Epsilon Energy Ltd. — Q1 2019 Form 10-Q Summary
Business context and reporting period
Epsilon Energy Ltd. is an Alberta, Canada-incorporated independent oil and gas company focused primarily on acquiring, developing, gathering and producing natural gas in the United States, principally in Pennsylvania’s Marcellus Shale and Oklahoma’s Anadarko Basin. The company owns a 35% interest in the Auburn Gas Gathering System in Pennsylvania. This unaudited Form 10-Q covers the three months ended March 31, 2019, compared with the same period in 2018.
Epsilon began trading on Nasdaq under the symbol EPSN in February 2019 and voluntarily delisted from the TSX effective March 15, 2019. There were 27,355,247 common shares outstanding as of May 10, 2019.
Financial performance and liquidity
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Total revenue | $7.946 million | $7.778 million | +2.2% |
| Operating income | $2.616 million | $2.819 million | -7.2% |
| Net income | $1.374 million | $2.159 million | -36.4% |
| Diluted EPS | $0.05 | $0.08 | Decreased |
| Adjusted EBITDA | $4.393 million | $4.800 million | -8.5% |
| Cash flow from operations | $3.939 million | $2.423 million | +62.6% |
| Cash and cash equivalents at period-end | $16.591 million | $11.992 million | +38.4% |
Oil, gas, NGL and condensate revenue increased to $5.508 million from $5.002 million, while gas gathering and compression revenue declined to $2.438 million from $2.776 million. Operating margin was approximately 32.9% versus 36.2% in the prior-year quarter; net margin was approximately 17.3% versus 27.8%.
Net income was pressured by a $510,754 loss on commodity derivative contracts, compared with a $370,981 gain in Q1 2018, and by higher general and administrative expense. Income tax expense was $746,596, entirely deferred in Q1 2019, versus $987,042 in the prior-year period.
Cash used in investing activities was $1.511 million, primarily for Oklahoma and Pennsylvania leasehold, development and unproved-property expenditures. Cash used in financing activities was $248,381 for share repurchases. Cash increased by $2.190 million during the quarter.
Working capital was approximately $15.0 million at March 31, 2019. The company had no outstanding borrowings under its revolving credit facility and had $23.0 million of available borrowing capacity. The facility maturity was extended to March 1, 2022, and the borrowing base was increased from $15.0 million to $23.0 million in January 2019. Epsilon was in compliance with its financial covenants and expected to remain compliant for the following 12 months.
Material changes versus the prior comparable period
- Natural gas revenue rose 12.1% to $5.435 million, driven by higher realized prices; average natural gas price increased to approximately $2.98/Mcf from $2.55/Mcf.
- Natural gas production declined to 1.823 Bcf from 1.900 Bcf, while Oklahoma production declined 9% to 0.31 Bcfe.
- Gathering system revenue declined 12.7% because system throughput decreased 24%, partly offset by higher gathering and compression rates.
- Lease operating expense fell 11.0% to $1.718 million, and gathering system operating expense declined to $313,000 from $430,000.
- General and administrative expense increased 82.4% to approximately $1.473 million, primarily due to Nasdaq listing, TSX delisting, U.S. reporting and credit facility renewal costs.
- Capital investment increased materially: cash investing outlays were $1.511 million versus $319,000 in Q1 2018, including $596,500 for unproved oil and gas properties.
- The company repurchased 57,100 shares through its normal-course issuer bid at an average price of $4.26 per share and retired additional shares, reducing issued and outstanding shares modestly.
Outlook, management commentary, risks and unusual items
Management intends to maximize the value of its Marcellus and Anadarko assets while evaluating opportunities in other U.S. petroleum basins. Capital investment in Marcellus production is expected to depend on natural gas pricing. Management stated that local Marcellus prices have historically been pressured by infrastructure constraints and wide differentials to Henry Hub, although recently completed infrastructure has begun to improve local pricing.
The Auburn system gathered and delivered 24.9 Bcf gross, or 8.7 Bcf net to Epsilon’s interest, during the quarter, representing approximately 84% of maximum throughput. The gathering agreement includes a contractual 18% rate of return on invested capital and runs through 2026, after which rates will be renegotiated.
Epsilon uses fixed-price and basis-swap contracts to reduce natural gas price volatility. Outstanding contracts covered 14.797 million MMBtu for 2019 and 2020 and had a net derivative liability of $623,533 at March 31, 2019. Hedging reduces downside exposure but also limits benefits from higher commodity prices. The credit facility requires hedging coverage for specified portions of projected production.
Management identified commodity prices, production levels, transportation constraints, reserve estimates, gathering-system throughput, interest rates, foreign currency movements and counterparty performance as material risks. The company had $13.935 million of undiscounted asset retirement obligations, $1.212 million of gross derivative liabilities, $131,184 of capital expenditure commitments and $67,291 of operating lease commitments. No impairment was recorded, no litigation was pending, and no off-balance-sheet arrangements existed.
Management believes operating cash flow, cash on hand and available credit will be adequate to meet liquidity needs for the next 12 months and beyond. The filing provides no formal revenue or earnings guidance.
Important facts for investors to verify
- Reconcile the improvement in operating cash flow and liquidity with the decline in net income and Adjusted EBITDA.
- Assess the impact of the $510,754 derivative loss and the $623,533 net derivative liability on future cash flows and reported earnings.
- Monitor Marcellus basis differentials, local infrastructure developments, realized gas prices and Auburn system throughput.
- Review the higher corporate cost structure following the Nasdaq listing, TSX delisting and expanded U.S. reporting requirements.
- Confirm the borrowing-base redetermination, covenant compliance and required hedge coverage under the revolving credit facility.
- Evaluate reserve estimates, future production declines, capital spending needs and the $13.935 million undiscounted asset retirement obligation.
- Verify customer concentration: two natural gas customers represented 53% and 34% of total revenue in Q1 2019.