Epsilon Energy Ltd. — FY2019 Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2019. The filing is an annual report, not a standalone 2019 fourth-quarter filing. Epsilon is a North American onshore natural gas and oil company with upstream operations in Pennsylvania and Oklahoma and a 35% interest in the Auburn Gas Gathering System in Pennsylvania. Amounts are in U.S. dollars unless otherwise indicated.
Business Context
- Primary revenue sources are Pennsylvania natural gas production and Auburn gathering and compression fees. Approximately 96% of 2019 production came from the Marcellus region in Pennsylvania.
- At year-end, Epsilon reported 124,161 MMcf of net proved natural gas reserves and 116 MBbl of oil and other liquids, with 78,101 gross and 13,100 net leasehold acres.
- The Auburn system delivered 87.8 Bcf gross, or approximately 241 MMcf/d, at about 73% of designed capacity. The gathering agreement runs through 2026 and provides the system owners an 18% contractual return on invested capital through a cost-of-service model.
- Epsilon began trading on NASDAQ in February 2019 and voluntarily delisted from the TSX in March 2019.
Financial and Operating Metrics
| Metric | 2019 | 2018 | Change |
|---|---|---|---|
| Total revenue | $26.7 million | $29.7 million | Down 10.9% |
| Operating income | $8.2 million | $9.4 million | Down 13.2% |
| Operating margin | 30.7% | 31.8% | Down 1.1 percentage points |
| Net income | $8.7 million | $6.7 million | Up 30.6% |
| Net margin | 32.6% | 22.4% | Improved |
| Adjusted EBITDA | $18.0 million | $15.6 million | Up 15.6% |
| Cash flow from operations | $13.0 million | $10.3 million | Up 26.0% |
| Net cash used in investing | $10.5 million | $2.2 million | Higher investment |
| Net cash used in financing | $2.8 million | $3.6 million | Primarily share repurchases |
| Cash and equivalents | $14.1 million | $14.4 million | Down slightly |
| Working capital surplus | $16.3 million | $13.6 million | Up $2.7 million |
| Total assets | $97.7 million | $87.9 million | Up 11.1% |
| Total liabilities | $21.3 million | $18.0 million | Up 18.7% |
- Natural gas revenue declined to $16.9 million from $19.0 million as the average realized price fell to $2.18/Mcf from $2.52/Mcf, partly offset by production increasing to 7.757 Bcf from 7.563 Bcf.
- Oil and other liquids revenue decreased to $0.4 million from $0.7 million, reflecting lower volumes and prices.
- Gathering system revenue declined to $9.3 million from $10.0 million, primarily because throughput decreased 12.3%.
- Operating expenses were broadly stable at $7.9 million. DD&A increased to $7.4 million from $7.2 million, while general and administrative expense decreased to $4.5 million from $4.9 million.
- Net income benefited materially from a $4.25 million gain on derivative contracts, compared with a $1.94 million loss in 2018. The 2019 gain included $1.95 million of cash settlements.
- The standardized measure of discounted future net cash flows from proved reserves declined to $49.6 million from $59.1 million. This measure excludes future cash flows from the gathering system.
Material Changes Versus 2018
- Production increased in Pennsylvania following the completion and startup of wells drilled in 2018 and 2019. The Pennsylvania exit production rate increased to 30.5 MMcf/d from 21.2 MMcf/d.
- Epsilon participated in four gross, or 1.07 net, lower Marcellus wells in 2019. It also completed four wells spud in late 2018 and brought five wells online during 2019.
- In Oklahoma, production decreased to 0.29 Bcfe from 0.35 Bcfe. One of two 2019 wells was completed; completion of the other was postponed because of lower oil and NGL prices.
- Capital expenditures increased substantially to approximately $13.9 million from $2.5 million, principally for Pennsylvania development, Oklahoma drilling and acreage acquisition.
- The company repurchased 696,096 shares for approximately $2.8 million at an average price of $3.72 per share. Shares outstanding declined to 26.8 million from approximately 27.4 million at year-end 2018.
- The senior secured credit facility was amended to extend maturity to March 1, 2022 and increase the borrowing base from $13.5 million to $23 million. There were no borrowings at year-end.
- Proved reserves increased to 124.2 Bcf of natural gas from 119.1 Bcf, primarily due to improved recoveries, partly offset by revisions and production.
Liquidity, Debt and Commitments
- Cash and equivalents were $14.1 million, with an additional $0.6 million of restricted cash. The company reported no borrowings under its $100 million committed revolving facility and a $23 million borrowing base.
- Management stated that operating cash flow, cash on hand and available credit were expected to fund obligations and planned operating and development activities for the next 12 months and beyond.
- The company was in compliance with its interest coverage, current ratio and leverage covenants and expected to remain compliant over the following 12 months.
- Contractual obligations totaled $11.3 million, including $8.9 million of undiscounted asset retirement obligations, $2.0 million of capital expenditure commitments, $0.3 million of operating leases and $0.2 million of derivative liabilities.
Guidance, Outlook and Risks
- Management’s target is to maintain current production or grow modestly, but only if natural gas prices improve and capital spending meets internal return hurdles.
- Management expected local Appalachian production to decline modestly during the second half of 2020 as major producers reduced capital programs. Longer term, management cited potential support from LNG exports, exports to Mexico and coal-to-gas switching.
- Epsilon planned to limit Oklahoma capital deployment while NGL and natural gas prices remained depressed, while continuing to monitor offset operator activity.
- The filing, dated March 18, 2020, highlighted uncertainty from the COVID-19 crisis, the OPEC+ dispute and significant commodity-price declines. It stated that the company could not predict the duration or effect of the downturn.
- Key risks include commodity-price volatility, substantial Pennsylvania concentration, depressed Northeast Pennsylvania gas differentials, limited interstate transportation capacity, dependence on third-party operators and anchor shippers, gathering-system throughput risk and potential borrowing-base reductions.
- The Auburn gathering rate is recalculated annually under the cost-of-service model. Lower throughput can increase the rate and potentially make new drilling less economic. The current agreement expires in 2026, when rates will be renegotiated.
- The company had no pending or threatened legal proceedings and recorded no asset impairment in 2019 or 2018. Environmental, hydraulic-fracturing, climate-change and regulatory developments could increase costs or restrict operations.
Important Facts for Investors to Verify
- Determine how much of 2019 net income and adjusted EBITDA depended on the $4.25 million derivative gain and whether that benefit is repeatable.
- Review 2020 and subsequent commodity prices, Northeast Pennsylvania basis differentials and their effect on cash flow, reserves and borrowing capacity.
- Assess whether the planned development of proved undeveloped reserves can be completed within five years and at attractive returns.
- Monitor Auburn system throughput, anchor-shipper drilling activity, gathering rates and the 2026 contract renegotiation.
- Reconcile reported cash flow with capital commitments, asset retirement obligations and the company’s stated liquidity needs.
- Review the impact of the COVID-19 downturn and related reductions in producer capital spending on production, well completions and Oklahoma development.
- Consider customer concentration: two customers accounted for approximately 74% of total 2019 revenue, based on the filing’s segment disclosure.