Epsilon Energy Ltd. 2020 First-Quarter Form 10-Q Summary
Business Context and Reporting Period
Epsilon Energy Ltd. is a North American independent oil and natural gas company focused primarily on natural gas acquisition, development, production and gathering in Pennsylvania and Oklahoma. The filing covers the three months ended March 31, 2020 and compares results with the three months ended March 31, 2019. Epsilon owns a 35% interest in the Auburn Gas Gathering System in Pennsylvania, with the related operating agreement extending through 2026.
Key Financial Metrics
| Metric | Q1 2020 | Q1 2019 | Change |
|---|---|---|---|
| Total revenue | $6.43 million | $7.95 million | Down 19.1% |
| Operating income | $(1.08) million | $2.62 million | Down $3.69 million |
| Net income | $0.31 million | $1.37 million | Down 77.4% |
| Diluted EPS | $0.01 | $0.05 | Down $0.04 |
| Operating cash flow | $5.21 million | $3.94 million | Up 32.3% |
| Capital expenditures | $2.35 million | $1.51 million | Up $0.84 million |
| Adjusted EBITDA | $4.62 million | $4.39 million | Up 5.2% |
Natural gas revenue was $4.02 million, down 26%, as the average natural gas price declined to approximately $1.47 per Mcf from $2.98, despite production increasing to 2.727 Bcf from 1.823 Bcf. Gas gathering and compression revenue was $2.32 million, down 5.0%.
Operating expenses increased to $7.50 million from $5.33 million, principally because of higher lease operating costs, higher depletion, depreciation, amortization and accretion expense, and a $1.76 million impairment of Oklahoma proved properties. The approximate operating margin was negative 16.8%, compared with 32.9% in the prior-year quarter. The approximate net margin was 4.8%, compared with 17.3%.
Derivative contracts produced a $1.72 million gain, including $1.35 million of cash settlements, compared with a $0.51 million loss in Q1 2019. The derivative asset had a net fair value of $2.37 million at March 31, 2020. Outstanding swaps covered 7.965 million MMBtu, including fixed-price swaps at $2.73 per MMBtu and basis swaps with a $(0.46) differential.
Liquidity, Debt and Capital Resources
- Cash and cash equivalents were $15.41 million at March 31, 2020; cash, cash equivalents and restricted cash totaled $15.97 million.
- Working capital surplus was $16.6 million, compared with $14.9 million at December 31, 2019.
- The company had no borrowings under its senior secured revolving credit facility. The facility had a $23 million borrowing base and matures March 1, 2022.
- Epsilon was in compliance with its credit facility covenants and expected to remain compliant for the next 12 months.
- Financing cash outflow was $1.50 million for share repurchases. Since May 20, 2019, the company had repurchased 1,353,410 shares under an authorization for up to 1,367,762 shares.
- Contractual obligations totaled $12.48 million, including $3.15 million of capital expenditure commitments, $8.93 million of undiscounted asset retirement obligations, $0.30 million of operating lease commitments and $0.10 million of gross derivative liabilities.
Material Changes Versus the Prior Comparable Period
- Revenue declined primarily because of lower realized natural gas prices, although Pennsylvania production increased 49.6% to 2.727 Bcf.
- Oklahoma production increased 17% to 0.070 Bcfe, but the region was affected by lower commodity prices and a $1.76 million asset impairment.
- Lease operating expenses increased 19.2% to $2.05 million, partly due to four new wells placed online in October 2019.
- DD&A increased 32% to $2.41 million, reflecting additional wells and lower reserve volumes used in the March 31, 2020 calculation.
- General and administrative expense decreased 19.8% to $1.18 million, primarily because prior-year costs related to the TSX delisting and NASDAQ listing did not recur.
- Operating cash flow increased despite lower net income, supported by derivative cash settlements and working-capital changes.
- The weighted-average diluted share count declined to 26.6 million from 27.4 million, reflecting share repurchases.
Outlook, Risks and Unusual Items
Management described the operating environment as challenging because of COVID-19, the March 2020 crude oil price conflict, depressed natural gas liquids prices, reduced demand and potential excess supply. The company reported no significant operational disruption during the quarter and stated that it did not need to use CARES Act relief programs.
Epsilon expects local Appalachian production to decline modestly during the second half of 2020. Management’s target is to maintain current production or grow modestly only if commodity prices improve and capital investments meet internal return thresholds. The company is not deploying capital in the Northwest STACK because of depressed natural gas and NGL prices, although those leases remain held by production.
Management stated that cash on hand, operating cash flow and available credit were expected to fund operations and planned development for the next 12 months and beyond, while acknowledging that sustained market deterioration could require additional liquidity. The filing states that the company does not anticipate prolonged negative financial consequences, but also notes that the duration and severity of COVID-19 and commodity-market effects cannot be predicted.
The company disclosed a material weakness in internal control over financial reporting related to the preparation and review of its oil and gas properties impairment calculation. The reported error was corrected in the Form 10-Q reporting process, and management concluded that the financial statements fairly present the periods reported. A remediation plan was being developed, including additional training and accounting research resources.
Other risks include potential additional impairments, commodity price volatility, customer and counterparty concentration, reserve and production uncertainty, derivative exposure, operational disruptions and possible future financing constraints. Three customers accounted for 62%, 13% and 12% of total revenue in Q1 2020.
Investor Verification Checklist
- Verify the sustainability of cash flow and Adjusted EBITDA after excluding the unusually favorable derivative gain and cash settlements.
- Assess sensitivity to natural gas, oil and NGL prices, including the potential for further Oklahoma or other asset impairments.
- Review the company’s derivative volumes, settlement schedule, counterparty exposure and the extent to which hedges limit upside in higher-price environments.
- Confirm the status and remediation of the disclosed material weakness in impairment accounting and review subsequent control disclosures.
- Monitor the $3.15 million capital expenditure commitments, future development spending and the $23 million borrowing-base redeterminations.
- Evaluate customer concentration and the dependence of Pennsylvania production on the Auburn Gas Gathering System.
- Confirm completion or expiration of the share repurchase authorization, which had 183,637 shares remaining at March 31, 2020.