to the Texas Margin Tax. Lynden Corp incurred no material income or loss, or related income tax expense or benefit, for the six months ended June 30, 2017.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Statement Regarding Forward-Looking Information
This discussion and other items in this Quarterly Report on Form 10-Q contain forward-looking statements and information that are based on management’s beliefs, as well as assumptions made by, and information currently available to, management. When used in this document, the words “believe,” “anticipate,” “estimate,” “expect,” “intend,” “may,” “will,” “project,” “forecast,” “plan,” and similar expressions are intended to identify forward-looking statements. Although management believes that the expectations reflected in these forward-looking statements are reasonable, it can give no assurance that these expectations will prove to have been correct. These statements are subject to numerous risks, uncertainties and assumptions. Certain of these risks are summarized in this report and under “Item 1A. Risk Factors” in our 2017 Annual Report on Form 10-K that was filed with the Securities and Exchange Commission (“SEC”), which you should read carefully in connection with our forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated. We undertake no obligation to release publicly any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
You should read “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in conjunction with the corresponding sections and our audited consolidated financial statements for the year ended December 31, 2017, which are included in our 2017 Annual Report on Form 10-K.
Overview
Earthstone Energy, Inc., a Delaware corporation ("Earthstone" and together with its consolidated subsidiaries, the "Company," "our," "we," "us," or similar terms), is a growth-oriented independent oil and gas company engaged in the acquisition and development of oil and gas reserves through activities that include the acquisition, drilling and development of undeveloped leases, asset and corporate acquisitions and mergers and, to a lesser extent, exploration activities. Our operations are all in the upstream segment of the oil and natural gas industry and all our properties are onshore in the United States. At present, our primary assets are located in the Midland Basin of west Texas and the Eagle Ford Trend of south Texas.
Since the closing of the Bold Transaction in May 2017 (described below), our focus has been primarily in the Midland Basin of west Texas where our acreage has multiple stacked pay intervals in the Wolfcamp and, to a lesser extent, the Spraberry formations. We believe the Midland Basin area is characterized by high oil and liquids-rich natural gas content, multiple vertical and horizontal target horizons and high drilling success rates.
Earthstone is the sole managing member of Earthstone Energy Holdings, LLC, a Delaware limited liability company (together with its wholly-owned consolidated subsidiaries, “EEH”), with a controlling interest in EEH. Earthstone, together with its wholly-owned subsidiary, Lynden Energy Corp., a corporation organized under the laws of British Columbia (“Lynden Corp”), and Lynden Corp’s wholly-owned consolidated subsidiary, Lynden USA Inc., a Utah corporation (“Lynden US”) and also a member of EEH, consolidates the financial results of EEH and records a noncontrolling interest in the Condensed Consolidated Financial Statements representing the economic interests of EEH's members other than Earthstone and Lynden US.
Bold Transaction
On May 9, 2017, Earthstone completed a contribution agreement dated as of November 7, 2016 and as amended on March 21, 2017 (the “Bold Contribution Agreement”), by and among Earthstone, EEH, Lynden US, Lynden USA Operating, LLC, a Texas limited liability company (“Lynden Op”), Bold Energy Holdings, LLC, a Texas limited liability company (“Bold Holdings”), and Bold Energy III LLC, a Texas limited liability company (“Bold”). The purpose of the Bold Contribution Agreement was to provide for, among other things described below, the business combination between Earthstone and Bold, which owns significant developed and undeveloped oil and natural gas properties in the Midland Basin of west Texas (the “Bold Transaction”).
The Bold Transaction was structured in a manner commonly known as an “Up-C.” Under this structure and the Bold Contribution Agreement, (i) Earthstone recapitalized its common stock into two classes – Class A common stock, $0.001 par value per share

22


(the “Class A Common Stock”), and Class B common stock, $0.001 par value per share (the “Class B Common Stock”), and all of Earthstone’s existing outstanding common stock, $0.001 par value per share (the “Common Stock”), was recapitalized on a one-for-one basis for Class A Common Stock (the “Recapitalization”); (ii) Earthstone transferred all of its membership interests in Earthstone Operating, LLC, Sabine River Energy, LLC, EF Non-Op, LLC and Earthstone Legacy Properties, LLC (formerly Earthstone GP, LLC) and $36,071 in cash from the sale of Class B Common Stock to Bold Holdings (collectively, the “Earthstone Assets”) to EEH, in exchange for 16,791,296 membership units of EEH (the “EEH Units”); (iii) Lynden US transferred all of its membership interests in Lynden Op to EEH in exchange for 5,865,328 EEH Units; (iv) Bold Holdings transferred all of its membership interests in Bold to EEH in exchange for 36,070,828 EEH Units and purchased 36,070,828 shares of Class B Common Stock issued by Earthstone for $36,071; and (v) Earthstone granted an aggregate of 150,000 fully vested shares of Class A Common Stock under Earthstone’s 2014 Long-Term Incentive Plan, as amended (the “2014 Plan”), to certain employees of Bold. Each EEH Unit, together with one share of Class B Common Stock, are convertible into one share of Class A Common Stock.
Upon closing of the Bold Transaction on May 9, 2017, Bold Holdings owned approximately 61.4% of the outstanding shares of Class A Common Stock, on a fully diluted, as converted basis. The EEH Units and the shares of Class B Common Stock issued to Bold Holdings were not registered under the Securities Act of 1933, as amended (the “Securities Act”), but were issued by EEH and Earthstone in reliance on the exemption provided under Section 4(a)(2) of the Securities Act.
Pursuant to the terms of the Bold Contribution Agreement, at the closing of the Bold Transaction, Earthstone, Bold Holdings, and the unitholders of Bold Holdings entered into a registration rights agreement (the “Registration Rights Agreement”) relating to the shares of Class A Common Stock issuable upon the exchange of the EEH Units and Class B Common Stock held by Bold Holdings or its unitholders. In accordance with the Registration Rights Agreement, Earthstone filed a registration statement (the “Registration Statement”) with the SEC to permit the public resale of the shares of Class A Common Stock issued by Earthstone to Bold Holdings or its unitholders in connection with the exchange of Class B Common Stock and EEH Units in accordance with the terms of the First Amended and Restated Limited Liability Company Agreement of EEH. On October 18, 2017, the Registration Statement was declared effective by the SEC.
On May 9, 2017, in connection with the closing of the Bold Contribution Agreement, Earthstone, EnCap Investments L.P. (“EnCap”), Oak Valley Resources, LLC (“Oak Valley”), and Bold Holdings entered into a voting agreement (the “Voting Agreement”), pursuant to which EnCap, Oak Valley, and Bold Holdings agreed not to vote any shares of Class A Common Stock or Class B Common Stock held by them in favor of any action, or take any action that would in any way alter the composition of the board of directors of Earthstone (the “Board”) from its composition immediately following the closing of the Bold Contribution Agreement as long as the Voting Agreement is in effect.
Immediately following the closing of the Bold Contribution Agreement, the Board was increased to nine members from eight members, four of which are designated by EnCap, three of which are independent, and two of which are members of management, including Earthstone’s Chief Executive Officer. At any time during the effectiveness of the Voting Agreement during which EnCap’s collective ownership of Earthstone exceeds 50% of the total issued and outstanding voting stock, EnCap may remove and replace one director that was not originally designated by EnCap, and his or her successors. Any such removal and replacement will be conducted in accordance with the provisions of Earthstone’s certificate of incorporation and bylaws then in effect. The Voting Agreement terminates on the earlier of (i) the fifth anniversary of the closing date of the Bold Contribution Agreement and (ii) the date upon which EnCap, Oak Valley, and Bold Holdings collectively own, of record and beneficially, less than 20% of Earthstone’s outstanding voting stock.
On May 9, 2017, the closing sale price of the Class A Common Stock was $13.58 per share. On May 10, 2017, the Class A Common Stock was uplisted from the NYSE American, LLC (formerly the NYSE MKT) (the “NYSE American”) to the New York Stock Exchange (the “NYSE”) where it is listed under the symbol “ESTE.”
Management’s Plans
Our plans for 2018 include a focus on the Midland Basin by continuing the development of our properties and by further expanding our acreage footprint as an operator. Our development program for 2018 presently includes drilling approximately 15 wells and our acreage expansion program includes looking for opportunities where we can trade acreage with other operators or bolt on acreage through acquisitions. Our intent is to increase our overall operated locations and allow us to develop our acreage with long horizontal laterals (7,500 to 10,000+ foot lateral lengths). We will also remain active in seeking M&A transactions in this highly economic return geographic area. At our Eagle Ford Trend properties, our development program includes drilling approximately 10 wells. In order to achieve these plans, we have an approved budget of $170.0 million of which we plan to spend approximately $140 million. Commodity prices continue to be volatile and we intend to be vigilant to adjust our business plans accordingly.

23


Areas of Operation
Our primary focus is concentrated in the Midland Basin of west Texas, a high oil and liquids rich resource which provides us with multiple horizontal targets with proven production results, long-lived reserves and historically high drilling success rates.
Midland Basin
Although adequate take-away capacity existed in the Midland Basin in the second quarter, we experienced increasing negative oil price differentials, which we believe are related to market concerns about future take-away capacity. While we believe the economic returns from our operations are very attractive at current price levels and our wells are meeting or exceeding our type curves, our cashflows are being impacted by these negative differentials, which averaged -$5.15/Bbl in the 2nd quarter of 2018. Increasing and sustained negative oil price differentials will adversely affect our future cashflows and could cause us to alter the pace of development of our properties. We completed 10 wells (six operated and four non-operated) during the second quarter of 2018 that were drilled in 2017 or in the first quarter of 2018. We also spud four wells (two operated and two non-operated) during the second quarter of 2018. Two operated wells were completed in early July 2018 and we currently expect to complete approximately four additional operated wells during the third quarter of 2018. We intend to continue to initiate completion activities when we accumulate an adequate inventory of wells for efficient operations.
Eagle Ford Trend
In our operated leasehold acreage located in the Eagle Ford Trend, we initiated completion activities on the five wells we spud during the first quarter. These wells were completed and production commenced in mid-July 2018.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires us to use our judgment to make estimates and assumptions that affect certain amounts reported in our financial statements. As additional information becomes available, these estimates and assumptions are subject to change and thus impact amounts reported in the future. Critical accounting policies are those accounting policies that involve judgment and uncertainties affecting the application of those policies and the likelihood that materially different amounts would be reported under different conditions or using differing assumptions. We periodically update our estimates used in the preparation of the financial statements based on our latest assessment of the current and projected business and general economic environment. There have been no significant changes to our critical accounting policies during the six months ended June 30, 2018.

24


Results of Operations
Three Months Ended June 30, 2018, compared to the Three Months Ended June 30, 2017
 
 
Three Months Ended June 30,
 
 
 
 
2018
 
2017
 
Change
Sales volumes:
 
 
 
 
 
 
Oil (MBbl)
 
505

 
480

 
5
 %
Natural gas (MMcf)
 
892

 
729

 
22
 %
Natural gas liquids (MBbl)
 
151

 
120

 
26
 %
Barrels of oil equivalent (MBOE)
 
805

 
721

 
12
 %
 
 
 
 
 
 
 
Average prices realized: (1)
 
 
 
 
 
 
Oil (per Bbl)
 
$
63.16

 
$
44.88

 
41
 %
Natural gas (per Mcf)
 
$
2.00

 
$
2.92

 
(32
)%
Natural gas liquids (per Bbl)
 
$
22.92

 
$
17.39

 
32
 %
 
 
 
 
 
 
 
(In thousands)
 
 
 
 
 
 
Oil revenues
 
$
31,903

 
21,563

 
48
 %
Natural gas revenues
 
$
1,783

 
2,131

 
(16
)%
Natural gas liquids revenues
 
$
3,464

 
2,083

 
66
 %
 
 
 
 
 
 
 
Lease operating expense
 
$
5,009

 
5,243

 
(4
)%
Severance taxes
 
$
1,824

 
1,327

 
37
 %
Impairment expense
 
$

 
66,648

 
NM

Depreciation, depletion and amortization
 
$
10,812

 
10,039

 
8
 %
 
 
 
 
 
 
 
General and administrative expense (excluding stock-based compensation)
 
$
5,213

 
5,738

 
(9
)%
Stock-based compensation
 
$
2,073

 
1,647

 
26
 %
General and administrative expense
 
$
7,286

 
7,385

 
(1
)%
 
 
 
 
 
 
 
Transaction costs
 
$

 
3,764

 
NM

Gain on sale of oil and gas properties
 
$
63

 
1,691

 
NM

Interest expense, net
 
$
(610
)
 
(633
)
 
(4
)%
Write-off of deferred financing costs
 
$

 
(526
)
 
NM

(Loss) gain on derivative contracts, net
 
$
(10,850
)
 
3,340

 
NM

Income tax benefit
 
$
302

 
9,914

 
NM

(1) Prices presented exclude any effects of oil and natural gas derivatives.
NM – Not Meaningful
Oil revenues
For the three months ended June 30, 2018, oil revenues increased by $10.3 million or 48% relative to the comparable period in 2017. Of the increase, $8.8 million was attributable to an increase in our realized price and $1.5 million was attributable to increased volume. Our average realized price per Bbl increased from $44.88 for the three months ended June 30, 2017 to $63.16 or 41% for the three months ended June 30, 2018. We had a net increase in the volume of oil sold of 25 MBbls or 5%, primarily due to the timing of the Bold Transaction which substantially increased our Midland Basin properties on May 9, 2017, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Natural gas revenues
For the three months ended June 30, 2018, natural gas revenues decreased by $0.3 million or 16% relative to the comparable period in 2017. Of the decrease, $0.7 million was attributable to a decrease in our realized price, offset by $0.4 million attributable to increased volume. Our average realized price per Mcf decreased from $2.92 for the three months ended June 30, 2017 to $2.00

25


or 32% for the three months ended June 30, 2018. The total volume of natural gas produced and sold increased 163 MMcf or 22% primarily due to increased production at our Midland Basin properties as well as the impact of the timing of the Bold Transaction, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Natural gas liquids revenues
For the three months ended June 30, 2018, natural gas liquids revenues increased by $1.4 million or 66% relative to the comparable period in 2017. Of the increase, $0.7 million was attributable to an increase in our realized price and $0.7 million was attributable to increased volume. The volume of natural gas liquids produced and sold increased by 31 MBbls or 26%, primarily due to the timing of the Bold Transaction, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Lease operating expense (“LOE”)
LOE decreased by $0.2 million or 4% for the three months ended June 30, 2018 relative to the comparable period in 2017. Although sales volumes increased 12% over the prior year period, the relative increase in LOE was offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Severance taxes
Severance taxes for the three months ended June 30, 2018 increased by $0.5 million or 37% relative to the comparable period in 2017, primarily due to the increased prices of oil and natural gas liquids, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017. However, as a percentage of revenues from oil, natural gas, and natural gas liquids, severance taxes remained relatively flat when compared to the prior year period.
Depreciation, depletion and amortization (“DD&A”)
DD&A increased for the three months ended June 30, 2018 by $0.8 million, or 8% relative to the comparable period in 2017, due to the addition of the assets acquired in the Bold Transaction to the depletable base, as well as increased production volumes, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
General and administrative expense (“G&A”)
G&A decreased by $0.1 million for the three months ended June 30, 2018 relative to the comparable period in 2017, primarily due to the Company's decision to discontinue payment for the employees' portion of taxes on the vesting of restricted stock awards starting in June 2017, partially offset by expanded organization and infrastructure, primarily employee-related costs, resulting from the Bold Transaction. Included in G&A, was stock-based compensation of $2.1 million and $1.6 million for the three months ended June 30, 2018 and 2017, respectively. The increase in stock-based compensation was due to accumulation of 2016 and 2017 equity awards as well as the increased number of eligible employees resulting from the Bold Transaction.
Gain on sale of oil and gas properties
During the three months ended June 30, 2017, we sold certain non-core oil and gas properties, recording gains totaling $1.7 million.
Interest expense, net
Interest expense remained flat at $0.6 million for the three months ended June 30, 2018 compared to the prior year period. See Note 10. Long-Term Debt in the Notes to Unaudited Condensed Consolidated Financial Statements.
(Loss) gain on derivative contracts, net
For the three months ended June 30, 2018, we recorded a net loss on derivative contracts of $10.9 million, consisting of unrealized mark-to-market losses of $5.9 million and net realized losses on settlements of $5.0 million. For the three months ended June 30, 2017, we recorded a net gain on derivative contracts of $3.3 million, consisting of unrealized mark-to-market gains of $3.0 million and net realized gains on settlements of $0.3 million.

26


Income tax benefit
During the three months ended June 30, 2018, the Company recorded a $0.5 million discrete income tax benefit related to refundable AMT tax credits resulting from the Tax Cuts and Jobs Act ("TCJA"), offset by recording a deferred income tax expense of $0.2 million related to the Texas Margin Tax.
During the three months ended June 30, 2017, the Company (1) recorded an income tax benefit for Lynden US of $2.9 million as a result of its standalone pre-tax loss incurred before the Bold Transaction and its share of the distributable loss from EEH after the Bold Transaction, (2) recorded a $7.5 million income tax benefit for Earthstone as a discrete item during the current reporting period, which resulted from a change in assessment of the realization of its net deferred tax assets due to the deferred tax liability that was recorded with respect to its investment in EEH as part of the Bold Transaction as an adjustment to Additional paid-in capital in the Condensed Consolidated Statement of Equity and (3) recorded deferred income tax expense of $0.5 million related to the Texas Margin Tax.

Six Months Ended June 30, 2018, compared to the Six Months Ended June 30, 2017
 
 
Six Months Ended June 30,
 
 
 
 
2018
 
2017
 
Change
Sales volumes:
 
 
 
 
 
 
Oil (MBbl)
 
1,051

 
737

 
43
 %
Natural gas (MMcf)
 
1,936

 
1,361

 
42
 %
Natural gas liquids (MBbl)
 
301

 
184

 
64
 %
Barrels of oil equivalent (MBOE)
 
1,675

 
1,148

 
46
 %
 
 
 
 
 
 
 
Average prices realized: (1)
 
 
 
 
 
 
Oil (per Bbl)
 
$
63.11

 
$
46.23

 
37
 %
Natural gas (per Mcf)
 
$
2.31

 
$
2.81

 
(18
)%
Natural gas liquids (per Bbl)
 
$
24.11

 
$
17.47

 
38
 %
 
 
 
 
 
 
 
(In thousands)
 
 
 
 
 
 
Oil revenues
 
$
66,320

 
$
34,082

 
95
 %
Natural gas revenues
 
$
4,467

 
$
3,825

 
17
 %
Natural gas liquids revenues
 
$
7,258

 
$
3,213

 
126
 %
 
 
 
 
 
 
 
Lease operating expense
 
$
9,666

 
$
9,582

 
1
 %
Severance taxes
 
$
3,861

 
$
2,117

 
82
 %
Impairment expense
 
$

 
$
66,648

 
NM

Depreciation, depletion and amortization
 
$
20,520

 
$
17,928

 
14
 %
 
 
 
 
 
 
 
General and administrative expense (excluding stock-based compensation)
 
$
9,852

 
$
9,230

 
7
 %
Stock-based compensation
 
$
4,013

 
$
2,958

 
36
 %
General and administrative expense
 
$
13,865

 
$
12,188

 
14
 %
 
 
 
 
 
 
 
Transaction costs
 
$

 
$
4,567

 
NM

Gain on sale of oil and gas properties
 
$
512

 
$
1,691

 
(70
)%
Interest expense, net
 
$
(1,223
)
 
$
(970
)
 
26
 %
Write-off of deferred financing costs
 
$

 
$
(526
)
 
NM

(Loss) gain on derivative contracts, net
 
$
(16,125
)
 
$
7,800

 
NM

Income tax benefit
 
$
53

 
$
9,952

 
NM

(1) Prices presented exclude any effects of oil and natural gas derivatives.
NM – Not Meaningful

27


Oil revenues
For the six months ended June 30, 2018, oil revenues increased by $32.2 million or 95% relative to the comparable period in 2017. Of the increase, $12.4 million was attributable to an increase in our realized price and $19.8 million was attributable to increased volume. Our average realized price per Bbl increased from $46.23 for the six months ended June 30, 2017 to $63.11 or 37% for the six months ended June 30, 2018. We had a net increase in the volume of oil sold of 314 MBbls or 43%, primarily due to the timing of the Bold Transaction which substantially increased our Midland Basin properties on May 9, 2017, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Natural gas revenues
For the six months ended June 30, 2018, natural gas revenues increased by $0.6 million or 17% relative to the comparable period in 2017. Of the increase, $1.3 million was attributable to increased volume, offset by $0.7 million attributable to a decrease in our realized price. Our average realized price per Mcf decreased from $2.81 for the six months ended June 30, 2017 to $2.31 or 18% for the six months ended June 30, 2018. The total volume of natural gas produced and sold increased 575 MMcf or 42% primarily due to increased production at our Midland Basin properties as well as the impact of the timing of the Bold Transaction, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Natural gas liquids revenues
For the six months ended June 30, 2018, natural gas liquids revenues increased by $4.0 million or 126% relative to the comparable period in 2017. Of the increase, $1.2 million was attributable to an increase in our realized price and $2.8 million was attributable to increased volume. The volume of natural gas liquids produced and sold increased by 117 MBbls or 64%, primarily due to the timing of the Bold Transaction which substantially increased our Midland Basin properties on May 9, 2017, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Lease operating expense (“LOE”)
LOE increased by $0.1 million or 1% for the six months ended June 30, 2018 relative to the comparable period in 2017. Although sales volumes increased 46% over the prior year period, the relative increase in LOE was offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
Severance taxes
Severance taxes for the six months ended June 30, 2018 increased by $1.7 million or 82% relative to the comparable period in 2017, primarily due to the increased prices of oil and natural gas liquids, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017. However, as a percentage of revenues from oil, natural gas, and natural gas liquids, severance taxes remained flat when compared to the prior year period.
Depreciation, depletion and amortization (“DD&A”)
DD&A increased for the six months ended June 30, 2018 by $2.6 million, or 14% relative to the comparable period in 2017, due to the addition of the assets acquired in the Bold Transaction to the depletable base, as well as increased production volumes, partially offset by the impact of non-core asset divestitures that took place in the third and fourth quarters of 2017.
General and administrative expense (“G&A”)
G&A increased by $1.7 million for the six months ended June 30, 2018 relative to the comparable period in 2017, due to the expanded organization and infrastructure, primarily employee-related costs, resulting from the Bold Transaction. Included in G&A, was stock-based compensation of $4.0 million and $3.0 million for the six months ended June 30, 2018 and 2017, respectively. The increase in stock-based compensation was due to accumulation of 2016 and 2017 equity awards as well as the increased number of eligible employees resulting from the Bold Transaction.
Gain on sale of oil and gas properties
During the six months ended June 30, 2018 and 2017, we sold certain non-core oil and gas properties, recording gains totaling $0.5 million and $1.7 million, respectively.
Interest expense, net

28


Interest expense increased from $1.0 million for the six months ended June 30, 2017 to $1.2 million for the six months ended June 30, 2018, primarily due to higher average borrowings outstanding compared to the prior year period. See Note 10. Long-Term Debt in the Notes to Unaudited Condensed Consolidated Financial Statements.
Gain (loss) on derivative contracts, net
For the six months ended June 30, 2018, we recorded a net loss on derivative contracts of $16.1 million, consisting of unrealized mark-to-market losses of $6.8 million and net realized losses on settlements of $9.3 million. For the six months ended June 30, 2017, we recorded a net gain on derivative contracts of $7.8 million, consisting of unrealized mark-to-market gains of $8.1 million partially offset by net realized losses on settlements of $0.3 million.
Income tax benefit
During the six months ended June 30, 2018, the Company recorded a net income tax benefit of approximately $0.1 million which included (1) income tax expense for Lynden US of $0.2 million as a result of its share of the distributable income from EEH, offset by a $0.5 million discrete income tax benefit related to refundable AMT tax credits resulting from the TCJA, (2) income tax expense for Earthstone of $0.9 million as a result of its share of the distributable income from EEH, which was used to reduce the valuation recorded against its deferred tax asset as future realization of the net deferred tax asset cannot be assured and (3) deferred income tax expense of $0.2 million related to the Texas Margin Tax. Lynden Corp incurred no material income or loss, or related income tax expense or benefit, for the six months ended June 30, 2018.
During the six months ended June 30, 2017, the Company (1) recorded an income tax benefit for Lynden US of $2.9 million as a result of its standalone pre-tax loss incurred before the Bold Transaction and its share of the distributable loss from EEH after the Bold Transaction, (2) recorded a $7.5 million income tax benefit for Earthstone as a discrete item during the current reporting period, which resulted from a change in assessment of the realization of its net deferred tax assets due to the deferred tax liability that was recorded with respect to its investment in EEH as part of the Bold Transaction as an adjustment to Additional paid-in capital in the Condensed Consolidated Statement of Equity and (3) recorded deferred income tax expense of $0.5 million related to the Texas Margin Tax. Lynden Corp incurred no material income or loss, or related income tax expense or benefit, for the six months ended June 30, 2017.
Liquidity and Capital Resources
With the Bold Transaction, we acquired significant undeveloped acreage and future drilling locations. Drilling horizontal wells, generally consisting of 7,500 to 10,000-foot lateral lengths, in the Midland Basin is capital intensive. At June 30, 2018, we had approximately $4 million in cash and approximately $203 million in unused borrowing capacity under the EEH Credit Agreement (discussed below) for a total of $207 million in cash available for operational and capital funding. We currently estimate 2018 capital expenditures will be approximately $140 million, which assumes an approximate 15 well program running one rig for our operated acreage in the Midland Basin and an approximate 10 well program for our operated Eagle Ford acreage as well as some activity for our non-operated Midland Basin properties and land and infrastructure activities. We likely will continue to outspend our cash flows provided by operating activities over at least the next 12 months from the date of this report based on current assumptions; however, we believe we will have sufficient liquidity with cash flows from operations and borrowings under the EEH Credit Agreement for the next 12 months to meet our cash requirements. We will continue to evaluate and prepare operationally for the possible deployment of a second rig in our operated Midland Basin acreage.  
Working Capital, defined as Total current assets less Total current liabilities as set forth in our Condensed Consolidated Balance Sheets, was a deficit of $58.3 million as of June 30, 2018 compared to a deficit of $21.8 million as of December 31, 2017. The $68.5 million used to fund our capital program and $2.5 million used to reduce our outstanding borrowings under the EEH Credit Agreement was facilitated by $53.4 million of net cash provided by our operating activities and a reduction of our cash on hand by $18.8 million. Due to the costs incurred related to our drilling program, we may incur additional working capital deficits in the future. We expect that our pace of development, production volumes, commodity prices and differentials to NYMEX prices for our oil and natural gas production will continue to be the largest variables affecting our working capital.
We expect to finance future acquisition and development activities through available working capital, cash flows from operating activities, borrowings under the EEH Credit Agreement and, various means of corporate and project financing, assuming we can effectively access debt and equity markets. In addition, we may continue to partially finance our drilling activities through the sale of participating rights to financial institutions or industry participants, and we could structure such arrangements on a promoted basis, whereby we may earn working interests in reserves and production greater than our proportionate share of capital costs.

29


Cash Flows from Operating Activities
Cash flows provided by operating activities for the six months ended June 30, 2018 were $53.4 million compared to $11.7 million for the six months ended June 30, 2017. The increase in operating cash flows from the prior year period was primarily due to the operating cash flows from the producing assets acquired in the Bold Transaction.
Cash Flows from Investing Activities
Cash flows used in investing activities for the six months ended June 30, 2018 and 2017 were $68.4 million and $63.3 million, respectively. Cash flows used in investing activities for the six months ended June 30, 2018 included $68.5 million in capital expenditures primarily related to the drilling and completion of wells in the Midland Basin on acreage acquired in the Bold Transaction. Cash flows used in investing activities for the six months ended June 30, 2017 related primarily to the cash required to complete the Bold Transaction.
Cash Flows from Financing Activities
Cash flows used in financing activities for the six months ended June 30, 2018 were $3.8 million which consisted of $2.5 million in net repayment of borrowings under the EEH Credit Agreement, $1.1 million related to the exchange and cancellation of Class A Common Stock and $0.2 million in deferred financing costs. Cash flows provided by financing activities for the six months ended June 30, 2017 were $58.1 million which consisted of $70.0 million in borrowings under the EEH Credit Agreement used to repay all outstanding borrowings under Bold's credit agreement assumed by EEH in the Bold Transaction, offset by $10.0 million in repayments of those borrowings, $0.8 million in repayment of borrowings under an unsecured promissory note and $1.1 million in deferred financing costs.
Capital Expenditures
We have set our 2018 capital budget, which currently assumes a one-rig program for our operated acreage in the Midland Basin and a 10 well program for our operated Eagle Ford acreage. We will continue to evaluate and prepare operationally for the possible deployment of a second rig in our operated Midland Basin acreage in the latter half of 2018. Our capital expenditures for 2018 are currently estimated to be approximately $140 million, of which we have spent $74.5 million to-date.
Our accrual basis capital expenditures for the three and six months ended June 30, 2018 were as follows (in thousands):
 
 
Three Months Ended June 30, 2018
 
Six Months Ended June 30, 2018
Drilling and completions
 
$
50,650

 
$
72,970

Leasehold costs
 
1,358

 
1,494

Total capital expenditures
 
$
52,008

 
$
74,464

Credit Agreement
On May 23, 2018, Earthstone Energy Holdings, LLC (“EEH” or the “Borrower”), a subsidiary of Earthstone Energy, Inc. (the “Company”), each of Earthstone Operating, LLC, EF Non-Op, LLC, Sabine River Energy, LLC, Earthstone Legacy Properties, LLC, Lynden USA Operating, LLC, Bold Energy III LLC, Bold Operating, LLC, as guarantors (the “Guarantors”), BOKF, NA dba Bank Of Texas, as Administrative Agent, and the lenders party thereto (the “Lenders”), entered into an amendment (the “Amendment”) to the Credit Agreement dated May 9, 2017, by and among EEH, as Borrower, the Guarantors, BOKF, NA dba Bank Of Texas, as Agent and Lead Arranger, Wells Fargo Bank, National Association, as Syndication Agent, and the Lenders (together with all amendments or other modifications, the “Credit Agreement”). Among other things, the Amendment increased the borrowing base from $185.0 million to $225.0 million, provided for a 50-basis point decrease in the interest rate on outstanding loans, increased flexibility related to hedging limitations and provided the ability to obtain short-term borrowings via a swingline as a part of the borrowing base.
On May 9, 2017, in connection with the closing of the Bold Transaction, the Company exited its credit agreement dated December 19, 2014, by and among Earthstone, Oak Valley Operating, LLC, EF Non-OP, LLC, Sabine River Energy, LLC, Basic Petroleum Services, Inc., BOKF, NA dba Bank of Texas, and the Lenders party thereto (as amended, modified or restated from time to time, the “ESTE Credit Agreement”). At that time, all outstanding borrowings of $10.0 million under the ESTE Credit Agreement were repaid and $0.5 million of remaining unamortized deferred financing costs were expensed and included in Write-off of deferred financing costs in the Condensed Consolidated Statements of Operations.  

30


On May 9, 2017, EEH (the “Borrower”), Earthstone Operating, LLC, EF Non-Op, LLC, Sabine River Energy, LLC, Earthstone Legacy Properties, LLC, Lynden Op, Bold, Bold Operating, LLC (the “Guarantors”), BOKF, NA dba Bank of Texas, as Agent and Lead Arranger, Wells Fargo Bank, National Association as Syndication Agent and the Lenders party thereto (the “Lenders”), entered into a credit agreement (the “EEH Credit Agreement”).
The borrowing base under the EEH Credit Agreement is subject to redetermination on or about November 1st and May 1st of each year. The amounts borrowed under the EEH Credit Agreement bear annual interest rates at either (a) the London Interbank Offered Rate (“LIBOR”) plus 1.75% to 2.75% or (b) the prime lending rate of Bank of Texas plus 0.75% to 1.75%, depending on the amounts borrowed under the EEH Credit Agreement. Principal amounts outstanding under the EEH Credit Agreement are due and payable in full at maturity on May 9, 2022. All of the obligations under the EEH Credit Agreement, and the guarantees of those obligations, are secured by substantially all of EEH’s assets. Additional payments due under the EEH Credit Agreement include paying a commitment fee of 0.375% or 0.50%, depending on borrowing base utilization, per year to the Lenders in respect of the unutilized commitments thereunder, as well as certain other customary fees.
The EEH Credit Agreement contains a number of covenants that, among other things, restrict, subject to certain exceptions, EEH’s ability to incur additional indebtedness, create liens on assets, make investments, enter into sale and leaseback transactions, pay dividends and make distributions or repurchase its limited liability interests, engage in mergers or consolidations, sell certain assets, sell or discount any notes receivable or accounts receivable and engage in certain transactions with affiliates.
In addition, the EEH Credit Agreement requires EEH to maintain the following financial covenants: a current ratio of not less than 1.0 to 1.0 and a leverage ratio of not greater than 4.0 to 1.0. Leverage ratio means the ratio of (i) the aggregate debt of EEH and its consolidated subsidiaries as at the last day of the fiscal quarter (excluding any debt from obligations relating to non-cash losses under FASB ASC 815 as a result of changes in the fair market value of derivatives) to (ii) the product of EBITDAX for such fiscal quarter multiplied by four. The term “EBITDAX” means, for any period, the sum of consolidated net income for such period plus (a) the following expenses or charges to the extent deducted from consolidated net income in such period: (i) interest, (ii) taxes, (iii) depreciation, (iv) depletion, (v) amortization, (vi) non-cash losses under FASB ASC 815 as a result of changes in the fair market value of derivatives, (vii) exploration expenses, (viii) impairment expenses, and (ix) non-cash compensation expenses and minus (b) to the extent included in consolidated net income in such period, non-cash gains under FASB ASC 815 as a result of changes in the fair market value of derivatives.
The EEH Credit Agreement contains customary affirmative covenants and defines events of default to include failure to pay principal or interest, breach of covenants, breach of representations and warranties, insolvency, judgment default, and if Frank A. Lodzinski ceases to serve and function as Chief Executive Officer of EEH and the majority of the Lenders do not approve of Mr. Lodzinski’s successor. Upon the occurrence and continuance of an event of default, the Lenders have the right to accelerate repayment of the loans and exercise their remedies with respect to the collateral. As of June 30, 2018, EEH was in compliance with these covenants under the EEH Credit Agreement.
As of June 30, 2018, the Company had a $225.0 million borrowing base under the EEH Credit Agreement, of which $22.5 million was outstanding, bearing annual interest of 3.838%, resulting in an additional $202.5 million of borrowing base availability under the EEH Credit Agreement.
Hedging Activities
As of June 30, 2018, we had hedged a total of 873 MBbls of remaining 2018 oil production at an average price of $54.31/Bbl and 1,220,000 MMBtu of remaining 2018 natural gas production at average price of $2.95/MMBbtu. As of June 30, 2018, we had hedged a total of 1,259 MBbls of 2019 oil production at an average price of $57.15/Bbl. Additionally, we had 303.6 MBbls of WTI Midland Argus Crude Oil Basis Swaps at -$0.15/Bbl and 184 MBbls of LLS Crude Oil Basis Swaps at +$6.35/Bbl remaining for 2018 oil production. For 2019, we had 365 MBbls of WTI Midland Argus Crude Basis Swaps at -$5.95/Bbl and 365 MBbls of LLS Crude Oil Basis Swaps at +$4.50/Bbl. For 2020, we had 366 MBbls of WTI Midland Argus Crude Oil Swaps at -$5.95/Bbl.
Obligations and Commitments
There have been no changes from the obligations and commitments disclosed in the Obligations and Commitments section of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2017 Annual Report on Form 10-K.
Environmental Regulations

31


Our operations are subject to risks normally associated with the exploration for and the production of oil and natural gas, including blowouts, fires, and environmental risks such as oil spills or natural gas leaks that could expose us to liabilities associated with these risks.
In our acquisition of existing or previously drilled well bores, we may not be aware of prior environmental safeguards, if any, that were taken at the time such wells were drilled or during such time the wells were operated. We maintain comprehensive insurance coverage that we believe is adequate to mitigate the risk of any adverse financial effects associated with these risks.
However, should it be determined that a liability exists with respect to any environmental cleanup or restoration, the liability to cure such a violation could still accrue to us. No claim has been made, nor are we aware of any liability which we may have, as it relates to any environmental cleanup, restoration, or the violation of any rules or regulations relating thereto.
Recently Issued Accounting Standards
See Note 1. Basis of Presentation and Summary of Significant Accounting Policies in the Notes to Unaudited Condensed Consolidated Financial Statements in this report for discussion of recently issued and adopted accounting standards affecting us.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risks associated with interest rate risks, commodity price risk and credit risk. We have established risk management processes to monitor and manage these market risks.
Commodity Price Risk, Derivative Instruments and Hedging Activity
We are exposed to various risks including energy commodity price risk. When oil, natural gas, and natural gas liquids prices decline significantly our ability to finance our capital budget and operations may be adversely impacted. We expect energy prices to remain volatile and unpredictable. Our hedging activities consist of derivative instruments entered into in order to hedge against changes in oil and natural gas prices through the use of fixed price swap agreements. Swaps exchange floating price risk in the future for a fixed price at the time of the hedge.
The Company has entered into a series of derivative instruments to hedge a significant portion of its expected oil and natural gas production for the remainder of 2018 through December 31, 2020. Typically, these derivative instruments require payments to (receipts from) counterparties based on specific indices as required by the derivative agreements. Although not risk free, we believe these instruments reduce our exposure to oil and natural gas price fluctuations and, thereby, allow us to achieve a more predictable cash flow.
The following is a summary of our open oil and natural gas derivative contracts as of June 30, 2018
 
 
Price Swaps
Period
 
Commodity
 
Volume
(Bbls / MMBtu)
 
Weighted Average Price
($/Bbl / $/MMBtu)
Q3 - Q4 2018
 
Crude Oil
 
873,400

 
$
54.31

Q1 - Q4 2019
 
Crude Oil
 
1,259,100

 
$
57.15

Q3 - Q4 2018
 
Crude Oil (Basis Swap)(1)
 
303,600

 
$
(0.15
)
Q1 - Q4 2019
 
Crude Oil (Basis Swap)(1)
 
365,000

 
$
(5.95
)
Q1 - Q4 2020
 
Crude Oil (Basis Swap)(1)
 
366,000

 
$
(5.95
)
Q3 - Q4 2018
 
Crude Oil (Basis Swap)(2)
 
184,000

 
$
6.35

Q1 - Q4 2019
 
Crude Oil (Basis Swap)(2)
 
365,000

 
$
4.50

Q3 - Q4 2018
 
Natural Gas
 
1,220,000

 
$
2.95

(1)
The basis differential price is between WTI Midland Argus Crude and the WTI NYMEX.
(2)
The basis differential price is between LLS Argus Crude and the WTI NYMEX.
Additionally, on July 9, 2018, we entered into additional crude oil basis swap agreements, limiting the basis differential between Midland - WTI and the NYMEX - WTI to a weighted average price differential of $7.75/Bbl for 547,500 Bbls of our 2019 oil production.

Changes in fair value of commodity derivative instruments are reported in earnings in the period in which they occur. Our open commodity derivative instruments were in a net liability position with a fair value of $20.3 million at June 30, 2018. Based on the published commodity futures price curves for the underlying commodity as of June 30, 2018, a 10% increase in per unit commodity prices would cause the total fair value of our commodity derivative financial instruments to decrease by approximately $13.9

32


million to an overall net liability position of $34.2 million. A 10% decrease in per unit commodity prices would cause the total fair value of our commodity derivative financial instruments to increase by approximately $13.9 million to an overall net liability position of $6.4 million. There would also be a similar increase or decrease in (Loss) gain on derivative contracts, net in the Condensed Consolidated Statements of Operations.
Interest Rate Sensitivity
We are also exposed to market risk related to adverse changes in interest rates. Our interest rate risk exposure results primarily from fluctuations in short-term rates, which are based on LIBOR and the prime rate and may result in reductions of earnings or cash flows due to increases in the interest rates we pay on these obligations.
At June 30, 2018, the outstanding borrowings under the EEH Credit Agreement were $22.5 million bearing interest at rates described in Note 10. Long-Term Debt in the Notes to Unaudited Condensed Consolidated Financial Statements. Fluctuations in interest rates will cause our annual interest costs to fluctuate. At June 30, 2018, the interest rate on borrowings under the EEH Credit Agreement was 3.838% per year. If borrowings at June 30, 2018 were to remain constant, a 10% change in interest rates would impact our future cash flows by approximately $0.1 million per year.
Disclosure of Limitations
Because the information above included only those exposures that existed at June 30, 2018, it does not consider those exposures or positions which could arise after that date. As a result, our ultimate realized gain or loss with respect to interest rate and commodity price fluctuations will depend on the exposures that arise during future periods.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
In accordance with Securities Exchange Act of 1934, as amended (the “Exchange Act”), Rules 13a-15(e) and 15d-15(e), we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Principal Accounting Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Principal Accounting Officer concluded that our disclosure controls and procedures were effective as of June 30, 2018 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Principal Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
From time to time, we may be involved in various legal proceedings and claims in the ordinary course of business. As of June 30, 2018, and through the filing date of this report, we do not believe the ultimate resolution of any such actions or potential actions of which we are currently aware will have a material effect on our consolidated financial position or results of operations.