Business Context and Reporting Period
Company: Epsilon Energy Ltd.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2018
Business Overview: Epsilon is a North American on-shore independent oil and gas company focused on the acquisition, development, gathering, and production of reserves. Primary operations are in the Marcellus Shale (Pennsylvania) and the Anadarko Basin (Oklahoma). The company owns a 35% interest in the Auburn Gas Gathering System in Pennsylvania. As of December 31, 2018, the company held 119,116 MMcf of natural gas reserves and 30,502 barrels of oil/liquids.
Key Financial Metrics
| Metric ($ in thousands) | 2018 | 2017 |
|---|---|---|
| Total Revenues | $29,684 | $25,757 |
| Net Income | $6,662 | $7,436 |
| Operating Income | $9,621 | $3,648 |
| Adjusted EBITDA | $15,600 | $17,000 |
| Cash and Cash Equivalents | $14,401 | $9,999 |
| Working Capital Surplus | $13,600 | $7,900 |
| Revolving Credit Facility (Borrowing Base) | $23,000 (Available) | $13,500 (Available) |
| Debt Outstanding | $0 | $2,900 |
Production & Pricing (2018):
- Natural Gas: 7,563 MMcf at an average price of $2.52/Mcf.
- Oil & Liquids: 17.1 MBO at an average price of $39.31/Bbl.
- Gathering System Revenue: $9,982 (up 55.2% from 2017).
Material Changes vs. Prior Period
- Revenue Growth: Total revenues increased 15.2% to $29.7 million, driven primarily by a 55.2% increase in gathering system revenue due to higher throughput volumes and rate adjustments.
- Net Income Decline: Net income decreased 10.4% to $6.7 million. This was largely due to a $1.9 million loss on commodity derivative contracts in 2018, compared to a $2.6 million gain in 2017.
- Depletion, Depreciation, Amortization (DD&A): DD&A expenses decreased 35.1% to $7.2 million, attributed to a significant increase in reported reserves in late 2017 and lower production volumes in 2018.
- Debt Reduction: The company paid off its revolving line of credit balance entirely during 2018, reducing interest expense by 85.3% compared to 2017.
- Reserve Revisions: Net proved reserves decreased by approximately 96,472 MMcf from 2017 levels, primarily due to production and revisions of previous estimates.
Guidance, Outlook, and Risks
Management Commentary & Outlook:
Management aims to maximize the value of integrated Marcellus and Anadarko assets. The company intends to invest capital to increase production when natural gas pricing improves. The Auburn Gas Gathering System is operating at approximately 83% of designed throughput capacity. The company believes cash generated from operations, combined with cash on hand and the $23 million credit facility, is adequate to meet liquidity needs for the next 12 months.
Key Risks:
- Commodity Price Volatility: Revenues are highly dependent on natural gas prices, which are subject to wide fluctuations and significant discounts (differentials) in the Northeast Pennsylvania region relative to Henry Hub.
- Geographic Concentration: Approximately 97% of production in 2018 was derived from the Marcellus region in Pennsylvania, exposing the company to regional regulatory and capacity risks.
- Capital Access: As a smaller reporting company, access to capital markets may be more difficult than for larger competitors. The borrowing base is subject to redetermination based on commodity prices and reserve values.
- Regulatory Environment: Operations are subject to extensive environmental regulations, including those regarding hydraulic fracturing and greenhouse gas emissions.
Investor Verification Checklist
- Derivative Exposure: Verify the impact of the $1.9 million loss on commodity contracts and the current fair value of outstanding swaps ($297,023 liability as of Dec 31, 2018).
- Reserve Revisions: Investigate the reasons for the significant downward revision of proved reserves (approx. 96 Bcf decrease) and the impact on future DD&A calculations.
- Gathering System Economics: Review the "Cost of Service" model for the Auburn Gas Gathering System to understand how rate adjustments affect future margins if throughput declines.
- Price Differentials: Assess the current natural gas price differential in Northeast Pennsylvania and its potential to erode upstream margins despite higher realized prices.
- Credit Facility Covenants: Confirm continued compliance with financial covenants (Interest coverage > 3, Current ratio > 1, Leverage ratio < 3.5) given the volatility in commodity prices.