Epsilon Energy Ltd. Form 10-Q Summary
Business Context and Reporting Period
Epsilon Energy Ltd. is a North American onshore natural gas and oil company focused primarily on acquisition, development, production and gathering activities in Pennsylvania and Oklahoma. The company owns a 35% interest in the Auburn Gas Gathering System in Pennsylvania. This unaudited Form 10-Q covers the three and six months ended June 30, 2020, with comparisons to the corresponding 2019 periods.
Financial Performance and Liquidity
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Total revenue | $6.3 million | $6.8 million | $12.7 million | $14.7 million |
| Operating income (loss) | $(0.6) million | $2.8 million | $(1.7) million | $5.4 million |
| Net income (loss) | $(0.6) million | $3.8 million | $(0.3) million | $5.2 million |
| Adjusted EBITDA | $3.1 million | $5.2 million | $7.8 million | $9.6 million |
| Cash flow from operations | Approximately $3.1 million | Approximately $4.1 million | $8.3 million | $8.0 million |
- Revenue declined 7.2% in Q2 and 13.6% year to date, primarily because of lower natural gas, oil and NGL prices. Natural gas revenue declined 19% year to date despite higher production.
- Approximate operating margins were negative 10.2% in Q2 and negative 13.5% year to date. Approximate net margins were negative 9.0% and negative 2.0%, respectively.
- Adjusted EBITDA margin was approximately 50.0% in Q2 and 61.0% year to date, but Adjusted EBITDA declined from the prior-year periods.
- June 30 cash and cash equivalents were $16.3 million, plus $0.6 million of restricted cash. Working capital surplus was approximately $17.2 million.
- The company had no borrowings under its revolving credit facility. The available borrowing base was $23 million, with maturity extended to March 1, 2022. The company was in compliance with its covenants.
- Six-month investing cash use was $4.1 million, primarily for Pennsylvania development. Financing cash use was $1.9 million for share repurchases. Cash, cash equivalents and restricted cash increased by $2.3 million during the first six months.
- June 30 total assets were $93.8 million and shareholders’ equity was $74.5 million. Property and equipment, net, declined to $70.6 million from $74.7 million at December 31, 2019.
Material Changes Versus the Prior Comparable Period
- Natural gas production increased to 2.86 Bcf in Q2 and 5.59 Bcf year to date, compared with 1.92 Bcf and 3.74 Bcf, respectively, in 2019. However, average natural gas prices fell to approximately $1.36 per Mcf in Q2 and $1.41 per Mcf year to date, from $2.26 and $2.61.
- Auburn gathering and compression revenue was broadly stable, declining less than 1% in Q2 and 2.6% year to date. Gathering volumes declined because system pressure reductions lowered capacity from approximately 330 MMcf per day to approximately 200 MMcf per day.
- Lease operating expenses increased 28.4% in Q2 and 23.6% year to date, partly due to four wells placed into service in October 2019. DD&A increased 32% year to date.
- The company recorded a $1.76 million impairment of Oklahoma assets in the first quarter because of historically low oil and NGL prices. No additional impairment was recorded in Q2.
- The company recorded an $819,000 bad debt expense and allowance related to unpaid gathering fees associated with Chesapeake Energy Corporation’s Chapter 11 filing.
- Derivative gains declined to a loss of $85,000 in Q2 from a $2.7 million gain in Q2 2019. Year-to-date derivative gains were $1.6 million versus $2.2 million in 2019. Cash settlements received were $2.4 million year to date.
- The company repurchased 1.35 million shares under its normal-course issuer bid through May 2020 at an average price of $3.33 per share. Subsequent to quarter-end, it accepted 2.34 million shares in a tender offer for approximately $7.15 million, funded with cash.
Outlook, Risks, Contingencies and Unusual Items
- Management expects production to remain stable or grow modestly only if natural gas prices improve and invested capital meets internal return objectives. The company is not currently deploying capital in its Oklahoma Northwest STACK assets because of depressed natural gas liquids and natural gas prices.
- Management expects current cash, operating cash flow and available credit to meet requirements for the next 12 months and beyond, but acknowledges that sustained commodity-price weakness or a prolonged COVID-19 downturn could require additional liquidity.
- COVID-19, oversupply, reduced demand and the 2020 oil-price disruption caused significant commodity-price volatility. Management could not estimate the full effect on 2020 financial condition, liquidity or operations.
- Chesapeake’s bankruptcy creates collection risk for pre-petition Auburn gathering fees. Epsilon’s share of unpaid May and June fees was reserved at $819,000. The timing and ultimate recovery of these amounts remain uncertain.
- At June 30, 2020, outstanding commodity derivatives covered approximately 4.75 million MMbtu, with a net fair value asset of $1.26 million. Hedging reduces downside exposure but limits potential benefit from higher prices and creates counterparty risk.
- Contractual obligations totaled approximately $11.8 million, including $2.5 million of capital expenditure commitments, $8.9 million of undiscounted asset retirement obligations, operating leases and derivative liabilities.
- Management reported a material weakness in internal control over financial reporting related to the preparation and review of the March 31, 2020 oil and gas impairment calculation. Remediation procedures and third-party review were implemented, but management had not yet established that the weakness was fully remediated.
- The filing reports no current litigation and no off-balance-sheet arrangements.
Important Facts for Investors to Verify
- Confirm the effect of the July 2020 tender offer on cash, shares outstanding and liquidity; shares outstanding were 23,796,637 as of August 7, 2020.
- Track Chesapeake’s bankruptcy proceedings and the recoverability of the reserved gathering-fee receivable.
- Assess sensitivity to natural gas, oil and NGL prices, including the company’s derivative volumes, strike prices and settlement profile.
- Review whether the Oklahoma impairment assumptions remain appropriate under updated commodity-price forecasts.
- Monitor Auburn gathering-system throughput, capacity restrictions, customer concentration and the 2026 expiration of the gathering agreement.
- Verify remediation and operating effectiveness testing for the material weakness in impairment controls.
- Reconcile planned capital expenditures and asset-retirement obligations with available cash and the undrawn $23 million borrowing base.