Epsilon Energy Ltd. annual report, FY2021

Epsilon Energy Ltd. — FY2021 Form 10-K Summary

Business context and reporting period

Epsilon Energy Ltd. is an Alberta-incorporated, U.S.-focused independent oil and natural gas company engaged in upstream acquisition, development, production and gas gathering. Its principal operations are in Pennsylvania’s Marcellus Shale and Oklahoma’s Anadarko Basin. The filing covers the fiscal year ended December 31, 2021, with comparisons to fiscal 2020; it is not a quarterly filing.

Epsilon owns a 35% interest in the Auburn Gas Gathering System in Pennsylvania under an agreement expiring December 31, 2026.
At year-end, the company reported 110,969 MMcf of proved natural gas reserves, 819,726 barrels of NGL reserves and 305,052 barrels of oil and other liquids reserves.
Leasehold interests totaled approximately 76,544 gross acres and 13,176 net acres, including 275 gross and 35.84 net wells.

Financial and operating performance

Metric	FY2021	FY2020	Change
Total revenue	$42.4 million	$24.4 million	Up 73.6%
Natural gas revenue	$31.7 million	$15.2 million	Up 109%
Oil and other liquids revenue	$2.8 million	$0.3 million	Up 736%
Gathering and compression revenue	$7.9 million	$8.9 million	Down 11%
Operating income	$20.6 million	$(1.0) million	Improved
Net income	$11.6 million	$0.9 million	Up materially
Adjusted EBITDA	$24.1 million	$15.7 million	Up 53.6%
Net cash from operations	$20.0 million	$14.8 million	Up 35%
Capital expenditures and other investing cash outflows	$4.4 million	$6.5 million	Down 32%

Natural gas production was 10,233 MMcf versus 11,204 MMcf in 2020. The Pennsylvania exit rate declined to 29.3 MMcf per day from 32.8 MMcf per day.
The average realized natural gas price increased to $3.10/Mcf from $1.36/Mcf. The filing separately identifies a Pennsylvania realized price of $3.04/Mcf.
Oil and other liquids production increased to 54.4 MBO from 14.9 MBO, while the average realized price increased to $52.02/Bbl from $22.66/Bbl.
Oklahoma production increased to 0.73 Bcfe from 0.31 Bcfe, and the realized price for Oklahoma production increased to $6.34/Mcfe from $2.36/Mcfe.
Lease operating expense declined slightly to $7.9 million, while gathering system operating expense increased to $0.7 million from $0.4 million.
DD&A declined to $6.6 million from $9.6 million, and impairment expense declined to $0.2 million from $1.8 million. Epsilon recorded a $0.5 million gain on the sale of shallow Oklahoma rights and wells.
The company recorded a $4.5 million derivative-contract loss in 2021, compared with a $2.5 million gain in 2020, and paid net cash settlements of $4.2 million on derivatives.

Balance sheet, liquidity and capital structure

Cash and cash equivalents were $26.5 million at December 31, 2021, compared with $13.3 million at December 31, 2020. Cash, cash equivalents and restricted cash totaled $27.1 million.
Working capital surplus was $24.1 million, up from $13.3 million.
Total assets were $99.5 million and shareholders’ equity was $79.3 million at year-end.
The senior secured revolving credit facility has a total commitment of up to $100 million, but the borrowing base was $14 million after a reduction from $18 million in June 2021. There were no borrowings outstanding.
The facility maturity was extended to March 1, 2024. Epsilon was in compliance with its financial covenants and expected to remain compliant for the following 12 months.
2021 financing cash outflows included $2.4 million of share repurchases for 534,015 shares at an average price of $4.54 per share.
Capital expenditure commitments were approximately $3.7 million to $3.8 million, substantially expected to be incurred in 2022. Management stated that cash on hand, operating cash flow and available credit should meet requirements for the next 12 months and beyond.

Material changes versus FY2020

Higher commodity prices and increased Oklahoma production drove the substantial improvement in revenue, operating income, net income and EBITDA despite lower Pennsylvania gas volumes.
Proved natural gas reserves increased to 110,969 MMcf from 88,658 MMcf. The increase primarily reflected higher Pennsylvania gas prices, reserve revisions, extensions and new development.
Standardized measure of discounted future net cash flows increased to $77.7 million from $16.0 million. This measure excludes future cash flows from the gathering system.
Auburn GGS throughput decreased to 63.2 Bcf from 69.5 Bcf, and gathering system revenue decreased to $7.9 million from $8.9 million.
The company drilled three gross Pennsylvania wells and four gross Oklahoma wells, completed three gross Pennsylvania wells and two gross Oklahoma wells, and had additional wells awaiting completion at year-end.
Net income benefited from lower DD&A and impairment expense but was reduced by derivative losses and higher income taxes. The effective tax rate was 27.61%, versus 39.66% in 2020.
Management disclosed that a material weakness identified as of September 30, 2021 related to reporting hedge losses and the related review control was remediated by year-end. Management concluded that disclosure controls and internal control over financial reporting were effective as of December 31, 2021; the auditor did not attest to internal control effectiveness because Epsilon qualifies for the emerging growth company exemption.

Guidance, outlook, risks and unusual items

Management expects Appalachian regional production to be broadly flat in 2022 because major producers remain focused on capital discipline. Epsilon’s target is to maintain current production or grow modestly, subject to adequate gas prices and acceptable investment returns.
Management cited potential longer-term support from LNG exports, exports to Mexico, coal-to-gas switching and moderating supply growth, but provided no formal revenue, earnings or production guidance.
The Oklahoma Meramec appraisal well was reported to be outperforming pre-completion type-curve expectations. Additional appraisal wells had been drilled but not completed.
At December 31, 2021, the company had two natural gas collar contracts covering 590,000 MMBtu for 2022, with a $3.34 ceiling and $2.80 floor. Derivatives had a net fair value liability of $0.2 million.
Epsilon initiated a quarterly cash dividend of $0.0625 per share beginning March 2022, implying an indicated annual rate of $0.25 per share, subject to board approval.
The board authorized a new repurchase program for up to 1,183,410 shares, or 5% of outstanding shares, with aggregate purchases capped at $8.0 million through March 7, 2023.
Epsilon is pursuing litigation against Chesapeake Appalachia concerning alleged breaches of settlement and operating agreements related to the Auburn Development. The amended complaint was dismissed without prejudice, reconsideration was denied, and both parties filed appeals. A decision was expected in the fourth quarter of 2022.
Key risks include volatile commodity prices, Pennsylvania gas discounts and limited interstate transportation, concentration in Pennsylvania, dependence on third-party operators, gathering-system throughput and rate risk, reserve-estimation uncertainty, drilling and service-cost inflation, regulatory and environmental requirements, climate-related policy changes, hydraulic-fracturing restrictions, derivative losses and counterparty credit risk.

Most important facts for investors to verify

Whether Pennsylvania gas prices, regional basis differentials and Auburn GGS throughput support the company’s 2022 production and cash-flow expectations.
The outcome and potential operational implications of the Chesapeake litigation and any effect on Auburn Development activity.
The next borrowing-base redetermination and continued compliance with credit-facility covenants.
The extent to which reserve growth reflects sustainable production performance rather than commodity-price and SEC pricing assumptions.
The cash-flow sustainability of the new dividend and share-repurchase program alongside approximately $3.7 million to $3.8 million of committed capital expenditures.
The effect of derivative contracts on realized prices and cash flow if natural gas prices remain above the collar ceiling or production differs from hedged volumes.
Management’s remediation of the hedge-accounting control weakness and the absence of an independent auditor attestation on internal control effectiveness.