Attached files

file filename
EX-3.1 - EX-3.1 - Epsilon Energy Ltd.epsn-20200930ex318489ef0.htm
EX-32.2 - EX-32.2 - Epsilon Energy Ltd.epsn-20200930ex322235967.htm
EX-32.1 - EX-32.1 - Epsilon Energy Ltd.epsn-20200930ex321471fd9.htm
EX-31.2 - EX-31.2 - Epsilon Energy Ltd.epsn-20200930ex31222d3ee.htm
EX-31.1 - EX-31.1 - Epsilon Energy Ltd.epsn-20200930ex31115dcf3.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2020

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

For the transition period from to

Commission file number: 001-38770

EPSILON ENERGY LTD.

(Exact name of registrant as specified in its charter)

Alberta, Canada

98-1476367

(State or other jurisdiction of incorporation or organization)

(I.R.S Employer Identification No.)

16945 Northchase Drive, Suite 1610

Houston, Texas 77060

(281) 670-0002

(Address of principal executive offices including zip code and

telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading Symbol

Name of each exchange on which registered

Common Shares, no par value

“EPSN”

NASDAQ Global Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the 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

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. Yes No

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

As of November 10, 2020, there were 23,859,136 Common Shares outstanding.


Table of Contents

Contents

    

FORWARD-LOOKING STATEMENTS

4

PART I-FINANCIAL INFORMATION

5

ITEM 1. FINANCIAL STATEMENTS

5

Unaudited Condensed Consolidated Balance Sheets

5

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income

6

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity

7

Unaudited Condensed Consolidated Statements of Cash Flows

9

Notes to the Unaudited Condensed Consolidated Financial Statements

10

1.

Description of Business

10

2.

Basis of Preparation

11

Interim Financial Statements

11

Principles of Consolidation

11

Use of Estimates

11

Recently Issued Accounting Standards

11

3.

Cash, Cash Equivalents, and Restricted Cash

12

4.

Property and Equipment

13

Property Additions and Acquisitions

13

Property Impairment

13

5.

Revolving Line of Credit

13

6.

Shareholders’ Equity

15

7.

Revenue Recognition

18

8.

Accumulated Other Comprehensive Income (Loss)

20

9.

Income Taxes

20

10.

Commitments and Contingencies

21

Litigation

21

11.

Net Income Per Share

21

12.

Operating Segments

22

13.

Risk Management Activities

25

Commodity Price Risks

25

Commodity Derivative Contracts

26

14.

Asset Retirement Obligations

27

15.

Fair Value Measurements

27

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

28

Overview

28

Business Strategy

28

Operational Highlights

31

Non-GAAP Financial Measures-Adjusted EBITDA

31

Net Operating Revenues

32

Operating Costs

33

Depletion, Depreciation, Amortization and Accretion (“DD&A”)

34

General and Administrative

35

Interest Expense

35

Net Gain (Loss) on Commodity Contracts

35


Miscellaneous Income (Expense)

36

Capital Resources and Liquidity

36

Cash Flow

36

Credit Agreement

37

Derivative Transactions

38

Contractual Obligations

38

Off-Balance Sheet Arrangements

39

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

39

Gathering System Revenue Risk

39

Interest Rate Risk

39

Commodity Contracts

39

ITEM 4. CONTROLS AND PROCEDURES

39

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

39

Changes in Internal Control Over Financial Reporting

40

PART II OTHER INFORMATION

40

ITEM 1. LEGAL PROCEEDINGS

40

ITEM 1A. RISK FACTORS

40

ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

41

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

42

ITEM 4. MINE SAFETY DISCLOSURES

42

ITEM 5. OTHER INFORMATION

42

ITEM 6. EXHIBITS

43

SIGNATURES

43


FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute forward-looking statements. The use of any of the words ‘‘anticipate,’’ ‘‘continue,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘may,’’ ‘‘will,’’ ‘‘project,’’ ‘‘should,’’ ‘‘believe,’’ and similar expressions and statements relating to matters that are not historical facts constitute ‘‘forward looking information’’ within the meaning of applicable securities laws. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated. Such forward-looking statements are based on reasonable assumptions, but no assurance can be given that these expectations will prove to be correct and the forward-looking statements included in this report should not be unduly relied upon. These statements are made only as of the date of this report. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future — including statements relating to natural gas and oil production rates, commodity prices for crude oil or natural gas, supply and demand for natural gas and oil; the estimated quantity of natural gas and oil reserves, including reserve life; future development and production costs, and statements expressing general views about future operating results — are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2019, and those described from time to time in our future reports filed with the Securities and Exchange Commission. You should consider carefully the statements under Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2019 and in the quarterly reports on Form 10-Q  for the quarters ended June 30, 2020 and March 31, 2020, which describe factors that could cause our actual results to differ from those set forth in the forward-looking statements. Our Annual Report on Form 10-K for the year ended December 31, 2019 and quarterly reports on Form 10-Q for the quarters ended June 30, 2020 and March 31, 2020 are available on our website at www.epsilonenergyltd.com.

4


PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets

    

September 30, 

    

December 31, 

2020

2019

ASSETS

Current assets

Cash and cash equivalents

$

11,580,278

$

14,052,417

Accounts receivable, net of allowance for doubtful accounts of $819,000 at September 30, 2020 and nil at December 31, 2019

3,652,036

4,296,917

Fair value of derivatives

20,258

1,999,802

Prepaid income taxes

2,091,399

1,641,501

Other current assets

511,483

433,687

Total current assets

17,855,454

22,424,324

Non-current assets

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

133,138,412

130,819,256

Unproved properties

21,448,546

21,047,512

Accumulated depletion, depreciation, amortization and impairment

(96,864,983)

(89,255,035)

Total oil and gas properties, net

57,721,975

62,611,733

Gathering system

41,912,242

41,445,225

Accumulated depletion, depreciation, amortization and impairment

(31,697,749)

(29,961,690)

Total gathering system, net

10,214,493

11,483,535

Land

637,464

375,314

Buildings and other property and equipment, net

343,677

211,879

Total property and equipment, net

68,917,609

74,682,461

Other assets:

Restricted cash

565,049

561,294

Prepaid drilling costs

1,341

1,124

Total non-current assets

69,483,999

75,244,879

Total assets

$

87,339,453

$

97,669,203

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities

Accounts payable trade

$

1,638,763

$

2,828,495

Royalties payable

1,046,899

1,306,922

Accrued capital expenditures

95,237

627,356

Accrued gathering fees

529,722

373,929

Other accrued liabilities

1,427,489

858,188

Asset retirement obligation

1,581,561

1,503,978

Total current liabilities

6,319,671

7,498,868

Non-current liabilities

Asset retirement obligation

1,489,386

1,405,877

Deferred income taxes

12,201,046

12,401,464

Total non-current liabilities

13,690,432

13,807,341

Total liabilities

20,010,103

21,306,209

Commitments and contingencies (Note 10)

Shareholders' equity

Common shares, no par value, unlimited shares authorized and 23,817,470 issued and outstanding at September 30, 2020 and 26,790,985 shares issued and outstanding at December 31, 2019.

131,730,401

140,808,923

Additional paid-in capital

7,614,593

7,029,488

Accumulated deficit

(81,834,413)

(81,285,895)

Accumulated other comprehensive income

9,818,769

9,810,478

Total shareholders' equity

67,329,350

76,362,994

Total liabilities and shareholders' equity

$

87,339,453

$

97,669,203

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

5


EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Revenues from contracts with customers:

Gas, oil, NGLs and condensate revenue

$

3,590,706

$

2,999,581

$

11,716,897

$

13,005,722

Gas gathering and compression revenue

2,219,905

2,219,613

6,800,347

6,923,058

Total revenue

5,810,611

5,219,194

18,517,244

19,928,780

Operating costs and expenses:

Lease operating expenses

2,147,795

1,548,902

6,229,682

4,851,090

Gathering system operating expenses

43,711

461,036

221,191

1,012,709

Development geological and geophysical expenses

2,693

7,595

83,748

Depletion, depreciation, amortization, and accretion

2,769,193

1,851,466

7,761,339

5,630,368

Impairment of proved properties

1,760,000

Gain on sale of property

(445,173)

(1,375,000)

Bad debt expense

819,000

General and administrative expenses:

Stock based compensation expense

239,134

133,720

585,105

401,161

Other general and administrative expenses

1,330,604

952,503

3,575,445

3,213,371

Total operating costs and expenses

6,533,130

4,502,454

20,959,357

13,817,447

Operating income (loss)

(722,519)

716,740

(2,442,113)

6,111,333

Other income (expense):

Interest income

4,724

38,618

39,294

127,906

Interest expense

(28,629)

(29,416)

(84,952)

(86,035)

Gain on derivative contracts

419,879

1,270,494

2,055,548

3,494,727

Other income (expense)

1

(2,228)

456

Other income, net

395,974

1,279,697

2,007,662

3,537,054

Income (loss) before income tax expense

(326,545)

1,996,437

(434,451)

9,648,387

Income tax expense (benefit)

(33,762)

543,139

114,067

2,983,555

NET INCOME (LOSS)

$

(292,783)

$

1,453,298

$

(548,518)

$

6,664,832

Currency translation adjustments

2,273

(900)

8,291

10,944

NET COMPREHENSIVE INCOME (LOSS)

$

(290,510)

$

1,452,398

$

(540,227)

$

6,675,776

Net income (loss) per share, basic

$

(0.01)

$

0.05

$

(0.02)

$

0.24

Net income (loss) per share, diluted

$

(0.01)

$

0.05

$

(0.02)

$

0.24

Weighted average number of shares outstanding, basic

23,955,619

27,060,387

25,550,194

27,218,162

Weighted average number of shares outstanding, diluted

23,955,619

27,094,391

25,550,194

27,240,117

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

6


EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity

    

  

  

  

  

  

Accumulated

  

  

Other

Total

Common Shares Issued

Treasury Shares

Additional

Comprehensive

Accumulated

Shareholders'

Shares

Amount

Shares

Amount

paid-in Capital

Income

Deficit

Equity

Balance at January 1, 2020

26,790,985

$

140,808,923

$

$

7,029,488

$

9,810,478

$

(81,285,895)

$

76,362,994

Net income

310,299

310,299

Stock-based compensation expenses

173,919

173,919

Buyback of common shares

(488,029)

(1,499,586)

(1,499,586)

Other comprehensive loss

(114)

(114)

Balance at March 31, 2020

26,790,985

$

140,808,923

(488,029)

$

(1,499,586)

$

7,203,407

$

9,810,364

$

(80,975,596)

$

75,347,512

Net loss

(566,034)

(566,034)

Stock-based compensation expenses

172,052

172,052

Buyback of common shares

(169,285)

(427,612)

(427,612)

Other comprehensive income

6,132

6,132

Balance at June 30, 2020

26,790,985

$

140,808,923

(657,314)

$

(1,927,198)

$

7,375,459

$

9,816,496

$

(81,541,630)

$

74,532,050

Net income

(292,783)

(292,783)

Stock-based compensation expenses

239,134

239,134

Retirement of treasury shares

(657,314)

(1,927,198)

657,314

1,927,198

Shares retired through tender offer

(2,337,034)

(7,151,324)

(7,151,324)

Vesting of shares of stock

20,833

Other comprehensive income

2,273

2,273

Balance at September 30, 2020

23,817,470

$

131,730,401

$

$

7,614,593

$

9,818,769

$

(81,834,413)

$

67,329,350

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

7


    

  

  

  

  

  

Accumulated

  

  

Other

Total

Common Shares Issued

Treasury Shares

Additional

Comprehensive

Accumulated

Shareholders'

Shares

Amount

Shares

Amount

paid-in Capital

Income

Deficit

Equity

Balance at January 1, 2019

27,439,300

$

143,705,441

(26,953)

$

(94,418)

$

6,519,028

$

9,797,930

$

(89,983,894)

$

69,944,087

Net income

1,373,676

1,373,676

Stock-based compensation expenses

133,720

133,720

Retirement of treasury shares

(26,953)

(94,418)

26,953

94,418

Buyback and retirement of common shares

(57,100)

(248,381)

(248,381)

Other comprehensive income

10,792

10,792

Balance at March 31, 2019

27,355,247

$

143,362,642

$

$

6,652,748

$

9,808,722

$

(88,610,218)

$

71,213,894

Net income

3,837,858

3,837,858

Stock-based compensation expenses

133,721

133,721

Buyback of common shares

(237,189)

(985,264)

(985,264)

Other comprehensive income

1,052

1,052

Balance at June 30, 2019

27,355,247

$

143,362,642

(237,189)

$

(985,264)

$

6,786,469

$

9,809,774

$

(84,772,360)

$

74,201,261

Net income

1,453,298

1,453,298

Stock-based compensation expenses

133,720

133,720

Exercise of stock options

25,000

54,250

54,250

Buyback of common shares

(126,341)

(480,646)

(480,646)

Other comprehensive loss

(900)

(900)

Balance at September 30, 2019

27,380,247

$

143,416,892

(363,530)

$

(1,465,910)

$

6,920,189

$

9,808,874

$

(83,319,062)

$

75,360,983

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

8


EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows

Nine months ended September 30, 

    

2020

    

2019

Cash flows from operating activities:

Net income (loss)

$

(548,518)

$

6,664,832

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

Depletion, depreciation, amortization, and accretion

7,761,339

5,630,368

Impairment of proved properties

1,760,000

Bad debt expense

819,000

Gain on sale/disposal of properties

(1,375,000)

Gain on derivative contracts

(2,055,548)

(3,494,727)

Cash received from settlements of derivative contracts

4,035,092

1,344,690

Stock-based compensation expense

585,105

401,161

Deferred income tax expense (benefit)

(200,418)

853,116

Changes in assets and liabilities:

Accounts receivable

(174,119)

1,869,411

Prepaid income taxes and other current assets

(527,694)

19,321

Accounts payable, royalties payable and other accrued liabilities

639,224

(1,422,238)

Income taxes payable

1,338,225

Net cash provided by operating activities

12,093,463

11,829,159

Cash flows from investing activities:

Acquisition of unproved oil and gas properties

(596,500)

Additions to unproved oil and gas properties

(401,034)

(919,873)

Additions to proved oil and gas properties

(4,238,580)

(5,452,166)

Additions to gathering system properties

(436,111)

(238,823)

Additions to land, buildings and property and equipment

(415,674)

Prepaid drilling costs

(217)

(1,739)

Proceeds from sale of leases

1,375,000

Net cash used in investing activities

(5,491,616)

(5,834,101)

Cash flows from financing activities:

Buyback of common shares

(9,078,522)

(1,714,291)

Exercise of stock options

54,250

Net cash used in financing activities

(9,078,522)

(1,660,041)

Effect of currency rates on cash, cash equivalents and restricted cash

8,291

10,944

Increase (decrease) in cash, cash equivalents and restricted cash

(2,468,384)

4,345,961

Cash, cash equivalents and restricted cash, beginning of period

14,613,711

14,959,518

Cash, cash equivalents and restricted cash, end of period

$

12,145,327

$

19,305,479

Supplemental cash flow disclosures:

Income taxes paid

$

760,000

$

733,200

Interest paid

$

84,952

$

89,817

Non-cash investing activities:

Change in proved properties accrued in accounts payable and accrued liabilities

$

(1,926,910)

$

1,129,972

Change in gathering system accrued in accounts payable and accrued liabilities

$

30,906

$

(1,142)

Asset retirement obligation asset additions and adjustments

$

7,487

$

9,997

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

9


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

Epsilon Energy Ltd. (the “Company” or “Epsilon” or “we”) was incorporated under the laws of the Province of Alberta, Canada on March 14, 2005. On October 24, 2007, the Company became a publicly traded entity trading on the Toronto Stock Exchange (“TSX”) in Canada. On February 14, 2019, Epsilon’s registration statement on Form 10 was declared effective by the United States Securities and Exchange Commission and on February 19, 2019, the Company began trading in the United States on the NASDAQ Global Market under the trading symbol “EPSN.” The Company is engaged in the acquisition, development, gathering and production of primarily natural gas reserves in the United States.

Recent Developments

The significant demand declines caused by the global response to the coronavirus 2019 pandemic (“COVID-19”) as well as the actions taken by a number of global oil producers has contributed to steep declines in the demand and pricing for oil, natural gas and NGLs, negatively impacting U.S. producers. The commodity price environment is expected to remain depressed based on over-supply, decreased demand and a drastic global economic downturn. While Epsilon did not incur significant disruptions to operations during the nine months ended September 30, 2020 as a result of the COVID-19 pandemic, the Company did need to recognize an impairment on its legacy Oklahoma producing assets due to the historically low commodity prices. The full impact of the COVID-19 pandemic continues to evolve as of the date of this report. As such, the full magnitude that the pandemic will have on the Company’s financial condition, liquidity, and future results of operations is uncertain. Management is actively monitoring the impact of the COVID-19 pandemic on the Company's financial condition, liquidity, operations, suppliers, industry and ability to obtain financing in future reporting periods. Given the daily evolution of the COVID-19 pandemic and the global responses to curb its spread, the Company is currently not able to estimate the effects of the COVID-19 pandemic on its results of operations, financial condition, or liquidity for the future. However, if the pandemic and the low oil and gas price environment continue, it may have a material adverse effect on the Company’s operating cash flows, liquidity, and future development plans.

The federal government has passed a series of relief and stimulus packages, including the CARES Act, for the country, but Epsilon has not and does not anticipate that it will apply for assistance under such programs. Accordingly, these programs have no effect on Epsilon’s financial statements.

On June 28, 2020, Chesapeake Energy Corporation (“CHK”) filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code (“Petition”). Chesapeake Energy Marketing, Inc. is one of the Anchor Shippers under the Anchor Ship Gas Gathering Agreement (“ASGGA”) for the Auburn GGS with a 43.8750% voting percentage. The Williams Companies Inc. (“Williams”), including its subsidiary Appalachia Midstream Services, L.L.C. (“AMS”), is listed in the petition as a top 30 creditor of CHK, with an amount due by CHK under the ASGGA. On June 28, 2020 unpaid fees attributable to CHK for the ASGGA for May and June 2020 gathering fees were $1.1 million and $1.3 million respectively. As of September 30, 2020, Epsilon has recorded an allowance for doubtful accounts for the Company’s 35% share of these payments for a total bad debt expense of $0.8 million. Epsilon is a 35% owner in the ASGGA. Whether and when these pre-petition amounts are paid depends on how the bankruptcy proceeding unfolds related to the ASGGA. Pre-petition amounts are handled differently than post-petition amounts (amounts for services related to CHK’s production after June 28, 2020).  The general rule post-petition is that, if CHK wants to receive the continued provision of services under the ASGGA, Williams is required to continue to perform under the ASGGA provided that Williams is paid for such performance.  Currently, CHK continues to produce into the gathering system, and drill and complete wells in the areas covered by the ASGGA, as such, no further provision for amounts post-petition was required. In addition, one well that we have interest in began production in October 2020, and another is scheduled to begin in November.

Accordingly, the Company is unable to predict the impact that the COVID-19 pandemic and the CHK bankruptcy will have on it, including our financial position, operating results, liquidity and ability to obtain financing in future reporting periods, due to numerous uncertainties.

10


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

2. Basis of Preparation

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the appropriate rules and regulations of the SEC. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. All adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented have been included. The interim financial information and notes hereto should be read in conjunction with the Company’s consolidated financial statements as of and for the years ended December 31, 2019 and 2018. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.

Principles of Consolidation

The Company’s unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Epsilon Energy USA, Inc. and its wholly owned subsidiaries, Epsilon Midstream, LLC, Dewey Energy GP, LLC, Dewey Energy Holdings, LLC, Epsilon Operating, LLC, and Altolisa Holdings, LLC. With regard to the gathering system, in which Epsilon owns an undivided interest in the asset, proportionate consolidation accounting is used. All inter-company transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates pertain to proved natural gas and oil reserves and related cash flow estimates used in impairment tests of natural gas and oil, and gathering system properties, asset retirement obligations, accrued natural gas and oil revenues and operating expenses, accrued gathering system revenues and operating expenses, as well as the valuation of commodity derivative instruments. Actual results could differ from those estimates.

Recently Issued Accounting Standards

The Company, an emerging growth company (“EGC”), has elected to take advantage of the benefits of the extended transition period provided for in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised accounting standards which allows the Company to defer adoption of certain accounting standards until those standards would otherwise apply to private companies.

In March 2020, the FASB issued ASU No. 2020-04 - Reference Rate Reform (Topic 848), codified as ASC 848 (“ASC 848”). The purpose of ASC 848 is to provide optional guidance to ease the potential effects on financial reporting of the market-wide migration away from Interbank Offered Rates (“IBORs”) to alternative reference rates. ASC 848 applies only to contracts, hedging relationships, and other transactions that reference a reference rate expected to be discontinued because of reference rate reform. The guidance may be applied upon issuance of ASC 848 through December 31, 2022. The Company is currently assessing the impact of adopting this new guidance.

In December 2019, the Financial Accounting Standards Board (“FASB”) issued ASU 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes,” which simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740, Income Taxes. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted. The Company is currently assessing the impact of adopting this new guidance.

11


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all recognition thresholds and will require companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument’s contractual life. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and must be applied retrospectively. Early adoption is permitted. Epsilon will adopt ASU 2016-13 as of January 1, 2023.

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (ASU 2016-02), which significantly changes accounting for leases by requiring that lessees recognize a right of use asset and a related lease liability representing the obligation to make lease payments, for all lease transactions with terms greater than one year. Additional disclosures about an entity’s lease transactions will also be required. ASU 2016-02 defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” ASU 2016-02 is effective for the Company for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. In July, the FASB voted to extend the adoption date by one year for private and non-profit companies, and thus emerging growth companies as well. As an emerging growth company, Epsilon plans to defer adoption of ASU 2016-02 until the fiscal year beginning after December 15, 2021. Lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented in the financial statements using a modified retrospective approach. Epsilon is reviewing the provisions of ASU 2016-02 and anticipates the addition of an insignificant asset and related liability associated with our office lease beginning in January 2022.

3. Cash, Cash Equivalents, and Restricted Cash

Cash and cash equivalents include cash on hand and short term, highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Restricted cash consists of amounts deposited to back bonds or letters of credit for potential well liabilities. The Company presents restricted cash with cash and cash equivalents in the Consolidated Statements of Cash Flows. The following table provides a reconciliation of cash, cash equivalents and restricted cash reported in the Consolidated Balance Sheets to the total of the amounts in the Consolidated Statements of Cash Flows as of September 30, 2020 and 2019:

    

September 30, 

    

September 30, 

2020

2019

Cash and cash equivalents

$

11,580,278

$

18,746,426

Restricted cash included in other assets

565,049

559,053

Cash, cash equivalents and restricted cash in the statement of cash flows

$

12,145,327

$

19,305,479

12


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

4.  Property and Equipment

The following table summarizes the Company’s property and equipment as at September 30, 2020 and December 31, 2019:

    

September 30, 

    

December 31, 

2020

2019

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

$

133,138,412

$

130,819,256

Unproved properties

21,448,546

21,047,512

Accumulated depletion, depreciation, amortization and impairment

(96,864,983)

(89,255,035)

Total oil and gas properties, net

57,721,975

62,611,733

Gathering system

41,912,242

41,445,225

Accumulated depletion, depreciation, amortization and impairment

(31,697,749)

(29,961,690)

Total gathering system, net

10,214,493

11,483,535

Land

637,464

375,314

Buildings and other property and equipment, net

343,677

211,879

Total property and equipment, net

$

68,917,609

$

74,682,461

Property Additions and Acquisitions

No acquisitions were made during the nine months ended September 30, 2020. During the year ended December 31, 2019, the Company acquired additional acres in the Anadarko Basin for $596,500.

Property Sale

In June 2019, the Company completed the first part of a sale of undeveloped, stranded leases in Pennsylvania. At that time, the Company received $1.0 million. The sale was completed in July 2019 with a final payment of $0.4 million for a total of $1.4 million received for the stranded leases. No subsequent sales have occurred.

Property Impairment

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, tests require that the Company first compare expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the natural gas properties to their estimated fair values is required. This is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions.

During the three months ended March 31, 2020, Epsilon recognized certain indicators of impairments specific to our Oklahoma assets related to historically low oil and NGL prices and determined that the carrying value of those assets was not recoverable. As a result of this assessment, a $1.76 million impairment was assessed on the Company’s Oklahoma assets at March 31, 2020. No further impairment was required at September 30, 2020 and no impairment was required as of December 31, 2019.

5. Revolving Line of Credit

Effective July 30, 2013, Epsilon Energy USA Inc., a wholly owned subsidiary of the Company, executed a three-year senior secured revolving credit facility with a bank (‘‘Credit Facility’’) for a total commitment of up to $100 million.

13


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Upon each advance, interest is charged at the rate of LIBOR plus an ‘‘applicable margin’’. The applicable margin ranges from 2.75 - 3.75% and is based on the percent of the line of credit utilized.

The terms “Borrowing Base” and “Mortgaged Properties” include the Company’s gathering system assets in addition to the natural gas and oil properties. The “Required Reserve Value” is the lesser of 90% of the recognized value of all proved natural gas and oil properties or 150% of the then current borrowing base.

On January 7, 2019, the maturity date of the Credit Facility was extended to March 1, 2022 and the borrowing base was increased from $13.5 million to $23 million. The borrowing base is subject to twice per annum redetermination by the lenders based on, among other things, their evaluation of the Company’s natural gas reserves. Additionally, the Company is required to maintain acceptable commodity hedging agreements covering at least 25% of projected production of natural gas for the succeeding calendar year, along with 50% for the current calendar year.

On August 14, 2019 the commodity hedging requirements were updated. Currently, when the Company’s utilization exceeds 25%, the Company must have in place acceptable commodity hedging agreements covering at least 75% of projected production for the first full twelve months after such occurrence and 50% of projected production of natural gas for the succeeding nine months.

On February 11, 2020 the borrowing base was reaffirmed at $23 million and hedging requirements remained unchanged.

The lender under the Credit Facility has a first priority security interest in the tangible and intangible assets, including the gathering system, of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

Leverage ratio less than 3.5 based on income adjusted for interest, taxes and non-cash amounts.

The Company was in compliance with the financial covenants of the Credit Facility as of September 30, 2020 and December 31, 2019 and expects to be in compliance with the financial covenants for the next 12 months.

A commitment fee of 0.50% is assessed quarterly on the daily average unused borrowing base on the Credit Facility.

    

Balance at

    

Balance at

    

    

September 30, 

    

December 31, 

Current

Interest Rate

    

2020

2019

    

Borrowing Base

    

3 mo.

Revolving line of credit

$

$

$

23,000,000

LIBOR + 2.75% (1)


(1)At September 30, 2020, the weighted average interest rate was 2.98%.

14


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

6. Shareholders’ Equity

(a)Authorized shares

The Company is authorized to issue an unlimited number of Common Shares with no par value and an unlimited number of Preferred Shares with no par value.

(b)Purchases of Equity Shares

Normal Course Issuer Bid

Prior to moving the Company listing from the TSX to the NASDAQ, and prior to the purchase of the equity shares on the NASDAQ shown below, the Company purchased shares through a normal-course issuer bid (“NCIB”) program with the TSX, which expired February 28, 2019. On the TSX the Company repurchased and retired 57,100 shares of common stock through the year ended December 31, 2019. The repurchased stock had an average price of $4.26 per share. The average share price (converted to US$ using a rate of Cdn$1.33 to US$1) on the TSX from January 1, 2019 through the last day of trading on the TSX, March 15, 2019, was $4.22.

Commencing on May 20, 2019, the Company entered into a share repurchase program on the NASDAQ conducted in accordance with Rule 10b-18 promulgated under the Securities Exchange Act of 1934. The Company was authorized to repurchase up to 1,367,762 of its outstanding common shares, representing 5% of the outstanding common shares of Epsilon as of May 20, 2019, for an aggregate purchase price of not more than $5.0 million. The program ended on May 19, 2020, but Epsilon’s final repurchase under this program occurred on May 8, 2020.

Repurchases were made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares was, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company funded the purchases out of available cash and did not incur debt to fund the share repurchase program.

Substantial Issuer Bid/Issuer Tender Offer

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 Common Shares plus 2% of its issued and outstanding Common Shares, or an aggregate total of up to 2,522,673 Common Shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand. As of November 10, 2020, the Company has 23,859,136 shares issued and outstanding.

15


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table contains activity relating to our acquisition of equity securities during the nine months ended September 30, 2020:

    

Total number

Maximum number

of shares

of shares that

purchased as

may yet be

Total number

Average price

part of publicly

purchased under

of shares

paid per

announced plans

the plans or

    

purchased

share

    

or programs (4)

    

programs (5)

Beginning of normal-course issuer bid, May 20, 2019

1,367,762

Shares purchased through December 31, 2019 (1) (2)

696,096

$

3.72

January 2020 (2)

102,051

$

2.95

February 2020 (2)

261,519

$

3.11

March 2020 (2)

124,459

$

2.98

April 2020 (2)

156,585

$

2.48

May 2020 (2)

12,700

$

2.91

July 2020 (3)

2,337,034

$

3.06

2,337,034

Total as of September 30, 2020

3,690,444

$

3.16

2,337,034


(1)Shares purchased through December 31, 2019 were cancelled prior to the year ended December 31, 2019.

(2)Epsilon repurchased these shares under its share repurchase program that commenced on May 20, 2019, as described above.

(3)Epsilon repurchased these shares under its substantial issuer bid/issuer tender offer dated May 19, 2020, as described above.

(4)The Company announced its intention to commence a substantial issuer bid/issuer tender offer on May 14, 2020, and the substantial issuer bid/issuer tender offer commenced May 19, 2020, as described above.

(5)The normal-course issuer bid expired on May 19, 2020, and the substantial issuer bid/issuer tender offer expired on June 30, 2020.

(c)Equity Incentive Plan

Epsilon’s board of directors (the “Board”) adopted the 2020 Equity Incentive Plan (the “2020 Plan”) on July 22, subject to approval by Epsilon’s shareholders at Epsilon’s 2020 Annual General and Special Meeting of shareholders, which occurred on September 1, 2020 (the “Meeting”).  Shareholders approved the 2020 Plan at the Meeting. Following Epsilon’s listing on the NASDAQ Global Market, the Board determined that it is in the best interest of the shareholders to approve a new incentive plan that is compliant with U.S. public company equity plan rules and practices that would replace Epsilon’s Amended and Restated 2017 Stock Option Plan (including its predecessors) and the Share Compensation Plan (collectively referred to as the “Predecessor Plans”). No further awards will be granted under the Predecessor Plans.

The 2020 Plan provides for incentive compensation in the form of stock options, stock appreciation rights, restricted stock and stock units, performance shares and units, other stock-based awards and cash-based awards. Under the 2020 Plan, Epsilon will be authorized to issue up to 2,000,000 Common Shares. As of September 30, 2020, the Company granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, and the shareholders approved the 2020 Plan at the Meeting on September 1, 2020, 125,000 awards to Mr. Raleigh, leaving 1,875,000 shares available to be granted under the 2020 Plan. No shares subject to awards currently outstanding under the Predecessor Plans that expire or are forfeited will become available for issuance under the 2020 Plan.

16


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Restricted and Performance Stock Units

For the nine months ended September 30, 2020, 20,833 performance-based, restricted shares were awarded to Michael Raleigh, the Company’s chief executive officer, based on the approval by the Company’s independent compensation committee. Additionally, Mr. Raleigh was granted 104,167 Performance Stock Units (“PSU”) that will potentially vest over the next 3 years, with the potential to add another 125,000 bonus shares. These shares are based on certain terms, target formulas, and relative peer group performance, and Mr. Raleigh’s continued employment. Compensation related to these PSUs was immaterial for the three months ended September 30, 2020, and therefore was not recognized..

For the year ended December 31, 2019, 184,500 common shares of Restricted Stock were awarded to the Company’s officers, employees, and board of directors. These shares vest over a three-year period, with one-third of the shares being issued per period on the anniversary of the award resolution. The vesting of the shares is contingent on the individuals’ continued employment or service. The Company determined the fair value of the granted Restricted Stock based on the market price of the common shares of the Company on the date of grant.

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three and nine months ended September 30, 2020 was $239,134 and $583,238, respectively (for the three and nine months ended September 30, 2019, $127,419 and $382,258, respectively).

At September 30, 2020, the Company had unrecognized stock based compensation related to these shares of $793,439 to be recognized over a weighted average period of 1.02 years (at December 31, 2019: $1,309,594 over 1.34 years).

The following table summarizes Restricted Stock activity for the nine months ended September 30, 2020, and the year ended December 31, 2019:

Nine months ended

Year ended

September 30, 2020

December 31, 2019

Weighted

Weighted

Number of

Average

Number of

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested Restricted Stock at beginning of period

346,499

1.67

282,833

2.56

Granted

20,833

184,500

3.00

Vested

(20,833)

(106,834)

Forfeited

(14,000)

2.64

Balance non-vested Restricted Stock at end of period

346,499

0.92

346,499

1.67

Stock Options

Through September 30, 2020, the Company had outstanding stock options covering 245,000 Common Shares at an overall average exercise price of $5.27 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 245,000 options have a weighted average expected remaining term of approximately 2.5 years.

17


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes stock option activity for the nine months ended September 30, 2020 and the year ended December 31, 2019:

Nine months ended

Year ended

September 30, 2020

December 31, 2019

Weighted

Weighted

Number of

Average

Number of

Average

Options

Exercise

Options

Exercise

Exercise price in US$

    

Outstanding

    

Price (1)

    

Outstanding

    

Price (1)

Balance at beginning of period

245,000

$

5.27

290,750

$

5.02

Exercised

(25,000)

2.17

Expired/Forfeited

(20,750)

5.37

Balance at period-end

245,000

$

5.27

245,000

$

5.27

Exercisable at period-end

245,000

$

5.27

206,670

$

5.32


(1)Exercise price has been converted to US$ using the rate of Cdn$1.33 to US$1, the rate on March 15, 2019, the date Epsilon Energy, Ltd was delisted from the TSX.

At September 30, 2020, using the Black Scholes model, the Company had unrecognized stock based compensation, related to these options, of nil (at December 31, 2019: $1,867 over 0.08 years). The aggregate intrinsic value at September 30, 2020 was nil (at December 31, 2019: nil). For the three and nine months ended September 30, 2020, nil and $1,867, respectively, of stock compensation expense, related to these options, was recognized (for the three and nine months ended September 30, 2019, $6,301 and $18,903, respectively).

During the nine months ended September 30, 2020 and the year ended December 31, 2019, the Company awarded no stock options.

7. Revenue Recognition

Revenues are comprised primarily of sales of natural gas along with the revenue generated from the Company’s ownership interest in the gas gathering system in the Auburn field in Northeastern Pennsylvania. Also included to a much lesser degree is natural gas, crude oil and NGLs from Oklahoma.

Overall, product sales revenue generally is recorded in the month when contractual delivery obligations are satisfied, which occurs when control is transferred to the Company’s customers at delivery based on contractual terms and conditions. In addition, gathering and compression revenue generally is recorded in the month when contractual service obligations are satisfied, which occurs as control of those services is transferred to the Company’s customers.

The following table details revenue for the three and nine months ended September 30, 2020 and 2019.

    

Three months ended September 30, 

Nine Months Ended September 30, 

2020

    

2019

    

2020

    

2019

Operating revenue

Natural gas

$

3,573,908

$

2,933,695

$

11,470,012

$

12,698,643

Natural gas liquids

14,843

23,905

56,705

88,256

Oil and condensate

1,955

41,981

190,180

218,823

Gathering and compression fees

2,219,905

2,219,613

6,800,347

6,923,058

Total operating revenue

$

5,810,611

$

5,219,194

$

18,517,244

$

19,928,780

18


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Product Sales Revenue

The Company enters into contracts with third party purchasers to sell its natural gas, oil, NGLs and condensate production. Under these product sales arrangements, the sale of each unit of product represents a distinct performance obligation. Product sales revenue is recognized at the point in time that control of the product transfers to the purchaser based on contractual terms which reflect prevailing commodity market prices. To the extent that marketing costs are incurred by the Company prior to the transfer of control of the product, those costs are included in lease operating expenses on the Company’s consolidated statements of operations.

Settlement statements for product sales, and the related cash consideration, are received from the purchaser within 30 days. As a result, the Company must estimate the amount of production delivered to the customer and the consideration that will ultimately be received for sale of the natural gas, oil, NGLs, or condensate. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Gas Gathering and Compression Revenue

The Company also provides natural gas gathering and compression services through its ownership interest in the gas gathering system in the Auburn field. For the provision of gas gathering and compression services, the Company collects its share of the gathering and compression fees per unit of gas serviced and recognizes gathering revenue over time using an output method based on units of gas gathered.

The settlement statement from the operator of the Auburn Gas Gathering System is received two months after transmission and compression has occurred. As a result, the Company must estimate the amount of production that was transmitted and compressed within the system. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Allowance for Doubtful Accounts

The Company records an allowance for doubtful accounts on a case by case basis once there is evidence that collection is not probable. Due to the bankruptcy filed by Chesapeake Energy Corporation (“CHK”) on June 28, 2020, the Company recorded an allowance for possible uncollectable fees. Unpaid fees attributable to CHK for May and June 2020 gathering system services were $1.1 million and $1.3 million respectively. As of September 30, 2020, Epsilon has recorded an allowance for doubtful accounts for the Company’s 35% share of these payments for a total bad debt expense of $0.8 million. Additional amounts of bad debt expense are not needed as CHK is currently paying all post-petition amounts.

The following table details accounts receivable net of allowance for doubtful accounts as at September 30, 2020 and December 31, 2019.

    

September 30, 

    

December 31, 

2020

2019

Accounts receivable

Natural gas and oil sales

$

1,792,828

$

2,293,044

Joint interest billing

61,556

59,127

Gathering and compression fees

2,612,753

1,940,308

Other

3,899

4,438

Total accounts receivable

4,471,036

4,296,917

Less: allowance for doubtful accounts

(819,000)

Total accounts receivable, net of allowance for doubtful accounts

$

3,652,036

$

4,296,917

19


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

8. Accumulated Other Comprehensive Income

Accumulated other comprehensive income (loss) includes certain transactions that have generally been reported in the condensed consolidated statements of changes in shareholders’ equity, including translation gains (losses) related to the convertible debentures that will remain frozen in accumulated other comprehensive income until such time Epsilon Energy Ltd. is liquidated. Activity within Accumulated other comprehensive income for the three and nine months ended September 30, 2020 and 2019 consisted of the following:

    

Three months ended September 30, 

Nine Months Ended September 30, 

2020

    

2019

    

2020

    

2019

Balance at beginning of period

$

9,816,496

$

9,809,774

$

9,810,478

$

9,797,930

Translation gain other

2,273

(900)

8,291

10,944

Balance at end of period

$

9,818,769

$

9,808,874

$

9,818,769

$

9,808,874

9. Income Taxes

Income tax provisions for the three and nine months ended September 30, 2020 and 2019 are as follows:

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Current:

Federal

$

159,626

$

1,622,486

$

272,016

$

1,622,486

State

4,829

460,765

42,469

507,953

Total current income tax expense

164,455

2,083,251

314,485

2,130,439

Deferred:

Federal

(185,265)

(1,256,553)

(251,979)

509,308

State

(12,952)

(283,559)

51,561

343,808

Total deferred tax expense (benefit)

(198,217)

(1,540,112)

(200,418)

853,116

Income tax expense (benefit)

$

(33,762)

$

543,139

$

114,067

$

2,983,555

The Company files federal income tax returns in the United States and Canada, and various returns in state and local jurisdictions.

The Company believes it has appropriate support for the income tax positions taken and to be taken on our tax returns and that the accruals for tax liabilities are adequate for all open years based on our assessment of various factors including past experience and interpretations of tax law applied to the facts of each matter. The Company's tax returns are open to audit under the statute of limitations for the years ending December 31, 2016 through December 31, 2019. To the extent we utilize net operating losses generated in earlier years, such earlier years may also be subject to audit.

Our effective tax rate will typically differ from the statutory federal rate primarily as a result of state income taxes and the valuation allowance against the Canadian net operating loss. The effective tax rate for the nine months ended September 30, 2020 was higher than the statutory federal rate as a result of the state income taxes and the valuation allowance against the Canadian net operating loss.

20


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

10. Commitments and Contingencies

The Company’s future minimum lease commitments as of September 30, 2020 are summarized in the following table:

Year ended

    

December 31, 

    

Payments

2020

25,147

2021

103,073

2022

106,797

2023

36,013

$

271,030

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of September 30, 2020, the Company had commitments of $2.63 million for capital expenditures.

Litigation

The Company is not currently involved in any litigation. Management is of the opinion that the potential for litigation is remote.

11. Net Income (Loss) Per Share

Basic net income (loss) per share is computed on the basis of the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed based upon the weighted-average number of common shares outstanding during the period plus the assumed issuance of common shares for all potentially dilutive securities.

The net income (loss) used in the calculation of basic and diluted net income (loss) per share is as follows:

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Net income (loss) available to shareholders

$

(292,783)

$

1,453,298

$

(548,518)

$

6,664,832

In calculating the net income (loss) per share, basic and diluted, the following weighted-average shares were used:

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Basic weighted-average number of shares outstanding

23,955,619

27,060,387

25,550,194

27,218,162

Dilutive stock options

 

 

 

 

Unvested restricted shares granted

 

 

34,004

 

 

21,955

Diluted weighted average shares outstanding

 

23,955,619

 

27,094,391

 

25,550,194

 

27,240,117

The Company excluded the following shares from the diluted EPS because their inclusion would have been anti-dilutive.

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Anti-dilutive options

245,000

255,000

245,000

255,000

Anti-dilutive unvested restricted shares

346,499

248,829

346,499

260,878

Total Anti-dilutive shares

 

591,499

 

503,829

 

591,499

 

515,878

21


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

12. Operating Segments

Operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as executive management. Segment performance is evaluated based on operating profit or loss as shown in the table below. Interest income and expense, and income taxes are managed separately on a group basis.

22


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The Company’s reportable segments are as follows:

a.The Upstream segment activities include acquisition, development and production of oil, natural gas, and other liquid reserves on properties within the United States;
b.The Gas Gathering segment partners with two other companies to operate a natural gas gathering system; and
c.The Corporate segment activities include corporate listing and governance functions of the Company.

Segment activity as of, and for the nine months ended September 30, 2020 and 2019 is as follows:

    

Upstream

    

Gas Gathering

    

Corporate

    

Elimination

    

Consolidated

As of and for the nine months ended September 30, 2020

Operating revenue

Natural gas

$

11,470,012

$

$

$

$

11,470,012

Natural gas liquids

56,705

56,705

Oil and condensate

190,180

190,180

Gathering and compression fees

8,210,255

(1,409,908)

6,800,347

Total operating revenue

$

11,716,897

(1)

$

8,210,255

$

$

(1,409,908)

$

18,517,244

Net earnings (loss) for the period

$

(2,301,433)

$

4,019,870

$

(2,266,955)

(3)

$

$

(548,518)

Operating costs

6,229,682

1,631,099

(1,409,908)

6,450,873

Development geological and geophysical expenses

7,595

7,595

Depletion, deprec., amortization and accretion

6,021,053

1,740,286

7,761,339

Impairment

1,760,000

1,760,000

Bad debt expense

819,000

819,000

Segment assets

$

70,549,241

$

16,698,193

$

92,019

$

$

87,339,453

Capital expenditures(2)

3,128,378

467,017

3,595,395

Proved properties

36,273,429

36,273,429

Unproved properties

21,448,546

21,448,546

Gathering system

10,214,493

10,214,493

Other property and equipment

981,141

981,141

As of and for the nine months ended September 30, 2019

Operating revenue

Natural gas

$

12,698,643

$

$

$

$

12,698,643

Natural gas liquids

88,256

88,256

Oil and condensate

218,823

218,823

Gathering and compression fees

7,779,107

(856,049)

6,923,058

Total operating revenue

$

13,005,722

(1)

$

7,779,107

$

$

(856,049)

$

19,928,780

Net earnings for the period

$

5,259,959

$

4,465,906

$

(3,061,033)

(3)

$

$

6,664,832

Operating costs

4,851,090

1,868,758

(856,049)

5,863,799

Development geological and geophysical expenses

83,748

83,748

Depletion, deprec., amortization and accretion

4,185,925

1,444,443

5,630,368

Gain on sale of property

(1,375,000)

(1,375,000)

Segment assets

$

78,581,513

$

16,340,875

$

87,991

$

$

95,010,379

Capital expenditures(2)

8,098,511

237,681

8,336,192

Proved properties

37,535,119

37,535,119

Unproved properties

21,015,039

21,015,039

Gathering system

11,696,643

11,696,643


(1)Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the nine months ended September 30, 2020 and 2019 have been eliminated upon consolidation. For the nine months ended September 30, 2020, Epsilon sold natural gas to 23 unique customers. The four customers over 10% comprised 27%, 22%, 16% and 13% of total revenue. For the nine months ended September 30, 2019, Epsilon sold natural gas to 26 unique customers. The three customers over 10% comprised 36%, 35% and 11% of total revenue.

23


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

(2)Capital expenditures for Upstream segment consist primarily of the acquisition of properties, and the drilling and completing of wells while Gas Gathering consists of expenditures relating to the expansion and completion of the gathering and compression facility.
(3)Segment reporting for net earnings for the period does not include non-monetary compensation, general and administrative expense, interest income, interest expense, both gains and (losses) on derivative contracts, or income tax amounts as they are managed on a group basis and are instead included in the corporate column for reconciliation purposes.

Segment activity for the three months ended September 30, 2020 and 2019 is as follows:

    

Upstream

    

Gas Gathering

    

Corporate

    

Elimination

    

Consolidated

For the three months ended September 30, 2020

Operating revenue

Natural gas

$

3,573,908

$

$

$

$

3,573,908

Natural gas liquids

14,843

14,843

Oil and condensate

1,955

1,955

Gathering and compression fees

2,740,186

(520,281)

2,219,905

Total operating revenue

$

3,590,706

(1)

$

2,740,186

$

$

(520,281)

5,810,611

Net earnings for the period

$

(694,490)

$

1,541,709

$

(1,140,002)

(3)

$

(292,783)

Operating costs

2,147,795

563,992

(520,281)

2,191,506

Development geological and geophysical expenses

2,693

2,693

Depletion, deprec., amortization and accretion

2,134,708

634,485

2,769,193

Bad debt expense

Capital expenditures(2)

673,716

325,071

998,787

For the three months ended September 30, 2019

Operating revenue

Natural gas

$

2,933,695

$

$

$

$

2,933,695

Natural gas liquids

23,905

23,905

Oil and condensate

41,981

41,981

Gathering and compression fees

2,498,232

(278,619)

2,219,613

Total operating revenue

$

2,999,581

(1)

$

2,498,232

$

$

(278,619)

5,219,194

Net earnings for the period

$

516,408

$

1,286,555

$

(349,665)

(3)

$

$

1,453,298

Operating costs

1,548,902

739,655

(278,619)

2,009,938

Development geological and geophysical expenses

Depletion, deprec., amortization and accretion

1,379,444

472,022

1,851,466

Gain on sale of property

(445,173)

(445,173)

Capital expenditures(2)

4,821,766

(7,944)

4,813,822


(1)Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the three months ended September 30, 2020 and 2019 have been eliminated upon consolidation. For the three months ended September 30, 2020, Epsilon sold natural gas to 20 unique customers. The three customers over 10% comprised 25%, 22% and 21% of total revenue. For the three months ended September 30, 2019, Epsilon sold natural gas to 21 unique customers. The two customers over 10% comprised 60% and 11% of total revenue.
(2)Capital expenditures for Upstream segment consist primarily of the acquisition of properties, and the drilling and completing of wells while Gas Gathering consists of expenditures relating to the expansion and completion of the gathering and compression facility.
(3)Segment reporting for net earnings for the period does not include non-monetary compensation, general and administrative expense, interest income, interest expense, both gains and (losses) on derivative contracts, or income tax amounts as they are managed on a group basis and are instead included in the corporate column for reconciliation purposes.

24


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

13. Commodity Risk Management Activities

Commodity Price Risks

Epsilon engages in price risk management activities from time to time. These activities are intended to manage Epsilon’s exposure to fluctuations in commodity prices for natural gas by securing fixed price contracts for a portion of expected sales volumes.

Inherent in the Company’s fixed price contracts, are certain business risks, including market risk and credit risk. Market risk is the risk that the price of natural gas and oil will change, either favorably or unfavorably, in response to changing market conditions. Credit risk is the risk of loss from nonperformance by the Company’s counterparty to a contract. The Company does not currently require collateral from any of its counterparties nor does its counterparties require collateral from the Company.

The Company enters into certain commodity derivative instruments to mitigate commodity price risk associated with a portion of its future natural gas production and related cash flows. The natural gas revenues and cash flows are affected by changes in commodity product prices, which are volatile and cannot be accurately predicted. The objective for holding these commodity derivatives is to protect the operating revenues and cash flows related to a portion of the future natural gas sales from the risk of significant declines in commodity prices, which helps ensure the Company’s ability to fund the capital budget.

In January 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (“COVID-19”) and the significant risks to the international community and economies as the virus spreads globally beyond its point of origin.  In March 2020, the WHO classified COVID-19 as a pandemic, based on the rapid increase in exposure globally, and throughout the second quarter of 2020 and thereafter, COVID-19 continued to spread throughout the U.S. In addition, after the Organization of the Petroleum Exporting Countries (“OPEC”) and a group of oil producing nations led by Russia failed in March 2020 to agree on oil production cuts, Saudi Arabia announced that it would cut oil prices and increase production, leading to a sharp further decline in oil and natural gas prices. While OPEC, Russia and other oil producing countries reached an agreement in April 2020 to reduce production levels, U.S. production has declined, and a significant crude oil price recovery is not expected until global supply matches current lower levels of demand caused by a number of factors, including the uncertainty around the extent and timing of an economic recovery due to the COVID-19 pandemic. The effects of COVID-19 and concerns regarding its domestic and global spread, as well as the recent actions by Russia and Saudi Arabia, could continue to negatively impact the domestic and international supply and demand for oil and natural gas, to sustain continued price volatility and impact the price paid for oil and natural gas and to materially and adversely affect the demand for and marketability of oil and natural gas production.

Epsilon has historically elected not to designate any of its financial commodity derivative contracts as accounting hedges and, accordingly, accounts for these financial commodity derivative contracts using the mark-to-market accounting method. Under this accounting method, changes in the fair value of outstanding financial instruments are recognized as gains or losses in the period of change and are recorded as gain (loss) on derivative contracts on the condensed consolidated statements of operations and comprehensive income. The related cash flow impact is reflected in cash flows from operating activities. During the three and nine months ended September 30, 2020, Epsilon recognized gains on commodity derivative contracts of $419,879 and $2,055,548, respectively. This amount included cash received on settlements of these contracts of $1,657,323 during the three months ended September 30, 2020 and $4,035,092 during the nine months ended September 30, 2020. For the three and nine months ended September 30, 2019, Epsilon recognized gains on commodity derivative contracts of $1,270,494 and $3,494,727 respectively. This amount included cash received on settlements of these contracts of $1,157,271 during the three months ended September 30, 2019 and $1,344,690 during the nine months ended September 30, 2019.

25


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Commodity Derivative Contracts

Presented below is a summary of Epsilon’s natural gas price and basis swap contracts as of September 30, 2020.

Weighted Average Price ($/MMbtu)

Fair Value

Volume

Basis

September 30, 

Derivative Type

    

(MMbtu)

    

 Swaps 

    

Differential

    

2020

2020

Fixed price swap

 

762,500

$

2.73

$

 

(73,029)

Basis swap

 

762,500

$

$

(0.44)

 

93,287

 

$

20,258

As of September 30, 2020 and 2019, all of the Company’s economic derivative hedge positions were with large financial institutions, which are not known to the Company to be in default on their derivative positions. The Company is exposed to credit risk to the extent of non-performance by the counterparties in the derivative contracts discussed above; however, the Company does not anticipate non-performance by such counterparties. None of the Company’s derivative instruments contains credit-risk related contingent features. Derivatives are net on the balance sheet as they are subject to the right to offset the liabilities with the assets.

The following tables summarize the gross fair values of our derivative instruments, presenting the impact of offsetting the derivative assets and liabilities on our condensed consolidated balance sheets as of the dates indicated below:

Fair Value of Derivative 
Assets

    

September 30, 

    

December 31, 

2020

2019

Current

 

  

 

  

Basis swap

 

$

97,899

$

162,844

Fixed price swap

 

 

76,522

 

2,001,496

 

$

174,421

$

2,164,340

Fair Value of Derivative
 Liabilities

    

September 30, 

    

December 31, 

2020

2019

Current

 

  

 

  

Basis swap

 

$

(4,611)

$

(164,538)

Fixed price swap

 

(149,552)

 

 

$

(154,163)

$

(164,538)

Net Fair Value of Derivatives

 

$

20,258

$

1,999,802

The following table presents the changes in the fair value of Epsilon’s commodity derivatives for the periods indicated:

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Fair value of asset (liability), beginning of the period

$

1,257,702

$

1,739,791

$

1,999,802

$

(297,023)

Gains (losses) on derivative contracts included in earnings

 

419,879

 

1,270,494

 

2,055,548

 

3,494,727

Settlement of commodity derivative contracts

 

(1,657,323)

 

(1,157,271)

 

(4,035,092)

 

(1,344,690)

Fair value of asset, end of the period

$

20,258

$

1,853,014

$

20,258

$

1,853,014

26


Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

14. Asset Retirement Obligations

Asset retirement obligations were estimated by management based on Epsilon’s net ownership interest in all wells and the gathering system, estimated costs to reclaim and abandon such assets and the estimated timing of the costs to be incurred in future periods.

The following tables summarize the changes in asset retirement obligations for the periods indicated:

Nine Months Ended

Year ended

September 30, 

December 31, 

2020

    

2019

Balance beginning of period

$

2,909,855

$

1,625,154

Liabilities from drilling of new wells

5,306

16,163

Change in estimates

2,181

1,153,740

Accretion

153,605

114,798

Balance end of period

$

3,070,947

$

2,909,855

15. Fair Value Measurements

The methodologies used to determine the fair value of our financial assets and liabilities at September 30, 2020 were the same as those used at December 31, 2019.

Cash, cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. The Company’s revolving line of credit has a recorded value that approximates its fair value since its variable interest rate is tied to current market rates and the applicable margins represent market rates.

Commodity derivative instruments consist of fixed-price swaps and basis swap contracts for natural gas. The Company’s derivative contracts are valued based on an income approach. The model considers various assumptions, such as quoted forward prices for commodities, time value and volatility factors. These assumptions are observable in the marketplace throughout the full term of the contract, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace, and are therefore designated as Level 2 within the valuation hierarchy. The Company utilizes its counterparties’ valuations to assess the reasonableness of its own valuations.

27


ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in the understanding of trends and significant changes in or results of operations and the financial condition of Epsilon Energy Ltd. and its subsidiaries for the periods presented. The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto presented in this report, including the unaudited condensed consolidated financial statements as of September 30, 2020 and 2019 and for the nine months then ended together with accompanying notes, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2019. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forward- looking statements due to a number of factors. See “Part II. Item 1A. Risk Factors” and “Forward-Looking Statements.”

Overview

Epsilon Energy Ltd. (the “Company”) is a North American onshore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves. Our primary area of operation is Pennsylvania. Our assets are concentrated in areas with known hydrocarbon resources, which are conducive to multi well, repeatable drilling programs.

Substantially all of the production from our Pennsylvania acreage (4,130 net) is dedicated to the Auburn Gas Gathering System, or the Auburn GGS, located in Susquehanna County, Pennsylvania for a 15 year term expiring in 2026 under an operating agreement whereby the Auburn GGS owners receive a fixed percentage rate of return on the total capital invested in the construction of the system. Epsilon owns a 35% interest in the system which is operated by a subsidiary of Williams Partners, LP. In the three and nine months ended September 30, 2020, Epsilon paid $0.52 million and $1.41 million, respectively to the Auburn GGS to gather and treat our 3.0 Bcf and 8.4 Bcf of natural gas production in Pennsylvania ($0.28 million and $0.86 million to the Auburn GGS to gather and treat our 1.8 Bcf and 5.4 Bcf of natural gas in the three and nine months ended September 30, 2019, respectively).

Epsilon realized a net loss of $0.3 million and $0.6 million for the three and nine months ended September 30, 2020, respectively, as compared to net income of $1.5 million and $6.7 million for the three and nine months ended September 30, 2019, respectively.

Our common shares trade on the NASDAQ Global Market under the ticker symbol “EPSN.”

Business Strategy

Our business strategy is to manage the cash flow generated from our producing leasehold and midstream assets in a manner where the risked capital allocation provides attractive rates of return. Our remaining inventory of drillable locations within existing leasehold is sufficient to maintain this cash flow for several years at capital expenditure levels well within the yearly free cash flow generated from these assets. In addition, the Company seeks to identify attractive onshore natural gas and oil properties in the United States, to acquire a leasehold interest and to develop the leasehold interest with the goal of deploying capital at attractive rates.

The core Marcellus Shale is one of the most attractive dry gas resources in the lower United States and has attracted significant development capital. Well productivity has improved dramatically for many years resulting in increasing initial production rates and gas recoveries. The resulting supply of natural gas has at times stressed the transportation infrastructure of the Northeast U.S. and exacerbated the local price discount to Henry Hub. In many other basins throughout the U.S., the increase in natural gas production has outpaced demand. This market condition has resulted in historically weaker natural gas prices for the benchmark index Henry Hub.

In the Marcellus, the Company continues to critically evaluate the value of our core assets. As part of this process we analyze existing well spacing and completion productivity data for both the Lower and Upper Marcellus. In addition, we contract third party experts in the technical modelling aspects of integrating rock mechanics, fluid pumping and proppant placement variables associated with best completion practices. Epsilon continually meets with our well operators

28


to seek increased operating efficiencies. In addition, Epsilon works closely with our gathering system partners in order to enhance operational safety and to preserve and grow the long-term value of our gathering system assets.

The major producers in the Appalachian region are under tremendous pressure from capital markets to demonstrate capital discipline and control costs. Several major producers have announced reduced capital programs to balance the supply-demand for the commodity. Accordingly, the Company expects local production to remain flat or decline modestly throughout the remainder of 2020. The Company cannot, however, predict the duration of the current global market conditions that resulted in a drastic global economic downturn and its impact on oil and gas demand and commodity prices. Our target is to maintain our current production level or grow modestly, but only if natural gas prices improve and the capital deployed can achieve our internal rate of return.

In the longer term, Epsilon believes natural gas prices will become more constructive due to a moderating of supply and incremental demand from LNG exports, exports to Mexico and further coal to gas switching for domestic electrical power generation. Specifically, LNG export capacity is expected to grow more than 70% from the current ~ 10.0 Bcf/d to 17 Bcf/d by 2024 based only on facilities currently commissioning or under construction.

In the Northwest STACK, the Company chooses to not deploy capital due to depressed natural gas liquids and natural gas pricing. However, the leases are held by production which provides a long-term right to develop additional sales when commodity prices appear attractive. In the interim, the Company intends to closely monitor development activities from offset operators in our area in an effort to further appraise our leasehold interest without risking capital.

Recent Developments

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 Common Shares plus 2% of its issued and outstanding Common Shares, or an aggregate total of up to 2,522,673 Common Shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand. After giving effect to the cancellation of the common shares purchased under the tender offer, 23,796,637 common shares were issued and outstanding.  As of November 9, 2020, the Company has 23,859,136 shares issued and outstanding.

On March 11, 2020, the World Health Organization characterized the global outbreak of the novel strain of coronavirus, COVID-19, as a “pandemic.” To limit the spread of COVID-19, governments have taken various actions including the issuance of stay-at-home orders and social distancing guidelines, causing some businesses to suspend operations and a reduction in demand for many products from direct or ultimate customers. Such actions have resulted in a swift and unprecedented reduction in international and U.S. economic activity which, in turn, has adversely affected the demand and prices for oil and natural gas and caused significant volatility and disruption of the financial markets.

Epsilon is closely monitoring the current and potential impacts of COVID-19 on all aspects of our business and geographies, including how it has impacted, and may in the future impact our operations, financial results, liquidity, contractors, customers, employees and vendors. The Company continues to monitor a number of factors that may cause actual results of operations to differ from our historical results or current expectations. These factors include but are not limited to: the impact of the COVID-19 pandemic and the related economic downturn, the historically low natural gas liquids prices, and  ramifications of the crude oil price war between the Organization of Petroleum Exporting Countries ("OPEC") /Saudi Arabia and Russia that occurred in March. While OPEC agreed in April to cut production, production of oil in the United States has declined, and oil prices remain low and may remain so for the foreseeable future, particularly given concerns over available storage capacity for refined products such as crude, and refinery inputs including condensate and NGL’s. These and other factors, such as those described in this paragraph, could negatively affect the Company’s oil and gas properties, operations, earnings and cash flows for some time and could cause our financial condition and results

29


from operations to not be comparable to those of the same period in previous years. Commodity prices are expected to continue to be volatile as a result of the changes in oil and natural gas production, inventories and demand, as well as national and international economic pressure. The Company cannot predict when prices will improve and stabilize. The results presented in this Form 10-Q are not necessarily indicative of future operating results.

Epsilon did not incur significant disruptions to operations during the nine months ended September 30, 2020 as a result of the COVID-19 pandemic. However, during the three months ended March 31, 2020, Epsilon recognized certain indicators of impairment specific to its Oklahoma assets due to historically low oil and NGL prices. Epsilon determined that the carrying value of those assets was not recoverable, based on the current indicators. As a result of this assessment, a $1.76 million impairment was assessed on the Company’s Oklahoma assets at March 31, 2020, but no further impairment was required at September 30, 2020 and no impairment was required as of December 31, 2019.

Additionally, the Company is unable to predict the impact that the COVID-19 pandemic will have on us, including our financial position, operating results, liquidity and ability to obtain financing in future reporting periods, due to numerous uncertainties. These uncertainties include the severity of the virus, the duration of the outbreak, governmental or other actions taken to combat the virus (which could include limitations on our operations or the operations of our customers and vendors), and the effect that the COVID-19 pandemic and the current oil price war have on the demand for natural gas and natural gas liquids. The situation surrounding COVID-19 remains fluid and unpredictable, and Epsilon is actively managing our response and assessing potential impacts to our financial position and operating results, as well as any adverse developments that could impact our business. However, at this point, Epsilon does not anticipate any prolonged negative financial consequences to our financial position. At September 30, 2020, Epsilon has no debt and after accounting for the payment of approximately $7.15 million under the substantial issuer bid, excluding fees and expenses, has approximately $12 million of cash on hand to fund planned operating activities and to potentially weather a prolonged depressed economic environment.

The federal government has passed a series of relief and stimulus packages, including the CARES Act, for the country but Epsilon has not and does not believe it will need to avail itself of them and as such, these programs have no effect on Epsilon’s financial statements at this time.

Epsilon has also taken, and is continuing to take, proactive steps to keep our employees safe and manage any disruption in our business caused by COVID-19. For instance, the Company was an early adopter in employing a work-from-home system, even before any government mandate on non-essential businesses was enacted. Epsilon increased its technology platform, infrastructure and security to allow for a work-from-home environment prior to COVID-19. Epsilon has also deployed additional layered safety protocols at our office in order to keep our operations running without material disruptions.

On June 28, 2020, Chesapeake Energy Corporation (“CHK”) filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code (“Petition”). Chesapeake Energy Marketing, Inc. is one of the Anchor Shippers under the Anchor Ship Gas Gathering Agreement (“ASGGA”) for the Auburn GGS with a 43.8750% voting percentage. The Williams Companies Inc. (“Williams”), including its subsidiary Appalachia Midstream Services, L.L.C. (“AMS”), is listed in the petition as a top 30 creditor of CHK, with an amount due by CHK under the ASGGA. On June 28, 2020 unpaid fees attributable to CHK for the ASGGA for May and June 2020 gathering fees were $1.1 million and $1.3 million respectively. As of September 30, 2020, Epsilon has recorded an allowance for doubtful accounts for the Company’s 35% share of these payments for a total bad debt expense of $0.8 million. Epsilon is a 35% owner in the ASGGA. Whether and when these pre-petition amounts are paid depends on how the bankruptcy proceeding unfolds related to the ASGGA. Pre-petition amounts are handled differently than post-petition amounts (amounts for services related to CHK’s production after June 28, 2020).  The general rule post-petition is that, if CHK wants to receive the continued provision of services under the ASGGA, Williams is required to continue to perform under the ASGGA provided that Williams is paid for such performance.  Currently, CHK continues to produce into the gathering system, and drill and complete wells in the areas covered by the ASGGA, as such, no further provision for amounts post-petition was required. In addition, one well that we have interest in began production in October 2020, and another is scheduled to begin in November.

30


Three and Nine months ended September 30, 2020 Highlights

Operational Highlights

Marcellus Shale – Pennsylvania

During the three months ended September 30, 2020, Epsilon’s realized natural gas price was $1.18 per Mcf, a 28% decrease over the three months ended September 30, 2019. During the nine months ended September 30, 2020, Epsilon’s realized natural gas price was $1.32 per Mcf, a 42% decrease over the nine months ended September 30, 2019.

During the three months ended September 30, 2020, Epsilon’s natural gas production was 3.0 Bcf, as compared to 1.8 Bcf during the same period in 2019. Total nine months ended September 30, 2020 natural gas production was 8.5 Bcf, as compared to 5.4 Bcf during the same period in 2019.

Marcellus working interest (WI) gas averaged 37.4 MMcf/d and 35.4 MMcf/d for the three and nine months ended September 30, 2020, respectively.

Gathered and delivered 15.3 Bcf gross (5.4 Bcf net to Epsilon’s interest) during the three months ended September 30, 2020 through the Auburn GGS which represents approximately 83% of maximum throughput as currently configured. Gathered and delivered 54.2 Bcf gross (19.0 Bcf net to Epsilon’s interest) during the nine months ended September 30, 2020.  Gathering volumes decreased 3% and 17% for the three and nine months ended September 30, 2020, respectively, as compared to the three and nine months ended September 30, 2019. The decrease is almost entirely attributable to the expansion of a compression facility in an adjacent midstream system which reduced the crossflow volumes received by the Auburn GGS.

Anadarko, NW Stack Trend – Oklahoma

During the three months ended September 30, 2020, Epsilon’s realized price for all Oklahoma production was $1.01 per Mcfe, a 54% decrease over the three months ended September 30, 2019. During the nine months ended September 30, 2020, Epsilon’s realized price for all Oklahoma production was $2.17 per Mcfe, a 32% decrease over the nine months ended September 30, 2019.

Total production for the three months ended September 30, 2020 included natural gas, oil, and other liquids and was 0.07 Bcfe, 18.5% increase over the same period in 2019. Total production for the nine months ended September 30, 2020 included natural gas, oil, and associated liquids was 0.24 Bcfe, a 13.3% increase over the same period in 2019.

Non-GAAP Financial Measures-Adjusted EBITDA

Epsilon defines Adjusted EBITDA as earnings before (1) net interest expense, (2) taxes, (3) depreciation, depletion, amortization and accretion expense, (4) impairments of natural gas and oil properties, (5) non-cash stock compensation expense, (6) gain or loss on derivative contracts net of cash received or paid on settlement, and (7) other income. Adjusted EBITDA is not a measure of financial performance as determined under U.S. GAAP and should not be considered in isolation from or as a substitute for net income or cash flow measures prepared in accordance with U.S. GAAP or as a measure of profitability or liquidity.

Additionally, Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. Epsilon has included Adjusted EBITDA as a supplemental disclosure because its management believes that EBITDA provides useful information regarding its ability to service debt and to fund capital expenditures. It further provides investors a helpful measure for comparing operating performance on a normalized or recurring basis with the performance of other companies, without giving effect to certain non-cash expenses and other items. This provides management, investors and analysts with comparative information for evaluating the Company in relation to other natural gas and oil companies providing corresponding non-U.S. GAAP financial measures or that have different financing and capital

31


structures or tax rates. These non-U.S. GAAP financial measures should be considered in addition to, but not as a substitute for, measures for financial performance prepared in accordance with U.S. GAAP.

The table below sets forth a reconciliation of net income to Adjusted EBITDA for the three and nine months ended September 30, 2020 and 2019, which is the most directly comparable measure of financial performance calculated under U.S. GAAP and should be reviewed carefully.

Three months ended September 30, 

Nine months ended September 30, 

    

2020

   

2019

   

2020

   

2019

Net income (loss)

$

(292,783)

$

1,453,298

$

(548,518)

$

6,664,832

Add Back:

Net interest (income) expense

23,905

(9,202)

45,658

(41,871)

Income tax expense (benefit)

(33,762)

543,139

114,067

2,983,555

Depreciation, depletion, amortization, and accretion

2,769,193

1,851,466

7,761,339

5,630,368

Impairment expense

1,760,000

Stock based compensation expense

239,134

133,720

585,105

401,161

(Gain) loss on derivative contracts net of cash received or paid on settlement

1,237,444

(113,223)

1,979,544

(2,150,037)

Foreign currency translation (gain) loss

(1)

2,228

(456)

Adjusted EBITDA

$

3,943,131

$

3,859,197

$

11,699,423

$

13,487,552

Results of Operations

Net Operating Revenues

For the three months ended September 30, 2020 revenues increased $0.6 million to $5.8 million from $5.2 million during the same period of 2019. During the nine months ended September 30, 2020 revenues decreased $1.4 million, or 7.1%, to $18.5 million from $19.9 million during the same period of 2019.

Revenue and volume statistics for the three and nine months ended September 30, 2020 and 2019 were as follows:

Three months ended

Nine months ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Revenues

Natural gas revenue

$

3,573,908

$

2,933,695

$

11,470,012

$

12,698,643

Volume (MMcf)

 

3,037

 

1,790

 

8,622

 

5,533

Avg. Price ($/Mcf)

$

1.18

$

1.64

$

1.33

$

2.29

PA Exit Rate (MMcfpd)

 

29.9

 

16.7

 

29.9

 

16.7

Oil and other liquids revenue

$

16,798

$

65,886

$

246,885

$

307,079

Volume (MBO)

 

3.4

 

2.8

 

11.3

 

10.6

Avg. Price ($/Bbl)

$

4.99

$

23.69

$

21.93

$

28.99

Gathering system revenue

$

2,219,905

$

2,219,613

$

6,800,347

$

6,923,058

Total Revenues

$

5,810,611

$

5,219,194

$

18,517,244

$

19,928,780

We earn gathering system revenue as a 35% owner of the Auburn Gas Gathering system. This revenue consists of fees paid by Anchor Shippers (parties listed in Anchor Shipper Gas Gathering Agreement for Northern Pennsylvania, including Epsilon Midstream, LLC) and third-party customers of the system to transport gas from the wellhead to the compression facility, and then to the delivery meter at the Tennessee Gas Pipeline. For the nine months ended September 30, 2020, approximately 82% of the Auburn GGS revenues earned were gathering fees, while 18% were compression fees. Gathering revenues from third-party customers represented approximately 5% of total gathering revenues and third-party compression revenues represented 12% of total compression revenues. For the three months ended September 30, 2020, approximately 82% of the Auburn GGS revenues earned were gathering fees, while 18% were compression fees. Third-

32


party customers represented approximately 0.7% of gathering revenues and 3% of compression revenues. For the nine months ended September 30, 2019, approximately 87% of the Auburn GGS revenues earned were gathering fees, while 13% were compression fees. Gathering revenues from third-party customers represented approximately 11% of revenues and third-party compression revenues represented 5% of revenues. For the three months ended September 30, 2019, approximately 86% of the Auburn GGS revenues earned were gathering fees, while 14% were compression fees. Third party customers represented approximately 15% of gathering revenues and 7% of compression revenues. Revenues derived from Epsilon’s production which have been eliminated from gathering system revenues amounted to $0.52 and $1.41 million for the three and nine months ended September 30, 2020, respectively and $0.28 and $0.86 million for the three and nine months ended September 30, 2019, respectively.

Upstream natural gas revenue for the nine months ended September 30, 2020 decreased by $1.4 million, or 7%, over the same period in 2019. This was a result of lower natural gas prices; however, this was offset by higher volumes being produced. For the three months ended September 30, 2020, upstream natural gas revenue increased $0.6 million or 11.3% over the same period in 2019.This was a result of higher volumes, but was offset by lower natural gas prices.

The Company’s share of gathering system revenue remained generally consistent during the three and nine months ended September 30, 2020, increasing by less than 1% and decreasing by 1.8%, respectively, over the same periods in 2019. However, total upstream gathering fees increased due to increased production from Epsilon, which resulted in an increase in the amount of revenues eliminated from the consolidated operating statements. This increased elimination entry resulted in a net decrease in gathering system revenue to Epsilon. The Auburn GGS is subject to a cost of service model, whereby the Anchor Shippers dedicate acreage and reserves to the Auburn GGS. In exchange for this dedication, the owners of the Auburn system agree to a fixed rate of return on capital invested which cannot be exceeded. Therefore, rather than being subject to a fixed gathering rate, the Shippers are subject to a fluctuating gathering rate which is redetermined annually in order to produce the contractual return on capital to the Auburn GGS owners. The term of the model is fixed from 2012 to 2026. Each year, actual throughput, revenue, operating expenses and capital are captured in the model, and the remaining years are forecasted. The model then resolves a gathering rate that yields the contractual rate of return. All else being equal, to the extent that throughput is higher or capital is lower than the preceding year’s forecast, the gathering rate will decline.

Operating Costs

The following table presents total cost and cost per unit of production (Mcfe), including ad valorem, severance, and production taxes for the three and nine months ended September 30, 2020 and 2019:

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Lease operating costs

$

2,147,795

$

1,548,902

$

6,229,682

$

4,851,090

Gathering system operating costs

43,711

461,036

221,191

1,012,709

$

2,191,506

$

2,009,938

$

6,450,873

$

5,863,799

Upstream operating costs—Total $/Mcfe

0.71

0.86

0.72

0.88

Gathering system operating costs $ / Mcf

0.02

0.16

0.03

0.11

Upstream operating costs consist of lease operating expenses necessary to extract natural gas and oil, including gathering and treating the natural gas and oil to ready it for sale.

Upstream operating costs for three months ended September 30, 2020 increased $0.6 million, or 38.7%, over the same period in 2019. For the nine months ended September 30, 2020, upstream operating costs increased $1.4 million, or 28.4%, from the same period in 2019 The increase in total cost was primarily due to the increase in volumes produced and the cost of operating four new wells that went online in October of 2019, in addition to four new wells that went online in May of 2020.

Gathering system operating costs consist primarily of rental payments for the natural gas fueled compression units. Other significant gathering system operating costs include chemicals (to prevent corrosion and to reduce water vapor in the gas stream), saltwater disposal, measurement equipment / calibration and general project management.

33


The gathering system total per unit operating costs reported include the effects of elimination entries to remove the gas gathering fees billed by the gas gathering system operator to Epsilon’s upstream operations, and the volume associated with those fees. The elimination entries amounted to $1.41 million and $0.86 million for the nine months ended September 30, 2020 and 2019, respectively, and $0.52 million and $0.28 million for the three months ended September 30, 2020 and 2019, respectively, (see Note 12, ‘‘Operating Segments,’’ of the Notes to Unaudited Condensed Consolidated Financial Statements).

Gathering system costs (net of intercompany elimination) for the nine months ended September 30, 2020 decreased $0.8 million over the same period in 2019 and $0.4 million for the three months ended September 30, 2020 over the same period in 2019. The Company’s share of total gathering system costs decreased only $0.2 million and $0.2 million for the three and nine months ended September 30, 2020 over 2019; however, due to increased production from Epsilon and the resulting increase in the elimination of entry costs subtracted from the consolidated operating statements resulted in the large decrease in gathering system operating costs reported, and a very low cost per Mcf.

Depletion, Depreciation, Amortization and Accretion (“DD&A”)

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Depletion, depreciation, amortization and accretion

$

2,769,193

$

1,851,466

$

7,761,339

$

5,630,368

Natural gas and oil and gathering system assets are depleted and depreciated using the units of production method aggregating properties on a field basis. For leasehold acquisition costs and the cost to acquire proved and unproved properties, the reserve base used to calculate depreciation and depletion is total proved reserves. At this time, the Company has only minimal leasehold acquisition costs, and only in Oklahoma. For natural gas and oil development and gathering system costs, the reserve base used to calculate depletion and depreciation is proved developed reserves. A reserve report is prepared as of December 31, each year. The depletion for the first three quarters of the next year is normally based on the reserve report prepared at the end of the previous year, taking into consideration the limited development of the reserves over these time periods. The fourth quarter depletion is calculated using the reserve volumes from the reserve report prepared as of December 31 of the current year. However, for the three months ended March 31, 2020 and the three months ended June 30, 2020, due to the historically low commodity prices, the December 31, 2019 reserves report volumes were updated based on relevant prices and the depletion and depreciation were calculated using the lower volumes that resulted from the economics of the properties due to the lower prices because of the COVID-19 pandemic. For the three months ended September 30, 2020, volumes remained consistent with the June 30, 2020 volumes.

Depreciation expense includes primarily amounts pertaining to our office furniture and fixtures, leasehold improvements, and computer hardware. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, ranging from 3 to 7 years. Also included in depreciation expense is an amount pertaining to buildings owned by the Company. Depreciation for the buildings is calculated using the straight-line method over an estimated useful life of 30 years.

Accretion expense is related to the asset retirement obligations.

DD&A expense increased $2.1 million, or 38% for the nine months ended September 30, 2020 compared to the same period in 2019, and $0.9 million, or 50% for the three months ended September 30, 2020 compared to the same period in 2019. This was mainly due to the reduction of the line pressure of the gathering system, and the addition of four new wells that went online in October 2019, and four new wells that went online in May 2020 which resulted in increased production volumes.

Impairment

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Impairment

$

$

$

1,760,000

$

34


Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, tests require that the Company first compare expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the natural gas properties to their estimated fair values is required.

During the three months ended March 31, 2020, the Company recognized certain indicators of impairments specific to our Oklahoma assets and determined that carrying value of those assets was not recoverable based on the current indicators. As a result of this assessment, a $1.76 million impairment was assessed on the Company’s Oklahoma assets at March 31, 2020. No impairment was required as of September 30, 2020 or September 30, 2019.

General and Administrative

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

General and administrative

$

1,569,738

$

1,086,223

$

4,160,550

$

3,614,532

G&A expenses consist of general corporate expenses such as compensation, legal, accounting and professional fees, consulting services, travel and other related corporate costs such as stock options and restricted stock granted and the related non-cash compensation.

G&A expenses for the three months ended September 30, 2020 increased $0.5 million or 44.5%. For the nine months ended September 30, 2020, G&A expenses increased $0.5 million, or 15.1%, compared to the same period in 2019. This was due to legal and administrative fees related to the tender offer in June 2020, which closed in July 2020, legal fees related to executive compensation, and increased stock based compensation associated with the 2019 and 2020 stock grants.

Interest Expense

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Interest expense

$

28,629

$

29,416

$

84,952

$

86,035

Interest expense relates to the commitment fees paid on the revolving line of credit.

Interest expense remained consistent during the three and nine months ended September 30, 2020 as compared to the three and nine months ended September 30, 2019. Interest expense for the periods consists primarily of commitment fees as Epsilon did not access our line of credit during this time.

Gain (Loss) on Derivative Contracts

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Gain on derivative contracts

$

419,879

$

1,270,494

$

2,055,548

$

3,494,727

For the nine months ended September 30, 2020 and 2019, Epsilon entered into NYMEX Henry Hub Natural Gas Futures swap and Dominion basis swap derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three and nine months ended September 30, 2020 we received net cash settlements of $1,657,323 and $4,035,092 respectively. For the three and nine months ended September 30, 2019, Epsilon received $1,157,271, and $1,344,690, respectively on the settlement of contracts.

35


For the three months ended September 30, 2020, an $840,285 decrease in the value of Henry Hub swaps, due to an increase in Henry Hub prices, was offset by a $1,272,589 increase in the value of Dominion basis swaps, due to widening regional basis, and $12,425 in transaction costs. For the three months ended September 30, 2019, the value of the Henry Hub swaps and Dominion basis swaps increased $680,918 and $601,651, respectively, due to lower Henry Hub prices and widening regional basis, partially offset by $12,075 of transaction costs.

For the nine months ended September 30, 2020, the value of the Henry Hub swaps and Dominion basis swaps increased $997,303 and $1,099,776, respectively, due to lower Henry Hub prices and widening regional basis, partially offset by $41,531 of transaction costs. For the nine months ended September 30, 2019, the value of the Henry Hub swaps and Dominion basis swaps increased $3,371,735 and $160,143, respectively, due to lower Henry Hub prices and widening regional basis, partially offset by $37,150 of transaction costs.

Other Income (Expense)

Three months ended September 30, 

Nine months ended September 30, 

    

2020

    

2019

    

2020

    

2019

Interest income and other income (expense)

$

4,721

$

38,619

$

37,064

$

128,362

For the three and nine months ended September 30, 2020 and 2019 other income consisted primarily of interest income.

Capital Resources and Liquidity

Cash Flow

The primary source of cash for Epsilon during the three and nine months ended September 30, 2020 was funds generated from operations, and cash received on the settlement of derivative contracts. For the three and nine months ended September 30, 2019, the primary source of funds was from operations. In addition to operations, the primary uses of cash for the three and nine months ended September 30, 2020 were development of natural gas properties, and the repurchase of shares of common stock under Epsilon’s substantial issuer bid/issuer tender offer dated May 19, 2020, as amended. Under its substantial issuer bid/tender offer, Epsilon utilized cash on hand to pay for the 2,337,034 properly tendered and not withdrawn common shares at a cost of approximately $7.15 million, excluding fees and expenses. For the three and nine months ended September 30, 2019 cash was used for income tax pre-payments, repurchase of shares of common stock, and acquisitions and development of oil and gas properties.

At September 30, 2020, we had a working capital surplus of $11.5 million, a decrease of $3.4 million over the $14.9 million surplus at December 31, 2019. The surplus decreased from December 31, 2019 due to the $7.15 million of cash spent on the repurchase of stock under the substantial bid/issuer tender offer. This decrease in cash was offset by the cash that is continually being generated by operations and cash received from the settlement of derivative contracts. The Company anticipates its current cash balance, cash flows from operations, and available sources of liquidity to be sufficient to meet its cash requirements. However, as the impact of recent declines in worldwide crude oil and natural gas prices and the impact of COVID-19 on the economy evolves, Epsilon will continue to assess its liquidity needs. In the event of a sustained market deterioration, the Company may need additional liquidity, which would require it to evaluate available alternatives and take appropriate actions.

Three and nine months ended September 30, 2020 compared to 2019

During the nine months ended September 30, 2020, $12.1 million was provided by the Company’s operating activities, compared to $11.8 million provided during the same period in 2019, a $0.3 million, and 2.2% increase. The increase was mainly due to increased cash received on the settlement of derivative contracts, but was offset by a decrease in revenues received as discussed previously. During the three months ended September 30, 2020, $3.8 million was provided by the Company’s operating activities compared to a consistent $3.8 million also provided during the same period in 2019.

36


The Company used $1.4 million and $5.5 million of cash for investing activities during the three and nine months ended September 30, 2020, respectively. This was spent primarily on leasehold and development costs targeting increasing production in Pennsylvania. For the three and nine months ended September 30, 2019, the Company used $1.2 million and $5.8 million, respectively mainly on cash calls for wells to be developed in Oklahoma and leasehold development costs in Pennsylvania.

The $7.2 million and $9.1 million for the three and nine months ended September 30, 2020, respectively, and the $0.4 million and $1.7 million for the three and nine months ended September 30, 2019, respectively, of cash used for financing activity was related to the repurchase of common shares of the Company.

Credit Agreement

In addition, the Company has a senior secured credit facility which includes a total commitment of up to $100 million. The current effective borrowing base is $23 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If Epsilon decided to access the facility, depending on the level of borrowing, the Company might need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (2.75%-3.75% based on the percent of the line of credit utilized), b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%. Effective January 7, 2019 the agreement was amended to extend the maturity date to March 1, 2022.

The bank has a first priority security interest in the tangible and intangible assets of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

Leverage ratio less than 3.5 based on income adjusted for interest, taxes and non-cash amounts.

Epsilon was in compliance with the financial covenants of the agreement as of September 30, 2020 and December 31, 2019 and expect to be in compliance for the next 12 months. We expect to remain in compliance as we currently have no borrowings under the facility and funded all operations for 2019 and all operations through September 30, 2020 out of operating cash flow and cash on hand and expect to continue to do so through 2020.

Balance at

Balance at

September 30, 

December 31, 

Borrowing Base

Interest

    

2020

    

2019

    

September 30, 2020

    

Rate

Revolving line of credit

$

$

$

23,000,000

 

3 mo. LIBOR + 2.75%

Available borrowing capacity under the credit agreement is $23 million was reaffirmed on February 11, 2020.

Repurchase Transactions

Since May 20, 2019, Epsilon has conducted a normal course issuer bid (“NCIB”) to repurchase our issued and outstanding common shares, when doing so has been accretive to management's estimates of intrinsic value per share. The NCIB ended on May 19, 2020. Since the commencement of the NCIB on May 20, 2019, Epsilon has strengthened its financial position and overhead costs. With sufficient cash flow from operations, it used discretionary cash to fund these repurchases. Since May 20, 2019, Epsilon has repurchased 1,353,410 common shares of the authorized 1,367,762 purchase amount. During the nine months ended September 30, 2020, the Company spent $1,910,765, excluding fees and expenses,

37


under the NCIB. For the nine months ended September 30, 2019, Epsilon spent $1,456,417, excluding fees and expenses, to repurchase common shares.

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Exchange Act and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 common shares plus 2% of its issued and outstanding common shares, or an aggregate total of up to 2,522,673 common shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand.

Accordingly, during the nine months ended September 30, 2020, the Company has spent $9,062,089, excluding fees and expenses, to repurchase common shares.

Derivative Transactions

The Company has entered into hedging arrangements to reduce the impact of natural gas price volatility on operations. By removing the price volatility from a significant portion of natural gas production, the potential effects of changing prices on operating cash flows have been mitigated, but not eliminated. While mitigating the negative effects of falling commodity prices, these derivative contracts also limit the benefits we might otherwise receive from increases in commodity prices.

At September 30, 2020, Epsilon’s outstanding natural gas commodity swap contracts consisted of the following:

Weighted Average Price ($/MMbtu)

Volume

Basis

Fair Value of Asset

Derivative Type

    

(MMbtu)

    

 Swaps 

    

Differential

    

September 30, 2020

2020

Fixed price swap

 

762,500

$

2.73

$

 

(73,029)

Basis swap

 

762,500

$

$

(0.44)

 

93,287

 

1,525,000

$

20,258

Contractual Obligations

The following table summarizes Epsilon’s contractual obligations at September 30, 2020:

Payments Due by Period

Less than

1 – 3

Greater than

    

Total

    

1 Year

    

Years

    

3 Years

Derivative liabilities(1)

 

154,163

 

154,163

 

 

Asset retirement obligation, undiscounted

 

8,948,964

 

1,608,499

 

 

7,340,465

Capital expenditure commitments

 

2,627,774

 

655,398

 

1,972,376

 

Operating leases

 

271,030

 

25,147

 

209,870

 

36,013

Total future commitments

$

12,001,931

$

2,443,207

$

2,182,246

$

7,376,478

________________________

(1)The liability balance shown represents the gross mark-to-market liability balance of derivative contracts before being offset by contracts in an asset position.

We enter into commitments for capital expenditures in advance of the expenditures being made. At a given point in time, it is estimated that we have committed to capital expenditures equal to approximately one quarter of our capital budget by means of giving the necessary authorizations to the asset operator to incur the expenditures in a future period. Current commitments have been included in the contractual obligations table above.

38


Based on current natural gas prices and anticipated levels of production, we believe that the estimated net cash generated from operations, together with cash on hand and amounts available under our credit agreement, will be adequate to meet liquidity needs for the next 12 months and beyond, including satisfying our financial obligations and funding our operating and development activities.

Off-Balance Sheet Arrangements

As of September 30, 2020, the Company had no off-balance sheet arrangements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our earnings and cash flow are significantly affected by changes in the market price of commodities. The prices of natural gas and oil can fluctuate widely and are influenced by numerous factors such as demand, production levels, world political and economic events, and the strength of the US dollar relative to other currencies. Should the price of natural gas and oil decline substantially, the value of our assets could fall dramatically, impacting our future operations and exploration and development activities, along with our gas gathering system revenues. In addition, our operations are exposed to market risks in the ordinary course of our business, including interest rate and certain exposure as well as risks relating to changes in the general economic conditions in the United States.

Gathering System Revenue Risk

The Auburn Gas Gathering System lies within the Marcellus Basin with historically high levels of recoverable reserves and low cost of production. We believe that a short-term low commodity price environment will not significantly impact the reserves produced and thus the revenue of our gas gathering system.

Interest Rate Risk

Market risk is estimated as the change in fair value resulting from a hypothetical 100 basis point change in the interest rate on the outstanding balance under our credit agreement. The credit agreement allows us to fix the interest rate for all or a portion of the principal balance for a period up to nine months. To the extent that the interest rate is fixed, interest rate changes affect the instrument’s fair market value but do not affect results of operations or cash flows. Conversely, for the portion of the credit agreement that has a floating interest rate, interest rate changes will not affect the fair market value but will affect future results of operations and cash flows.

At September 30, 2020 and 2019, the outstanding principal balance under the credit agreement was nil.

Derivative Contracts

The Company’s financial results and condition depend on the prices received for natural gas production. Natural gas prices have fluctuated widely and are determined by economic and political factors. Supply and demand factors, including weather, general economic conditions, the ability to transport the gas to other regions, as well as conditions in other natural gas regions, impact prices. Epsilon has established a hedging strategy and may manage the risk associated with changes in commodity prices by entering into various derivative financial instrument agreements and physical contracts. Although these commodity price risk management activities could expose Epsilon to losses or gains, entering into these contracts helps to stabilize cash flows and support the Company’s capital spending program.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Exchange Act, we have evaluated, under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this 10-Q. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file

39


under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.

Based upon such evaluation, we have concluded that as of September 30, 2020 our disclosure controls and procedures were effective. However, as of March 31, 2020 and June 30, 2020 our disclosure controls and procedures were not effective as of such date as a result of a material weakness in our internal control over financial reporting related to the preparation of our oil and gas properties impairment calculation in accordance with the relevant accounting literature and the related review control as of March 31, 2020.

The effect of the error that resulted from the material weakness discussed above was corrected as part of the 10-Q reporting process, and management has concluded that the consolidated financial statements included in both our report at March 31, 2020, and this report fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States.

Management’s Remediation Plan

Our management has implemented a remediation plan to address the operating effectiveness control deficiencies that led to the material weakness described above. Management’s plan of remediation included a review of Epsilon’s internal controls by a third-party consultant. The review of impairment and related processes has been completed and Epsilon has put into effect their recommendations regarding implementing new controls and processes over the calculation and evaluation of impairment. Additionally, Epsilon added a research subscription to the Company’s accounting resources, which management believes will improve the Company’s ability to research accounting rules and procedures. We believe the remediation to be complete, subject to testing.

Changes in Internal Control over Financial Reporting

Subject to these remediation efforts, that we implemented after March 31, 2020, there have been no significant changes in the Company’s internal control over financial reporting during the period covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that of limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company is not currently involved in any litigation.

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2019 and Part II, Item 1A in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 and June 30, 2020.

40


ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

(c) Purchases of Equity Securities by Epsilon Energy Ltd.

The following table contains information about our acquisition of equity securities during the nine months ended September 30, 2020:

    

Total number

Maximum number

of shares

of shares that

purchased as

may yet be

Total number

Average price

part of publicly

purchased under

of shares

paid per

announced plans

the plans or

    

purchased

share

    

or programs (4)

    

programs (5)

Beginning of normal-course issuer bid, May 20, 2019

1,367,762

Shares purchased through December 31, 2019 (1) (2)

696,096

$

3.72

January 2020 (2)

102,051

$

2.95

February 2020 (2)

261,519

$

3.11

March 2020 (2)

124,459

$

2.98

April 2020 (2)

156,585

$

2.48

May 2020 (2)

12,700

$

2.91

July 2020 (3)

2,337,034

$

3.06

2,337,034

Total as of September 30, 2020

3,690,444

$

3.16

2,337,034


(1)Shares purchased through December 31, 2019 were cancelled prior to the year ended December 31, 2019.

(2)Commencing on May 20, 2019, the Company entered into a share repurchase program on the NASDAQ conducted in accordance with Rule 10b-18 promulgated under the Securities Exchange Act of 1934. The Company was authorized to repurchase up to 1,367,762 of its outstanding common shares, representing 5% of the outstanding common shares of Epsilon as of May 20, 2019, for an aggregate purchase price of not more than $5.0 million. The program ended on May 19, 2020, but Epsilon’s final repurchase under this program occurred on May 8, 2020. Repurchases were made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares was, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company funded the purchase out of available cash and did not incur debt to fund the share repurchase program.

(3)On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Exchange Act and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 common shares plus 2% of its issued and outstanding common shares, or an aggregate total of up to 2,522,673 common shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand. After giving effect to the cancellation of the common shares purchased under the tender offer, 23,796,637 common shares were issued and outstanding.

(4)Although disclosed in the Company’s Form 10-Q filed August 26, 2019, the Company did not publicly announce the share repurchase program under which it purchased the shares described in the column “Total number of shares Purchased” for January through May 2020. The Company publicly announced its intention to commence a substantial issuer bid/issuer tender offer on May 14, 2020, and the issuer tender offer commenced May 19, 2020.

41


(5)The normal-course issuer bid expired on May 19, 2020, and the substantial issuer bid/issuer tender offer expired on June 30, 2020.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

42


ITEM 6. —EXHIBITS

Exhibit

No.

 

Description of Exhibit

3.1

 

Bylaws, as amended (effective September 1, 2020) (filed herewith)

 

 

 

31.1

 

Sarbanes-Oxley Section 302 certification of Principal Executive Officer.

 

 

31.2

 

Sarbanes-Oxley Section 302 certification of Principal Financial Officer.

 

 

32.1

 

Sarbanes-Oxley Section 906 certification of Principal Executive Officer.

 

 

32.2

 

Sarbanes-Oxley Section 906 certification of Principal Financial Officer.

101.INS

 

XBRL Instance Document.

 

 

101.SCH

 

XBRL Schema Document.

 

 

101.CAL

 

XBRL Calculation Linkbase Document.

 

 

101.DEF

 

XBRL Definition Linkbase Document.

 

 

101.LAB

 

XBRL Labels Linkbase Document.

 

 

101.PRE

 

XBRL Presentation Linkbase Document.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Epsilon Energy Ltd.

(Registrant)

Date: November 10, 2020

By:

/s/ B. Lane Bond

B. Lane Bond

Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)

43