Table of Contents
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 March 31, 2023
☐ 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.)
500 Dallas Street, Suite 1250
Houston, Texas 77002
(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).
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).
As of May 9, 2023, there were 22,926,444 Common Shares outstanding.
Contents
FORWARD-LOOKING STATEMENTS
4
PART I-FINANCIAL INFORMATION
5
ITEM 1. FINANCIAL STATEMENTS
Unaudited Condensed Consolidated Balance Sheets
Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)
6
Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity
7
Unaudited Condensed Consolidated Statements of Cash Flows
8
Notes to the Unaudited Condensed Consolidated Financial Statements
1.
Description of Business
9
2.
Basis of Preparation
Interim Financial Statements
Principles of Consolidation
Use of Estimates
Reclassification
Recently Issued Accounting Standards
3.
Cash, Cash Equivalents, and Restricted Cash
10
4.
Short Term Investments
5.
Property and Equipment
11
Property Impairment
6.
Revolving Line of Credit
7.
Shareholders’ Equity
12
8.
Revenue Recognition
16
9.
Income Taxes
17
10.
Commitments and Contingencies
Litigation
11.
Leases
18
12.
Net Income Per Share
19
13.
Operating Segments
20
14.
Commodity Risk Management Activities
22
Commodity Price Risks
Commodity Derivative Contracts
15.
Asset Retirement Obligations
23
16.
Fair Value Measurements
17.
Current Expected Credit Loss
24
18.
Subsequent Events
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
25
Overview
Business Strategy
Operational Highlights
Non-GAAP Financial Measures-Adjusted EBITDA
26
Net Operating Revenues
27
Operating Costs
28
Depletion, Depreciation, Amortization and Accretion
General and Administrative
29
Loss on Derivative Contracts
Capital Resources and Liquidity
Cash Flow
Credit Agreement
30
Repurchase Transactions
Derivative Transactions
31
Contractual Obligations
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Gathering System Revenue Risk
Interest Rate Risk
32
Derivative Contracts
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Changes in Internal Control Over Financial Reporting
Inherent Limitations on Effectiveness of Controls
PART II OTHER INFORMATION
33
ITEM 1. LEGAL PROCEEDINGS
ITEM 1A. RISK FACTORS
ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
34
ITEM 4. MINE SAFETY DISCLOSURES
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS
35
SIGNATURES
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, 2022, 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, 2022. Our Annual Report on Form 10-K for the year ended December 31, 2022 is available on our website at www.epsilonenergyltd.com.
March 31,
December 31,
2023
2022
ASSETS
Current assets
Cash and cash equivalents
$
19,110,225
45,236,584
Accounts receivable
4,805,320
7,201,386
Short term investments
30,138,743
—
Fair value of derivatives
1,927,450
1,222,090
Prepaid income taxes
1,140,094
Other current assets
496,731
632,154
Operating lease right-of-use assets
31,383
Total current assets
56,478,469
55,463,691
Non-current assets
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties
149,323,372
148,326,265
Unproved properties
18,275,226
18,169,157
Accumulated depletion, depreciation, amortization and impairment
(109,194,701)
(107,729,293)
Total oil and gas properties, net
58,403,897
58,766,129
Gathering system
42,660,626
42,639,001
(34,778,321)
(34,500,740)
Total gathering system, net
7,882,305
8,138,261
Land
637,764
Buildings and other property and equipment, net
318,805
286,035
Total property and equipment, net
67,242,771
67,828,189
Other assets:
Operating lease right-of-use assets, long term
532,013
Restricted cash
571,324
570,363
Total non-current assets
68,346,108
68,398,552
Total assets
124,824,577
123,862,243
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable trade
1,900,847
1,695,353
Gathering fees payable
867,533
935,012
Royalties payable
1,898,177
2,223,043
Income taxes payable
196,131
Accrued capital expenditures
348,135
41,694
Accrued compensation
233,172
598,351
Other accrued liabilities
257,788
690,655
Operating lease liabilities
2,756
35,299
Total current liabilities
5,704,539
6,219,407
Non-current liabilities
Asset retirement obligations
2,801,056
2,780,237
Deferred income taxes
10,605,286
10,617,394
Operating lease liabilities, long term
541,396
Total non-current liabilities
13,947,738
13,397,631
Total liabilities
19,652,277
19,617,038
Commitments and contingencies (Note 10)
Shareholders' equity
Preferred shares, no par value, unlimited shares authorized, none issued or outstanding
Common shares, no par value, unlimited shares authorized and 22,926,444 shares issued and 22,879,224 shares outstanding at March 31, 2023 and 23,117,144 issued and outstanding at December 31, 2022
122,789,659
123,904,965
Treasury shares, at cost, 47,220 at March 31, 2023 and 0 at December 31, 2022
(252,119)
Additional paid-in capital
10,035,977
9,856,229
Accumulated deficit
(37,173,168)
(39,290,540)
Accumulated other comprehensive income
9,771,951
9,774,551
Total shareholders' equity
105,172,300
104,245,205
Total liabilities and shareholders' equity
The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements
Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income
Three months ended March 31,
Revenues from contracts with customers:
Gas, oil, NGL, and condensate revenue
6,969,581
11,479,325
Gas gathering and compression revenue
2,386,695
2,120,773
Total revenue
9,356,276
13,600,098
Operating costs and expenses:
Lease operating expenses
1,404,279
1,405,490
Gathering system operating expenses
651,341
524,375
Development geological and geophysical expenses
2,386
Depletion, depreciation, amortization, and accretion
1,773,006
1,389,219
General and administrative expenses:
Stock based compensation expense
179,748
142,302
Other general and administrative expenses
2,023,773
1,171,132
Total operating costs and expenses
6,032,147
4,634,904
Operating income
3,324,129
8,965,194
Other income (expense):
Interest income
490,762
15,221
Interest expense
(28,437)
(15,319)
Gain (loss) on derivative contracts
1,068,660
(971,904)
Other income (expense)
1,635
(5,406)
Other income (expense), net
1,532,620
(977,408)
Net income before income tax expense
4,856,749
7,987,786
Income tax expense
1,326,922
2,181,898
NET INCOME
3,529,827
5,805,888
Currency translation adjustments
(2,600)
5,402
NET COMPREHENSIVE INCOME
3,527,227
5,811,290
Net income per share, basic
0.15
0.25
Net income per share, diluted
0.24
Weighted average number of shares outstanding, basic
22,990,893
23,677,842
Weighted average number of shares outstanding, diluted
23,027,684
23,862,428
Accumulated
Other
Total
Common Shares Issued
Treasury Shares
Additional
Comprehensive
Shareholders'
Shares
Amount
paid-in Capital
Income
Deficit
Equity
Balance at January 1, 2023
23,117,144
Net income
Dividends paid
(1,412,455)
Stock-based compensation expense
Buyback of common shares
(237,920)
(1,367,425)
Retirement of treasury shares
(190,700)
(1,115,306)
190,700
1,115,306
Other comprehensive loss
Balance at March 31, 2023
22,926,444
(47,220)
Balance at January 1, 2022
24,202,218
131,815,739
(534,015)
(2,423,007)
8,835,203
9,818,605
(68,783,207)
79,263,333
(1,483,027)
Exercise of stock options
38,750
209,312
534,015
2,423,007
Other comprehensive income
Balance at March 31, 2022
23,706,953
129,602,044
8,977,505
9,824,007
(64,460,346)
83,943,210
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
(Gain) loss on derivative contracts
(1,068,660)
971,904
Settlement received (paid) on derivative contracts
363,300
(1,211,728)
Settlement of asset retirement obligation
(73,998)
Deferred income tax expense (benefit)
(12,108)
22,686
Changes in assets and liabilities:
2,396,066
(1,871,330)
Other assets and liabilities
143,646
104,177
Accounts payable, royalties payable and other accrued liabilities
(1,062,898)
267,058
1,336,225
2,157,292
Net cash provided by operating activities
7,578,152
7,703,470
Cash flows from investing activities:
Additions to unproved oil and gas properties
(106,069)
(92,600)
Additions to proved oil and gas properties
(621,132)
(2,771,925)
(Additions) disposals to gathering system properties
(12,423)
3,612
Additions to land, buildings and property and equipment
(42,703)
Purchases of short term investments
(30,138,743)
Net cash used in investing activities
(30,921,070)
(2,860,913)
Cash flows from financing activities:
Net cash used in financing activities
(2,779,880)
(1,273,715)
Effect of currency rates on cash, cash equivalents, and restricted cash
(Decrease) increase in cash, cash equivalents, and restricted cash
(26,125,398)
3,574,244
Cash, cash equivalents, and restricted cash, beginning of period
45,806,947
27,065,423
Cash, cash equivalents, and restricted cash, end of period
19,681,549
30,639,667
Supplemental cash flow disclosures:
Interest paid
17,216
17,501
Non-cash investing activities:
Change in proved properties accrued in accounts payable and accrued liabilities
375,242
(253,632)
Change in gathering system accrued in accounts payable and accrued liabilities
9,201
19,005
Asset retirement obligation asset additions and adjustments
736
6,684
Epsilon Energy Ltd.
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, we began trading in the United States on the NASDAQ Global Market under the trading symbol “EPSN.” Effective as of the close of trading on March 15, 2019, Epsilon voluntarily delisted its common shares from the TSX. Epsilon is a North American on-shore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves.
2. Basis of Preparation
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 statement 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 year ended December 31, 2022. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.
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.
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.
The consolidated financial statements for the prior periods include certain reclassifications that were made to conform to the current period presentation. Such reclassifications have no impact on previously reported consolidated financial position, results of operations or cash flows.
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 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 removes all recognition thresholds and requires 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. Epsilon has adopted ASU 2016-13 as of January 1, 2023. There was no impact from the adoption of this ASU.
In 2020, the FASB issued ASU 2020-04, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which, for a limited period of time, adds ASC 848 to the Codification providing entities with certain practical expedients and exceptions from applying modification accounting if certain criteria are met. The amendments are designed to reduce operational challenges that entities will face in applying modification accounting to all contracts that will be revised due to reference rate reform. The guidance in ASC 848 was triggered by the pending discontinuation of certain benchmark reference rates and, in some cases, their replacement by new rates that are more observable or transaction-based and, therefore, less susceptible to manipulation, than certain interest-rate benchmark reference rates commonly used today, including the London Interbank Offered Rate (LIBOR). This process of reference rate reform will require entities to modify certain contracts by removing the discontinued rates and including new rates. Epsilon has adopted ASU 2020-04 as of January 1, 2023.
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 March 31, 2023 and December, 31 2022:
Restricted cash included in other assets
Cash, cash equivalents, and restricted cash in the statement of cash flows
4. Short Term Investments
Short term investments are highly liquid investments with original maturities between three and twelve months. The Company’s short term investments consist of US Treasury Notes. These investments are classified as held-to-maturity and are carried at amortized cost with the intent to be held to maturity. Interest on these investments is presented as interest income in the Consolidated Statements of Operations and Comprehensive Income.
As of March 31, 2023, there was $30.1 million in short term investments, $29.9 million of adjusted cost basis and $0.2 million in unrecognized gains.
5. Property and Equipment
The following table summarizes the Company’s property and equipment as of March 31, 2023 and December 31, 2022:
We perform a quantitative impairment test 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, GAAP requires 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. Additionally, if an exploratory well is determined not to have found proved reserves, the costs incurred, net of any salvage value, should be charged to expense.
During the three months ended March 31, 2023 and 2022, no impairment was recorded.
6. Revolving Line of Credit
The Company has a senior secured credit facility which includes a total commitment of up to $100 million. The effective borrowing base is $30 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If we decide to access the facility, depending on the level of borrowing, we might need to increase our hedging activity. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. 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) the Prime Rate, or b) the sum of the Federal Funds Rate plus 0.5%, plus an applicable margin (0.25%-1.25%, based on percentage utilization on the facility). The facility matures on March 1, 2024.
On February 10, 2023, Epsilon Energy USA entered into the Ninth Amendment of the Credit Agreement. The borrowing base was increased to $30 million. Per ASC 848, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, LIBOR was removed as a reference option in the calculation of interest. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. Also, cash distributions to the parent company (Epsilon Energy Ltd.) were allowed if the facility is < 80% utilized and the leverage ratio (total debt / income adjusted for interest, taxes and non-cash amounts) is less than 2 to 1.
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:
We were in compliance with the financial covenants of the agreement as of March 31, 2023.
7. 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
On March 9, 2023, the Board of Directors authorized a new share repurchase program of up to 2,292,644 common shares, representing 10% of the outstanding common shares of Epsilon, for an aggregate purchase price of not more than US $15.0 million. The program is pursuant to a normal course issuer bid and will be conducted in accordance with Rule 10b-18 under the Exchange Act. The program commenced on March 27, 2023 and will end on March 26, 2024, unless the maximum amount of common shares is purchased before then or Epsilon provides earlier notice of termination. During the three months ended March 31, 2023, we repurchased 47,220 common shares at an average price of $5.32 per share (excluding commissions).
Commencing on March 8, 2022, we implemented a plan to repurchase our issued and outstanding common shares and to return capital to our shareholders. We used cash on hand to fund these repurchases. During the year ended December 31, 2022, we repurchased 982,500 common shares of the maximum of 1,183,410 authorized for repurchase and spent $6,234,879 under the plan. The repurchased stock had an average price of $6.32 per share (excluding commissions) and was subsequently retired during the year ended December 31, 2022.
Under the same plan, in 2023, we repurchased and retired 190,700 common shares at an average price of $5.82 per share (excluding commissions) before the plan terminated on March 7, 2023.
The following table contains activity relating to our acquisition of equity securities during the three months ended March 31, 2023:
Maximum number
of shares
Total number
Average price
remaining to be
paid per
purchased under
purchased
share
the program
Beginning of normal-course issuer bid, March 8, 2022 (1)
1,183,410
January 2023
125,200
5.96
February 2023
65,500
5.63
Total as of March 7, 2023
5.82
10,210
Beginning of normal-course issuer bid, March 27, 2023 (2)
2,292,644
March 2023
47,220
5.32
Total as of March 31, 2023
2,245,424
(c)Equity Incentive Plan
Epsilon’s board of directors (the “Board”) adopted the 2020 Equity Incentive Plan (the “2020 Plan”) on July 22, 2020 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.
Restricted Stock Awards
For the three months ended March 31, 2023, no shares of Restricted Stock were awarded to the Company’s board of directors and employees. For the year ended December 31, 2022, 289,231 common shares of Restricted Stock with a weighted average market price at the grant date of $6.28 were awarded to the Company’s officers, employees, and board of directors. These shares vest over a three or four-year period, with an equal number of 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.
13
The following table summarizes Restricted Stock activity for the three months ended March 31, 2023, and the year ended December 31, 2022:
Three months ended
Year ended
March 31, 2023
December 31, 2022
Number of
Weighted
Restricted
Average
Remaining Life
Outstanding
(years)
Balance non-vested Restricted Stock at beginning of period
298,210
1.74
166,002
1.38
Granted
289,231
1.86
Vested
(157,023)
Balance non-vested Restricted Stock at end of period
1.49
Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2023 and 2022 was $165,064 and $95,112, respectively.
At March 31, 2023, the Company had unrecognized stock-based compensation related to these shares of $1,503,501 to be recognized over a weighted average period of 1.4 years (at December 31, 2022: $1,668,564 over 1.55 years).
Performance Share Unit Awards (“PSU”)
For the three months ended March 31, 2023, no PSUs vested and were issued. For the year ended December 31, 2022, a total of 135,667 common shares vested and were issued. The Company grants PSUs, which are paid in stock, to certain key employees. The PSUs will vest on the last day of the performance period. The number of PSUs that will ultimately vest is based on two performance targets as follows:
The number of shares ultimately issued under these awards can range from zero to 200% of target award amounts at the discretion of the Compensation Committee of the Board of Directors.
14
The following table summarizes PSUs for the three months ended March 31, 2023 and the year ended December 31, 2022:
Performance
Balance non-vested PSUs at beginning of period
15,833
1.00
151,500
3.84
(135,667)
Balance non-vested PSUs at end of period
0.75
Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2023 and 2022 related to PSUs was $14,684 and $47,190, respectively.
At March 31, 2023, the Company had unrecognized stock-based compensation related to these shares of $44,053 to be recognized over a weighted average period of 0.50 years (at December 31, 2022: $63,328 over 0.63 years).
Stock Options
As of March 31, 2023, the Company had outstanding stock options covering 70,000 Common Shares at an overall average exercise price of $5.03 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 70,000 options have a weighted average expected remaining term of approximately 0.80 years.
The following table summarizes stock option activity for the three months ended March 31, 2023 and the year ended December 31, 2022:
Options
Exercise
Exercise price in US$
Price
Price (1)
Balance at beginning of period
70,000
5.03
218,750
5.28
Exercised
(138,750)
5.38
Expired/Forfeited
(10,000)
5.51
Balance at period-end
Exercisable at period-end
At March 31, 2023, the Company had unrecognized stock-based compensation, related to these options, of nil (at December 31, 2022: nil). The aggregate intrinsic value at March 31, 2023 was $21,700 (at December 31, 2022: $112,000).
During the three months ended March 31, 2023 and the year ended December 31, 2022, the Company awarded no stock options.
(d) Dividends
On March 3, 2023, the Board declared quarterly dividends of $0.0625 per common share (annualized $0.25 per common share) totaling in aggregate an amount of approximately $1.41 million that was paid on March 31, 2023.
15
8. Revenue Recognition
Revenues are comprised of sales of natural gas, oil and NGLs, along with the revenue generated from the Company’s ownership interest in the gas gathering system in the Auburn field in Northeastern Pennsylvania.
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 points 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 months ended March 31, 2023 and 2022.
Three Months Ended March 31,
Operating revenue
Natural gas
6,256,178
10,703,084
Natural gas liquids
196,295
314,428
Oil and condensate
517,108
461,813
Gathering and compression fees
Total operating revenue
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 generally 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 GGS is received two months after gathering and compression has occurred. As a result, the Company must estimate the amount of production that was gathered 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 Credit Losses
The Company records an allowance for credit losses on a case-by-case basis once there is evidence that collection is not probable. For the three months ended March 31, 2023, there were no accounts for which collection was not probable.
The following table details accounts receivable as of March 31, 2023 and December 31, 2022.
Natural gas and oil sales
2,593,604
5,696,419
Joint interest billing
17,476
20,454
1,765,871
1,483,956
428,369
557
Total accounts receivable
9. Income Taxes
Income tax provisions for the three months ended March 31, 2023 and 2022 are as follows:
Current:
Federal
960,508
1,466,896
State
378,522
692,316
Total current income tax expense
1,339,030
2,159,212
Deferred:
(17,278)
22,015
5,170
671
Total deferred tax expense
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 no uncertain income tax positions. The Company's tax returns are open to audit under the statute of limitations for the years ending December 31, 2019 through December 31, 2022. 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 three months ended March 31, 2023 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.
10. Commitments and Contingencies
The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2023, the Company had commitments of $0.2 million for capital expenditures.
On March 10, 2021, Epsilon filed a complaint against Chesapeake Appalachia, LLC (“Chesapeake”) in the United States District Court for the Middle District of Pennsylvania, Scranton, Pennsylvania (“Middle District”). Epsilon claims that Chesapeake has breached a settlement agreement and several operating agreements (“JOAs”) to which Epsilon and Chesapeake are parties. Epsilon asserts that Chesapeake has failed to cooperate with Epsilon’s efforts to develop resources in the Auburn Development, located in Northeast Pennsylvania, as required under both the settlement agreement and JOAs.
Epsilon requested a preliminary injunction but was unsuccessful in obtaining that injunction. Epsilon filed a motion to amend its original Complaint. Chesapeake opposed. The Court ruled in Epsilon’s favor and allowed Epsilon’s amendment. Chesapeake moved to dismiss the amended Complaint. The Court granted the motion to dismiss without prejudice to Epsilon’s right to file a new lawsuit based on new proposals made after the Court’s decision. Epsilon filed a motion for reconsideration of that decision, but the court denied the motion for reconsideration on January 18, 2022.
Epsilon filed a notice of appeal on February 15, 2022 challenging both the motion to dismiss and motion for reconsideration decisions. Chesapeake filed a cross-appeal on March 1, 2022. A briefing schedule was set and briefing closed October 14, 2022. Oral argument was held in January 2023. A decision on the appeal is not expected until mid-2023.
Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022. Epsilon generally asserts similar claims as in the previous suit, pursuing declaratory judgment claims regarding Chesapeake’s obligation to Epsilon to cooperate with Epsilon’s efforts in the Auburn Development and regarding Chesapeake’s obstruction of Epsilon’s efforts with the Pennsylvania Department of Environmental Protection permitting process but not based on specific well proposals. Chesapeake filed a motion to stay pending a decision on the Third Circuit appeal, which was granted. The matter is stayed pending a decision from the Third Circuit.
11. Leases
Under ASC 842, Leases, the Company recognized an operating lease related to its corporate office as of March 31, 2023 summarized in the following table:
Asset
-
Total operating lease right-of-use assets
Liabilities
Total operating lease liabilities
544,152
Operating lease costs
35,233
32,097
Cash paid for amounts included in the measurement of lease liabilities
Operating cash flows from operating leases
27,010
106,798
Weighted average remaining lease term (years) - operating lease
3.39
0.33
Weighted average discount rate (annualized) - operating lease
8.25%
8.09%
The Company had one office lease that expired in April 2023. On March 1, 2023, the Company commenced a new office lease with a 70 month lease term and future lease payments estimated to be approximately $0.85 million. There are no other pending leases, and no lease arrangements in which the Company is the lessor. Lease expense for operating leases was $0.04 million and $0.03 million as of March 31, 2023 and December 31, 2022, respectively. This lease expense is presented in other general and administrative expenses in the consolidated statements of operations and comprehensive income.
Future minimum lease payments as of March 31, 2023 are as follows:
Operating Leases
2024
134,750
2025
173,550
2026
177,021
2027
180,492
Thereafter
183,963
Total minimum lease payments
849,776
Less: imputed interest
(305,624)
Present value of future minimum lease payments
Less: current obligations under leases
(2,756)
Long-term lease obligations
12. Net Income Per Share
Basic net income per share is computed on the basis of the weighted-average number of common shares outstanding during the period. Diluted net income 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 used in the calculation of basic and diluted net income per share is as follows:
In calculating the net income per share, basic and diluted, the following weighted-average shares were used:
Basic weighted-average number of shares outstanding
Dilutive stock options
8,512
16,728
Unvested time-based restricted shares
21,415
65,395
Unvested performance-based restricted shares
6,864
102,463
Diluted weighted average shares outstanding
The Company excluded the following shares from the diluted EPS because their inclusion would have been anti-dilutive.
Anti-dilutive options
61,488
163,272
Anti-dilutive unvested time-based restricted shares
276,795
100,607
Anti-dilutive unvested performance-based restricted shares
8,969
49,037
Total Anti-dilutive shares
347,252
312,916
13. 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 income (loss) as shown in the table below. Interest income and expense, and income taxes are managed separately on a group basis. As of March 31, 2023, general and administrative costs and interest income were moved to the Corporate segment because they are entirely comprised of corporate expenses and are not allocated to the Upstream and Gas Gathering segments. To be consistent with this current presentation, the general administrative costs of $1.3 million and interest income of $0.02 million for the three months ended March 31, 2022 has been reclassed as well.
The Company’s reportable segments are as follows:
Segment activity as of, and for the three months ended March 31, 2023 and 2022 is as follows:
Upstream
Gas Gathering
Corporate
Elimination
Consolidated
For the three months ended March 31, 2023
2,750,503
(363,808)
Total operating revenue (1)
Operating costs
1,768,087
651,371
2,203,491
4,259,141
Depletion, depreciation, amortization and accretion
1,493,755
279,251
3,707,739
1,819,881
(2,203,491)
Other (expense) income
652
983
1,040,875
491,745
4,748,614
(1,711,746)
Capital expenditures (2)
1,145,146
21,624
1,166,770
For the three months ended March 31, 2022
2,485,937
(365,164)
1,773,040
1,313,434
3,245,685
1,104,497
284,722
8,601,788
1,676,840
(1,313,434)
(987,223)
9,815
7,614,565
(1,303,619)
2,610,894
15,393
2,626,287
21
14. Commodity Risk Management Activities
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 derivative 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 oil and natural gas 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.
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 loss (gain) on derivative contracts on the condensed consolidated statements of operations and comprehensive income (loss). The related cash flow impact is reflected in cash flows from operating activities. During the three months ended March 31, 2023, Epsilon recognized gains on commodity derivative contracts of $1,068,660. This amount included cash received on settlements on these contracts of $363,300. For the three months ended March 31, 2022, Epsilon recognized losses on commodity derivative contracts of $971,904. This amount included cash paid on settlements on these contracts of $1,211,728.
At March 31, 2023, the Company had outstanding NYMEX HH swaps totaling 0.92 Bcf and Tennessee Z4 basis swaps totaling 0.92 Bcf outstanding.
Fair Value of Derivative Assets
Current
NYMEX Henry Hub swap
2,373,200
1,219,865
Tennessee Z4 basis swap
181,775
1,401,640
Fair Value of Derivative Liabilities
(445,750)
(179,550)
Net Fair Value of Derivatives
The following table presents the changes in the fair value of Epsilon’s commodity derivatives for the periods indicated:
Fair value of asset (liability), beginning of the period
(239,824)
Gains (losses) on derivative contracts included in earnings
Settlement of commodity derivative contracts
(363,300)
1,211,728
Fair value of asset (liability), end of the period
15. Asset Retirement Obligations
Asset retirement obligations are 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, and the forecast risk free cost of capital. Epsilon has estimated the value of its total asset retirement obligations to be $2.8 million as of March 31, 2023 ($2.8 million at December 31, 2022) based on a total net future undiscounted liability of approximately $7.5 million ($7.4 million at December 31, 2022). Each year we review, and to the extent necessary, revise our asset retirement obligations estimates.
The following tables summarize the changes in asset retirement obligations for the periods indicated:
Three Months Ended
Balance beginning of period
2,833,656
Liabilities acquired
12,053
Liabilities disposed of
(25,835)
Wells plugged and abandoned
(118,260)
Accretion
20,083
78,623
Balance end of period
16. Fair Value Measurements
The methodologies used to determine the fair value of our financial assets and liabilities at March 31, 2023 were the same as those used at December 31, 2022.
Cash and cash equivalents, restricted cash, accounts receivable, and accounts payable 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.
The Company has investments in U.S. Treasury Notes, some of which mature over a period greater than 90 days and are classified as short term investments. The U.S. Treasury Notes are carried at amortized cost. The carrying values are adjusted for accretion of discounts over the remaining life of the investment. The U.S. Treasury Notes are classified within Level 1 of the fair value hierarchy. As of March 31, 2023, there was $30.1 million in short term investments, $29.9 million of adjusted cost basis and $0.2 million in unrecognized gains.
Commodity derivative instruments consist of NYMEX Henry Hub swap and basis swap contracts for natural gas. The Company’s derivative contracts are valued based on a marked to market approach. 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.
17. Current Expected Credit Loss
Under ASU 326, Financial Instruments – Credit Losses, estimated losses on financial assets are provided through an allowance for credit losses. The majority of our financial assets are invested in U.S. Treasury Notes. We also have accounts receivable which are primarily from purchasers of oil and natural gas, counterparties to our financial instruments, and revenues earned for compression and gathering services. Our oil, gas, and natural gas liquids accounts receivables are generally collected within 30 days after the end of the month. Compression and gathering receivables are generally collected within 60 days after the end of the month. We assess collectability through various procedures, including review of our trade receivable balances by counterparty, assessing economic events and conditions, our historical experience with counterparties, the counterparty’s financial condition and the amount and age of past due accounts. As of the three months ended March 31, 2023, we determined that our allowance for credit loss was nil.
18. Subsequent Events
Effective April 13, 2023, Dewey Energy Holding, LLC divested two operated wells in the State of Oklahoma along with 1,298 net acres of leasehold. Subsequently, Dewey Energy Holdings, LLC now owns 7,228 net acres of leasehold in Oklahoma.
On May 9, 2023, Epsilon entered into definitive agreements to acquire 10% interest in two wellbores (located in Eddy Co, NM) from a private operator. The wells are currently on flow-back. Total capital expenditures (net to Epsilon) are estimated at $2.1 million.
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 March 31, 2023 and 2022 and for the three 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, 2022. 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.”
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 areas of operations are the Marcellus shale section of the Appalachian basin in Pennsylvania and the NW Anadarko basin in Oklahoma. In Pennsylvania, we hold 5,098 net acres producing 25 MMcf/d net to our revenue interest. In Oklahoma, we hold 7,228 net acres producing 2.7 MMcfe/d net to our revenue interest.
In Pennsylvania, the Company owns a 35% interest in the 52 mile Auburn Gas Gathering System (“Auburn GGS") which is operated by a subsidiary of Williams Partners, LP.
Our common shares trade on the NASDAQ Global Market under the ticker symbol “EPSN.”
The Company is focused on high rate of return capital investments in onshore North American natural gas and oil basins. We are committed to disciplined capital allocation which should include shareholder returns in the form of dividends and share buybacks. We expect that our strong balance sheet and large liquidity position will allow us to opportunistically invest in both our existing project areas and potential new projects.
To date, our investments have been focused in our position in the prolific Marcellus unconventional reservoir in Pennsylvania (“PA”). Our PA assets are supported by our 35% ownership in the Auburn GGS. We have a substantial remaining drillable location inventory within our existing leaseholds.
The Company is actively seeking new opportunities in several other onshore North American natural gas and oil basins.
Three months ended March 31, 2023 Highlights
Marcellus Shale – Pennsylvania
●
During the three months ended March 31, 2023, Epsilon’s realized natural gas price was $2.56 per Mcf compared to $4.47 per Mcf over the same period in 2022, a 43% decrease.
During the three months ended March 31, 2023, Epsilon’s natural gas production was 2.5 Bcf compared to 2.4 Bcf during the same period in 2022, a 0.8% increase.
Anadarko, NW Stack Trend – Oklahoma
During the three months ended March 31, 2023, Epsilon’s realized price for all Oklahoma production was $6.44 per Mcfe compared to $7.71 per Mcfe over the same period in 2022, a 17% decrease.
Total production for the three months ended March 31, 2023 included natural gas, natural gas liquids, and oil and condensate and was 0.17 Bcfe, as compared to 0.17 Bcfe during the same period in 2022.
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 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 months ended March 31, 2023 and 2022, which is the most directly comparable measure of financial performance calculated under U.S. GAAP and should be reviewed carefully.
Add Back:
Interest (income) expense, net
(462,325)
98
Depreciation, depletion, amortization, and accretion
Gain on derivative contracts net of cash received or paid on settlement
(705,360)
Foreign currency translation loss
(983)
Adjusted EBITDA
5,640,835
9,284,983
Results of Operations
For the three months ended March 31, 2023 revenues decreased $4.2 million, or 31%, to $9.4 million from $13.6 million during the same period of 2022.
Revenue and volume statistics for the three months ended March 31, 2023 and 2022 were as follows:
Revenues
Pennsylvania
Natural gas revenue
5,852,725
10,131,015
Volume (MMcf)
2,286
2,265
Avg. Price ($/Mcf)
2.56
4.47
Gathering system revenue
Total PA Revenues
8,239,420
12,251,788
Oklahoma
403,453
572,069
96
86
4.20
6.68
Natural liquids revenue
Volume (MBO)
6.1
9.8
Avg. Price ($/Bbl)
32.29
32.19
Oil and condensate revenue
6.8
5.1
76.15
90.62
Total OK Revenues
1,116,856
1,348,310
Total Revenues
Upstream natural gas revenue for the three months ended March 31, 2023 decreased by $4.4 million, or 42%, over the same period in 2022. A decrease of $4.6 million was due to lower natural gas prices partially offset by an increase of $0.2 million due to higher sales volumes.
Upstream natural gas liquids revenue for the three months ended March 31, 2023 decreased by $0.1 million, or 38% over the same period in 2022. This was a result of decreased NGL production.
Upstream oil and condensate revenue for the three months ended March 31, 2023 increased by $0.1 million, or 12% over the same period in 2022. An increase of $0.2 million was due to higher volumes offset by a decrease of $0.1 million due to lower prices.
Gathering system revenue for the three months ended March 31, 2023 increased by $0.3 million, or 13% over the same period in 2022. This was the result of anchor shipper volumes, which pay the full gathering rate, increasing from 62% to 88% of total throughput. Revenues derived from transporting and compressing our production, which have been eliminated from gathering system revenues amounted to $0.4 million for each of the three months ended March 31, 2023 and 2022.
The following table presents total cost and cost per unit of production (Mcfe), including ad valorem, severance, and production taxes for the three months ended March 31, 2023 and 2022:
Lease operating costs
Gathering system operating costs
2,055,620
1,929,865
Upstream operating costs—Total $/Mcfe
0.57
0.58
Gathering system operating costs $/Mcf
0.18
0.12
Operating costs include the effects of elimination entries to remove the gathering fees paid to Epsilon’s ownership in the gathering system.
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. For the three months ended March 31, 2023 and 2022, upstream operating costs remained consistent.
Gathering system operating costs consist primarily of rental payments for the natural gas fueled compression units and overhead fees due to the system’s operator. For the three months ended March 31, 2023, gathering system operating costs increased by $0.1 million, or 24% from the same period in 2022. This increase is due to a higher mix of anchor shipper volumes and a CPI-U adjusted increase to the G&A fee on these volumes.
Depletion, Depreciation, Amortization and Accretion (“DD&A”)
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. 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.
Depreciation expense includes amounts pertaining to our office furniture and fixtures, leasehold improvements, 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 costs.
For the three months ended March 31, 2023, DD&A expense was generally consistent compared to the same period in 2022, increasing by $0.2 million, or 12%.
General and Administrative (“G&A”)
General and administrative
2,203,521
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 granted and restricted shares of stock granted and the related non-cash compensation.
G&A expenses increased by $0.9 million, or 68%, during the three months ended March 31, 2023 from 2022. This was primarily due to $0.4 million in compensation associated with management transition, $0.1 million in legal fees related to the complaint filed against Chesapeake, $0.2 million in other service fees, and $0.2 million in other miscellaneous G&A.
For the three months ended March 31, 2023 and 2022, Epsilon was entered into NYMEX Henry Hub (“HH”) Natural Gas Futures swaps and Tennessee basis swap derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three months ended March 31, 2023, we received net cash settlements of $363,300. During the three months ended March 31, 2022, we paid net cash settlements of $1,211,728.
For the three months ended March 31, 2023, realized gains on derivative contracts increased as the NYMEX Henry Hub Natural Gas Futures prices decreased further from the prices at which the Company sold the Henry Hub swaps. As of March 31, 2023, the Company had no derivative contracts beyond December 31, 2023.
The primary source of cash for Epsilon during the three months ended March 31, 2023 and 2022 was funds generated from operations. The primary uses of cash for the three months ended March 31, 2023 were development of natural gas properties, investment in U.S. Treasury Notes, the repurchase of shares of common stock, and the distribution of dividends. The primary uses of cash for the three months ended March 31, 2022 were development of natural gas properties and the distribution of dividends.
At March 31, 2023, we had a working capital surplus of $50.8 million, an increase of $1.6 million over the $49.2 million surplus at December 31, 2022. The Company anticipates its current cash balance, cash flows from operations, and available sources of liquidity to be sufficient to meet its cash requirements for the next twelve months and beyond.
Three months ended March 31, 2023 compared to 2022
During the three months ended March 31, 2023, $7.6 million was provided by the Company’s operating activities, compared to $7.7 million provided during the same period in 2022, a $0.1 million, and 2% decrease.
The Company used $30.9 million and $2.9 million of cash for investing activities during the three months ended March 31, 2023 and 2022, respectively. The Company invested $30,1 million in U.S Treasury Notes and $0.8 million on leasehold and development costs targeting increasing production in Pennsylvania and Oklahoma.
The Company used $2.8 million of cash for financing activities during the three months ended March 31, 2023. This was spent primarily on dividend payments and the repurchase of shares of common stock. The Company used $1.3 million of cash for financing activities during the three months ended March 31, 2022. This cash was spent on dividend payments.
We were in compliance with the financial covenants of the agreement as of March 31, 2023 and expect to be in compliance for the next 12 months. We currently have no borrowings under the facility.
Commencing on March 8, 2022, we implemented a plan to repurchase our issued and outstanding common shares and to return capital to our shareholders. We used cash on hand to fund these repurchases. During the year ended December 31, 2022, we repurchased 982,500 common shares of the maximum of 1,183,410 authorized for repurchase and spent
$6,234,879 under the plan. The repurchased stock had an average price of $6.32 per share (excluding commissions) and was subsequently retired during the year ended December 31, 2022.
The Company has entered into hedging arrangements to reduce the impact of natural gas price volatility on operations. By reducing the price volatility from a significant portion of natural gas production, the potential effects of changing prices on operating cash flows have been mitigated, but not eliminated. While mitigating the negative effects of falling commodity prices, these derivative contracts also limit the benefits we might otherwise receive from increases in commodity prices.
At March 31, 2023, Epsilon’s outstanding natural gas commodity contracts consisted of the following:
Weighted Average Price ($/MMbtu)
Volume
Basis
Fair Value of Asset
Derivative Type
(MMbtu)
Swaps
Differential
920,000
5.21
(1.25)
1,840,000
The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2023, the Company had short term commitments of $0.2 million for capital expenditures and long term commitments of $7.4 million for asset retirement obligations.
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.
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.
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.
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 three 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 March 31, 2023 and 2022, the outstanding principal balance under the credit agreement was nil.
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.
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 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. Our principal executive officer and principal financial officer have concluded that our current disclosure controls and procedures were effective as of March 31, 2023 at the reasonable assurance level.
Changes in Internal Control over Financial Reporting
No changes in our internal control over financial reporting occurred during the quarter ended March 31, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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.
Epsilon requested a preliminary injunction but was unsuccessful in obtaining that injunction. Epsilon filed a motion to amend its original Complaint. Chesapeake opposed. The Court ruled in Epsilon’s favor and allowed Epsilon’s amendment. Chesapeake moved to dismiss the amended Complaint. The Court granted the motion to dismiss on a narrow issue without prejudice to Epsilon’s right to file a new lawsuit based on new proposals made after the Court’s decision. Epsilon filed a motion for reconsideration of that decision, but the court denied the motion for reconsideration on January 18, 2022.
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, 2022.
(c) Purchases of Equity Securities by Epsilon Energy Ltd.
The following table contains information about our acquisition of equity securities during the three months ended March 31, 2023.
Not applicable.
ITEM 6. —EXHIBITS
Exhibit
No.
Description of Exhibit
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
Inline XBRL Instance Document.
101.SCH
Inline XBRL Schema Document.
101.CAL
Inline XBRL Calculation Linkbase Document.
101.DEF
Inline XBRL Definition Linkbase Document.
101.LAB
Inline XBRL Labels Linkbase Document.
101.PRE
Inline XBRL Presentation Linkbase Document.
104
Cover Page Interactive Data File (embedded within the Inline XBRL document)
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.
(Registrant)
Date: May 10, 2023
By:
/s/ J. Andrew Williamson
J. Andrew Williamson
Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)