Item 1. Business
Our Company
Alta Mesa Holdings, LP (“Alta Mesa,” the “Company,” “us,” “our,” or “we”) is a privately held company engaged primarily in onshore oil and natural gas acquisition, exploitation, exploration and production whose focus is to maximize the profitability of our assets in a safe and environmentally sound manner. We seek to maintain a portfolio of lower risk properties in plays with known resources where we identify a large inventory of lower risk drilling, development, and enhanced recovery and exploitation opportunities. Our core properties are located in Texas, Louisiana, and Oklahoma. We believe there exist decades of future development potential in our balanced portfolio of assets - principally historically prolific fields in Oklahoma, the onshore Gulf Coast areas of Texas and South Louisiana, East Texas, and the Eagle Ford Shale in South Texas. We maximize the profitability of our assets by focusing on sound engineering, enhanced geological techniques including 3-D seismic analysis, and proven drilling, stimulation, completion, and production methods.
We have increased production at a compounded annual rate of approximately 39% since 2008 through a focused program of drilling and field re-development complemented by strategic acquisitions. As of December 31, 2012, our estimated total proved oil and natural gas reserves were approximately 310 Bcfe, of which 64% were classified as proved developed. Our proved reserve mix is approximately 49% natural gas, 40% oil and 11% natural gas liquids with a reserve life index of 8.6 years for the year ended December 31, 2012. Excluding the Hilltop field and Eagle Ford Shale assets, which include approximately 35% of the PV-10 value of our proved reserves and where EnCana Oil & Gas (USA), Inc. (“EnCana”) and Murphy Oil Corporation (“Murphy Oil”), respectively, are the principal operators, we maintain operational control of the majority of our properties, either through directly operating them, or through structured operating arrangements with minority interest holders.
Our areas of focus are typically characterized by multiple hydrocarbon pay zones, and because in many cases we are re-developing fields and areas originally discovered and developed by major oil and natural gas companies and other independent producers, our assets are typically served by existing infrastructure. As a result, we believe that our business model lowers geological, mechanical, and market-related risks. We focus on properties within our core operating areas that we believe have significant development and exploration opportunities and where we can apply our technical experience and economies of scale to increase production and proved reserves while lowering lease operating and capital costs. Additionally, we have consistently created value through workovers and re-completions of existing wells, infill drilling, operations improvements, secondary recovery and 3-D seismic-driven drilling. We expect to continue production growth in our core areas by exploiting known resources with continued well workovers, development drilling and enhanced recovery programs, and disciplined exploration.
Corporate Partner and Structure
We began operations in 1987, and have funded development and operating activities primarily through cash from operations, capital raised from equity contributed by our founder, capital contributed by a private equity partner, borrowings under our bank credit facilities, and proceeds from the issuance in October 2010 and October 2012 of an aggregate $450 million of principal amount of our senior secured notes due October 15, 2018 (“senior notes”). Our capital partner, Alta Mesa Investment Holdings Inc. (“AMIH”), is an affiliate of Denham Commodity Partners Fund IV LP (“DCPF IV”). DCPF IV is advised by Denham Capital Management LP, a private equity firm focused on energy and commodities. Since investing in us as a limited partner in 2006, AMIH has contributed $150 million in equity and has received $50 million in distributions.
As a limited partnership, our operations and activities are managed by the board of directors of our general partner, Alta Mesa Holdings GP, LLC (“Alta Mesa GP”), and the officers of Alta Mesa Services, LP (“Alta Mesa Services”), an entity wholly owned by us. The sole member of Alta Mesa GP is Alta Mesa Resources, LP, an entity owned by Michael E. Ellis, the founder of our company, Chief Operating Officer, and Chairman of the Board of Directors of Alta Mesa GP, and his spouse, Mickey Ellis.
Acquisition Activity
In 2010, we acquired The Meridian Resource Corporation (“Meridian”), a public exploration and production company, at a cost of $158 million. With this major acquisition we expanded our holdings in Texas and South Louisiana, and increased our reserves by 75 Bcfe, approximately 30%. Significant properties acquired included Weeks Island, a prolific mature oilfield in Louisiana first developed by major oil companies, and certain unproved acreage in Karnes County, Texas, which we are developing in the Eagle Ford shale.
We followed the Meridian purchase in 2011 with acquisitions of properties from Sydson Energy (“Sydson”) and Texas Oil Distribution & Development, Inc. and Matrix Petroleum LLC (“TODD”). The Sydson and TODD acquisitions enhanced our ownership of legacy Meridian properties, including properties in our Eagle Ford shale development. Total cost of the two acquisitions was $51.8 million, and total reserves added were approximately 9 Bcfe.
Index to Financial Statements Additionally, with our acquisition of an interest in Hilltop field in East Texas in 2009, we increased our reserves approximately 80% at the time. Although we are currently deemphasizing capital spending in this prolific dry gas field, it has been a significant contributor to our growth through reserve development and by providing significant cash flow.
Our Strategy
Our objective is to increase reserves and production by applying sound engineering and geological analyses, combined with safe and cost-effective operations, in areas we have identified as under-developed and over-looked.
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Exploit Known Resources in a Repeatable Manner. The majority of our assets are in mature fields previously developed by major oil and natural gas companies or other independent producers, prior to the advent of newer technology that can be applied today. Our objective is to enhance existing production in these properties by using our engineering and geological expertise to convert undeveloped reserves to active production, and to efficiently reduce operating and capital costs. We leverage previous experience and knowledge to continually improve our operations and guide our future development and expansion.
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Maximize Development Opportunities with Sound Engineering and Technology. We seek to exploit and redevelop mature properties by using state-of-the-art technology including 2-D and 3-D seismic imaging and advanced seismic modeling. We apply sound engineering and geologic science, including modern well log analysis and advanced fracture stimulation design, to define the appropriate application of various recovery techniques, including recompletions, infill/step out drilling, horizontal drilling, and/or secondary recovery methods to enhance oil and natural gas production. Our geologists, geophysicists, engineers, and petrophysicists systematically integrate reservoir performance data with geologic and geophysical data, an approach that reduces drilling risks, lowers finding costs and provides for more efficient production of oil and natural gas from our properties.
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Create High-Potential, High-Impact Opportunities while Mitigating Exploration Risk. We target high impact prospects that offer an opportunity to significantly grow reserves. We minimize exploration risk by obtaining and synthesizing engineering, geologic, and seismic data to create a robust knowledge of producing zones in and around our prospective areas. We seek multiple targets in a given exploratory well to maximize and prolong the impact of our capital spending, and seek exploration opportunities that will, upon success, lead to multiple development wells. We diversify our risk across a number of prospects and further mitigate risk by typically bringing in industry partners to participate in our exploration prospects.
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Optimize Production Mix Based on Market Conditions. Our diversified asset base enables us to efficiently and rapidly adjust our development activity in response to market prices. Currently, we intend to take advantage of the favorable oil price environment by continuing to exploit oil and natural gas liquids opportunities within our portfolio. Oil and natural gas liquids together represent 40% of our 2012 production, measured on the traditional energy content ratio of 6:1 between natural gas and crude oil. However, 70% of our products revenues came from oil and natural gas liquids for the year ended December 31, 2012 (79% excluding hedging gains and losses). Oil and liquids-rich gas opportunities represented approximately 92% of our 2012 capital budget and represent approximately 90% of our 2013 capital budget. Commodity mix will be a key consideration as we evaluate future drilling and acquisition opportunities.
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Pursue Value-Based Acquisitions that Leverage Current Internal Knowledge. We continually review opportunities to acquire producing properties, leasehold acreage and drilling prospects. We pursue acquisition targets where our own field exploitation methods can be profitably employed, and identify properties that other energy companies may consider lower-valued and/or non-strategic. While we are biased toward acquisitions that leverage our local knowledge and proprietary field exploitation methods to obtain readily executable opportunities, we consider acquisitions that can provide geographic and geological diversity to mitigate market, weather and other risks. While we prefer to control operations, we also engage in partnerships with other capable operators and service providers so we can capitalize on their data, knowledge and access to equipment.
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Mitigate Commodity Price Risk. Due to the volatility of oil and natural gas prices, we periodically enter into derivative transactions for a portion of our oil and natural gas production. This allows us to reduce exposure to low prices and achieve more predictable cash flows. We retain commodity price upside potential through active management of our portfolio of derivative transactions, as well as through future production and reserve growth. As of December 31, 2012, we have hedged approximately 81% of our forecasted PDP production through 2017 at average annual prices ranging from $4.72 per MMBtu to $5.91 per MMBtu and $90.00 per Bbl to $108.08 per Bbl.
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Maintain Financial Flexibility. In order to maintain our financial flexibility, we plan to fund our 2013 capital budget predominantly with cash flow from operations supplemented by borrowings under our credit facility. Our operational
Index to Financial Statements
control of many properties enables us to manage the timing of a substantial portion of our capital investments. At December 31, 2012, under our senior secured revolving credit facility, we had $155 million in borrowings outstanding and $159 million available for borrowing.
Our Strengths
We believe that the following strengths provide us with significant competitive advantages and position us to continue to achieve our business objective and execute our strategies:
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Proven Track Record of Reserves and Production Growth. We have increased production at a compounded annual rate of approximately 39% since 2008 through a focused program of drilling and field re-development complemented by strategic acquisitions. Based on our long-term historical performance and our business strategy, we believe we have the opportunities, experience and knowledge to continue growing both our reserves and production.
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High Quality Portfolio of Under-Exploited Properties and Multi-Year, Low-Risk Drilling and Wellbore Utilization Inventory. The bulk of our assets are producing properties with significant opportunities for additional exploitation and exploration. We have created and expect to maintain a multi-year drilling inventory and a continuing program of well recompletions, typically to shallower productive zones as deeper formations deplete over time. As of December 31, 2012, our inventory of proved reserve projects consists of 237 PDNP opportunities, 98 of which are recompletions in East Texas (which includes five in Hilltop field), and 157 PUD locations, including 70 PUD locations in the Eagle Ford Shale, 44 PUD locations in Oklahoma, and nine PUD locations in Weeks Island. We believe that we have significant additional development opportunities that are not classified as proved reserves. By targeting productive zones in multiple stacked pays we are able to minimize exploration risk and costs.
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Geographically and Geologically Diverse Asset Base. We have a balanced portfolio of low-risk conventional and high-impact resource assets across various historically productive basins. Our core assets are located in South Texas, where our Eagle Ford Shale assets are an oil and liquids-rich gas resource; in South Louisiana, where our most significant field is Weeks Island, a large oil field with multiple stacked pay sands; in the Hilltop field in East Texas, where the Deep Bossier is a prolific natural gas sand formation, and we believe prospective potential exists in the shallower, oil-prone zones including the Woodbine and Austin Chalk; in other East Texas legacy fields with condensate-rich gas; and in Oklahoma, where our assets are predominantly shallow-decline, long-lived oil fields, which we believe have additional prospective potential in the Mississippian Lime, Hunton, and other formations. Our core properties are located in areas that benefit from an experienced and well-established service sector, efficient state regulation, and available midstream infrastructure and services. In addition, based on our reserve report as of December 31, 2012, approximately 85% of our total future net undiscounted revenues are expected to be generated from the production of proved oil and NGL reserves. We believe our geographic and geologic diversification enables us to allocate our capital more profitably, manage market, weather and regulatory risks, and capitalize on technological improvements.
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Strong Management Team and Seasoned Technical Expertise. We have an experienced and technically-adept management team, averaging more than 25 years of industry experience among our top eight executives. We have built a strong technical staff of geologists and geophysicists, field operations managers, and engineers in all relevant disciplines. Our engineers and operations staff typically began their careers with major oil companies, large independent producers, or leading service companies, and have direct experience in our areas of operation. We believe our engineers are among the best in their respective fields.
Index to Financial Statements Reserve and Production Overview
The following table describes our reserves and production profile as of December 31, 2012:
(1) Computed as a percentage of total reserves of the property.
(2) Based on unweighted average prices as of the first of each month during the 12 months ended December 31, 2012 of $94.71 per Bbl and $2.76 per MMBtu.
(3) Includes developed and undeveloped acreage.
(4) Calculated by dividing total proved reserves as of December 31, 2012 by average daily net production for 2012.
Our Properties
Our core properties are located in South Louisiana, the Eagle Ford Shale in South Texas, East Texas, and Oklahoma. With the exception of our Eagle Ford properties, the majority of our assets are producing properties located in mature fields characterized by what we believe to be low geologic risk and a large inventory of repeatable development opportunities with multiple pay zones.
South Louisiana
We have three major areas of operation in South Louisiana, in fields originally developed by major oil companies. These areas have multiple low-risk exploration and development targets, potential for exploiting substantial bypassed and overlooked oil pay zones, and opportunities to increase profitability through production enhancements and drilling. We had 75 producing wells, 43 PDNP opportunities, and 13 PUDs in this area as of December 31, 2012.
Weeks Island Field. Weeks Island, located in Iberia Parish, contains some of our largest developed oil reserves. It is a historically-prolific oil field with 55 potential pay zones that are structurally trapped against a piercement salt dome, which we believe offer significant future opportunities for added production and reserves. The field was discovered in 1945 by Shell and purchased by Meridian in 1998. Since mid-2011 we have continuously employed one drilling rig and one completion rig in Weeks Island to exploit its potential for development through sidetracking, new drilling and recompletions. We expect to continue development activity in this field in 2013. Weeks Island oil sales prices are based on the Louisiana Light Sweet crude market price index, which has trended appreciably higher than the West Texas Intermediate index in 2012. As of December 31, 2012, we owned an average working interest of 87% in 35 producing wells in this field. We have identified 27 PDNP opportunities and nine PUD locations. We produced 795 MBOE net to Alta Mesa from Weeks Island in 2012.
Ramos Field. The Ramos field is a multi-well, multi-zone producing field located in Terrebonne Parish, Louisiana, which produces condensate-rich gas. We have increased the profitability of Ramos through facilities de-bottlenecking, production well and facility enhancements, and a recompletion since acquiring it with our purchase of Meridian in 2010. As of December 31, 2012, we owned an average 72% working interest in four producing wells in Ramos field. We have identified three PDNP opportunities and two PUD locations. We produced 3.1 Bcfe net to Alta Mesa from the Ramos field in 2012.
South Hayes Field. The South Hayes field is located in Calcasieu and Cameron Parishes. This field produces natural gas with a high liquid content. It has been the focus of our geologic and geophysical efforts for 15 years, including a proprietary 3-D survey covering 90 square miles integrated with over 300 square miles of previously-existing 3-D data. The field has potential for multiple low-risk targets in historically productive zones, as well as exploratory activity. As of December 31, 2012, we had a 47% average working interest in five producing wells, and had identified five PDNP opportunities in this field. We produced 0.8 Bcfe net to Alta Mesa from South Hayes field in 2012.
South Texas Eagle Ford Shale
Our Eagle Ford Shale assets have grown in significance to our operations, and we believe they will continue to be a growing portion of our portfolio in terms of oil production, oil reserves, and investment for several years. As of December 31, 2012, the field contributes 18% of our total proved oil and natural gas liquids reserves. As part of the Meridian transaction in 2010, we acquired interests primarily in an area of Karnes County, Texas referred to as the Eagleville field. Our acreage position also includes portions
Index to Financial Statements
of Goliad and DeWitt Counties. The Eagle Ford is a shale typically developed with horizontal wells. Our interest has grown to 70 producing wells, plus four wells awaiting completion as of year-end 2012, with an average working interest of 14%, and 70 PUD locations identified as of December 31, 2012. The wells are primarily operated by Murphy Oil, which has a multiyear development program. Production from the Eagleville field in 2012 was 790 MBOE net to Alta Mesa of oil and natural gas liquids.
East Texas
Our operations in this area are low-risk expansions of well-established natural gas fields through a consistent, integrated, multi-discipline technical approach to field re-development. Our principal assets in the area are the Urbana and Cold Springs and Cold Springs West fields, which are adjacent fields with similar geologic formations producing condensate-rich gas principally from the Wilcox formation. We have materially increased reserves and extended the life of these fields by utilizing modern well log and geochemical analyses, modern fracture stimulation techniques, and the integration of 3-D seismic for exploitation as well as exploration. Through Meridian we acquired additional acreage and producing wells in the area in 2010.
Urbana Field. We are the operator of 22 wells with an average working interest of 97% in the Urbana field, located in San Jacinto County, Texas. Urbana is a known structure with multiple pay zones, and as many as 35 productive reservoirs from 7,200 feet to 11,600 feet deep. The liquids/oil to natural gas ratio from Urbana makes our wells economic even at low natural gas prices. As of December 31, 2012, we have identified 40 PDNP opportunities and one PUD location in this field. We produced 1.2 Bcfe net to Alta Mesa from Urbana field in 2012.
Cold Springs and Cold Springs West Fields. The Cold Springs and Cold Springs West fields are located west of the Urbana field in San Jacinto County, Texas. These fields are in a known structure with multiple pay zones, similar to the Urbana field but we believe with larger and greater development and expansion potential. We acquired additional seismic data in 2011, which has allowed us to identify opportunities for shallow, relatively inexpensive drilling and recompletion activity. As of December 31, 2012, we had a 75% average working interest in 33 producing wells, and had identified 26 PDNP opportunities and nine PUD locations in these two fields. We produced 2.1 Bcfe net to Alta Mesa from Cold Springs and Cold Springs West in 2012.
Oklahoma
Our assets in Oklahoma are located in large mature oil fields with multiple pay zones at depths from less than 2,000 feet to 7,500 feet. The fields are located in the Sooner Trend area of the Anadarko Basin. These assets are predominantly shallow-decline, long-lived oil fields originally drilled on 80-acre spacing and waterflooded to varying degrees.
Our activity in these fields includes downspacing to 40 acres or less in the historically principal field pay zones that had been unitized for water flooding, as well as drilling or recompleting wells for non-unit pay zones such as the Mississippian Lime, Hunton Lime, Red Fork, and other zones. In 2012, we added production and reserves in the Mississippian Lime formation by deepening or reactivating existing wells, and by drilling new vertical wells. In certain areas of our properties, we also developed the Hunton Lime in this manner. We have applied the knowledge obtained by this effort to define our approach for 2013 and beyond to target the Mississippian Lime and the Hunton Lime.
As of December 31, 2012, we had a 73% average working interest in 244 producing wells, and had identified 80 PDNP opportunities and 44 PUD locations in this area. We produced 359 MBOE net to Alta Mesa from our properties in Oklahoma in 2012.
Hilltop Field
Our Hilltop field is our largest natural gas asset due to the reserves in the Deep Bossier and Knowles Lime formations, contributing 14% of total reserves as of December 31, 2012. The field has been significantly developed in the Deep Bossier formation, a prolific producer of primarily dry natural gas which occurs at 15,000-20,000 feet. Our interests here, which are operated primarily by EnCana and Gastar, have increased from 30 producing wells in 2009 to 58 producing wells at year-end 2012, in which we own an average 28% working interest. Our highest net production from this field occurred in mid-2011 at approximately 58,000 Mcf per day and decreased to approximately 37,000 Mcf per day by the end of that year and to 25,450 Mcf per day by the end of 2012. Total production for 2012 was 10.0 Bcf net to Alta Mesa. Although the Deep Bossier has potential for additional development, we, together with other operators, have redirected our near-term focus to other more liquids-rich zones. The decrease in production reflects natural declines without significant investments in drilling or other development. Our operating agreements with EnCana and Gastar allow us the flexibility to defer additional capital investment in response to the natural gas market. Our interest in this field included five PDNP opportunities and one PUD location as of December 31, 2012.
Index to Financial Statements Hilltop field contains additional potential in the Woodbine, Eagle Ford, and Austin Chalk formations for oil exploration using horizontal drilling. These formations are located at a depth of approximately 7,000 feet in the Hilltop area. In 2012, we drilled a vertical Woodbine well in which we have 100% working interest, and EnCana drilled five horizontal Woodbine/Eagle Ford (Eaglebine) wells in which we have varying interests ranging from a small overriding royalty and after-payout working interest, to a 24% working interest. The learning curve for the Woodbine and Eagle Ford is being developed by EnCana, Alta Mesa, and other nearby operators. Our efforts in 2012 focused on defining the technical and economic basis for further development. We do not currently plan to allocate substantial capital to development of these zones in 2013.
Other shallower formations in the area that we believe have oil potential include the Pettet, James Lime, Glen Rose, and Buda formations. Deeper formations that we believe have natural gas potential include the Knowles Lime, Bossier Shale, and Travis Peak.
Other Assets
In addition to our core areas, we conduct operations in other areas including the Blackjack Creek oil field in Florida, West Virginia acreage productive in the Marcellus Shale, and other fields in South Texas and South Louisiana. We continually evaluate the operations in these areas to determine future development, expansion, acquisition opportunities, and strategic divestiture plans. In West Virginia we successfully drilled two wells in 2012, and deferred completion until gas market conditions warrant. Although natural gas prices do not currently support extensive development of the area, we believe it has substantial additional development potential for natural gas and liquids from the Marcellus Shale and potentially other zones.
Our Oil and Natural Gas Reserves
The table below summarizes our estimated net proved reserves as of December 31, 2012.
(1) Our proved reserves as of December 31, 2012 were calculated using oil and natural gas price parameters established by current SEC guidelines and accounting rules based on average prices as of the first day of each of the twelve months ended on such date. These average prices were $94.71 per Bbl for oil and $2.76 per MMBtu for natural gas. Pricing was adjusted for basis differentials by field based on our historical realized prices. See “Note 19 - Supplemental Oil and Natural Gas Disclosures” in the accompanying Notes to Consolidated Financial Statements included elsewhere in this report for information concerning proved reserves.
The table above represents estimates only. Reserves estimates are based upon various assumptions, including assumptions required by the SEC relating to oil and natural gas prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The process of estimating reserves is complex. This process requires significant decisions and assumptions in the evaluation of available geological, geophysical, engineering and economic data for each reservoir. Furthermore, different reserve engineers may make different estimates of reserves and cash flow based on the same available data and these differences may be significant. Therefore, these estimates are not precise. Actual future production, oil and natural gas prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable oil and natural gas reserves will most likely vary from those estimated. In addition, we may adjust estimates of proved reserves to reflect production history, results of exploration and development, prevailing oil and natural gas prices and other factors, many of which are beyond our control.
Index to Financial Statements Internal Control and Qualifications
The reserve estimation process begins with our internal engineering department, which prepares much of the data used in estimating reserves. Working and net revenue interests are cross-checked and verified by our land department. Cost data are provided by our accounting department on a preliminary basis and reviewed by the engineering department. Our Vice President of Corporate Reserves and Planning is the technical person primarily responsible for overseeing the preparation of our reserve estimates. His qualifications include the following:
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over 10 years of practical experience in petroleum engineering and in the estimation and evaluation of reserves
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Bachelor of Science Degree in Chemical Engineering
Our methodologies include reviews of production trends, material balance calculations, analogy to comparable properties, and/or volumetric analysis. Performance methods are preferred. Reserve estimates for developed non-producing properties and for undeveloped properties are based primarily on volumetric analysis or analogy to offset production in the same field.
We maintain internal controls including the following to ensure the reliability of reserves estimations:
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no employee’s compensation is tied to the amount of reserves booked;
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we follow comprehensive SEC-compliant internal policies to determine and report proved reserves;
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reserve estimates are made by experienced reservoir engineers or under their direct supervision;
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each quarter, our Chief Operating Officer and Chief Executive Officer review all significant reserves changes and all new proved undeveloped reserves additions.
In addition, a third-party engineering firm, Netherland, Sewell & Associates, Inc. (“NSAI”), audited 100% of our 2012 reserve estimates.
A copy of the audit letter issued by NSAI is filed with this report as Exhibit 99.1. The qualifications of the technical person at NSAI primarily responsible for overseeing his firm’s audit of our reserve estimates are set forth below.
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over 11 years of practical experience in petroleum engineering, with over six years of experience in the estimation and evaluation of reserves
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a Registered Professional Engineer in the states of Texas and Louisiana
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Bachelor of Science Degree in Petroleum Engineering
The audit by NSAI conformed to the meaning of “reserves audit” as presented in the SEC’s Regulation S-K, Item 1202.
A reserves audit and a financial audit are separate activities with unique and different processes and results. These two activities should not be confused. As currently defined by the SEC within Regulation S-K, Item 1202, a reserves audit is the process of reviewing certain of the pertinent facts interpreted and assumptions underlying a reserves estimate prepared by another party and the rendering of an opinion about the appropriateness of the methodologies employed, the adequacy and quality of the data relied upon, the depth and thoroughness of the reserves estimation process, the classification of reserves appropriate to the relevant definitions used, and the reasonableness of the estimated reserves quantities. A financial audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A financial audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
Proved Undeveloped Reserves
At December 31, 2012 we had proved undeveloped reserves of 111 Bcfe, or approximately 36% of total proved reserves. The PUDs are primarily in our Eagleville field in the Eagle Ford play in South Texas, in South Louisiana, and in Florida. Total PUDs at December 31, 2011 were 96 Bcfe, or 28% of our total reserves.
In 2012, we converted 13.2 Bcfe, or 14% of total year end 2011 PUDs, to proved developed reserves. Costs relating to the development of PUDs were approximately $49.8 million in 2012. Costs of PUD development in 2012 do not represent the total costs of these conversions, as additional costs may have been recorded in previous years. Estimated future development costs relating to the development of 2012 year-end PUDs are $238 million. All PUDs but two are scheduled to be drilled by 2017; those two are sidetrack developments in producing wells which will be drilled after the current zones are depleted.
We dropped, revised, or reclassified to unproved categories, approximately 28.2 Bcfe from our 2011 PUD balance due to decreased natural gas prices. These were primarily in our Hilltop field and in one other field in South Texas. We added approximately 45.3 Bcfe in PUDs during 2012, primarily in our Eagle Ford shale properties (28.8 Bcfe), in our Weeks Island field in South Louisiana (9.6 Bcfe net increase), and from an acquisition (6.9 Bcfe). Total PUDs also increased approximately 11.3 Bcfe for various reasons, primarily due to revisions based on performance and/or reinterpretation of data.
Index to Financial Statements None of our PUDs at December 31, 2012 originated more than five years ago.
Production, Price and Production Cost History
The following table sets forth certain information regarding the production volumes, average prices received and average production costs associated with our sale of oil and natural gas for the periods indicated below.
The following table provides a summary of our production, average sales prices and average production costs for the Eagleville Field in South Texas, our Eagle Ford shale development, which was the only oil and gas field contributing 15% or more of our total proved reserves as of December 31, 2012:
Index to Financial Statements Drilling Activity
The following table sets forth, for each of the three years ended December 31, 2012, the number of net productive and dry exploratory and developmental wells completed, regardless of when drilling was initiated (all wells are located in the United States). The information should not be considered indicative of future performance, nor should it be assumed that there is necessarily any correlation between the number of productive wells drilled, quantities of reserves found or economic value. We own one drilling rig which currently is under contract to a third party.
Present Activities
As of December 31, 2012, we were drilling 30 gross (14.2 net) wells.
Productive Wells
The following table sets forth information with respect to our ownership interest in productive wells, all of which are located in the United States, as of December 31, 2012:
Of the total well count for 2012, 1 well (0.9 net) is a multiple completion. In addition, we operate 11 wells (9.7 net) which produce from two formations commingled through a single tubing string.
Index to Financial Statements Developed and Undeveloped Acreage Position
The following table sets forth information with respect to our gross and net developed and undeveloped oil and natural gas acreage under lease as of December 31, 2012, all of which is located in the United States:
As is customary in the oil and natural gas industry, we can generally retain interest in undeveloped acreage through drilling activity that establishes commercial production sufficient to maintain the leases or by paying delay rentals during the remaining primary term of leases. The oil and natural gas leases in which we have an interest are for varying primary terms and, if production under a lease continues from developed lease acreage beyond the primary term, we are entitled to hold the lease for as long as oil or natural gas is produced. The oil and natural gas properties consist primarily of oil and natural gas wells and interests in leasehold acreage, both developed and undeveloped.
Undeveloped Acreage Expirations
The following table sets forth information with respect to our gross and net undeveloped oil and natural gas acreage under lease as of December 31, 2012, all of which is located in the United States, that will expire over the following three years by region unless production is established within the spacing units covering the acreage prior to the expiration dates:
Marketing and Customers
The market for our oil and natural gas production depends on factors beyond our control, including the extent of domestic production and imports of oil and natural gas, the proximity and capacity of natural gas pipelines and other transportation facilities, the demand for oil and natural gas, the marketing of competitive fuels and the effect of state and federal regulation. The oil and natural gas industry also competes with other industries in supplying the energy and fuel requirements of industrial, commercial and individual consumers. The prices received for oil and natural gas sales are generally tied to monthly or daily indices as quoted in industry publications.
Crude oil and natural gas purchasers vary by area. We market substantially all our oil and natural gas production pursuant to marketing contracts.
For the year ended December 31, 2012, based on revenues excluding hedging activities, three major customers accounted for 10% or more of those revenues individually, with contributions of $63.3 million, $50.1 million, and $44.8 million. We believe that the loss of such customers would not have a material adverse effect on us because alternative purchasers are readily available.
Competition
We encounter intense competition from other oil and natural gas companies in all areas of our operations, including the acquisition of producing properties and undeveloped acreage. Our competitors include major integrated oil and natural gas companies, numerous independent oil and natural gas companies and individuals. Many of our competitors are large, well-established companies
Index to Financial Statements
with substantially larger operating staffs and greater capital resources and have been engaged in the oil and natural gas business for a much longer time than us. These companies may be able to pay more for productive oil and natural gas properties, exploratory prospects and to define, evaluate, bid for and purchase a greater number of properties and prospects than our financial or human resources permit. Our ability to acquire additional properties and to discover reserves in the future will be dependent upon our ability to evaluate and select suitable properties and to consummate transactions in this highly competitive environment.
We are also affected by competition for drilling rigs and the availability of related equipment. In the past, the oil and natural gas industry has experienced shortages of drilling rigs, equipment, pipe and personnel, which have delayed development, exploitation and exploration activities. We are unable to predict when, or if, such shortages may occur or how they would affect our exploitation and development program.
Employees
As of December 31, 2012, we had 192 full-time employees. We are not a party to any collective bargaining agreements and have not experienced any strikes or work stoppages. We believe our relationships with our employees are good. From time to time, we utilize the services of independent contractors to perform various field and other services. See “Item 13. Certain Relationships and Related Party Transactions, and Director Independence - Shared Services and Expenses Agreement.”
Insurance
In accordance with industry practice, we maintain insurance against some, but not all, of the operating risks to which our business is exposed. We currently have insurance policies that include coverage for general liability (includes sudden and accidental pollution), physical damage to our oil and gas properties, control of well, auto liability, marine liability, worker’s compensation and employer’s liability, among other things.
Currently, we have general liability insurance coverage up to $1 million per occurrence, which includes sudden and accidental environmental liability coverage for the effects of pollution on third parties arising from our operations. Our insurance policies contain maximum policy limits and in most cases, deductibles (generally ranging from $25,000 to $1.8 million) that must be met prior to recovery. These insurance policies are subject to certain customary exclusions and limitations. In addition, we maintain excess liability coverage, which is in addition to and triggered if the general liability per occurrence limit is reached.
Our offshore activities are limited to non-operator positions in five older fields acquired with the Meridian purchase. Our offshore reserves are not a significant portion of our total reserves; the fields are in declining production with no drilling activity. Our consolidated balance sheets include asset retirement liabilities which we believe are sufficient to cover the eventual costs of dismantlement and abandonment. We believe that due to the nature of the operations in these fields, and the limited activity, the risk of environmental damage is not as high as it would be in an actively drilling offshore field. Our insurance program includes property damage, pollution liability, and control of well. The property damage coverage extends to total loss of the equipment (not the reserves) with replacement cost coverage retained on one of the five fields. The pollution coverage, which is applicable to both offshore and onshore events, is $10 million per incident with a $100,000 deductible.
We require all of our third-party contractors, including those that perform hydraulic fracturing operations, to sign master service agreements in which they agree to indemnify us for injuries and deaths of the service provider’s employees as well as contractors and subcontractors hired by the service provider. Similarly, we generally agree to indemnify each third-party contractor against claims made by our employees and other contractors. Additionally, each party generally is responsible for damage to its own property. We do not currently have any insurance policies in effect that are intended to provide coverage for losses solely related to hydraulic fracturing operations.
We re-evaluate the purchase of insurance, coverage limits and deductibles annually. Future insurance coverage for the oil and gas industry could increase in cost and may include higher deductibles or retentions. In addition, some forms of insurance may become unavailable in the future or unavailable on terms that are economically acceptable. No assurance can be given that we will be able to maintain insurance in the future at rates that we consider reasonable and we may elect to self-insure or maintain only catastrophic coverage for certain risks in the future.
Index to Financial Statements Environmental Matters and Regulation
Our operations are subject to stringent and complex federal, state and local laws and regulations that govern the protection of the environment, as well as the discharge of materials into the environment. These laws and regulations may, among other things:
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require the acquisition of various permits before drilling commences;
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require the installation of pollution control equipment in connection with operations;
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place restrictions or regulations upon the use of the material based on our operations and upon the disposal of waste from our operations;
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restrict the types, quantities and concentrations of various substances that can be released into the environment or used in connection with drilling, production and transportation activities;
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limit or prohibit drilling activities on lands lying within wilderness, wetlands and other protected areas; and
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require remedial measures to mitigate pollution from former and ongoing operations, such as site restoration, pit closure and plugging of abandoned wells.
These laws, rules and regulations may also restrict the rate of oil and natural gas production below the rate that would otherwise be possible. The regulatory burden on the oil and natural gas industry increases the cost of doing business in the industry and consequently affects profitability. Additionally, Congress and federal, state and local agencies frequently revise environmental laws and regulations, and such changes could result in increased costs for environmental compliance, such as waste handling, permitting, or cleanup for the oil and natural gas industry and could have a significant impact on our operating costs. In general, the oil and natural gas industry recently has been the subject of increased legislative attention with respect to environmental matters.
The following is a summary of some of the existing laws, rules and regulations to which our business operations are subject.
Solid and Hazardous Waste Handling
The federal Resource Conservation and Recovery Act, or RCRA and comparable state statutes regulate the generation, transportation, treatment, storage, disposal and cleanup of hazardous solid waste. Although oil and natural gas waste generally is exempt from regulations as hazardous waste under RCRA, we generate waste as a routine part of our operations that may be subject to RCRA and not all states similarly exempt oil and gas waste from hazardous waste regulation. Although a substantial amount of the waste generated in our operations are regulated as non-hazardous solid waste rather than hazardous waste, there is no guarantee that the Environmental Protection Agency (“EPA”) or individual states will not adopt more stringent requirements for the handling of non-hazardous waste or categorize some of our waste as hazardous in the future. Any such change could result in an increase in our costs to manage and dispose of waste, which could have a material adverse effect on our results of operations and financial position.
Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”)
CERCLA imposes joint and several liability for costs of investigation and remediation and for natural resource damages without regard to fault or legality of the original conduct, on certain classes of persons with respect to the release into the environment of substances designated under CERCLA as hazardous substances (“Hazardous Substances”). These classes of persons, or so-called potentially responsible parties (“PRPs”) include the current and past owners or operators of a site where the release occurred and anyone who disposed or arranged for the disposal of a hazardous substance found at a site where a release has occurred. CERCLA also authorizes the EPA and, in some instances, third parties to take actions in response to threats to public health or the environment and to seek to recover from the PRPs the costs of such action. Many states have adopted comparable or more stringent state statutes.
Although CERCLA generally exempts “petroleum” from the definition of Hazardous Substance, in the course of our operations, we have generated and will generate wastes that may fall within CERCLA’s definition of Hazardous Substances and may have disposed of these wastes at disposal sites owned and operated by others. Comparable state statutes may not provide a comparable exemption for petroleum. We may also be the owner or operator of sites on which Hazardous Substances have been released. To our knowledge, neither we nor our predecessors have been designated as a PRP by the EPA under CERCLA; we also do not know of any prior owners or operators of our properties that are named as PRPs related to their ownership or operation of such properties. In the event contamination is discovered at a site on which we are or have been an owner or operator or to which we sent Hazardous Substances, we could be liable for the costs of investigation and remediation and natural resources damages.
We currently own, lease, or operate numerous properties that have been used for oil and natural gas exploration and production for many years. Although we believe we have utilized operating and waste disposal practices that were standard in the industry at the time, Hazardous Substances, wastes or hydrocarbons may have been released on or under the properties owned or leased by us, or on or under other locations, including offsite locations, where such materials have been taken for disposal. In addition, some of these properties have been operated by third parties or by previous owners or operators whose treatment and disposal of
Index to Financial Statements
Hazardous Substances, wastes, or hydrocarbons were not under our control. These properties and the materials disposed or released on them may be subject to CERCLA or RCRA and analogous state laws. In the future, we could be required to remediate property, including groundwater, containing or impacted by previously disposed materials (including wastes disposed or released by prior owners or operators, or property contamination, including groundwater contamination by prior owners or operators) or to perform remedial plugging operations to prevent future or mitigate existing contamination.
Clean Water Act
The Federal Water Pollution Control Act (the “Clean Water Act”) and analogous state laws impose restrictions and strict controls with respect to the discharge of pollutants, including spills and leaks of produced water and other oil and natural gas wastes, into waters of the United States, a term broadly defined. The discharge of pollutants into regulated waters is prohibited, except in accordance with the terms of a permit issued by EPA or an analogous state agency. The Clean Water Act also prohibits the discharge of dredge and fill material in regulated waters, including wetlands, unless authorized by a permit issued by the U.S. Army Corps of Engineers. Federal and state regulatory agencies can impose administrative, civil and criminal penalties, as well as require remedial or mitigation measures, for non-compliance with discharge permits or other requirements of the Clean Water Act and analogous state laws and regulations. In the event of an unauthorized discharge of wastes, we may be liable for penalties and cleanup and response costs.
Oil Pollution Act
The primary federal law related to oil spill liability is the Oil Pollution Act (the “OPA”) which amends and augments oil spill provisions of the Clean Water Act and imposes certain duties and liabilities on certain “responsible parties” related to the prevention of oil spills and damages resulting from such spills in or threatening United States waters or adjoining shorelines. A liable “responsible party” includes the owner or operator of a facility, vessel or pipeline that is a source of an oil discharge or that poses the substantial threat of discharge, or in the case of offshore facilities, the lessee or permittee of the area in which a discharging facility is located. OPA assigns joint and several liability, without regard to fault, to each liable party for oil removal costs and a variety of public and private damages. Although defenses exist to the liability imposed by OPA, they are limited. In the event of an oil discharge or substantial threat of discharge, we may be liable for costs and damages.
Safe Drinking Water Act
Many of our development projects require hydraulic fracturing procedures to economically develop the formations. Generally, we perform two types of hydraulic fracturing. In our Eagle Ford shale (Eagleville Field, south Texas), Woodbine (Hilltop Field, East Texas), and Marcellus Shale (West Virginia) plays, we perform hydraulic fracturing in horizontally drilled wells. These procedures are more extensive, time-consuming and expensive than hydraulic fracturing of vertical wells. We perform hydraulic fracturing in vertical wells where the target zones are the Wilcox and Frio formations; this is done in our East Texas and South Texas fields, including primarily Urbana and Cold Springs (both in East Texas). We also have performed hydraulic fracturing in vertical wells completed in the Deep Bossier formation in our Hilltop field.
Currently, most hydraulic fracturing activities are regulated at the state level, as the Safe Drinking Water Act (“SDWA”) exempts most hydraulic fracturing (except for hydraulic fracturing activities involving the use of diesel) from the definition of underground injection. The EPA had released draft guidance on permitting of hydraulic fracturing activities using diesel. Congress has periodically considered legislation to amend the federal SDWA to remove the exemption from permitting and regulation provided to injection for hydraulic fracturing and to require the disclosure and reporting of the chemicals used in hydraulic fracturing. This type of legislation if adopted could lead to additional regulation and permitting requirements that could result in operational delays or increased operating costs, making it more difficult to perform hydraulic fracturing and increasing our costs of compliance and operation.
The EPA has commenced a wide-ranging study on the effects of hydraulic fracturing on drinking water resources. A first progress report of the study was issued in December 2012, with a final draft expected in 2014. In addition, in December 2011, the EPA published an unrelated draft report concluding that hydraulic fracturing caused groundwater pollution in a natural gas field in Wyoming; this study remains subject to review and public comment. In March 2012, the EPA agreed to re-sample its Wyoming wells in partnership with the USGS, the State of Wyoming, and various tribes. The comment period on the Wyoming study closes on September 30, 2013.
The EPA also announced that one of its enforcement initiatives for 2011 to 2013 would be to focus on environmental compliance by the energy extraction sector. This study and enforcement initiative could result in additional regulatory scrutiny that could make it difficult to perform hydraulic fracturing and increase our costs of compliance and doing business. Consequently, these studies and initiatives could spur further legislative or regulatory action regarding hydraulic fracturing or similar production operations.
Index to Financial Statements Many states and other regional and local regulatory authorities have enacted or are considering regulations on hydraulic fracturing, including disclosure requirements and regulations that could restrict or prohibit hydraulic fracturing in certain circumstances. In compliance with the law enacted in Texas, we have disclosed and will continue to disclose hydraulic fracturing data. Further, the Bureau of Land Management has indicated that it is considering regulations for hydraulic fracturing. EPA has also announced an initiative under the Toxic Substance Control Act to develop regulations governing the disclosure and evaluation of hydraulic fracturing chemicals.
We diligently review best practices and industry standards, and comply with all regulatory requirements in the protection of potable water sources. Protective practices include, but are not limited to, setting multiple strings of protection pipe across the potable water sources and cementing these pipes from setting depth to surface, continuously monitoring the hydraulic fracturing process in real time, and disposing of all non-commercially produced fluids in certified disposal wells at depths below the potable water sources. There have not been any incidents, citations or suits related to our hydraulic fracturing activities involving environmental concerns.
If new legislation is enacted or other new requirements or restrictions regarding hydraulic fracturing are adopted, we could incur substantial compliance costs and the requirements could negatively impact our ability to conduct fracturing activities on our assets.
National Environmental Policy Act
Oil and natural gas exploration and production activities on federal lands (including offshore leasing) may be subject to the National Environmental Policy Act (the “NEPA”), which requires federal agencies, including the Department of Interior, to evaluate major agency actions having the potential to significantly impact the environment. In the course of such evaluations, an agency will prepare an Environmental Assessment that assesses the potential direct, indirect and cumulative impacts of a proposed project and, if necessary, will prepare a more detailed Environmental Impact Statement that may be made available for public review and comment. All of our current exploration and production activities, as well as proposed exploration and development plans, on federal lands require governmental permits that are subject to the requirements of NEPA. As a result of the events in the Gulf of Mexico, the NEPA process is being reviewed and may become more stringent. This process has the potential to delay or impose additional conditions upon the development of oil and natural gas projects.
Index to Financial Statements Air Emissions
Our operations are subject to local, state and federal regulations for the control of emissions from sources of air pollution. Federal and state laws require new and modified sources of air pollutants to obtain permits prior to commencing construction. Major sources of air pollutants are subject to more stringent, federally imposed requirements including additional permits. Federal and state laws designed to control hazardous air pollutants, might require installation of additional controls. Administrative enforcement actions for failure to comply strictly with air pollution regulations or permits are generally resolved by payment of monetary fines and correction of any identified deficiencies. Alternatively, regulatory agencies could bring lawsuits for civil penalties or require us to forego construction, modification or operation of certain air emission sources.
Climate Change Regulation and Legislation
More stringent laws and regulations relating to climate change and greenhouse gases (“GHGs”) may be adopted in the future and could cause us to incur material expenses in complying with them. Both houses of Congress have actively considered legislation to reduce emissions of GHGs, but no legislation has yet passed. In the absence of comprehensive federal legislation on GHG emission control, the EPA has been moving forward with rulemaking under the CAA to regulate GHGs as pollutants under the CAA. The EPA has adopted regulations that would require a reduction in emissions of GHGs from motor vehicles, thus triggering permit requirements for GHGs from certain stationary sources. In June 2010, the EPA adopted the Prevention of Significant Deterioration and Title V Greenhouse Gas Tailoring Rule, which phases in permitting requirements for stationary sources of GHGs, beginning January 2, 2011. This rule “tailors” these permitting programs to apply to certain stationary sources of GHG emissions in a multi-step process, with the largest sources first subject to permitting. We do not believe our operations currently are subject to subject to these permitting requirements, but if our operations become subject to these or other similar requirements, we could incur significant costs to control our emissions and comply with regulatory requirements. In addition, the EPA has adopted a mandatory GHG emissions reporting program that imposes reporting and monitoring requirements on various types of facilities and industries. In November 2010, the EPA expanded its GHG reporting rule to include onshore and offshore oil and natural gas production, processing, transmission, storage, and distribution facilities, requiring reporting of GHG emissions from such facilities on an annual basis, with reporting beginning in 2012 for emissions occurring in 2011. Our operations are subject to GHG reporting requirements, and we have complied with respect to the initial reporting year 2011 and will continue to comply.
Because of the lack of any comprehensive legislative program addressing GHGs, there is a great deal of uncertainty as to how and when federal regulation of GHGs might take place. Some members of Congress have expressed the intention to promote legislation to curb the EPA’s authority to regulation GHGs. In addition to possible federal regulation, a number of states, individually and regionally, also are considering or have implemented GHG regulatory programs. These potential regional and state initiatives may result in so-called cap and trade programs, under which overall GHG emissions are limited and GHG emissions are then allocated and sold, and possibly other regulatory requirements, that could result in our incurring material expenses to comply, e.g., by being required to purchase or to surrender allowances for GHGs resulting from our operations. The federal, regional and local regulatory initiatives also could adversely affect the marketability of the oil and natural gas we produce. The impact of such future programs cannot be predicted, but we do not expect our operations to be affected any differently than other similarly situated domestic competitors.
On April 17, 2012, the EPA issued final rules that subject oil and natural gas production, processing, transmission, and storage operations to regulation under the New Source Performance Standards (“NSPS”) and National Emission Standards for Hazardous Air Pollutants (“NESHAP”) programs. The EPA rules include NSPS standards for completions of hydraulically fractured natural gas wells. Before January 1, 2015, these standards require owners/operators to reduce VOC emissions from natural gas not sent to the gathering line during well completion either by flaring using a completion combustion device or by capturing the natural gas using green completions with a completion combustion device. Beginning January 1, 2015, operators must capture the natural gas and make it available for use or sale, which can be done through the use of green completions. The standards are applicable to newly fractured wells and also existing wells that are refractured. Further, the finalized regulations also establish specific new requirements, effective in 2012, for emission from compressors, controllers, dehydrators, storage tanks, natural gas processing plants and other equipment. These rules may require changes to our operations, including the installation of new equipment to control emissions. We have evaluated the effect these rules will have on our business and are taking steps to ensure compliance.
Other Laws and Regulations
Our operations are also subject to regulations governing the handling, transportation, storage and disposal of naturally occurring radioactive materials. Furthermore, owners, lessees and operators of natural gas and oil properties are also subject to increasing civil liability brought by surface owners and adjoining property owners. Such claims are predicated on the damage to or contamination of land resources occasioned by drilling and production operations and the products derived therefrom, and are often based on negligence, trespass, nuisance, strict liability or fraud.
Index to Financial Statements The Endangered Species Act was established to protect endangered and threatened species. Pursuant to that act, if a species is listed as threatened or endangered, restrictions may be imposed on activities that would harm the species or that would adversely affect that species’ habitat. Similar protections are offered to migratory birds under the Migratory Bird Treaty Act. The U.S. Fish and Wildlife Service designates the species’ protected habitat as part of the effort to protect the species. A protected habitat
designation or the mere presence of threatened or endangered species could result in material restrictions to our use of the land and may materially delay or prohibit land access for our development.
OSHA and Other Laws and Regulation
To the extent not preempted by other applicable laws, we are subject to the requirements of the federal Occupational Safety and Health Act (“OSHA”) and comparable state statutes, where applicable. These laws and the implementing regulations strictly govern the protection of the health and safety of employees. The OSHA hazard communication standard, the EPA community right-to-know regulations under the Title III of CERCLA and similar state statutes require that we organize and/or disclose information about hazardous materials used or produced in our operations. We believe that we are in substantial compliance with these applicable requirements.
We believe that we are in substantial compliance with all existing environmental laws and regulations applicable to our current operations and that our continued compliance with existing requirements will not have a material adverse impact on our financial condition and results of operations. We did not incur any material capital expenditures for remediation or pollution control activities for the years ended December 31, 2012, 2011 and 2010. Additionally, we are not aware of any environmental issues or claims that will require material capital expenditures during 2013 or that will otherwise have a material impact on our financial position or results of operations in the future. However, we cannot assure you that the passage of more stringent laws and regulations in the future will not have a negative impact our business activities, financial condition or results of operations.
Other Regulation of the Oil and Natural Gas Industry
The oil and natural gas industry is extensively regulated by numerous federal, state and local authorities. Legislation affecting the oil and natural gas industry is under constant review for amendment or expansion, frequently increasing the regulatory burden. Also, numerous departments and agencies, both federal and state, are authorized by statute to issue rules and regulations binding on the oil and natural gas industry and its individual members, some of which carry substantial penalties for failure to comply. Although the regulatory burden on the oil and natural gas industry increases our cost of doing business and, consequently, affects our profitability, these burdens generally do not affect us any differently or to any greater or lesser extent than they affect other companies in the industry with similar types, quantities and locations of production.
Legislation continues to be introduced in Congress and development of regulations continues in the Department of Homeland Security and other agencies concerning the security of industrial facilities, including oil and natural gas facilities. Our operations may be subject to such laws and regulations. Presently, it is not possible to accurately estimate the costs we could incur to comply with any such facility security laws or regulations, but such expenditures could be substantial.
Drilling and Production
Our operations are subject to various types of regulation at the federal, state and local levels. These types of regulation include requiring permits for the drilling of wells, drilling bonds and reports concerning operations. Most states and some counties and municipalities in which we operate also regulate one or more of the following:
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the location of wells;
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the method of drilling, casing, and completing wells;
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the surface use and restoration of properties upon which wells are drilled; and
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the plugging and abandoning of wells.
State laws regulate the size and shape of drilling and spacing units or proration units and govern the pooling of oil and natural gas properties. Some states allow forced pooling or integration of tracts to facilitate exploitation while other states rely on voluntary pooling of lands and leases. In some instances, forced pooling or unitization may be implemented by third parties and may reduce our interest in the unitized properties. In addition, state conservation laws establish maximum rates of production from oil and natural gas wells, generally limit the venting or flaring of natural gas and impose requirements regarding the ratability of production. These laws and regulations may limit the amount of oil and natural gas we can produce from our wells or limit the number of wells or the locations at which we can drill. Moreover, each state generally imposes a production or severance tax with respect to the production and sale of oil, natural gas and natural gas liquids within its jurisdiction and an ad valorem tax with respect to the assessed value of the oil and natural gas mineral property.
Index to Financial Statements In addition, eleven states have enacted surface damage statutes (“SDAs”). These laws are designed to compensate the surface owners/users for damage caused by mineral development. Most SDAs contain entry notification and negotiation requirements to facilitate contact between operators and surface owners/users. Most also contain bonding requirements and specific expenses for exploration and producing activities. Costs and delays associated with SDAs could impair operational effectiveness and increase development costs.
We do not control the availability of transportation and processing facilities used in the marketing of our production. For example, we may have to shut-in a productive natural gas well because of a lack of available natural gas gathering or transportation facilities.
If we conduct operations on federal, state or Indian oil and natural gas leases, these operations must comply with numerous regulatory restrictions, including various non-discrimination statutes, royalty and related valuation requirements, and certain of these operations must be conducted pursuant to certain on-site security regulations and other appropriate permits issued by the Bureau of Land Management, the Bureau of Ocean Energy Management or other appropriate federal or state agencies.
Federal Natural Gas Regulation
The availability, terms and cost of transportation significantly affect our ability to make sales of natural gas. The interstate transportation and sale for resale of natural gas are subject to federal regulation, including regulation of the terms, conditions and rates for interstate transportation and storage services by the Federal Energy Regulatory Commission (“FERC”). Federal and state regulation governs the price and terms for access to natural gas pipeline transportation. FERC regulation of interstate natural gas transmission in some circumstances may also affect the rates for intrastate transportation of natural gas and the operations of intrastate pipelines.
Since 1985, FERC has taken numerous actions to increase competition within the natural gas industry by making natural gas transportation more accessible to natural gas buyers and sellers on an open-access, nondiscriminatory basis. FERC has also adopted a light-handed regulatory approach to setting interstate pipeline transportation rates where competition among pipeline transportation alternatives exists, and has established criteria to allow storage providers to charge market-based (i.e. negotiated) rates for storage services utilizing new storage facilities.
Although natural gas prices are currently unregulated, Congress historically has been active in the area of natural gas regulation. We cannot predict whether new legislation to regulate natural gas might be proposed, what proposals, if any, might actually be enacted by Congress or the various state legislatures, and what effect, if any, the proposals might have on the operations of the underlying properties. Sales of oil, condensate, and natural gas liquids are not currently regulated and are made at market prices.
State Natural Gas Regulation
Various states regulate the drilling for, and the production, gathering, intrastate transportation and sale of, natural gas, including imposing severance taxes and requirements for obtaining drilling permits. States also regulate the method of developing new fields, the spacing and operation of wells and the prevention of waste of natural gas resources. States may regulate rates of production and may establish maximum daily production allowables from natural gas wells based on market demand or resource conservation, or both. States do not regulate wellhead prices or engage in other similar direct economic regulation, but there can be no assurance that they will not do so in the future. The effect of these regulations may be to limit the amounts of natural gas that may be produced from our wells and to limit the number of wells or locations we can drill.
Other Regulation
In addition to the regulation of oil and natural gas pipeline transportation rates, the oil and natural gas industry generally is subject to compliance with various other federal, state and local regulations and laws. Some of those laws relate to occupational safety, resource conservation and equal employment opportunity.
General Corporate Information
Alta Mesa Holdings, LP is a Texas limited partnership founded in 1987 with principal offices at 15021 Katy Freeway, Suite 400, Houston, Texas 77094. We can be reached at (281) 530-0991 and our website address is www.altamesa.net. Information on the website is not part of this report.
Index to Financial Statements Item 1A.
Item 1A. Risk Factors
Each of the following risk factors could adversely affect our business, operating results and financial condition. It is not possible to foresee or identify all such factors. Investors should not consider this list an exhaustive statement of all risks and uncertainties. This report also contains forward-looking statements that involve risks and uncertainties. Our actual results may differ from those anticipated in these forward-looking statements as a result of both the risks described below and factors described elsewhere in this report. You should read the section above entitled “Cautionary Statement Regarding Forward-Looking Statements” for further discussion of these matters.
Our exploration, exploitation, development and acquisition operations will require substantial capital expenditures. We may be unable to obtain needed capital or financing on satisfactory terms, which could lead to a decline in our production and reserves.
The oil and natural gas industry is capital intensive. We have made and expect to continue to make substantial capital expenditures in our business for the exploration, exploitation, development and acquisition of oil and natural gas reserves. Our capital expenditures for 2012 totaled $278.6 million including $30.3 million for acquisitions. Our budgeted capital expenditures for 2013 are currently expected to be approximately $250-270 million. We have funded development and operating activities primarily through equity capital raised from a private equity partner, through borrowings under our bank credit facilities, through the issuance of our senior notes, and through internal operating cash flows. We intend to finance our future capital expenditures predominantly with cash flows from operations. If necessary, we may also access capital through proceeds from potential asset dispositions, borrowings under our senior secured revolving credit facility and the future issuance of debt and/or equity securities. Our cash flow from operations and access to capital are subject to a number of variables, including:
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the estimated quantities of our oil and natural gas reserves;
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the amount of oil and natural gas we produce from existing wells;
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the prices at which we sell our production;
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take-away capacity; and
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our ability to acquire, locate and produce new reserves.
If our revenues or the borrowing base under our senior secured revolving credit facility decrease as a result of lower commodity prices, operating difficulties, declines in reserves or for any other reason, we may have limited ability to obtain the capital necessary to conduct our operations at expected levels. Our senior secured revolving credit facility may restrict our ability to obtain new debt financing. If additional capital is required, we may not be able to obtain debt and/or equity financing on terms favorable to us, or at all. If cash generated by operations or available under our senior secured revolving credit facility is not sufficient to meet our capital requirements, the failure to obtain additional financing could result in a curtailment of our operations relating to development of our prospects, which in turn could lead to a decline in our reserves and production, and could adversely affect our business, results of operation, financial conditions and ability to make payments on our outstanding indebtedness.
External financing may be required in the future to fund our growth. We may not be able to obtain additional financing, and financing under our senior secured revolving credit facility may not be available in the future. Without additional capital resources, we may be unable to pursue and consummate acquisition opportunities as they become available, and we may be forced to limit or defer our planned oil and natural gas development program, which will adversely affect the recoverability and ultimate value of our oil and natural gas properties, in turn negatively affecting our business, financial condition and results of operations.
Lower oil and natural gas prices may cause us to record non-cash write-downs, which could negatively impact our results of operations.
Natural gas prices have declined substantially in the last year, and are expected to remain depressed for the foreseeable future. Approximately 60% of our 2012 production on an Mcfe basis was natural gas. Sustained depressed prices of natural gas will adversely affect our assets, development plans, results of operations and financial position, perhaps materially.
Natural gas prices have declined from $4.22 per MMbtu for the January 2011 NYMEX Henry Hub Futures contract settled December 29, 2010 to $3.35 per MMbtu for the January 2013 Henry Hub Futures contract settled December 31, 2012. The reduction in prices has been caused by many factors, including recent increases in natural gas production from non-conventional (shale) reserves, warmer than normal weather and high levels of natural gas in storage. We have hedged approximately 81% of our forecasted PDP production through 2017 at prices higher than those currently prevailing. However, if prices for natural gas remain depressed for long periods, we may be required to revise our development plans, which may cause certain of our undeveloped well locations to no longer be deemed proved. In addition, sustained low prices for natural gas will reduce the amounts we would otherwise have available to pay expenses and service our debt obligations.
Index to Financial Statements Oil and natural gas prices are volatile and a decline in prices can significantly affect our financial condition and results of operations.
Our revenue, profitability and cash flow depend upon the prices for oil and natural gas. The prices we receive for oil and natural gas production are volatile and a decrease in prices can significantly affect our financial results and impede our growth, including our ability to maintain or increase our borrowing capacity, to repay current or future indebtedness and to obtain additional capital on attractive terms. Changes in oil and natural gas prices have a significant impact on the value of our reserves and on our cash flows. Prices for oil and natural gas may fluctuate widely in response to relatively minor changes in supply and demand, market uncertainty and a variety of additional factors that are beyond our control, such as:
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the domestic and foreign supply of and demand for oil and natural gas;
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the price and quantity of foreign imports of oil and natural gas;
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the level of consumer product demand;
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weather conditions;
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domestic and foreign governmental regulations and taxation;
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overall domestic and global economic conditions, including the European credit crisis and the U. S. budget crisis;
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the value of the dollar relative to the currencies of other countries;
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political and economic conditions and events in foreign oil and natural gas producing countries, including embargoes, continued hostilities in the Middle East and other sustained military campaigns, conditions in South America, Central America, China and Russia, and acts of terrorism or sabotage;
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the ability of members of the Organization of Petroleum Exporting Countries to agree to and maintain oil price and production controls;
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the proximity and capacity of natural gas pipelines and other transportation facilities to our production;
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technological advances affecting energy consumption;
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the price and availability of alternative fuels; and
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the impact of energy conservation efforts.
Low oil or natural gas prices will decrease our revenues, and may also reduce the volumetric amount of oil or natural gas that we can economically produce. This may result in our having to make substantial downward adjustments to our estimated proved reserves. If this occurs, or if our estimates of development costs increase, production data factors change or drilling results deteriorate, accounting rules may require us to write down, as a non-cash charge to earnings, the carrying value of our oil and natural gas properties for impairments. We are required to perform impairment tests on our assets whenever events or changes in circumstances lead to a reduction of the estimated useful life or estimated future cash flows that would indicate that the carrying amount may not be recoverable or whenever management’s plans change with respect to those assets. We may incur impairment charges in the future, which could have a material adverse effect on our results of operations in the period taken and our ability to borrow funds under our senior secured revolving credit facility.
We will depend on successful exploration, exploitation, development and acquisitions to maintain reserves and revenue in the future.
In general, the volume of production from oil and natural gas properties declines as reserves are depleted, with the rate of decline depending on each reservoir’s characteristics. Except to the extent that we conduct successful exploration and development activities or acquire properties containing proved reserves, or both, our proved reserves will decline as reserves are produced. Our future oil and natural gas production is, therefore, highly dependent on our level of success in finding or acquiring additional reserves. Additionally, the business of exploring for, developing, or acquiring reserves is capital intensive. Recovery of our reserves, particularly undeveloped reserves, will require significant additional capital expenditures and successful drilling operations. To the extent cash flow from operations is reduced and external sources of capital become limited or unavailable, our ability to make the necessary capital investment to maintain or expand our asset base of oil and natural gas reserves would be impaired. In addition, we are dependent on finding partners for our exploratory activity. To the extent that others in the industry do not have the financial resources or choose not to participate in our exploration activities, we may be adversely affected.
Our estimated oil and natural gas reserve quantities and future production rates are based on many assumptions that may prove to be inaccurate. Any material inaccuracies in these reserve estimates or the underlying assumptions will materially affect the quantities and present value of our reserves.
Numerous uncertainties are inherent in estimating quantities of oil and natural gas reserves. Our estimates of our proved reserve quantities are based upon our estimated net proved reserves as of December 31, 2012. The process of estimating oil and
Index to Financial Statements
natural gas reserves is complex, requiring significant decisions and assumptions in the evaluation of available geological, engineering and economic data for each reservoir, and these reports rely upon various assumptions, including assumptions regarding future oil and natural gas prices, production levels, and operating and development costs. As a result, estimated quantities of proved reserves and projections of future production rates and the timing of development expenditures may prove to be inaccurate. Over time, we may make material changes to reserve estimates taking into account the results of actual drilling and production. Any significant variance in our assumptions and actual results could greatly affect our estimates of reserves, the economically recoverable quantities of oil and natural gas attributable to any particular group of properties, the classifications of reserves based on risk of recovery, and estimates of the future net cash flows. In addition, changes in future production costs assumptions could have a significant effect on our proved reserve quantities.
The present value of future net revenues from our proved reserves or “PV-10” will not necessarily be the same as the current market value of our estimated oil and natural gas reserves.
You should not assume that the present value of future net revenues from our proved reserves is the current market value of our estimated oil and natural gas reserves. In accordance with SEC requirements, we base the estimated discounted future net revenues from our proved reserves on the twelve-month unweighted arithmetic average of the first-day-of-the-month price for the preceding twelve months. Actual future net revenues from our oil and natural gas properties will be affected by factors such as:
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actual prices we receive for crude oil and natural gas;
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actual cost of development and production expenditures;
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the amount and timing of actual production;
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transportation and processing; and
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changes in governmental regulations or taxation.
The timing of both our production and our incurrence of expenses in connection with the development and production of oil and natural gas properties will affect the timing and amount of actual future net revenues from proved reserves, and thus their actual present value. In addition, the 10% discount factor we use when calculating discounted future net revenues may not be the most appropriate discount factor based on interest rates in effect from time to time and risks associated with us or the oil and natural gas industry in general. Actual future prices and costs may differ materially from those used in the present value estimate. If oil and natural gas prices decline by 10%, then our PV-10 as of December 31, 2012 would decrease approximately $172 million.
Approximately 36% of our total estimated proved reserves at December 31, 2012 were proved undeveloped reserves requiring substantial capital expenditures and may ultimately prove to be less than estimated.
Recovery of proved undeveloped reserves requires significant capital expenditures and successful drilling operations. At December 31, 2012, approximately 111 Bcfe of our total estimated proved reserves were undeveloped. The reserve data included in our reserve reports assumes that substantial capital expenditures will be made to develop non-producing reserves. The calculation of our estimated net proved reserves as of December 31, 2012 assumes that we will spend $238 million to develop our estimated proved undeveloped reserves, including an estimated $107 million in 2013. Although cost and reserve estimates attributable to our natural gas and oil reserves have been prepared in accordance with industry standards, we cannot be sure that the estimated costs are accurate. We may need to raise additional capital in order to develop our estimated proved undeveloped reserves over the next five years and we cannot be certain that additional financing will be available to us on acceptable terms, if at all. Further, our drilling efforts may be delayed or unsuccessful, and actual reserves may prove to be less than current reserve estimates, which could have a material adverse effect on our financial condition, future cash flows and results of operations.
As part of our exploration and development operations, we have expanded, and expect to further expand, the application of horizontal drilling and multi-stage hydraulic fracture stimulation techniques. The utilization of these techniques requires substantially greater capital expenditures as compared to the completion cost of a vertical well. The incremental capital expenditures are the result of greater measured depths and additional hydraulic fracture stages in horizontal wellbores.
Index to Financial Statements We may experience difficulty in achieving and managing future growth.
Future growth may place strains on our resources and cause us to rely more on project partners and independent contractors, possibly negatively affecting our financial condition and results of operations. Our ability to grow will depend on a number of factors, including:
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the results of our drilling program;
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hydrocarbon prices;
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our ability to develop existing prospects;
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our ability to obtain leases or options on properties for which we have 3-D seismic data;
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our ability to acquire additional 3-D seismic data;
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our ability to identify and acquire new exploratory prospects;
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our ability to continue to retain and attract skilled personnel;
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our ability to maintain or enter into new relationships with project partners and independent contractors; and
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our access to capital.
Our use of 2-D and 3-D seismic data is subject to interpretation and may not accurately identify the presence of hydrocarbons, which could adversely affect the results of our drilling operations.
Even when properly used and interpreted, 2-D and 3-D seismic data and visualization techniques are only tools used to assist geoscientists in identifying subsurface structures and hydrocarbon indicators and do not enable geoscientists to know whether hydrocarbons are, in fact, present in those structures and the amount of hydrocarbons. We are employing 3-D seismic technology with respect to certain of our projects. The use of 2-D and 3-D seismic and other advanced technologies requires greater pre-drilling expenditures than traditional drilling strategies, and we could incur greater drilling and testing expenses as a result of such expenditures, which may result in a reduction in our returns or losses. As a result, our drilling activities may not be successful or economical, and our overall drilling success rate or our drilling success rate for activities in a particular area could decline.
We often gather 2-D and 3-D seismic data over large areas. Our interpretation of seismic data delineates those portions of an area that we believe are desirable for drilling. Therefore, we may choose not to acquire option or lease rights prior to acquiring seismic data, and, in many cases, we may identify hydrocarbon indicators before seeking option or lease rights in the location. If we are not able to lease those locations on acceptable terms, we will have made substantial expenditures to acquire and analyze 2-D and 3-D data without having an opportunity to attempt to benefit from those expenditures.
We will rely on drilling to increase our levels of production. If our drilling is unsuccessful, our financial condition will be adversely affected.
The primary focus of our business strategy is to increase production levels by drilling wells. Although we were successful in drilling in the past, we cannot assure you that we will continue to maintain production levels through drilling. Our drilling involves numerous risks, including the risk that we will not encounter commercially productive oil or natural gas reservoirs. We must incur significant expenditures to drill and complete wells. The costs of drilling and completing wells are often uncertain, and it is possible that we will make substantial expenditures on drilling and not discover reserves in commercially viable quantities.
We may be unable to make attractive acquisitions or successfully integrate acquired businesses, and any inability to do so may disrupt our business and hinder our ability to grow.
In the future we may make acquisitions of businesses that complement or expand our current business. We may not be able to identify attractive acquisition opportunities. Even if we do identify attractive acquisition opportunities, we may not be able to complete the acquisition or do so on commercially acceptable terms. No assurance can be given that we will be able to identify additional suitable acquisition opportunities, negotiate acceptable terms, obtain financing for acquisitions on acceptable terms or successfully acquire identified targets.
The success of any completed acquisition will depend on our ability to integrate effectively the acquired business into our existing operations. The process of integrating acquired businesses may involve unforeseen difficulties and may require a disproportionate amount of our managerial and financial resources. Our failure to achieve consolidation savings, to incorporate the acquired businesses and assets into our existing operations successfully or to minimize any unforeseen operational difficulties could have a material adverse effect on our financial condition and results of operations.
In addition, our partnership agreement, our senior secured revolving credit facility and the indenture governing our senior notes impose certain limitations on our ability to enter into mergers or combination transactions. Our partnership agreement, our senior secured revolving credit facility and the indenture governing our senior notes also limit our ability to incur certain indebtedness, which could indirectly limit our ability to engage in acquisitions of businesses.
Index to Financial Statements Our business is subject to operational risks that will not be fully insured, which, if they were to occur, could adversely affect our financial condition or results of operations.
Our business activities are subject to operational risks, including:
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damages to equipment caused by adverse weather conditions, including tornadoes, hurricanes and flooding;
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facility or equipment malfunctions;
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pipeline ruptures or spills;
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surface fluid spills, salt water contamination, and surface or groundwater contamination form petroleum constituents or hydraulic fracturing chemical additions;
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fires, blowouts, craterings and explosions; and
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uncontrollable flows of oil or natural gas or well fluids.
In addition, a portion of our natural gas production is processed to extract natural gas liquids at processing plants that are owned by others. If these plants were to cease operations for any reason, we would need to arrange for alternative transportation and processing facilities. These alternative facilities may not be available, which could cause us to shut in our natural gas production. Further, such alternative facilities could be more expensive than the facilities we currently use.
Any of these events could adversely affect our ability to conduct operations or cause substantial losses, including personal injury or loss of life, damage to or destruction of property, natural resources and equipment, pollution or other environmental contamination, loss of wells, regulatory penalties, suspension of operations, and attorney’s fees and other expenses incurred in the prosecution or defense of litigation.
As is customary in the industry, we maintain insurance against some but not all of these risks. Additionally, we may elect not to obtain insurance if we believe that the cost of available insurance is excessive relative to the perceived risks presented. Losses could therefore occur for uninsurable or uninsured risks or in amounts in excess of existing insurance coverage. The occurrence of an event that is not fully covered by insurance could have a material adverse impact on our business activities, financial condition and results of operations.
Our hedging activities could result in financial losses or could reduce our net income.
To achieve more predictable cash flows and to reduce our exposure to fluctuations in the prices of oil and natural gas, we have and may continue to enter into hedging arrangements for a significant portion of our oil and natural gas production. As of December 31, 2012, we have hedged approximately 81% of our forecasted PDP production through 2017 at average annual prices ranging from $4.72 per MMBtu to $5.91 per MMBtu and $90.00 per Bbl to $108.08 per Bbl. If we experience a sustained material interruption in our production, we might be forced to satisfy all or a portion of our hedging obligations without the benefit of the cash flows from our sale of the underlying physical commodity, resulting in a substantial diminution of our liquidity. Lastly, an attendant risk exists in hedging activities that the counterparty in any derivative transaction cannot or will not perform under the instrument and that we will not realize the benefit of the hedge.
Our ability to use hedging transactions to protect us from future oil and natural gas price declines will be dependent upon oil and natural gas prices at the time we enter into future hedging transactions and our future levels of hedging, and as a result our future net cash flows may be more sensitive to commodity price changes.
Our policy has been to hedge a significant portion of our near-term estimated oil and natural gas production. However, our price hedging strategy and future hedging transactions will be determined at our discretion. We are not under an obligation to hedge a specific portion of our production. The prices at which we hedge our production in the future will be dependent upon commodities prices at the time we enter into these transactions, which may be substantially higher or lower than current oil and natural gas prices. Accordingly, our price hedging strategy may not protect us from significant declines in oil and natural gas prices received for our future production. Conversely, our hedging strategy may limit our ability to realize cash flows from commodity price increases. It is also possible that a substantially larger percentage of our future production will not be hedged as compared with the next few years, which would result in our oil and natural gas revenues becoming more sensitive to commodity price changes.
Index to Financial Statements Our hedging transactions expose us to counterparty credit risk.
Our hedging transactions expose us to risk of financial loss if a counterparty fails to perform under a derivative contract. Disruptions in the financial markets could lead to sudden changes in a counterparty’s liquidity, which could impair their ability to perform under the terms of the derivative contract. We are unable to predict sudden changes in a counterparty’s creditworthiness or ability to perform. Even if we do accurately predict sudden changes, our ability to negate the risk may be limited depending upon market conditions.
During periods of falling commodity prices our hedge receivable positions increase, which increases our exposure. If the creditworthiness of our counterparties deteriorates and results in their nonperformance, we could incur a significant loss.
Current or proposed financial legislation and rulemaking could have an adverse effect on our ability to use derivative instruments to reduce the effect of commodity price, interest rate and other risks associated with our business.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was signed into law on July 21, 2010, establishes, among other provisions, federal oversight and regulation of the over-the-counter derivatives market and entities that participate in that market. The Commodities Futures Trading Commission (the “CFTC”), federal regulators of banks and the SEC are required to implement rules relating to derivative contracts, including the derivative contracts we use to hedge our exposure to price and interest rate volatility.
In its rulemaking under the new legislation, on October 18, 2011, the CFTC issued a final rule to set position limits for certain futures and option contracts in the major energy markets and for swaps that are their economic equivalents (with exemptions for certain bona fide hedging transactions). The CFTC’s final rule on position limits was challenged in federal court by the Securities Industry Financial Markets Association and the International Swaps and Derivatives Association and was set aside by the U.S. District Court for the District of Columbia on September 28, 2012 and remanded to the CFTC to resolve ambiguity as to whether statutory requirements for such limits to be determined necessary and appropriate were satisfied. As a result, the rule has not yet taken effect, although the CFTC has indicated that it intends to appeal the court’s decision and that it believes the Dodd-Frank Act requires it to impose position limits. The impact of such regulations upon our business is not yet clear. Certain of our hedging and trading activities and those of our counterparties may be subject to the position limits, which may reduce our ability to enter into hedging transactions.
In addition, the Dodd-Frank Act does not explicitly exempt end users (such as us) from the requirement to use cleared exchanges, rather than hedging over-the-counter, and the requirements to post margin in connection with hedging activities. While it is not possible at this time to predict when the CFTC will finalize certain other related rules and regulations, the Dodd-Frank Act and related regulations may require us to comply with margin requirements and with certain clearing and trade-execution requirements in connection with our derivative activities, although whether these requirements will apply to our business is uncertain at this time. If the regulations ultimately adopted require that we post margin for our hedging activities or require our counterparties to hold margin or maintain capital levels, the cost of which could be passed through to us, or impose other requirements that are more burdensome than current regulations, our hedging would become more expensive and we may decide to alter our hedging strategy.
The financial reform legislation may also require the counterparties to our derivative instruments to spin off some of their derivatives activities to separate entities, which may not be as creditworthy as the current counterparties.
The Dodd-Frank Act and any new regulations could significantly increase the cost of derivative contracts (including through requirements to post collateral, which could adversely affect our available liquidity), materially alter the terms of derivative contracts, reduce the availability of derivatives to protect against risks we encounter, reduce our ability to monetize or restructure our existing derivative contracts, and increase our exposure to less creditworthy counterparties. If we reduce our use of derivatives as a result of the Dodd-Frank Act and regulations, our results of operations may become more volatile and our cash flows may be less predictable, which could adversely affect our ability to plan for and fund capital expenditures. Finally, the Dodd-Frank Act was intended, in part, to reduce the volatility of oil and natural gas prices, which some legislators attributed to speculative trading in derivatives and commodity instruments related to oil and natural gas. Our revenues could therefore be adversely affected if a consequence of the Dodd-Frank Act and regulations is to lower commodity prices. Any of these consequences could have a material adverse effect on our ability to hedge risks and on our business, consolidated financial position, results of operations and cash flows.
We may be unable to compete effectively with larger companies, which may adversely affect our ability to generate sufficient revenues.
The oil and natural gas industry is intensely competitive, and we compete with other companies that have greater resources than us. Our ability to acquire additional properties and to discover reserves in the future will be dependent upon our ability to evaluate and select suitable properties to consummate transactions in a highly competitive market. Many of our larger competitors not only drill for and produce oil and natural gas, but also engage in refining operations and market petroleum and other products on a
Index to Financial Statements
regional, national or worldwide basis. These companies may be able to pay more for oil and natural gas properties, and evaluate, bid for and purchase a greater number of properties than our financial or human resources permit. In addition, these companies may have a greater ability to continue drilling activities during periods of low oil and natural gas prices, to contract for drilling equipment, to secure trained personnel, and to absorb the burden of present and future federal, state, local and other laws and regulations. The oil and natural gas industry has periodically experienced shortages of drilling rigs, equipment, pipe and personnel, which has delayed development drilling and other exploitation activities and has caused significant price increases. Competition has been strong in hiring experienced personnel, particularly in the engineering and technical, accounting and financial reporting, tax and land departments. In addition, competition is strong for attractive oil and natural gas producing properties, oil and natural gas companies, and undeveloped leases and drilling rights. Our inability to compete effectively with larger companies could have a material adverse impact on our business activities, financial condition and results of operations.
The oil and natural gas industry is characterized by rapid and significant technological advancements and introductions of new products and services using new technologies. As others use or develop new technologies, we may be placed at a competitive disadvantage or competitive pressures may force us to implement those new technologies at substantial costs. In addition, other oil and natural gas companies may have greater financial, technical, and personnel resources that allow them to enjoy technological advantages and may in the future allow them to implement new technologies before we can. We may not be able to respond to these competitive pressures and implement new technologies on a timely basis or at an acceptable cost. If one or more of the technologies we use now or in the future were to become obsolete or if we are unable to use the most advanced commercially available technology, our business, financial condition, and results of operations could be materially adversely affected.
Deficiencies of title to our leased interests could significantly affect our financial condition.
If an examination of the title history of a property reveals that an oil or natural gas lease or other developed rights has been purchased in error from a person who is not the owner of the mineral interest desired, our interest would substantially decline in value. In such cases, the amount paid for such oil or natural gas lease or leases or other developed rights would be lost. It is management’s practice, in acquiring oil and natural gas leases or undivided interests in oil and natural gas leases or other developed rights, not to incur the expense of retaining lawyers to examine the title to the mineral interest to be acquired. Rather, we will rely upon the judgment of oil and natural gas lease brokers or landmen who perform the fieldwork in examining records in the appropriate governmental or county clerk’s office before attempting to acquire a lease or other developed rights in a specific mineral interest.
Prior to drilling an oil or natural gas well, however, it is the normal practice in the oil and natural gas industry for the person or company acting as the operator of the well to obtain a preliminary title review of the spacing unit within which the proposed oil or natural gas well is to be drilled to ensure there are no obvious deficiencies in title to the well. Frequently, as a result of such examinations, certain curative work must be done to correct deficiencies in the marketability of the title, such as obtaining affidavits of heirship or causing an estate to be administered. Such curative work entails expense, and it may happen, from time to time, that the operator may elect to proceed with a well despite defects to the title identified in the preliminary title opinion. Our failure to obtain perfect title to our leaseholds may adversely impact our ability in the future to increase production and reserves.
We are vulnerable to risks associated with operating in the inland waters region of South Louisiana.
Our operations and financial results could be significantly impacted by unique conditions in the inland waters region of South Louisiana because we explore and produce in that area. As a result of this activity, we are vulnerable to the risks associated with operating in the inland waters region of South Louisiana, including those relating to:
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adverse weather conditions and natural disasters;
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availability of required performance bonds and insurance;
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oil field service costs and availability;
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compliance with environmental and other laws and regulations;
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matters arising from the 2010 BP Macondo well oil spill including but not limited to new safety requirements, new regulations, increased costs of services and rig mobilizations, slowed issuance of permits for new wells and additional insurance costs and requirements;
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remediation and other costs resulting from oil spills or releases of hazardous materials; and
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failure of equipment or facilities.
For example, during Hurricane Isaac in September 2012, our production facilities in the Biloxi Marshland area in Southeast Louisiana sustained damage. Production from these facilities was shut-in in anticipation of the storm and remained shut-in until completion of repairs in November 2012. Production from this area accounted for approximately 3% of our average daily production, or 3 MMcfe per day, at the time the facilities were shut-in. Additionally, in anticipation of the storm, we shut-in production of some of our other Southeast Louisiana properties for several days, and we experienced minor delays in the development of our Weeks Island field. All such shut-in production has been restored to pre-hurricane levels.
Index to Financial Statements Further, production of reserves from reservoirs in the inland waters region of South Louisiana generally decline more rapidly than production of reservoirs from fields in many other producing regions of the world. This results in recovery of a relatively higher percentage of reserves from properties during the initial years of production, and as a result, our reserve replacement needs from new prospects may be greater in the inland waters region of South Louisiana than for our operations elsewhere. Also, our revenues and return on capital will depend significantly on prices prevailing during these relatively short production periods.
Our ability to pursue our business strategies may be adversely affected if we incur costs and liabilities due to a failure to comply with environmental regulations or a release of hazardous substances into the environment.
We may incur significant costs and liabilities as a result of environmental requirements applicable to the operation of our wells, gathering systems and other facilities. These costs and liabilities could arise under a wide range of federal, state and local environmental laws and regulations, including, for example:
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the Clean Air Act (“CAA”) and comparable state laws and regulations that impose obligations related to air emissions;
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the Clean Water Act and Oil Pollution Act (“OPA”) and comparable state laws and regulations that impose obligations related to discharges of pollutants into regulated bodies of water;
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the Safe Drinking Water Act (“SDWA”) and comparable state laws and regulations that impose obligations on, among other things, the subsurface injection of materials;
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the Resource Conservation and Recovery Act (“RCRA”), and comparable state laws that impose requirements for the handling and disposal of waste from our facilities;
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the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) and comparable state laws that regulate the cleanup of hazardous substances that may have been released at properties currently or previously owned or operated by us or at locations to which we have sent waste for disposal; and
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the emergency, planning, and community right to know regulations under the Title III of CERCLA and similar state statutes require that we organize and/or disclose information about hazardous materials used or produced in our operations.
Failure to comply with these laws and regulations may trigger a variety of administrative, civil and criminal enforcement measures, including the assessment of monetary penalties, the imposition of remedial requirements, and the issuance of orders enjoining future operations. Certain environmental statutes, including RCRA, CERCLA, the federal OPA and analogous state laws and regulations, impose strict joint and several liability for costs required to clean up and restore sites where hazardous substances or other waste products have been disposed of or otherwise released. More stringent laws and regulations, including any related to climate change, greenhouse gases, and hydraulic fracturing, may be adopted in the future. Moreover, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the release of hazardous substances or other materials into the environment.
Index to Financial Statements Climate change legislation or regulations restricting emissions of greenhouse gases (“GHGs”) could result in increased operating costs and reduced demand for the oil and natural gas we produce.
On December 15, 2009, the EPA officially published its findings that emissions of carbon dioxide, methane and other GHGs present an endangerment to public health and the environment because emissions of such gases are, according to the EPA, contributing to warming of the earth’s atmosphere and other climatic changes. These findings allowed the EPA to adopt and implement regulations that would restrict emissions of GHGs under existing provisions of the federal CAA. Accordingly, the EPA has adopted rules regulating GHG emissions from motor vehicles, thus triggering requirements to permit GHG emissions from stationary sources under the Prevention of Significant Deterioration and Title V permitting programs. EPA has adopted the so-called “Tailoring Rule,” requiring that the largest sources first obtain permit for GHG emissions. In addition, on October 30, 2009, the EPA published a final rule requiring the reporting of GHG emissions from specified large GHG emission sources in the United States beginning in 2011 for emissions occurring in 2010. In November 2010, the EPA expanded its GHG reporting rule to include onshore and offshore oil and natural gas production, processing, transmission, storage and distribution facilities. Reporting of GHG emissions from such facilities is required on an annual basis, with reporting beginning in 2012 for emissions occurring in 2011. Although both houses of Congress, in past sessions, have considered legislation to reduce emissions of GHGs, no comprehensive program has been enacted by Congress. Some members of Congress, however, continue to indicate an intention to promote legislation to curb EPA’s authority to regulate GHGs. In the absence of a comprehensive federal program, many states, either individually or through multistate regional initiatives, are considering or have begun implementing legal measures to reduce emissions of GHGs. The adoption and implementation of any statutes, regulations imposing reporting obligations on, or limiting emissions of GHGs from, our equipment and operations could require us to incur costs to reduce emissions of GHGs associated with our operations or could adversely affect demand for the oil and natural gas that we produce.
Significant physical effects of climatic change have the potential to damage our facilities, disrupt our production activities and cause us to incur significant costs in preparing for or responding to those effects.
Climate change could have an effect on the severity of weather (including hurricanes and floods), sea levels, the arability of farmland, and water availability and quality. If such effects were to occur, our development and production operations have the potential to be adversely affected. Potential adverse effects could include damages to our facilities from powerful winds or rising waters in low lying areas, disruption of our production activities either because of climate related damages to our facilities in our costs of operation potentially arising from such climatic effects, less efficient or non-routine operating practices necessitated by climate effects, or increased costs for insurance coverage in the aftermath of such effects. Significant physical effects of climate change could also have an indirect effect on our financing and operations by disrupting the transportation or process-related services provided by midstream companies, service companies or suppliers with whom we have a business relationship. We may not be able to recover through insurance some or any of the damages, losses or costs that may result from potential physical effects of climate change.
Federal legislation and state legislative and regulatory initiatives relating to hydraulic fracturing could result in increased costs and additional operating restrictions or delays.
Hydraulic fracturing is used in many of our operations to stimulate production of hydrocarbons, particularly natural gas. Congress has considered legislation to amend the SDWA to remove the exemption currently available to hydraulic fracturing, which would place additional regulatory burdens upon hydraulic fracturing operations including requirements to obtain a permit prior to commencing operations adhering to certain construction requirements, to establish financial assurance, and to require reporting and disclosure of the chemicals used in those operations. This legislation has not passed. The SDWA does not exempt hydraulic fracturing activities using diesel; EPA has developed draft guidance for permitting of hydraulic fracturing activities using diesel. The EPA has commenced a study of the potential environmental impacts of hydraulic fracturing activities, issued a progress report in December 2012, and expects to deliver the final results of the study in 2014. In addition, in December 2011, the EPA published an unrelated draft report concluding that hydraulic fracturing caused groundwater pollution in a natural gas field in Pavillion, Wyoming; it remains subject to review and comment. In September 2012, the US Geological Survey (“USGS”) released two reports related to samples taken from a Pavillion area monitoring well at the request of the State of Wyoming and in coordination with the EPA. Consistent with a cooperative agreement with Wyoming, the USGS did not interpret data as part of this sampling effort; however, the data has raised questions regarding the EPA’s methodology. The comment period on the EPA’s Wyoming study closes September 30, 2013.
In addition, some states have adopted, and other states are considering adopting, regulations that could restrict hydraulic fracturing in certain circumstances and that require the disclosure of the chemicals used in hydraulic fracturing operations. Any other new laws or regulations that impose new obligations on, or significantly restrict hydraulic fracturing, could make it more difficult or costly for us to perform hydraulic fracturing activities and thereby affect our determination of whether a well is commercially viable and increase our cost of doing business.
Index to Financial Statements Further, in April 2012, the EPA issued final rules that subject oil and natural gas production, processing, transmission, and storage operations to regulation under the NSPS and NESHAP programs. The EPA rules include NSPS standards for completions of hydraulically fractured natural gas wells. Before January 1, 2015, these standards require owners/operators to reduce VOC emissions from natural gas not sent to the gathering line during well completion either by flaring using a completion combustion device or by capturing the natural gas using green completions with a completion combustion device. Beginning January 1, 2015, operators must capture the natural gas and make it available for use or sale, which can be done through the use of green completions. The standards are applicable to newly fractured wells and also existing wells that are refractured. Further, the finalized regulations also establish specific new requirements, effective in 2012, for emission from compressors, controllers, dehydrators, storage tanks, natural gas processing plants and other equipment. Compliance with such regulations could require modifications to the operations of our natural gas exploration and production operations including the installation of new equipment, which could result in significant costs.
The unavailability or high cost of drilling rigs, equipment, supplies, personnel and oil field services could adversely affect our ability to execute development and exploitation plans on a timely basis and within budget, and consequently could adversely affect our anticipated cash flow.
We utilize third-party services to maximize the efficiency of our operation. The cost of oil field services typically fluctuates based on demand for those services. While we currently have excellent relationships with oil field service companies, there is no assurance that we will be able to contract for such services on a timely basis or that the cost of such services will remain at a satisfactory or affordable level. Shortages or the high cost of drilling rigs, equipment, supplies or personnel could delay or adversely affect our development and exploitation operations, which could have a material adverse effect on our business, financial condition or results of operations.
We are subject to complex federal, state, local and other laws and regulations that could adversely affect the cost, manner or feasibility of conducting our operations.
Our oil and natural gas exploration and production operations are subject to complex and stringent laws and regulations. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state and local governmental authorities. Failure or delay in obtaining regulatory approvals or drilling permits could have a material adverse effect on our ability to develop our properties, and receipt of drilling permits with onerous conditions could increase our compliance costs. In addition, regulations regarding conservation practices and the protection of correlative rights affect our operations by limiting the quantity of oil and natural gas we may produce and sell.
We are subject to federal, state and local laws and regulations as interpreted and enforced by governmental authorities possessing jurisdiction over various aspects of the exploration, production and transportation of oil and natural gas. The possibility exists that new laws, regulations or enforcement policies could be more stringent and significantly increase our compliance costs. If we are not able to recover the resulting costs through insurance or increased revenues, our financial position could be adversely affected.
We have limited control over activities on properties we do not operate, which could reduce our production and revenues.
We have limited control over properties, especially those in Hilltop and Eagle Ford, which we do not operate or do not otherwise control operations. If we do not operate or otherwise control the properties in which we own an interest, we do not have control over normal operating procedures, expenditures or future development of the underlying properties. The failure of an operator of our wells to adequately perform operations or an operator’s breach of the applicable agreements could reduce our production and revenues. The success and timing of our drilling and development activities on properties operated by others, therefore, depends upon a number of factors outside of our control, including the operator’s timing and amount of capital expenditures, expertise and financial resources, inclusion of other participants in drilling wells and use of technology.
AMIH, as our Class B limited partner, has the ability to take actions that conflict with the interests of other investors.
AMIH, an affiliate of a private equity fund focused on energy and commodities, is the holder of our Class B limited partner interest. Under our partnership agreement, the Class B limited partner has certain significant rights, including, without limitation:
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approval of material sales and acquisitions of properties and assets, the incurrence of debt, the appointment of any successor to our Chief Executive Officer and any other senior officers; the entering into of partnerships and joint ventures; our merger or consolidation with any entity; and the issuance of interests, ownership interests, debentures, bonds and other securities of the company;
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approval of our annual development plan and budget;
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the right to require us to implement measures to mitigate our commodity price risks;
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the right to part of the proceeds of any future debt or equity offering;
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the right to require our general partner to make distributions of “net cash from operations” subject to our compliance with the covenants of any senior debt, including the senior notes, or bank credit facility; “net cash from operations” is defined as the gross cash proceeds from our operations less amounts used to pay or fund our costs, expenses, contract operating costs (including operators’ general and administrative expenses), marketing costs, debt payments, capital expenditures, reserve replacements, tax distributions and agreed reserves (as agreed upon by us and our Class B limited partner);
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the right to cause our general partner to initiate a sale of us to a third party; and
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the right to remove the general partner for cause and replace the general partner in the Class B limited partner’s sole discretion.
The interests of the Class B limited partner could conflict with the interests of our other investors, such as the holders of our senior notes. For example, if we encounter financial difficulties or are unable to pay our debts as they mature, the interests of the Class B limited partner may conflict with the interests of the holders of our senior notes. The Class B limited partner also may have an interest in pursuing acquisitions, divestitures, financings or other transactions that, in its judgment, could enhance its investment, even though such transactions might involve risks to our other investors, including the holders of our senior notes.
We may not be able to repurchase the notes upon a change of control.
Under the terms of the indenture for the senior notes, if we experience certain specific change of control events, we will be required to offer to repurchase all of our outstanding notes at 101% of the principal amount of such senior notes plus accrued and unpaid interest to the date of repurchase. We may not have available funds sufficient to pay the change of control purchase price for any or all of the senior notes that might be tendered in the change of control offer.
The definition of change of control in the indenture governing the senior notes includes a phrase relating to the direct or indirect sale, transfer, conveyance or other disposition of “all or substantially all” of our and our restricted subsidiaries’ assets, taken as a whole. Although there is a limited body of case law interpreting the phrase “substantially all”, there is no precise established definition of the phrase under applicable law. Accordingly, the ability of a holder of senior notes to require us to repurchase such senior notes as a result of a sale, transfer, conveyance or other disposition of “less than all of our and our restricted subsidiaries” assets taken as a whole to another person or group may be uncertain. Our limited partnership agreement permits AMIH to cause our general partner to initiate a sale of our company to a third-party, which sale may be deemed to be a change of control. AMIH may exercise this right at a time that we do not have sufficient capital or are otherwise prohibited from repurchasing the senior notes. In addition, our senior secured revolving credit facility contains, and any future credit agreement likely will contain, restrictions or prohibitions on our ability to repurchase the senior notes under certain circumstances. If these change of control events occur at a time when we are prohibited from repurchasing the senior notes, we may seek the consent of our lenders to purchase the senior notes or could attempt to refinance the borrowings that contain these prohibitions or restrictions. If we do not obtain our lenders’ consent or refinance these borrowings, we will not be able to repurchase the senior notes. Accordingly, the holders of the senior notes may not receive the change of control purchase price for their notes in the event of a sale or other change of control, which will give the trustee and the holders of the senior notes the right to declare an event of default and accelerate the repayment of the senior notes.
Our private equity partner and its affiliates are not limited in their ability to compete with us for acquisition or drilling opportunities. This could cause conflicts of interest and limit our ability to acquire additional assets or businesses.
Our partnership agreement with our private equity partner does not prohibit it or its affiliates from owning assets or engaging in businesses that compete directly or indirectly with us. For instance, our private equity partner and its affiliates may acquire, develop or dispose of additional oil or natural gas properties or other assets in the future, without any obligation to offer us the opportunity to purchase or develop any of those assets. DCPF IV, an affiliate of our private equity partner, is part of a larger family of funds, which has significantly greater resources than we have, which may make it more difficult for us to compete for acquisition candidates if our private equity partner or its affiliates were to compete against us.
We depend on key personnel, the loss of any of whom could materially adversely affect future operations.
Our success will depend to a large extent upon the efforts and abilities of our executive officers and key operations personnel. The loss of the services of one or more of these key employees could have a material adverse effect on us. We do not maintain key-man life insurance with respect to any of our employees. Our business will also be dependent upon our ability to attract and retain qualified personnel. Acquiring and keeping these personnel could prove more difficult or cost substantially more than estimated. This could cause us to incur greater costs, or prevent us from pursuing our development and exploitation strategy as quickly as we would otherwise wish to do.
Index to Financial Statements We may encounter obstacles to marketing our oil and natural gas, which could adversely impact our revenues.
The marketability of our production will depend in part upon the availability and capacity of natural gas gathering systems, pipelines and other transportation facilities owned by third parties. Transportation space on the gathering systems and pipelines we utilize is occasionally limited or unavailable due to repairs or improvements to facilities or due to space being utilized by other companies that have priority transportation agreements. Our access to transportation options can also be affected by U.S. federal and state regulation of oil and natural gas production and transportation, general economic conditions and changes in supply and demand. The availability of markets is beyond our control. If market factors dramatically change, the impact on our revenues could be substantial and could adversely affect our ability to produce and market oil and natural gas.
We may experience a temporary decline in revenues and production if we lose one of our significant customers.
Historically, we have been dependent upon a few customers for a significant portion of our revenue. To the extent any significant customer reduces the volume of its oil or natural gas purchases from us, we could experience a temporary interruption in sales of, or a lower price for, our oil and natural gas production and our revenues could decline.
If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud.
While we have implemented the requirements of Sarbanes-Oxley Act Section 404 relating to financial processes and internal controls, we cannot be certain that our internal controls over financial reporting will be adequate in the future to ensure compliance with the requirements of the Sarbanes-Oxley Act. If we are not able to maintain adequate internal control over financial reporting, we may be susceptible to sanctions or investigation by regulatory authorities, such as the SEC. Any such action could adversely affect our financial results.
Our debt agreements contain restrictive covenants that may limit our ability to respond to changes in market conditions or pursue business opportunities.
Our senior secured revolving credit facility and the indenture for the senior notes contain restrictive covenants that limit our ability to, among other things:
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incur or guarantee additional debt;
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make distributions;
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repay subordinated debt prior to its maturity;
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grant additional liens on our assets;
Index to Financial Statements
•
enter into transactions with our affiliates;
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enter into hedging transactions with non-lender hedge counterparties;
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repurchase equity securities;
•
make certain investments or acquisitions of substantially all or a portion of another entity’s business assets; and
•
merge with another entity or dispose of any material assets.
In addition, our senior secured revolving credit facility requires us to maintain certain financial ratios and tests. The requirement that we comply with these provisions may materially adversely affect our ability to react to changes in market conditions, take advantage of business opportunities we believe to be desirable, obtain future financing, fund needed capital expenditures or withstand a continuing or future downturn in our business.
If we are unable to comply with the restrictions and covenants in our debt agreements, there could be a default under the terms of such agreements, which could result in an acceleration of repayment.
If we are unable to comply with the restrictions and covenants in our debt agreements, there could be a default under the terms of these agreements. Our ability to comply with these restrictions and covenants, including meeting financial ratios and tests, may be affected by events beyond our control. As a result, we cannot assure that we will be able to comply with these restrictions and covenants or meet such financial ratios and tests. Any default under these agreements governing our indebtedness that is not waived by the required lenders or holders, as the case may be, could prevent us from paying principal, premium, if any, and interest on the notes and substantially decrease the market value of the notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants, including financial and operating covenants in the instruments governing our indebtedness (including covenants in our credit facility and the indenture governing the notes), we could be in default under the terms of the agreements governing such indebtedness. In the event of such a default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under our credit facility could terminate their commitments to lend, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. Borrowings under other debt instruments that contain cross-acceleration or cross-default provisions may also be accelerated and become due and payable. If any of these events occur, our assets might not be sufficient to repay in full all of our outstanding indebtedness and we may be unable to find alternative financing. Even if we could obtain alternative financing, it might not be on terms that are favorable or acceptable to us. Additionally, we may not be able to amend our debt agreements or obtain needed waivers on satisfactory terms.
Our borrowings under our senior secured revolving credit facility expose us to interest rate risk.
Our earnings are exposed to interest rate risk associated with borrowings under our senior secured revolving credit facility. Our senior secured revolving credit facility carries a floating interest rate based upon short-term interest rate indices. If interest rates increase, so will our interest costs, which may have a material adverse effect on our results of operations and financial condition. We may use interest rate hedges in an effort to mitigate this risk, but those efforts may not prove successful.
To service our indebtedness, we require a significant amount of cash, and our ability to generate cash will depend on many factors beyond our control.
Our ability to make payments on and to refinance our indebtedness, and to fund planned capital expenditures depends in part on our ability to generate cash in the future. This ability is, to a certain extent, subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that we will generate sufficient cash flow from operations, that we will realize operating improvements on schedule, or that future borrowings will be available to us in an amount sufficient to enable us to service and repay our indebtedness or to fund our other liquidity needs. If we are unable to satisfy our debt obligations, we may have to undertake alternative financing plans, such as:
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refinancing or restructuring our debt;
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selling assets;
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reducing or delaying capital investments; or
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seeking to raise additional capital.
However, any alternative financing plans that we undertake, if necessary, may not allow us to meet our debt obligations.
We cannot assure you that any refinancing or debt restructuring would be possible, that any assets could be sold or that, if sold, the timing of the sales and the amount of proceeds realized from those sales would be favorable to us or that additional financing
Index to Financial Statements
could be obtained on acceptable terms. Our inability to generate sufficient cash flows to satisfy our debt obligations, including our obligations under the senior notes, or to obtain alternative financing, could materially and adversely affect our business, financial condition, results of operations and prospects.
Future disruptions in the global credit markets may make equity and debt markets less accessible, create a shortage in the availability of credit, and lead to credit market volatility which could limit our ability to grow.
The recovery from the global economic crisis of 2008 and resulting recession has been slow and uneven. Continuing concerns regarding the worldwide economic outlook and sovereign debt crisis in Europe have contributed to increased economic uncertainty and diminished expectations for the global economy. A slowdown in the current economic recovery or a return to a recession would negatively impact demand for petroleum products and prices for natural gas and oil. Disruptions in the capital and credit markets, as was experienced during 2008 and 2009, could adversely affect our ability to meet our liquidity needs or to refinance our indebtedness, including our ability to draw on our existing credit facility or enter into new credit facilities.
Cyber-attacks targeting systems and infrastructure used by the oil and gas industry may adversely impact our operations.
Our business has become increasingly dependent on digital technologies to conduct certain exploration, development, production and financial activities. We depend on digital technology to estimate quantities of oil and gas reserves, process and record financial and operating data, analyze seismic and drilling information, and communicate with our employees and third party partners. Unauthorized access to our seismic data, reserves information or other proprietary information could lead to data corruption, communication interruption, or other operational disruptions in our exploration or production operations. Also, computers control nearly all of the oil and gas distribution systems in the United States and abroad, which are necessary to transport our production to market. A cyber-attack directed at oil and gas distribution systems could damage critical distribution and storage assets or the environment, delay or prevent delivery of production to markets and make it difficult or impossible to accurately account for production and settle transactions. While we have not experienced cyber-attacks, there is no assurance that we will not suffer such attacks and resulting losses in the future. Further, as cyber-attacks continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any vulnerability to cyber-attacks.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties
Information regarding our properties is contained in “Item 1. Business” contained herein.
Item 3.
Item 3. Legal Proceedings
We are party to various litigation matters arising in the ordinary course of business. We do not believe the outcome of such disputes or legal actions will have a material adverse effect on our consolidated financial statements. Accruals for losses associated with litigation are made when losses are deemed probable and can be reasonably estimated.
Hilltop Field Litigation: On July 23, 2009, we made a payment of $25.5 million and took assignment of substantially all working interests that Chesapeake Energy Corporation (“Chesapeake”) had acquired from Gastar Exploration Ltd. (“Gastar”) in an approximate 50,000 acre area of Leon and Robertson Counties, Texas known as the Hilltop field, in which the Deep Bossier formation was the principal focus for development. We exercised our preferential right to purchase these interests from Gastar in late 2005, but Gastar and Chesapeake had opposed this and Chesapeake took record title at that time. We finally and conclusively prevailed when, in 2008, a Texas court of appeals directed that specific performance take place. In early 2009, the Texas Supreme Court denied the defendants’ request to review the appeal. As a result, we were able to take assignment of working interests in over 30 producing wells and participate in further development of the area, primarily with EnCana, but also with Gastar. A subsequent payment to EnCana of $15.2 million plus purchase accounting adjustments of $3.8 million brought the total cost of the acquisition to $44.5 million. While the ownership of these interests has been decided by the courts, we pursued other claims against Chesapeake and Gastar; Chesapeake claimed an additional $36.3 million of past expenses. The case was set for trial on April 24, 2012. Shortly before the trial was to begin, we reached an agreement to settle with the Chesapeake-related defendants and entered into a settlement agreement with Gastar. The effects of these settlements, recorded in the second quarter of 2012, were not material to our financial position or results of operations.
Index to Financial Statements Environmental Claims: Management has established a liability for soil contamination in Florida of approximately $1.0 million at December 31, 2012 and 2011, respectively, based on our undiscounted engineering estimates. The obligations are included in other long-term liabilities in the accompanying consolidated balance sheets.
Various landowners have sued Meridian (along with numerous other oil companies) in lawsuits concerning several fields in which Meridian has had operations. The lawsuits seek injunctive relief and other relief, including unspecified amounts in both actual and punitive damages for alleged breaches of mineral leases and alleged failure to restore the plaintiffs’ lands from alleged contamination and otherwise from Meridian’s oil and natural gas operations. We are unable to express an opinion with respect to the likelihood of an unfavorable outcome of the various environmental claims or to estimate the amount or range of potential loss should the outcome be unfavorable. Therefore, we have not provided any amount for these claims in our consolidated financial statements at December 31, 2012.
Due to the nature of our business, some contamination of the real estate property owned or leased by us is possible. Environmental site assessments of the property would be necessary to adequately determine remediation costs, if any. See additional disclosures in Note 11 of our consolidated financial statements and related notes included elsewhere in this report.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
Index to Financial Statements PART II
Item 5.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
No class of our limited partnership interests has been registered under the Exchange Act, and there is no established public trading market for our equity.
As of March 27, 2013, six holders of our limited partnership interests held 100% of such interests.
Distributions to our partners are determined by the terms of our partnership agreement, described further at Note 15 in the accompanying Notes to Consolidated Financial Statements. See also, “Risk Factors - AMIH, as our Class B limited partner, has the ability to take actions that conflict with the interests of other investors.” We are also currently restricted in our ability to pay dividends under our senior secured revolving credit facility. Historically, limited distributions have been made with the approval of our board of directors. In 2010, a $50 million distribution was made to AMIH, which was offset by an equivalent contribution from that partner earlier the same year.
Index to Financial Statements Item 6.
Item 6. Selected Financial Data
The following table presents our summary historical financial data for the periods indicated, giving effect to the Sydson acquisition from the acquisition date of April 21, 2011, the TODD acquisition from the acquisition date of June 17, 2011, the Meridian acquisition from the acquisition date of May 13, 2010 and the Hilltop Field acquisition from the acquisition date of July 23, 2009. The data as of and for the years ended December 31, 2012, 2011, 2010, 2009, and 2008 have been derived from our audited consolidated financial statements. For further information that will help you better understand the summary data, you should read this financial data in conjunction with “Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the “Selected Financial Data” and the consolidated financial statements and related notes included elsewhere in this report. The following discussion and analysis contains forward-looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward-looking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, the volatility of oil and natural gas prices, production timing and volumes, estimates of proved reserves, operating costs and capital expenditures, economic and competitive conditions, regulatory changes and other uncertainties, as well as those factors discussed below and elsewhere in this report, particularly in “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements,” all of which are difficult to predict. As a result of these risks, uncertainties and assumptions, the forward-looking events discussed may not occur. The consolidated historical financial information discussed below in this Management’s Discussion and Analysis of Financial Condition and Results of Operations represents Alta Mesa’s financial information for the periods indicated, giving effect to the Meridian, Sydson, and TODD acquisitions from the acquisition dates of May 13, 2010, April 21, 2011, and June 17, 2011, respectively.
Overview
We currently generate significant amounts of our revenue, earnings and cash flow from the production and sale of oil and natural gas from our core properties in South Louisiana, East Texas, including the Hilltop field, Oklahoma, and the Eagle Ford shale play in South Texas. We operate in one industry segment, oil and natural gas exploration and development, within one geographical segment, the United States.
The amount of cash we generate from our operations will fluctuate based on, among other things:
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the prices at which we will sell our production;
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the amount of oil and natural gas we produce; and
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the level of our operating and administrative costs.
In order to mitigate the impact of changes in oil and natural gas prices on our cash flows, we are a party to hedging and other price protection contracts, and we intend to enter into such transactions in the future to reduce the effect of oil and natural gas price volatility on our cash flows.
Substantially all of our oil and natural gas activities are conducted jointly with others and, accordingly, amounts presented reflect our proportionate interest in such activities. Inflation has not had a material impact on our results of operations and is not expected to have a material impact on our consolidated results of operations in the future.
Outlook
Natural gas prices declined significantly during 2011 and 2012, slightly rebounding in the second half of 2012, closing at $3.35 per MMbtu for the January 2013 NYMEX Henry Hub Futures contract settled December 31, 2012. A low point was reached with the May 2012 NYMEX closing at $2.04 per MMbtu. The reduction in prices has been caused by many factors, including recent increases in natural gas production from non-conventional (shale) reserves, warmer than normal winter weather and high levels of natural gas in storage.
The decrease in natural gas prices resulted in a significant non-cash write-down of a number of our oil and gas properties in the third and fourth quarters of 2012. Total impairment expense for the year ended December 31, 2012 was $96.2 million. Of this, $44.6 million was for our Hilltop field in East Texas, which produces dry gas, and is vulnerable to extremely low prices for natural gas. Other properties written down were also primarily in East Texas, where our natural gas production is most concentrated.
The unrealized values of our derivative contracts are reported at fair value on our consolidated balance sheets and are highly sensitive to changes in the price of oil and natural gas. Changes in these derivative assets and liabilities are reported in our consolidated statement of operations as unrealized hedging gain or loss, which is a non-cash item. In 2012, we recognized an unrealized loss on our derivative contracts of $17.4 million. Realized cash-based gains from our hedging program were $37.2 million during the year, offsetting the unrealized losses. The objective of our hedging program is that, over time, the combination of realized hedging gains and losses with ordinary oil and natural gas revenues will produce relative price stability. However, in the short term, both realized and unrealized hedging gains and losses can be significant to our results of operations, and we expect these gains and losses to continue to reflect the unpredictability and volatility of oil and natural gas prices.
We have hedged approximately 81% of our forecasted PDP production of oil and natural gas through 2017 at average prices generally higher than prices prevailing at year-end 2012. If low natural gas prices continue for an extended period of time, we may be unable to replace expiring hedge contracts or enter new contracts for additional natural gas production at favorable prices.
Index to Financial Statements Continued low prices may require us to write down the value of our oil and natural gas properties and/or revise our development plans, which may cause certain of our undeveloped well locations to no longer be deemed proved. This could cause a reduction in the borrowing base under our credit facility. Low prices may also reduce our cash available for distribution and for servicing our indebtedness.
Prices for oil did not significantly decline in 2011 but decreased somewhat in 2012, with a NYMEX West Texas Intermediate crude oil monthly average of $88.25 on December 31, 2012. We expect oil prices to remain volatile in the future. Factors affecting the price of oil include worldwide economic conditions, including the European credit crisis, geopolitical activities, including developments in the Middle East, worldwide supply disruptions, weather conditions, actions taken by the Organization of Petroleum Exporting Countries and the value of the U.S. dollar in international currency markets. Prices for natural gas liquids have declined during 2012 due to increased liquids-targeted drilling and volumes in storage.
The primary factors affecting our production levels are capital availability, the effectiveness and efficiency of our production operations, the success of our drilling program and our inventory of drilling prospects. We inherently face the challenge of natural production declines since as reservoirs are depleted, pressures decline, and the rate of production from a given well decreases. We attempt to overcome the cumulative effects of these natural declines primarily through developing our existing undeveloped reserves through drilling, enhanced completions and well recompletions, and other enhanced recovery methods. Our future growth will depend on our ability to continue to add reserves in excess of production. Our ability to add reserves is dependent on our capital resources and can be limited by many factors, including our ability to timely obtain drilling permits and regulatory approvals. Any delays in drilling, completing or connecting our new wells to gathering lines will negatively affect our production, which will have an adverse effect on our revenues and, as a result, cash flow from operations.
Index to Financial Statements Results of Operations: Year Ended December 31, 2012 v. Year Ended December 31, 2011
(1) We do not utilize hedging for natural gas liquids.
Index to Financial Statements Revenues
Natural gas revenues for the year ended December 31, 2012 decreased $50.3 million, or 34%, to $99.3 million from $149.6 million in 2011. The decrease in natural gas revenue was attributable to decreased production volumes and lower average realized prices during 2012. Approximately $43.7 million of the decrease was due to a decrease in production of 9.0 Bcf, or 29%. This decrease is primarily due to our Hilltop field, which produced 10.0 Bcf in 2012, compared to 18.1 Bcf in 2011. The price of natural gas exclusive of hedging decreased 31% in 2012; the overall realized price (including hedging gains and losses), decreased 6% from $4.86 per Mcf in 2011 to $4.56 per Mcf in 2012, resulting in a decrease in natural gas revenues of approximately $6.6 million.
Oil revenues for the year ended December 31, 2012 increased $58.9 million, or 36%, to $220.6 million from $161.7 million in 2011. The increase in revenue was attributable to increased production volumes coupled with a slightly higher average realized price. Approximately $57.1 million of the increase was due to an increase in production of 558 MBbls, or 35%. This increase is primarily due to production from our Eagleville field, which increased 399 MBbls in 2012 as compared to 2011, from 253 MBbls to 652 MBbls. The price of oil exclusive of hedging decreased 1% in 2012; the overall realized price (including hedging gains and losses) increased 1% from $102.35 per Bbl in 2011 to $103.18 per Bbl in 2012, resulting in an increase in oil revenues of approximately $1.8 million.
Natural gas liquids revenues decreased during 2012 to $12.3 million from $12.6 million for 2011. A 27% increase in volumes from 215 MBbls to 273 MBbls was offset by a decrease in our average price of 23%, from $58.75 per Bbl to $45.03 per Bbl. The increase in volume is due to production in the Eagleville field of 86 MBbls.
Other revenues were $4.6 million during 2012 as compared to $2.1 million during 2011. The increase is primarily the result of increased income from our drilling rig and from sale of prospects.
Unrealized gain - oil and natural gas derivative contracts was a loss of $17.4 million for 2012 as compared to a gain of $28.2 million for 2011. The significant fluctuation from period to period is due to the volatility of oil and natural gas prices and changes in our outstanding hedging contracts during these periods.
Expenses
Lease and plant operating expense increased $6.4 million to $69.0 million in 2012 as compared to $62.6 million in 2011. On a unit basis, lease and plant operating expense increased 26% from $1.51 per Mcfe to $1.91 per Mcfe for 2011 and 2012, respectively, which reflects the decrease in volume while costs increased. In general, lease operating expenses are higher for oil producing properties. Oil as a percentage of production on an equivalent basis increased from 23% in 2011 to 35% in 2012. Natural gas as a percentage of equivalent production during the same periods decreased from 74% to 60%. Production costs for field services increased $4.3 million, overhead increased $2.8 million, and salt water disposal costs increased $0.5 million, due to an increase in the number of wells and to the shift to more oil production. These increases were partially offset by a decrease in repairs and maintenance of $1.6 million.
Production and ad valorem taxes increased $4.1 million to $23.5 million, or 21%, for 2012, as compared to $19.4 million for 2011. Ad valorem taxes increased $3.8 million due to higher valuations and additions to properties. Production taxes as a percentage of unhedged revenue were approximately 6% in 2012 and 2011. On a per unit basis, the total expense increased to $0.65 per Mcfe for 2012 from $0.47 per Mcfe for 2011.
Workover expense increased $0.9 million to $12.7 million from $11.8 million for 2012 and 2011, respectively. This expense varies depending on activities in the field.
Exploration expense includes the costs of our geology departments, costs of geological and geophysical data, delay rentals, and dry holes. Exploration expense increased $6.1 million to $21.9 million for 2012 from $15.8 million for 2011. Dry hole expense increased $2.4 million; the balance of the increase was primarily due to increased expenditures for seismic data and processing.
Depreciation, depletion and amortization increased $15.0 million to $109.3 million for 2012 as compared to an expense of $94.3 million for 2011. On a per unit basis, this expense increased to $3.02 from $2.27 per Mcfe for 2012 and 2011, respectively. The rate is a function of capitalized costs of proved properties, reserves and production by field.
Impairment expense increased $77.5 million to $96.2 million in 2012 from $18.7 million in 2011. This expense varies with the results of exploratory drilling, as well as with price declines which may render some projects uneconomic, resulting in impairment. See “Critical Accounting Policies and Estimates - Impairment” below for more details related to impairment. The decreasing trend in natural gas prices resulted in a significant impairment in 2012. Of the $96.2 million total expense, $44.6 million was for our Hilltop field in East Texas, which produces dry gas, and is vulnerable to extremely low prices for natural gas. Other properties written down were also primarily in East Texas, where our natural gas production is most concentrated.
Index to Financial Statements Accretion expense is related to our obligation for retirement of oil and natural gas wells and facilities. We record these liabilities when we place the assets in service, using discounted present values of the estimated future obligation. We then record accretion of the liabilities as they approach maturity. Accretion expense was $1.8 million for each of 2012 and 2011, respectively.
General and administrative expense increased $7.1 million to $40.2 million in 2012 from $33.1 million in 2011. The increase is principally due to increased salary and benefits expenses of $5.2 million, primarily due to additional personnel and bonus accruals. Other employee expenses, primarily related to travel, increased $0.3 million. Engineering and information technology consulting services increased $0.9 million; information system licensing fees increased $0.5 million. A royalty ownership settlement of $0.7 million recorded in 2012 increased total general and administrative expenses. On a per unit basis, general and administrative expenses increased from $0.80 to $1.11 per Mcfe, which reflects the decrease in volume produced on a Mcfe basis, while costs increased.
Interest expense, net increased $9.2 million to $41.8 million in 2012 from $32.6 million in 2011. This increase is primarily due to a $3.0 million increase in interest on our senior notes, due to the increase in the balance after our tack-on offering of an additional $150 million in October 2012. Additionally, interest on our credit facility increased $1.1 million in 2012, due primarily to higher average outstanding balances during that period, and interest rate hedge gains of $5.4 million recorded in 2011 were not repeated in 2012. Partially offsetting these increases was a decrease in amortization of loan costs of $0.4 million due to the extension of the maturity date of our credit facility in May 2011.
Litigation settlement is related to the settlement of our litigation with Gastar, under which Gastar paid us $1.3 million in damages in 2012.
Gain on contract settlement is related to the settlement of an obligation we assumed with our acquisition of Meridian. The obligation related to underutilization of two contracted drilling rigs. We recorded an estimated liability of $9.8 million for the obligation upon purchase of Meridian in 2010. The obligation was subsequently settled in the second quarter of 2011 for $8.5 million, resulting in a gain of $1.3 million.
Index to Financial Statements Results of Operations: Year Ended December 31, 2011 v. Year Ended December 31, 2010
(1) We do not utilize hedging for natural gas liquids.
Index to Financial Statements Revenues
Natural gas revenues for the year ended December 31, 2011 increased $23.7 million, or 19%, to $149.6 million from $125.9 million in 2010. The increase in natural gas revenue was attributable to increased production volumes, partially offset by a lower average realized price during 2011. Approximately $35.2 million of the increase was due to an increase in production of 6.7 Bcf, or 28%. This increase is primarily due to our Hilltop field, which produced 18.1 Bcf in 2011, compared to 12.3 Bcf in 2010. The price of natural gas exclusive of hedging decreased 5% in 2011; the overall realized price (including hedging gains and losses), decreased 7% from $5.24 per Mcf in 2010 to $4.86 per Mcf in 2011, resulting in a decrease in natural gas revenues of approximately $11.5 million.
Oil revenues for the year ended December 31, 2011 increased $85.9 million, or 113%, to $161.7 million from $75.8 million in 2010. The increase in revenue was attributable to increased production volumes coupled with a higher average realized price. Approximately $48.5 million of the increase was due to an increase in production of 616 MBbls, or 64%. This increase is primarily due to the full-year effect of the acquisition of Meridian, which produced 985 MBbls in 2011 compared to 472 MBbls in 2010. The price of oil exclusive of hedging increased 33% in 2011; the overall realized price (including hedging gains and losses) increased 30% from $78.63 per Bbl in 2010 to $102.35 per Bbl in 2011, resulting in an increase in oil revenues of approximately $37.4 million.
Natural gas liquids revenues increased during 2011 to $12.6 million from $6.8 million for 2010. The increase was due to an increase in volumes sold, from 147 MBbls to 215 MBbls and an increase in the price, to $58.75 per Bbl in 2011 from $46.58 per Bbl in 2010. The volume increase was due to the full-year effect of the Meridian acquisition.
Other revenues were $2.1 million during 2011 as compared to $1.5 million during 2010. The increase is primarily the result of increased income from our drilling rig, offset by decreased income from investments, which includes distributions from a drilling company we partially own and do not consolidate.
Unrealized gain - oil and natural gas derivative contracts was a gain of $28.2 million for 2011 as compared to a gain of $10.1 million for 2010. The significant fluctuation from period to period is due to the volatility of oil and natural gas prices and changes in our outstanding hedging contracts during these periods.
Expenses
Lease and plant operating expense increased $20.7 million to $62.6 million in 2011 as compared to $41.9 million in 2010, due primarily to lease operating costs of $7.4 million associated with production from the Meridian acquisition, which occurred in May 2010. The Hilltop field reported an increase of $7.8 million in gas gathering and processing fees, primarily due to increased production, which increased to 18.1 Bcf in 2011 from 12.3 Bcf in 2010. In addition, there were increases in repairs, maintenance, utilities, and well services primarily in our East Texas, South Texas and Florida locations. On a per unit basis, lease and plant operating expense increased to $1.51 from $1.37 per Mcfe for 2011 and 2010, respectively.
Production and ad valorem taxes increased $8.2 million to $19.4 million, or 74%, for 2011, as compared to $11.1 million for 2010. The increase on a percentage basis follows the increase in our revenues from products, which was 55%. On a per unit basis, the expense increased to $0.47 per Mcfe for 2011 from $0.36 per Mcfe for 2010.
Workover expense increased $4.4 million to $11.8 million from $7.4 million for 2011 and 2010, respectively. The increase is primarily due to activities in the East Hennessey and Lincoln North fields in Oklahoma, South Hayes field in South Louisiana, and the Blackjack Creek field in Florida.
Exploration expense includes the costs of our geology departments, costs of geological and geophysical data, delay rentals, expired leases, and dry holes. Exploration expense decreased $15.2 million to $15.8 million for 2011 from $31.0 million for 2010. The decrease is primarily due to a decrease in exploratory dry hole costs of $9.7 million and a decrease in seismic expenditures of $6.7 million, primarily related to seismic license renewals related to the Meridian acquisition recorded in 2010.
Depreciation, depletion and amortization increased $35.2 million to $94.3 million for 2011 as compared to an expense of $59.1 million for 2010. On a per unit basis, this expense increased to $2.27 from $1.93 per Mcfe for 2011 and 2010, respectively. The increase is a function of increased production to reserves and the full year impact of the Meridian acquisition.
Impairment expense increased $10.3 million to $18.7 million in 2011 from $8.4 million in 2010. This expense varies with the results of exploratory drilling, as well as with price declines which may render some projects uneconomic, resulting in impairment. See “Critical Accounting Policies and Estimates - Impairment” below for more details related to impairment.
Accretion expense is related to our obligation for retirement of oil and natural gas wells and facilities. We record these liabilities when we place the assets in service, using discounted present values of the estimated future obligation. We then record accretion of the liabilities as they approach maturity. Accretion expense was $1.8 million and $1.4 million for 2011 and 2010, respectively. The increase was due to the full-year effect of the Meridian acquisition.
Index to Financial Statements General and administrative expense increased $13.0 million to $33.1 million in 2011 from $20.1 million in 2010. The increase resulted principally from increased payroll and burden costs of $7.8 million, primarily due to increased headcount and performance and net profit interest bonuses. This increase was partially offset by an increase in engineering and geology allocations to other expense categories. Consulting expenditures such as legal, engineering and other professional services increased $4.1 million, primarily due to on-going litigation, outside services provided by reservoir engineers, accounting, tax and compliance services. In addition, general and administrative costs such as office rent, office relocation and system conversions increased $1.2 million. On a per unit basis, general and administrative expense increased to $0.80 from $0.66 per Mcfe for 2011 and 2010, respectively.
Interest expense, net increased $5.5 million to $32.6 million in 2011 from $27.1 million in 2010, primarily due to new interest from our senior notes payable issued in October 2010 of $23 million. This increase was partially offset by decreased interest on the amount outstanding under our credit facility of $6.5 million, decreased interest rate hedge losses of $8.9 million, and decreased amortization of deferred loan costs $1.4 million. Other interest items decreased a total of $0.7 million year over year, primarily due to a significant prepayment penalty incurred in 2010 when we early retired our subordinate debt.
Liquidity and Capital Resources
Our principal requirements for capital are to fund our day-to-day operations, our exploration and development activities, and to satisfy our contractual obligations, primarily for the repayment of debt and any amounts owed during the period related to our hedging positions.
Our 2012 capital budget was primarily focused on the development of existing core areas through exploitation and development. Currently, we anticipate a capital budget of approximately $250-270 million for 2013. Approximately 75% of our 2013 capital budget is allocated to our properties in East Texas, Eagle Ford, Oklahoma and South Louisiana. Our future drilling plans, plans of our drilling operators and capital budgets are subject to change based upon various factors, some of which are beyond our control, including drilling results, oil and natural gas prices, the availability and cost of capital, drilling and production costs, availability of drilling services and equipment, actions of our operators, gathering system and pipeline transportation constraints and regulatory approvals. Because a large percentage of our acreage is held by production, we have the ability to materially decrease our drilling and recompletion budget in response to market conditions with minimal risk of losing significant acreage.
We expect to fund our 2013 capital budget predominantly with cash flows from operations, supplemented by borrowings under our credit facility. If necessary, we may also access capital through proceeds from potential asset dispositions and the future issuances of debt and/or equity securities, subject to the distribution of proceeds therefrom as set forth in our partnership agreement. We strive to maintain financial flexibility and may access capital markets as necessary to maintain substantial borrowing capacity under our senior secured revolving credit facility, facilitate drilling on our large undeveloped acreage position and permit us to selectively expand our acreage position. In the event our cash flows are materially less than anticipated and other sources of capital we historically have utilized are not available on acceptable terms, we may curtail our capital spending.
Senior Notes
In October 2010, we issued $300 million of 9.625% senior notes due 2018 (“senior notes”) at a discount of $2.1 million, with a yield to maturity of 9.75%. On October 15, 2012, we issued an additional $150 million of senior notes (“additional senior notes”) under the same indenture with the same interest rate, date of maturity, and other terms, at a discount of $1.5 million and with a yield to maturity of 9.85%. Net proceeds from the offering were approximately $145.3 million (after deducting estimated fees and offering expenses), which we used to repay existing indebtedness under our credit facility. In connection with the issuance of the additional senior notes, the borrowing base under our credit facility was automatically reduced to $313.7 million. The additional senior notes were issued in a private placement but were exchanged for substantially identical registered senior notes in February 2013.
The senior notes and additional senior notes are unsecured senior general corporate obligations, and effectively rank junior to any of our existing or future secured indebtedness, which includes our credit facility. The senior notes and the additional senior notes are unconditionally guaranteed on a senior unsecured basis by each of our material, wholly-owned subsidiaries.
Credit Facility
We have a senior secured revolving credit facility (“credit facility”) with Wells Fargo Bank, N.A. as the administrative agent, which matures May 23, 2016. As of December 31, 2012, the credit facility was subject to a $313.7 million borrowing base limit, and we had $154.8 million outstanding under the credit facility. Our restricted subsidiaries are guarantors of the credit facility.
Index to Financial Statements The borrowing base is redetermined each May 1 and November 1. In May 2012, the borrowing base was increased to $350 million. On October 15, 2012, as a result of the issuance of the additional senior notes and in accordance with the terms of the credit facility, the borrowing base was automatically reduced to $313.7 million. The borrowing base was confirmed during the November redetermination. As of March 27, 2013, outstanding borrowing under the credit facility was $186.8 million, and the available unused portion of the borrowing base was $126.9 million.
Our credit facility provides for two alternative interest rate bases and margins. Eurodollar loans accrue interest generally at the one-month London Interbank Offered Rate plus a margin ranging from 2.00% to 2.75%, depending on the utilization of our borrowing base. “Reference rate” loans accrue interest at the prime rate of Wells Fargo Bank, N.A., plus a margin ranging from 1.00% to 1.75%, depending on the utilization of our borrowing base. The average rate on all loans outstanding as of December 31, 2012 under the credit facility was 2.33%, which was based primarily on the Eurodollar option.
The credit facility and the indenture governing the senior notes and additional senior notes include covenants requiring us to maintain certain financial covenants including a current ratio, leverage ratio, and interest coverage ratio. At December 31, 2012, we were in compliance with the covenants. The terms of the credit facility also restrict our ability to make distributions and investments.
Cash Flow Provided by Operating Activities
Operating activities provided cash of $147.2 million in 2012, as compared to $150.7 million for 2011. The $3.5 million decrease in operating cash flows was attributable to various factors. Cash-based items of net income, including revenues (exclusive of unrealized commodity gains or losses), operating expenses and taxes, general and administrative expenses, and the cash portion of our interest expense, resulted in a net decrease of approximately $17.8 million in earnings and a negative impact on cash flow. This was offset by changes in our working capital accounts, which provided $9.7 million of cash flows as compared to having used $4.6 million in cash in 2011. This reversal resulted in a total increase of $14.3 million in cash flow from changes in working capital, which as noted above, partially offset the negative effects of decreased earnings.
Operating activities provided cash of $150.7 million in 2011, as compared to $61.2 million for 2010. The $89.5 million increase in operating cash flows was primarily attributable to our increased earnings. Cash-based items of net income, including revenues (exclusive of unrealized commodity gains or losses), operating expenses and taxes, general and administrative expenses, and the cash portion of our interest expense, provided a net increase of approximately $63.9 million in earnings and a positive impact on cash flow. This was augmented by changes in our working capital accounts, which used $4.6 million of cash flows as compared to having used $30.2 million in cash in 2010. This reversal resulted in a total increase of $25.6 million in cash flow from changes in working capital, which as noted above, augmented the positive effects of increased earnings.
Cash Flow Used in Investing Activities
Investing activities used cash of $255.1 million for the year ended December 31, 2012 as compared to cash used in investing of $266.1 million for the year ended December 31, 2011. The decrease in cash used in investing activities was primarily related to a decrease in acquisition expenditures of $42.1 million. Acquisitions in 2011 totaled $72.4 million, including $50 million for the Sydson and TODD acquisitions, as compared to a total of $30.3 million in 2012, for various smaller acquisitions. The decrease in acquisition expenditures was partially offset by an increase in expenditures for drilling and development of $30.9 million.
Investing activities used cash of $266.1 million for the year ended December 31, 2011 as compared to cash used in investing of $208.4 million for the year ended December 31, 2010. The increase in cash used in investing activities was primarily related to drilling and development expenditures, which increased by $83.7 million. This was partially offset by a decrease in acquisition expenditures of $29.0 million. Acquisitions in 2010 included $101.4 for Meridian, as compared to a total of $72.4 million in 2011, primarily for the Sydson and TODD acquisitions.
Cash Flow Provided by Financing Activities
Financing activities provided cash of $111.0 million during 2012 as compared to cash provided by financing of $113.3 million during 2011, a decrease of $2.3 million. Both periods reflected the effect of drawdowns from our credit facility. In 2012, we replaced $150 million of outstanding borrowings under the credit facility with the proceeds of our tack-on offering of senior notes. However, this did not reduce overall debt or the net cash inflow from additional borrowings.
Financing activities provided cash of $113.3 million during 2011 as compared to cash provided by financing of $147.8 million during 2010, a decrease of $34.5 million. The decrease in cash flows provided by financing activities was primarily due to higher cash flows from operations of $89.5 million, partially offset by an increase in cash used in investing of $57.7 million. The net increase in cash flow from these activities resulted in decreased borrowing in 2011 as compared to 2010.
Index to Financial Statements Risk Management Activities - Commodity Derivative Instruments
Due to the risk of low oil and natural gas prices, we periodically enter into price-risk management transactions (e.g., swaps, collars, puts, calls, and financial basis swap contracts) for a portion of our oil and natural gas production. In certain cases, this allows us to achieve a more predictable cash flow, as well as to reduce exposure from price fluctuations. The commodity derivative instruments apply to only a portion of our production, and provide only partial price protection against declines in oil and natural gas prices, and may partially limit our potential gains from future increases in prices. At December 31, 2012, commodity derivative instruments were in place covering approximately 88% of our projected oil and natural gas production from proved properties for 2013. See Note 6 to our consolidated financial statements as of December 31, 2012, “Derivative Financial Instruments”, for further information.
Contractual Obligations
The following table summarizes our contractual obligations as of December 31, 2012:
(1) Interest includes interest on the outstanding balance under our revolving credit agreement maturing in 2016, payable quarterly; on our senior notes due 2018, payable semiannually; and on the debt to our founder, which is payable with principal, at maturity in 2018. Projected obligation amounts are based on the payment schedules for interest, and are not presented on an accrual basis.
(2) Derivative contract premiums relate to open derivative contracts in place at December 31, 2012 and are due over time as the contracts mature and settle. They are included on our consolidated balance sheet with the related derivative contracts. Amounts presented above are net of $6.7 million for premiums due to us under derivative contracts from the same counterparties.
In addition to the items above, we have a contingent commitment to pay an amount up to a maximum of approximately $2.7 million for properties acquired in 2008 and prior years. The additional purchase consideration will be paid if certain product price conditions are met. We have a drilling commitment in which we must make a contingent payment in a range of $1- 4 million if we fail to perform under the commitment to varying degrees. We have an additional exploration commitment to spend $5 million during 2013.
Off-Balance Sheet Arrangements
As of December 31, 2012 we had no guarantees of third party obligations. Our off-balance sheet arrangements at December 31, 2012 consist of bonds posted in the aggregate amount of $12.6 million, primarily to cover future abandonment costs.
We have no plans to enter into any off-balance sheet arrangements in the foreseeable future.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). As used herein, the following acronyms have the following meanings: “FASB” means the Financial Accounting Standards Board; the “Codification” refers to the Accounting Standards Codification, the collected accounting and reporting guidance maintained by the FASB; “ASC” means Accounting Standards Codification and is generally followed by a number indicating a particular section of the Codification; and “ASU” means Accounting Standards Update, followed by an identification number, which are the periodic updates made to the Codification by the FASB.
The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect our reported results of operations and the amount of reported assets, liabilities and proved oil and natural gas reserves. Some accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been
Index to Financial Statements
used. Actual results may differ from the estimates and assumptions used in the preparation of our consolidated financial statements. Described below are the most significant policies we apply in preparing our consolidated financial statements, some of which are subject to alternative treatments under accounting principles generally accepted in the United States. We also describe the most significant estimates and assumptions we make in applying these policies.
Use of Estimates. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.
Reserve estimates significantly impact depreciation and depletion expense and potential impairments of oil and natural gas properties and are subject to change based on changes in oil and natural gas prices and trends and changes in estimated reserve quantities. We analyze estimates, including those related to oil and natural gas reserves, the value of oil and natural gas properties, oil and natural gas revenues, bad debts, asset retirement obligations, derivative contracts, income taxes and contingencies and litigation. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
Property and Equipment. Oil and natural gas producing activities are accounted for using the successful efforts method of accounting. Under the successful efforts method, lease acquisition costs and all development costs, including unsuccessful development wells, are capitalized.
Unproved Properties - Acquisition costs associated with the acquisition of leases are recorded as unproved properties and capitalized as incurred. These consist of costs incurred in obtaining a mineral interest or right in a property, such as a lease in addition to options to lease, broker fees, recording fees and other similar costs related to activities in acquiring properties. Unproved properties are classified as unproved until proved reserves are discovered, at which time related costs are transferred to proved oil and natural gas properties.
Exploration Expense - Exploration expenses, other than exploration drilling costs, are charged to expense as incurred. These expenses include seismic expenditures and other geological and geophysical costs, expired leases, and lease rentals. The costs of drilling exploratory wells and exploratory-type stratigraphic wells are initially capitalized pending determination of whether the well has discovered proved commercial reserves. If the exploratory well is determined to be unsuccessful, the cost of the well is transferred to expense. Exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made.
Proved Oil and Natural Gas Properties - Costs incurred to obtain access to proved reserves and to provide facilities for extracting, treating, gathering, and storing oil and natural gas are capitalized. All costs incurred to drill and equip successful exploratory wells, development wells, development-type stratigraphic test wells, and service wells, including unsuccessful development wells, are capitalized.
Impairment - The capitalized costs of proved oil and natural gas properties are reviewed at least quarterly for impairment following the guidance provided in ASC 360-10-35, Property, Plant and Equipment, Subsequent Measurement, whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset or asset group exceeds its fair market value and is not recoverable. The determination of recoverability is based on comparing the estimated undiscounted future net cash flows at a producing field level to the carrying value of the assets. If the future undiscounted cash flows, based on estimates of anticipated production from proved reserves and future crude oil and natural gas prices and operating costs, are lower than the carrying cost, the carrying cost of the asset or group of assets is reduced to fair value. For our proved oil and natural gas properties, we estimate fair value by discounting the projected future cash flows at an appropriate risk-adjusted discount rate.
Unproved properties are assessed at least annually to determine whether they have been impaired. Individually significant properties are assessed for impairment on a property-by-property basis, while individually insignificant unproved leasehold costs may be assessed in the aggregate. If unproved leasehold costs are found to be impaired, an impairment allowance is provided and a loss is recognized in the consolidated statement of operations.
Depreciation, Depletion and Amortization - Depreciation, depletion and amortization (“DD&A”) of capitalized costs of proved oil and natural gas properties is computed using the unit-of-production method based upon estimated proved reserves. Assets are grouped for DD&A on the basis of reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. The reserve base used to calculate DD&A for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. The reserve base used to calculate DD&A for lease and well equipment costs, which include development costs and successful exploration drilling costs, includes only proved developed reserves.
Index to Financial Statements Revenue Recognition. We recognize oil, natural gas and natural gas liquids revenues when products are delivered at a fixed or determinable price, title has transferred and collectability is reasonably assured. We use the sales method of accounting for recognition of natural gas imbalances. Revenue from drilling rigs has been recorded when services were performed.
Derivative Financial Instruments. We use derivative contracts to hedge the effects of fluctuations in the prices of oil, natural gas and interest rates. We account for such derivative instruments in accordance with ASC 815, Derivatives and Hedging, which establishes accounting and disclosure requirements for derivative instruments and requires them to be measured at fair value and recorded as assets or liabilities in the consolidated balance sheet (see Note 5 of the accompanying Notes to Consolidated Financial Statements for further information on fair value).
Under ASC 815, hedge accounting is used to defer recognition of unrealized changes in the fair value of such financial instruments, for those contracts which qualify as fair value or cash flow hedges, as defined in the guidance. Historically, we have not designated any of our derivative contracts as fair value or cash flow hedges. Accordingly, the unrealized changes in fair value of the contracts are included in net income in the period of the change as “Unrealized gain (loss) - oil and natural gas derivative contracts” for oil and natural gas contracts, and in interest expense for interest derivative contracts. Realized gains and losses are recorded in income in the period of settlement, and included in the related revenue account or in interest expense. Cash flows from settlements of derivative contracts are classified with the income or expense item to which such settlements directly relate.
Income Taxes. We have elected under the Internal Revenue Code provisions to be treated as individual partnerships for tax purposes. Accordingly, items of income, expense, gains and losses flow through to the partners and are taxed at the partner level. Accordingly, no tax provision for federal operations taxes is included in the consolidated financial statements.
We are subject to the Texas margin tax, which is considered a state income tax, and is included in “Benefit from (provision for) state income tax” on the consolidated statement of operations. We record state income tax (current and deferred) based on taxable income as defined under the rules for the margin tax.
Acquisitions. Acquisitions are accounted for as purchases using the acquisition method of accounting. Accordingly, the results of operations are included in our consolidated statements of operations from the closing date of the acquisitions. Purchase prices are allocated to acquired assets and assumed liabilities based on their estimated fair value at the time of the acquisition.
Asset Retirement Obligations. We estimate the present value of future costs of dismantlement and abandonment of our wells, facilities, and other tangible, long-lived assets, recording them as liabilities in the period incurred. We follow ASC 410, Asset Retirement and Environmental Obligations. ASC 410 requires that an asset retirement obligation (“ARO”) associated with the retirement of a tangible long-lived asset be recognized as a liability in the period in which it is incurred or becomes determinable (as defined by the standard), with an associated increase in the carrying amount of the related long-lived asset. The cost of the tangible asset, including the initially recognized asset retirement cost, is depreciated over the useful life of the asset and accretion expense is recognized over time as the discounted liability is accreted to its expected settlement value. The fair value of the ARO is measured using expected future cash outflows for abandonment discounted generally at our cost of capital at the time of recognition.
Investment. Our investment consists of a 10% ownership interest in a drilling company, Orion Drilling Company, LP (“Orion”). The investment is accounted for under the cost method. Under this method, our share of earnings or losses of the investment are not included in the statements of operations. Distributions from Orion are recognized in current period earnings as declared.
Deferred Financing Costs. Deferred financing costs are amortized using the straight-line method over the term of the related debt, so long as this approximates the interest rate method.
Recent Accounting Pronouncements
In December 2011, the FASB issued ASU No. 2011-11, which was clarified as to scope in January 2013 by ASU 2013-01. The two ASU’s address increases to disclosures about offsetting assets and liabilities. New disclosures are required to enable users of financial statements to understand significant quantitative differences in balance sheets prepared under GAAP and International Financial Reporting Standards (IFRS) related to the offsetting of financial instruments. The existing GAAP guidance allowing balance sheet offsetting, including industry-specific guidance, remains unchanged. The guidance in ASU Nos. 2011-11 and 2013-01 is effective for annual and interim reporting periods beginning on or after January 1, 2013. The disclosures should be applied retrospectively for all prior periods presented. We do not expect the adoption of these pronouncements to have a material impact on our consolidated financial statements.
We adopted ASU No. 2011-04 to Topic 820, Fair Value Measurements, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS” on January 1, 2012. The ASU changes certain definitions of
Index to Financial Statements
terms used in its guidance regarding fair value measurements, as well as modifying certain disclosure requirements and other aspects of the guidance. The additional disclosure is included in Note 5 in the accompanying Notes to Consolidated Financial Statements.
In February 2013 the FASB issued ASU 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income,” which updates a 2011 standard regarding disclosures about this component of capital accounts. ASU 2013-02 gives companies the flexibility to present information regarding significant amounts reclassified from Other Comprehensive Income either on the face of the financial statements or parenthetically in the notes thereto, provided that all of the required information is presented in a single location. The guidance is effective for annual and interim periods beginning after December 31, 2012. We do not expect the adoption of this pronouncement to have a material impact on our consolidated financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to certain market risks that are inherent in our consolidated financial statements that arise in the normal course of business. We may enter into derivative instruments to manage or reduce market risk, but we do not enter into derivative agreements for speculative purposes.
We do not designate these derivative instruments as hedges for accounting purposes. Accordingly, the changes in the fair value of these instruments are recognized currently in earnings.
Commodity Price Risk and Hedges
Our major market risk exposure is to prices for oil, natural gas and natural gas liquids. These prices have historically been volatile. As such, future earnings are subject to change due to changes in these prices. Realized prices are primarily driven by the prevailing worldwide price for oil and regional prices for natural gas. We have used, and expect to continue to use, oil and natural gas derivative contracts to reduce our exposure to the risks of changes in the prices of oil and natural gas. Pursuant to our risk management policy, we engage in these activities as a hedging mechanism against price volatility associated with pre-existing or anticipated sales of oil and natural gas.
As of December 31, 2012, we have hedged approximately 81% of our forecasted production from proved developed reserves through 2017 at average annual prices ranging from $4.72 per MMBtu to $5.91 per MMBtu and $90.00 per Bbl to $108.08 per Bbl. Forecasted production from proved reserves is estimated in our December 2012 reserve report using prices, costs and other assumptions required by SEC rules. Our actual production will vary from the amounts estimated in the report, perhaps materially. Please read the disclosures under “Our estimated oil and natural gas reserve quantities and future production rates are based on many assumptions that may prove to be inaccurate. Any material inaccuracies in these reserve estimates or the underlying assumptions will materially affect the quantities and present value of our reserves” in “Item 1A. Risk Factors” above.
The fair value of our oil and natural gas derivative contracts and basis swaps at December 31, 2012 was a net asset of $35.3 million. A 10% increase or decrease in oil and natural gas prices with all other factors held constant would result in an unrealized loss or gain, respectively, in the fair value (generally correlated to our estimated future net cash flows from such instruments) of our oil and natural gas commodity contracts of approximately $43.4 million (unrealized loss) or $41.3 million (unrealized gain), respectively, as of December 31, 2012.
Interest Rates
We are subject to interest rate risk on our long-term fixed interest rate debt and variable interest rate borrowings. Although in the past we have used interest rate swaps to mitigate the effect of fluctuating interest rates on interest expense, we currently have no open interest rate derivative contracts. A 1% increase in interest rates (100 LIBOR basis points) would increase interest expense on our variable rate debt by approximately $1.5 million.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements and supplementary financial information required to be filed under this item are presented beginning on page in Part IV, Item 15 of this annual report and are incorporated herein by reference.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
In accordance with Exchange Act Rule 13a-15 and 15d-15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our
Index to Financial Statements
disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2012 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act. We have performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our internal control over financial reporting. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2012. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.
Our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework issued to perform its assessment. Based on this assessment, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded, that as of December 31, 2012, our internal control over financial reporting was effective based on those criteria.
Changes in Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting during the year ended December 31, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers, and Corporate Governance
As is the case with many partnerships, we do not directly employ officers, directors or employees. Our operations and activities are managed by the board of directors of our general partner, Alta Mesa Holdings GP, LLC (“Alta Mesa GP”), and the officers and directors of Alta Mesa Services, LP (“Alta Mesa Services”), an entity wholly owned by us. Prior to the offering of the senior notes in October 2010, Alta Mesa Services was owned by Michael E. and Mickey Ellis. References to our directors are references to the directors of Alta Mesa GP. References to our officers and employees are references to the officers and employees of Alta Mesa Services.
All of our executive management personnel are employees of Alta Mesa Services and devote all of their time to our business and affairs. We also utilize a significant number of employees of Alta Mesa Services to operate our properties and provide us with certain general and administrative services. Under the shared services and expenses agreement, we reimburse Alta Mesa Services for its operational personnel who perform services for our benefit. See “Item 13. Certain Relationships and Related Party Transactions, and Director Independence - Shared Services and Expenses Agreement.”
Board Leadership Structure
Our Chairman is Michael E. Ellis, our Chief Operating Officer and founder of the Company. Our Board of Directors has no policy regarding the separation of the positions of Chief Executive Officer and Chairman. We also do not have a lead independent director.
Board Oversight of Risk
Like all businesses, we face risks in our business activities. Many of these risks are discussed under the caption “Risk Factors” elsewhere in this report. The board of directors has delegated to management the primary responsibility of risk management, while it has retained oversight of management in that regard.
Index to Financial Statements In addition, our Board of Directors considers our practices regarding risk assessment and risk management, reviews our contingent liabilities, reviews our oil and natural gas reserve estimation practices, as well as major legislative and regulatory developments that could affect us. Our Board reviews and attempts to mitigate risks which may result from our compensation policies.
Executive Officers and Directors
The following table sets forth the names, ages and offices of our present directors and executive officers as of December 31, 2012. Members of our Board of Directors are elected for one-year terms.
The following is a biographical summary of the business experience of these directors and executive officers:
Harlan H. Chappelle joined Alta Mesa as President and CEO in November 2004, and has led us in a period of significant growth, building a strong management and technical team, focusing us on our greatest opportunities, making strategic acquisitions, and restructuring our financing. Mr. Chappelle has over 30 years in field operations, engineering, management, marketing and trading, acquisitions and divestitures, and field re-development in collaboration with majors including Exxon and Chevron. He has worked for Louisiana Land & Exploration Company, Burlington Resources, Southern Company, and Mirant. Mr. Chappelle retired as a Commander from the U.S. Navy Reserve. He has a Bachelor of Chemical Engineering from Auburn University and a Master of Science in Petroleum Engineering from The University of Texas at Austin.
Michael E. Ellis founded Alta Mesa in 1987 after beginning his career with Amoco, and is our Chairman and Chief Operating Officer, as well as Vice President of Engineering. Mr. Ellis manages all day-to-day engineering and field operations of Alta Mesa. He built our asset base by starting with small earn-in exploitation projects, then progressively growing the company with successive acquisitions of fields from major oil companies, and consistent success in exploration and development drilling. He has over 30 years’ experience in management, engineering, exploration, and acquisitions and divestitures in the Gulf Coast, Midcontinent and West Texas regions. Mr. Ellis holds a Bachelor of Science in Civil Engineering from West Virginia University.
Mickey Ellis has served as a Director since our inception in 1987. Ms. Ellis is actively involved in the leadership of charitable organizations, as a Board Member of Houston Area Respite Care and The Confessing Movement of the United Methodist Church, Treasurer of the National Charity League Star Chapter, Committee Member on several committees within Mission Bend United Methodist Church, and Building Relocation Coordinator for Mission Bend Christian Academy. She is a major fundraiser for the Susan G. Komen Foundation, and an active volunteer for CanCare. Ms. Ellis is the spouse of Michael E. Ellis.
Michael A. McCabe, our Chief Financial Officer, joined Alta Mesa in September 2006. Mr. McCabe has over 25 years of corporate finance experience, with a focus on the energy industry. From 2004 until 2006, Mr. McCabe served as President and sole owner of Bridge Management Group, Inc., a private consulting firm primarily providing advisory services to us and to MultiFuels, Inc., a Houston based developer of natural gas storage facilities. He has served in senior positions with Bank of Tokyo, Bank of New England, and Key Bank. Mr. McCabe holds a Bachelor of Science in Chemistry and Physics from Bridgewater State University, a Master of Science in Chemical Engineering from Purdue University and a Masters of Business Administration in Financial Management from Pace University.
David Murrell has served as our Vice President, Land and Business Development since 2006. Mr. Murrell has over 25 years of experience in Gulf Coast leasing, exploration and development programs, contract management and acquisitions and divestitures. He created a structured land management system for Alta Mesa, and built a team of lease analysts, landmen, and field representatives that has facilitated our company’s growth. Mr. Murrell earned a Bachelor of Business Administration in Petroleum Land Management from the University of Oklahoma.
Qualifications of Directors
Mr. Chappelle’s experience as our Chief Executive Officer since 2004, combined with his significant equity ownership of us, uniquely qualify him to serve as a director of our general partner.
Index to Financial Statements Mr. Ellis is our founder; his experience in that capacity and as one of our executive officers since 1987 provide him intimate knowledge of our operations, finances and strategy and uniquely qualify him to serve as the Chairman of our general partner.
Ms. Ellis’ role in working with us since our inception in 1987 provides her with a knowledge of our business and operations.
Audit and Compensation Committee
We do not have a formal compensation committee and our full Board serves as our audit committee. Because we do not have and are not seeking to list any securities on a national securities exchange or on an inter-dealer quotation system, we are not subject to a number of the corporate governance requirements of the SEC or of any national securities exchange or inter-dealer quotation system. For example, we are not required to have a board of directors comprised of a majority of independent directors or to have an audit committee comprised of independent directors. Accordingly, our Board of Directors has not made any determination as to whether any of the members of our board of directors or committees thereof would qualify as independent under the listing standards of any national securities exchange or any inter-dealer quotation system or under any other independence definition. Additionally, for the same reason, we have not yet determined whether any of our directors is an audit committee financial expert.
Code of Ethics
The Board of Directors has adopted a Code of Ethics for Senior Financial Officers. The Code of Ethics is posted on the investor relations section of our website at www.altamesa.net and is available free of charge upon written request to 15021 Katy Freeway, Suite 400, Houston, Texas 77094.
Item 11.
Item 11. Executive Compensation
Compensation Discussion and Analysis
Because we are a partnership, we do not directly employ any of the persons responsible for managing our business. Our operations and activities are managed by the Board of Directors of our general partner, Alta Mesa Holdings GP, LLC (“Alta Mesa GP”) and the officers of Alta Mesa Services, LP (“Alta Mesa Services”), our wholly owned subsidiary. References to our officers and employees are references to the officers and employees of Alta Mesa Services. We refer to the Board of Directors of Alta Mesa GP as “our Board” or “our Board of Directors.”
Prior to the offering of our senior notes in October 2010, Alta Mesa Services was owned by an affiliate of our general partner and it provided services, including accounting, corporate development, finance, land administration and engineering, to us pursuant to an administrative services agreement. Pursuant to the administrative services agreement, expenses were allocated to us based on the portion of time that the employees allocated to our business. During 2012, all of Alta Mesa Services’ expenses were allocated to us under the above formula.
In connection with the offering our senior notes in 2010, we acquired Alta Mesa Services. All of our executive officers are employees of Alta Mesa Services and devote all of their time to our business and affairs.
Prior to the senior note offering, Alta Mesa Services had the ultimate decision-making authority with respect to our compensation program for our executive officers. The board of Alta Mesa Services was comprised of Michael E. Ellis, our Chief Operating Officer, Mickey Ellis, his wife, and Harlan H. Chappelle, our President and Chief Executive Officer. After the offering, our Board of Directors assumed responsibility for overseeing our executive remuneration programs and the fair and competitive compensation of our executive officers. Our Board consists of Michael E. Ellis, Mickey Ellis and Harlan H. Chappelle and meets each year to review our compensation program and to determine compensation levels for the ensuing fiscal year.
In this Compensation Discussion and Analysis, we discuss our compensation objectives, our decisions and the rationale behind those decisions relating to 2012 compensation for our named executive officers.
Objectives of Our Compensation Program
Our executive compensation program is intended to motivate our executive officers to achieve strong financial and operating results for us. In addition, our program is designed to achieve the following objectives:
•
attract and retain talented executive officers by providing reasonable total compensation levels competitive with that of executives holding comparable positions in similarly situated organizations;
•
provide total compensation that is justified by individual performance; and
•
provide performance-based compensation that is tied to both individual and our performance.
Index to Financial Statements What Our Compensation Program is Designed to Reward
Our strategy is to increase reserves and production by applying advanced engineering analytics and enhanced geological techniques in areas we have identified as underdeveloped and overlooked. Our compensation program is designed to reward performance that contributes to the achievement of our business strategy. In addition, we reward qualities that we believe help achieve our strategy, such as teamwork; individual performance in light of general economic and industry specific conditions; performance that supports our core values; resourcefulness; the ability to manage our existing corporate assets; the ability to explore new avenues to increase oil and natural gas production and reserves; level of job responsibility; and tenure with us.
Elements of Our Compensation Program and Why We Pay Each Element
To accomplish our objectives, our compensation program is comprised of three elements: base salary, cash bonus and benefits. We currently do not offer equity-based compensation.
We pay base salary in order to recognize each executive officer’s unique value and historical contributions to our success in light of salary norms in the industry and the general marketplace; to match competitors for executive talent; to provide executives with sufficient, regularly-paid income; and to reflect an executive’s position and level of responsibility.
We include an annual cash bonus as part of our compensation program because we believe this element of compensation helps to motivate executives to achieve key corporate objectives by providing annual recognition of achievement. The annual cash bonus also allows us to be competitive from a total remuneration standpoint.
We offer benefits such as a 401(k) plan and payment of insurance premiums in order to provide a competitive remuneration package as well as a measure of financial security to our employees.
How We Determine Each Element of Compensation
In determining the elements of compensation, we consider our ability to attract and retain executives as well as various measures of company and industrial performance including debt levels, revenues, cash flow, capital expenditures, reserves of oil and natural gas and costs. We did not retain a consultant with respect to determining 2012 compensation.
Messrs. Ellis, Chappelle, McCabe, and Murrell are parties to employment agreements with Alta Mesa Services. The employment agreements automatically renew annually, subject to prior notice of cancellation by either Alta Mesa Services or the executive. These employment agreements establish set minimum base salaries for each officer of $400,000, $400,000, $300,000, and $190,000 per annum, respectively, which we believe are competitive with other independent oil and natural gas companies with whom we compete for managerial talent. In addition, the employment agreements provide that the executives are each entitled to an annual bonus equal to a percentage of his respective annual base salary if performance criteria set by the board for the applicable period are met. The agreements also provide for benefits such as reimbursement of business expenses and participation in employee benefit plans.
Base salary. In reviewing base salaries, the board takes into account a combination of subjective factors, primarily relying on their own personal judgment and experience. Subjective factors the board considers include individual achievements, our performance, level of responsibility, experience, leadership abilities, increases or changes in duties and responsibilities and contributions to our performance. Mr. Ellis and Mr. Chappelle participate in and are present during the board’s review and determination of their respective base salaries. For 2012, the Board set the base salaries for Messrs. Ellis, Chappelle and McCabe at $450,000, $450,000 and $400,000, respectively. In addition, the board determined Mr. Murrell’s salary of $325,000 for 2012 was reasonable.
Bonus. A portion of each executive’s total compensation may be paid as bonus compensation. The board takes into consideration our achievements during the year and each executive’s contribution toward such achievements. While performance criteria may be set, the board takes into account subjective factors in determining if these criteria were met. Bonuses for any one year are usually determined and paid in the second or third quarter of the following year. Accordingly, bonus compensation for our executive officers for 2012 has not yet been determined. However, bonuses paid in 2012 for 2011 performance ranged from approximately 75% to 200% of base salary.
Benefits. We provide company benefits or perquisites that we believe are standard in the industry to all of our employees. These benefits consist of a group medical and dental insurance program for employees and their qualified dependents and a 401(k) employee savings and protection plan. The costs of these benefits are paid for entirely by us. We do not provide employee life insurance amounts surpassing the Internal Revenue Service maximum. We make matching contributions to the 401(k) contribution of each qualified participant. We pay all administrative costs to maintain the plan. In addition, we provide Messrs. Ellis, Chappelle, McCabe, and Murrell with company automobiles.
Index to Financial Statements Other Compensation. As part of his employment agreement, we provide Mr. McCabe an apartment near our headquarters and pay his commuting expenses to and from his permanent home to Houston. In 2012, these housing and commuting expenses totaled $106,845. We agreed to provide these benefits to Mr. McCabe because our Board believed it was necessary to retain Mr. McCabe’s services despite the fact that his permanent residence is outside of the Houston area. The Board considered the value of this additional compensation in evaluating Mr. McCabe’s total compensation package.
How Elements of Our Compensation Program are Related to Each Other
We view the various components of compensation as related but distinct and emphasize “pay for performance” with a portion of total compensation reflecting a risk aspect tied to our financial and strategic goals. We determine the appropriate level for each compensation component based in part, but not exclusively, on our view of internal equity and consistency, and other considerations we deem relevant, such as rewarding extraordinary performance.
Assessment of Risk
Our Board takes risk into account when making compensation decisions and has concluded that the executive compensation program as it is currently structured does not encourage excessive risk or unnecessary risk-taking.
Accounting and Tax Considerations
We have structured our compensation program to comply with Internal Revenue Code Section 409A. If an executive is entitled to nonqualified deferred compensation benefits that are subject to Section 409A, and such benefits do not comply with Section 409A, then the benefits are taxable in the first year they are not subject to a substantial risk of forfeiture. In such case, the service provider is subject to regular federal income tax, interest and an additional federal income tax of 20% of the benefit includible in income.
Compensation Committee Report
As we do not have a formal compensation committee, our entire Board of Directors serves as our compensation committee. Our Board of Directors has reviewed and discussed the above Compensation Discussion and Analysis with management and, based on such review and discussions, the Board of Directors recommended that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K.
Harlan H. Chappelle
Michael E. Ellis (Chairman)
Mickey Ellis
Index to Financial Statements Summary Compensation
The following table summarizes, with respect to our named executive officers, information relating to the compensation earned for services rendered in all capacities during the fiscal year ended December 31, 2012. There was no compensation awarded to, earned by or paid to any of the named executive officers related to option awards or non-equity incentive compensation plans. In addition, none of the named executive officers participate in a defined benefit pension plan.
(1) Bonuses for 2012 have not yet been determined. We expect these bonuses will be determined before the end of August 2013.
(2) Mr. Chappelle’s other compensation for the year ended December 31, 2012 consists of $10,000 in matching funds to his 401(k) account, $16,631 in auto expenses, and approximately $4,650 for club membership. Mr. Chappelle’s other compensation for the year ended December 31, 2011 consists of $9,800 in matching funds to his 401(k) account, and $17,802 in auto expenses.
(3) Mr. Ellis’ other compensation for the year ended December 31, 2012 consists of $10,000 in matching funds to his 401(k) account and $9,463 in auto expenses. Mr. Ellis’ other compensation for the year ended December 31, 2011 consists of $9,800 in matching funds to his 401(k) account and $18,189 in auto expenses.
(4) For the year ended December 31, 2012, Mr. McCabe’s other compensation consisted of $10,000 in matching funds to his 401(k) account, and $106,845 in travel and living expenses, which includes $24,255 for an apartment in Houston and $82,590 for travel, which consists primarily of airfare and the cost of a leased car and parking. For the year ended December 31, 2011, Mr. McCabe’s other compensation consisted of $9,800 in matching funds to his 401(k) account, and $66,601 in travel and living expenses, which includes $18,764 for an apartment in Houston and $47,837 for travel, which consists primarily of airfare and the cost of rental cars and parking.
(5) Mr. Murrell’s other compensation for the year ended December 31, 2012 consists of $10,000 in matching funds to his 401(k) account and $18,438 in auto expenses. Mr. Murrell’s other compensation for the year ended December 31, 2011 consists of $9,800 in matching funds to his 401(k) account and $14,227 in auto expense.
Index to Financial Statements Narrative Disclosure to Summary Compensation Table
Mr. Chappelle
Mr. Chappelle entered into an employment agreement on August 31, 2006 that provides that he will act as President and Chief Executive Officer until August 31, 2010, subject to automatic one year renewals of the term if neither party submits a notice of termination at least 60 days prior to the end of the then-current term. In accordance with the provisions of the employment agreement, in 2012, the agreement was automatically renewed for an additional one-year term. This agreement may be terminated by either party, at any time, subject to severance obligations in the event Mr. Chappelle is terminated by us without cause or he dies or is disabled.
Mr. Chappelle’s employment agreement provides for a minimum base salary of $400,000 and an annual bonus equal to a percentage of his base salary paid during each such annual period, such percentage to be established by our Board of Directors in the Board’s sole discretion.
Mr. Ellis
Mr. Ellis entered into an employment agreement on August 31, 2006 that provides that he will act as Vice President and Chief Operating Officer until August 31, 2010, subject to automatic one year renewals of the term if neither party submits a notice of termination at least 60 days prior to the end of the then-current term. In accordance with the provisions of the employment agreement, in 2012, the agreement was automatically renewed for an additional one-year term. This agreement may be terminated by either party, at any time, subject to severance obligations in the event Mr. Ellis is terminated by us without cause or he dies or is disabled.
Mr. Ellis’ employment agreement provides for a minimum base salary of $400,000 and an annual bonus equal to a percentage of his base salary paid during each such annual period, such percentage to be established by our Board of Directors in the Board’s sole discretion.
Mr. McCabe
Mr. McCabe entered into an employment agreement on August 31, 2006 that provides that he will act as Vice President and Chief Financial Officer until August 31, 2010, subject to automatic one year renewals of the term if neither party submits a notice of termination at least 60 days prior to the end of the then-current term. In accordance with the provisions of the employment agreement, in 2012, the agreement was automatically renewed for an additional one-year term. This agreement may be terminated by either party, at any time, subject to severance obligations in the event Mr. McCabe is terminated by us without cause or he dies or is disabled.
Mr. McCabe’s employment agreement provides for a minimum base salary of $300,000 and an annual bonus equal to a percentage of his base salary paid during each such annual period, such percentage to be established by our Board of Directors in the Board’s sole discretion.
Mr. McCabe’s employment agreement also provides that he is allowed to work from his residence in Massachusetts as well as in our Houston office so long as he is capable of performing his duties assigned to him. In his employment agreement, we also agree to provide Mr. McCabe with suitable housing (or a housing allowance) and an automobile or reimbursement for the lease of an automobile while he is in Houston.
Mr. Murrell
Mr. Murrell entered into an employment agreement on October 1, 2006 that provides that he will act as Vice President of Land and Business Development until October 1, 2007, subject to automatic one year renewals of the term if neither party submits a notice of termination at least 60 days prior to the end of the then-current term. In accordance with the provisions of the employment agreement, in 2012, the agreement was automatically renewed for an additional one-year term. This agreement may be terminated by either party, at any time, subject to severance obligations in the event Mr. Murrell is terminated by us without cause or he dies or is disabled.
Mr. Murrell’s employment agreement provides for a minimum base salary of $190,000 and an annual bonus equal to 0.5% of the taxable income less federal income tax of Alta Mesa Holdings, subject to a minimum bonus of $50,000 and a maximum bonus such that his combined salary plus bonus does not exceed $1,000,000.
Grants of Plan-Based Awards for Fiscal Year 2012
There were no grants of plan-based awards to our named executive officers during the fiscal year ended December 31, 2012.
Index to Financial Statements Outstanding Equity Awards Value at 2012 Fiscal Year-End
There were no outstanding equity awards for our named executive officers as of December 31, 2012.
Option Exercises and Equity Awards Vested in Fiscal Year 2012
There were no exercises of equity awards and no vesting of equity awards for our named executive officers during fiscal 2012.
Pension Benefits
We do not provide pension benefits for our named executive officers.
Nonqualified Deferred Compensation
We do not have a nonqualified deferred compensation plan and, as such, no compensation has been deferred by our named executive officers.
Termination of Employment and Change-in-Control Provisions
Messrs. Chappelle, Ellis, McCabe and Murrell are parties to employment agreements which provide them with post-termination benefits in a variety of circumstances. The amount of compensation payable in some cases may vary depending on the nature of the termination, whether as a result of retirement/voluntary termination, involuntary not-for-cause termination, termination following a change of control and in the event of disability or death of the executive. The discussion below describes the varying amounts payable in each of these situations. It assumes, in each case, that the officer’s termination was effective as of December 31, 2012. In presenting this disclosure, we describe amounts earned through December 31, 2012 and, in those cases where the actual amounts to be paid out can only be determined at the time of such executive’s separation from us, our estimates of the amounts which would be paid out to the executives upon their termination.
Provisions Under the Employment Agreements
Under the employment agreements, if the executive’s employment with us terminates, the executive is entitled to unpaid salary for the full month in which the termination date occurred. However, if the executive is terminated for cause, the executive is only entitled to receive accrued but unpaid salary through the termination date. In addition, if the executive’s employment terminates, the executive is entitled to unpaid vacation days for that year which have accrued through the termination date, reimbursement of reasonable business expenses that were incurred but unpaid as of the termination date, a pro rata portion of the annual bonus for that year and COBRA coverage as required by law. Salary and accrued vacation days are payable in cash lump sum less applicable withholdings. Business expenses are reimbursable in accordance with normal procedures.
If the executive’s employment is involuntarily terminated by us (except for cause or due to the death of the executive) or if the executive’s employment is terminated due to disability or retirement or by the executive for good reason, we are obligated to pay as additional compensation an amount in cash equal to two years, except in the case of Mr. Murrell, in which case it is six months, of the executive’s base salary in effect as of the termination date. Under the terms of Mr. Murrell’s employment agreement, upon such involuntary termination, he would also be paid 50% of the annual bonus then in effect. Assuming termination as of December 31, 2012, for both Messrs. Chappelle and Ellis, the termination benefit would have been $900,000; for Mr. McCabe, $800,000; and for Mr. Murrell, $275,000. In addition, the executive is entitled to continued group health plan coverage following the termination date for the executive and the executive’s eligible spouse and dependents for the maximum period for which such qualified beneficiaries are eligible to receive COBRA coverage. The executive shall not be required to pay more for COBRA coverage than officers who are then in active service for us and receiving coverage under the plan. Assuming termination as of December 31, 2012, for each of Messrs. Chappelle, Ellis, McCabe, and Murrell, this amount would have been $18.00 to each. Our total cost of providing this benefit would have been $29,285 for Mr. Chappelle, $42,976 for Mr. Ellis, $29,285 for Mr. McCabe, and $29,285 for Mr. Murrell.
Index to Financial Statements “Cause” means:
•
the executive’s conviction by a court of competent jurisdiction of a crime involving moral turpitude or a felony, or entering the plea of nolo contendere to such crime by the executive;
•
the commission by the executive of a demonstrable act of fraud, or a misappropriation of funds or property, of or upon us or any affiliate;
•
the engagement by the executive without approval of us and the board of directors in any material activity which directly competes with the business of us or any affiliate or which would directly result in a material injury to the business or reputation of us or any affiliate (including the partners of Alta Mesa); or
•
the breach by the executive of any material provision of the employment agreement, and the executive’s continued failure to cure such breach within a reasonable time period set by us but in no event less than twenty calendar days after the executive’s receipt of such notice.
“Good reason” means the occurrence of any of the following, if not cured and correct by us or our successor, within 60 days after written notice thereof is provided by the executive to us or our successor:
•
the demotion or reduction in title or rank of the executive, or the assignment to the executive of duties that are materially inconsistent with the executive’s current positions, duties, responsibilities and status with us, or any removal of the executive from, or any failure to re-elect the executive to, any of such positions (other than a change due to the executive’s disability or as an accommodation under the Americans with Disabilities Act), except for any such demotion, reduction, assignment, removal or failure that occurs in connection with (i) the executive’s termination of employment for cause, disability or death, or (ii) the executive’s prior written consent;
•
the reduction of the executive’s annual base salary or bonus opportunity as effective immediately prior to such reduction without the prior written consent of the executive; or
•
a relocation of the executive’s principal work location to a location in excess of 50 miles from its then current location.
“Retirement” means the termination of the executive’s employment for normal retirement at or after attaining age 70, provided that the executive has been with us for at least five years.
The employment agreements do not separately provide for benefits upon a change of control.
Compensation of Directors
The employee and non-employee members of the Board of Directors do not receive compensation for their services as directors. However, our directors may be reimbursed for their expenses in attending board meetings.
Compensation Committee Interlocks and Insider Participation
We do not currently have a compensation committee. None of our executive officers has served as a director or member of the compensation committee of any other entity whose executive officers served as a director or member of our compensation committee.
Index to Financial Statements Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth the limited partnership interests in Alta Mesa beneficially owned by:
•
all persons who, to the knowledge of our management team, beneficially own more than 5% of our outstanding limited partnership interests;
•
each current director of Alta Mesa GP, our general partner;
•
each principal officer of Alta Mesa GP; and
•
all current directors and principal officers of Alta Mesa GP as a group.
(1) Unless otherwise indicated, the address for all beneficial owners in this table is at 15021 Katy Freeway, Suite 400, Houston, Texas 77094.
(2) The address of Alta Mesa Investment Holdings Inc. is c/o Denham Capital Management LP, 600 Travis, Suite 2310, Houston, Texas 77002. For more information on the ability of our Class B Limited Partner to cause a liquidity event, see Note 15 in the accompanying Notes to Consolidated Financial Statements.
(3) The address of Macquarie Bank Limited is 333 Clay Street, Houston, Texas 77002.
(4) The address of RBS Equity Corporation is c/o The Royal Bank of Scotland plc, 600 Travis, Suite 6500, Houston, Texas 77002.
(5) Mr. Ellis does not own directly any partnership interests. Includes limited partner interests held by Alta Mesa Resources, LP, Galveston Bay Resources Holdings, LP, Petro Acquisition Holdings, LP and Petro Operating Company Holdings, Inc., all entities owned and controlled by Mr. Ellis.
(6) Mickey Ellis is the spouse of Michael E. Ellis. Ms. Ellis may be deemed to be the beneficial owner of the partnership interests owned by Mr. Ellis.
Additionally, our general partner, Alta Mesa GP, is owned by Mr. and Ms. Ellis. For further information regarding the manner in which we make cash distributions to our general and limited partners, see Note 15 in the accompanying Notes to Consolidated Financial Statements.
Securities Authorized for Issuance under Equity Compensation Plans
We do not have any equity compensation plans.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
We do not have any formal policy with respect to the review and approval of related party transactions.
Ownership in Us and Our General Partner by Founder
Michael E. Ellis, our Chairman and Chief Operating Officer, and his spouse Mickey Ellis, one of our directors, own 84.5% of our Class A interests. Our general partner, Alta Mesa GP, is owned 100% by Alta Mesa Resources, LP, an entity owned by Michael E. Ellis and Mickey Ellis. Our general partner has a 0.1% interest in us.
During 2012, Michael E. Ellis received a capital distribution from us of $165,000.
Index to Financial Statements Founder Notes
We were founded in 1987 by Michael E. Ellis and we or our subsidiaries have over time entered into promissory notes to repay Mr. Ellis for contributions of working capital and other amounts. See Note 9 in the accompanying Notes to Consolidated Financial Statements.
Land Consulting Services
David Murrell, our Vice President, Land and Business Development, is the principal of David Murrell & Associates, which provides land consulting services to us. The primary employee of David Murrell & Associates is his spouse, Brigid Murrell. Services are provided at a pre-negotiated hourly rate based on actual time employed by us. Total expenditures under this arrangement vary but over the last three years annual payment to Ms. Murrell has averaged over $120,000 per year. Payment for the year ended December 31, 2012 was approximately $116,000. The contract may be terminated by either party without penalty upon 30 days’ notice.
Employee
David McClure, one of our senior engineers and the son-in-law of our CEO, Harlan H. Chappelle, received total compensation of $330,000 for the year ended December 31, 2012. Additionally, his position provides him with the use of a company vehicle, similar to our other engineers whose duties include field oversight.
Director Independence
Our board of directors consists of three members, one of whom is a non-employee director. Because we only have debt securities registered with the SEC under the Exchange Act and because we do not have a class of securities listed on any national securities exchange, national securities association or inter-dealer quotation system, we are not required to have a board of directors comprised of a majority of independent directors under SEC rules or any listing standards. Accordingly, our board of directors has not made any determination as to whether the one non-employee director satisfies any independence requirements applicable to board members under the rules of the SEC or any national securities exchange, inter-dealer quotation system or any other independence definition.
Item 14.
Item 14. Principal Accountant Fees and Services
Our Board of Directors selected UHY LLP, an independent registered public accounting firm, to audit our consolidated financial statements for the fiscal year ended December 31, 2012. Aggregate fees for professional services rendered to us by UHY LLP for the years ended December 31, 2012 and 2011 were as follows:
Audit Fees
The audit fees for the years ended December 31, 2012 and 2011, respectively, were for professional services rendered for the audits of our consolidated financial statements and review of our quarterly financial statements. In addition, fees in both 2011 and 2012 were incurred in connection with issuance of debt. In 2011, we replaced our $300 million issue of privately placed bonds with registered bonds. In 2012 we privately placed an additional $150 million in bonds and filed a registration statement for the replacement of those bonds with registered bonds.
Audit-Related Fees
Audit-related fees for the years 2011 and 2012 also include fees for the audit of our 401(k) employee savings plan.
Tax Fees
The tax fees for the year ended December 31, 2011 were for professional services rendered for tax compliance.
Index to Financial Statements Pre-Approval Policies and Procedures
We currently have no Board committees. Our Board of Directors has adopted policies regarding the pre-approval of auditor services. Specifically, the Board of Directors approves all services provided by the independent public accountants at its March meeting. All additional services must be pre-approved on a case-by-case basis. Our Board of Directors reviews the actual and budgeted fees for the independent public accountants periodically at regularly scheduled board meetings. All of the services provided by UHY LLP during fiscal 2012 and 2011 were approved by the Board of Directors.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Documents filed as part of this report:
1. Financial Statements:
(i) Independent Registered Public Accounting Firm’s Report
(ii) Consolidated Statements of Operations for each of the three years in the period ended December 31, 2012
(iii) Consolidated Balance Sheets as of December 31, 2012 and 2011
(iv) Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2012
(v) Consolidated Statements of Changes in Partners’ Capital for each of the three years in the period ended December 31, 2012
(vi) Notes to Consolidated Financial Statements
(vii) Supplemental Oil and Natural Gas Information (Unaudited)
2. Financial Statement Schedules:
(i) All schedules are omitted as they are not applicable, not required or the required information is included in the consolidated financial statements or notes thereto.
3. Exhibits:
Index to Financial Statements
Index to Financial Statements
* Filed herewith.
+ Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability.
Index to Financial Statements SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ALTA MESA HOLDINGS, L.P.
(Registrant)
By
/S/ MICHAEL A. MCCABE
Michael A. McCabe
Chief Financial Officer
Dated March 27, 2013
In accordance with the Exchange Act, this report has been signed below on the 27th day of March, 2013, by the following persons on behalf of the registrant and in the capacities indicated.
Signature
Title
By:
/s/ HARLAN H. CHAPPELLE
Harlan H. Chappelle
President, Chief Executive Officer and Director (Principal Executive Officer)
By:
/s/ MICHAEL E. ELLIS
Michael E. Ellis
Founder, Chairman, Vice President of Engineering and Chief Operating Officer, Director
By:
/s/ MICKEY ELLIS
Mickey Ellis
Director
Index to Financial Statements GLOSSARY OF CERTAIN OIL AND NATURAL GAS TERMS
The definitions set forth below apply to the indicated terms as used in this Annual Report on Form 10-K. All volumes of natural gas referred to are stated at the legal pressure base of the state or area where the reserves exist and at 60 degrees Fahrenheit and in most instances are rounded to the nearest major multiple.
“3-D seismic”. (Three-Dimensional Seismic Data) Geophysical data that depicts the subsurface strata in three dimensions. 3-D seismic data typically provides a more detailed and accurate interpretation of the subsurface strata than two-dimensional seismic data.
“Bbl”. One stock tank barrel, of 42 U.S. gallons liquid volume, used herein in reference to crude oil, condensate or natural gas liquids.
“Bcf”. One billion cubic feet of natural gas.
“Bcfe”. One billion cubic feet of natural gas equivalent with one barrel of oil converted to six thousand cubic feet of natural gas. The ratio of six thousand cubic feet of natural gas to one Bbl of oil or natural gas liquids is commonly used in the oil and natural gas business and represents the approximate energy equivalency of six thousand cubic feet of natural gas to one Bbl of oil or natural gas liquids, and does not represent the sales price equivalency of natural gas to oil or natural gas liquids. Currently, the sales price of one Bbl of oil or natural gas liquids is significantly higher than the sales price of six thousand cubic feet of natural gas.
“Basin”. A large natural depression on the earth’s surface in which sediments generally brought by water accumulate.
“Btu or British Thermal Unit”. The quantity of heat required to raise the temperature of one pound of water by one degree Fahrenheit.
“Completion”. The process of treating a drilled well followed by the installation of permanent equipment for the production of natural gas or oil, or in the case of a dry hole, the reporting of abandonment to the appropriate agency.
“DD&A”. Depreciation, depletion and amortization.
“De-bottlenecking”. The process of increasing production capacity of existing facilities through the modification of existing equipment to remove throughput restrictions.
“Delineation”. The process of placing a number of wells in various parts of a reservoir to determine its boundaries and production characteristics.
“Developed acreage”. The number of acres that are allocated or assignable to productive wells or wells capable of production.
“Developed oil and natural gas reserves”. Developed oil and natural gas reserves are reserves of any category that can be expected to be recovered: (i) through existing wells with existing equipment and operating methods or in which the cost of the related equipment is relatively minor compared to the cost of a new well; and (ii) through installed extraction equipment and infrastructure operational at the time of the reserves estimate if the extraction is by means not involving a well.
“Development well”. A well drilled within the proved area of an oil or natural gas reservoir to the depth of a stratigraphic horizon known to be productive.
“Dry hole”. A well found to be incapable of producing hydrocarbons in sufficient quantities such that proceeds from the sale of such production exceed production expenses and taxes.
“Dry hole costs”. Costs incurred in drilling a well, assuming a well is not successful, including plugging and abandonment costs.
“Enhanced recovery”. The recovery of oil and natural gas through the injection of liquids or gases into the reservoir, supplementing its natural energy. Enhanced recovery methods are often applied when production slows due to depletion of the natural pressure.
“Exploratory well”. A well drilled to find and produce natural gas or oil reserves not classified as proved, to find a new reservoir in a field previously found to be productive of natural gas or oil in another reservoir or to extend a known reservoir.
“Farm-in or farm-out”. An agreement under which the owner of a working interest in an oil and natural gas lease assigns the working interest or a portion of the working interest to another party who desires to drill on the leased acreage. Generally, the assignee is required to drill one or more wells in order to earn its interest in the acreage. The assignor usually retains a royalty or reversionary interest in the lease. The interest received by an assignee is a “farm-in” while the interest transferred by the assignor is a “farm-out”.
“Fault”. A break or planar surface in brittle rock across which there is observable displacement.
“Field”. An area consisting of a single reservoir or multiple reservoirs all grouped on, or related to, the same individual geological structural feature or stratigraphic condition. The field name refers to the surface area, although it may refer to both the surface and the underground productive formations.
Index to Financial Statements “Formation”. A layer of rock which has distinct characteristics that differs from nearby rock.
“Fracing, fracture stimulation technology, hydraulic fracturing”. The technique of improving a well’s production or injection rates by pumping a mixture of fluids into the formation and rupturing the rock, creating an artificial channel. As part of this technique, sand or other material may also be injected into the formation to keep the channel open, so that fluids or natural gases may more easily flow through the formation.
“Gross acres or gross wells”. The total acres or wells, as the case may be, in which a working interest is owned.
“Horizontal drilling”. A drilling technique used in certain formations where a well is drilled vertically to a certain depth and then drilled at a right angle within a specified interval.
“Infill wells”. Wells drilled into the same pool as known producing wells so that oil or natural gas does not have to travel as far through the formation.
“Lease operating expenses”. The expenses of lifting oil or natural gas from a producing formation to the surface, constituting part of the current operating expenses of a working interest, and also including labor, superintendence, supplies, repairs, short-lived assets, maintenance, allocated overhead costs, workover, ad valorem taxes, insurance and other expenses incidental to production, but excluding lease acquisition or drilling or completion expenses.
“MBbl”. One thousand barrels of crude oil, condensate or natural gas liquids.
“Mcf”. One thousand cubic feet of natural gas.
“Mcfe”. One thousand cubic feet equivalent determined using the ratio of six Mcf of natural gas to one barrel of oil, condensate or natural gas liquids. The ratio of six Mcf of natural gas to one Bbl of oil or natural gas liquids is commonly used in the oil and natural gas business and represents the approximate energy equivalency of six Mcf of natural gas to one Bbl of oil or natural gas liquids, and does not represent the sales price equivalency of natural gas to oil or natural gas liquids. Currently, the sales price of one Bbl of oil or natural gas liquids is significantly higher than the sales price of six Mcf of natural gas.
“Mcfe/d”. Mcfe per day.
“MMBtu”. One million British thermal units.
“MMcf”. One million cubic feet of natural gas.
“MMcfe”. Million cubic feet equivalent, determined using the ratio of six Mcf of natural gas to one Bbl of crude oil, condensate or natural gas liquids.
“MMcfe/d”. MMcfe per day.
“MMBbl”. One million barrels of crude oil, condensate or natural gas liquids.
“NGLs”. Natural gas liquids. Hydrocarbons found in natural gas which may be extracted as liquefied petroleum gas and natural gasoline.
“NYMEX”. The New York Mercantile Exchange.
“Net Acres”. The percentage of total acres an owner has out of a particular number of acres, or a specified tract. An owner who has 50% interest in 100 acres owns 50 net acres.
“Non-operated working interests”. The working interest or fraction thereof in a lease or unit, the owner of which is without operating rights by reason of an operating agreement.
“Pay”. A reservoir or portion of a reservoir that contains economically producible hydrocarbons. The overall interval in which pay sections occur is the gross pay; the smaller portions of the gross pay that meet local criteria for pay (such as a minimum porosity, permeability and hydrocarbon saturation) are net pay.
“Productive well”. A well that is found to be capable of producing hydrocarbons in sufficient quantities such that proceeds from the sale of the production exceed production expenses and taxes.
“Prospect”. A specific geographic area which, based on supporting geological, geophysical or other data and also preliminary economic analysis using reasonably anticipated prices and costs, is deemed to have potential for the discovery of commercial hydrocarbons.
“PDNP”. Proved developed non-producing reserves.
“PDP”. Proved developed producing reserves.
Index to Financial Statements “Proved reserves”. Proved oil and natural gas reserves are those quantities of oil and natural gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible - from a given date forward from known reservoirs, and under existing economic conditions, operating methods and government regulations - prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The project to extract the hydrocarbons must have commenced or the operator must be reasonably certain that it will commence the project within a reasonable time.
“Proved undeveloped reserves (“PUD”)”. Proved undeveloped oil and natural gas reserves are reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion. Reserves on undrilled acreage are limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units are claimed only where it can be demonstrated with certainty that there is continuity of production from the existing productive formation. Estimates for proved undeveloped reserves will not be attributable to any acreage for which an application of fluid injection or other improved recovery technique is contemplated, unless such techniques have been proved effective by actual tests in the area and in the same reservoir.
“PV-10”. When used with respect to oil and natural gas reserves, PV-10 means the estimated future gross revenue to be generated from the production of proved reserves, net of estimated production and future development and abandonment costs, using prices and costs in effect at the determination date, before income taxes, and without giving effect to non-property related expenses, discounted to a present value using an annual discount rate of 10% in accordance with the guidelines of the SEC. PV-10 is not a financial measure calculated in accordance with generally accepted accounting principles (“GAAP”) and generally differs from Standardized Measure, the most directly comparable GAAP financial measure, because it does not include the effects of income taxes on future net revenues. Neither PV-10 nor Standardized Measure represents an estimate of the fair market value of our oil and natural gas properties. We and others in the industry use PV-10 as a measure to compare the relative size and value of proved reserves held by companies without regard to the specific tax characteristics of such entities. Our PV-10 is the same as our standardized measure for the periods presented in this report.
“Recompletion”. The process of re-entering an existing wellbore that is either producing or not producing and completing new reservoirs in an attempt to establish or increase existing production.
“Reserve life index”. A measure of the productive life of an oil and natural gas property or a group of properties, expressed in years.
“Reservoir”. A porous and permeable underground formation containing a natural accumulation of producible oil and/or natural gas that is confined by impermeable rock or water barriers and is separate from other reservoirs.
“Spacing”. The distance between wells producing from the same reservoir. Spacing is often expressed in terms of acres, e.g., 40-acre spacing, and is often established by regulatory agencies.
“Standardized measure”. Standardized measure is the present value of estimated future net revenues to be generated from the production of proved reserves, determined in accordance with the rules and regulations of the Securities and Exchange Commission, without giving effect to non - property related expenses such as certain general and administrative expenses, debt service and future federal income tax expenses or to depreciation, depletion and amortization and discounted using an annual discount rate of 10%. Our standardized measure includes future obligations under the Texas gross margin tax, but it does not include future federal income tax expenses because we are a partnership and are not subject to federal income taxes. Our standardized measure is the same as our PV-10 for the periods presented in this report.
“Undeveloped acreage”. Lease acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas regardless of whether such acreage contains proved reserves.
“Unit”. The joining of all or substantially all interests in a reservoir or field, rather than a single tract, to provide for development and operation without regard to separate property interests. Also, the area covered by a unitization agreement.
“Waterflood”. The injection of water into an oil reservoir to “push” additional oil out of the reservoir rock and into the wellbores of producing wells. Typically an enhanced recovery process.
“Wellbore”. The hole drilled by the bit that is equipped for natural gas production on a completed well. Also called well or borehole.
“Working interest”. The right granted to the lessee of a property to explore for and to produce and own natural gas or other minerals. The working interest owners bear the exploration, development, and operating costs on either a cash, penalty, or carried basis.
Index to Financial Statements
Below is an index to the financial statements and notes contained in Financial Statements and Supplementary Data.
Page
Audited Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Changes in Partners’ Capital
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Index to Financial Statements Independent Auditors’ Report
To the Partners of
Alta Mesa Holdings, LP and Subsidiaries
Houston, Texas
We have audited the accompanying consolidated balance sheets of Alta Mesa Holdings, LP and Subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations, changes in partners’ capital and cash flows for each of the three fiscal years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three fiscal years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.
/S/ UHY LLP
Houston, Texas
March 27, 2013
Index to Financial Statements ALTA MESA HOLDINGS, LP AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
Index to Financial Statements ALTA MESA HOLDINGS, LP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to consolidated financial statements.
Index to Financial Statements ALTA MESA HOLDINGS, LP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERS’ CAPITAL
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(dollars in thousands)
See notes to consolidated financial statements.
Index to Financial Statements ALTA MESA HOLDINGS, LP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
Index to Financial Statements ALTA MESA HOLDINGS, LP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011 AND 2010
NOTE 1 - SUMMARY OF ORGANIZATION AND NATURE OF OPERATIONS
Organization. The consolidated financial statements presented herein are of Alta Mesa Holdings, LP and (i) its wholly-owned subsidiaries: Alta Mesa Acquisition Sub, LLC, Alta Mesa Eagle, LLC, Alabama Energy Resources, LLC, Alta Mesa Drilling, LLC, Alta Mesa Energy, LLC, Alta Mesa Finance Services Corp., Alta Mesa GP, LLC, AM Idaho, LLC, AMH Energy New Mexico, LLC, and Virginia Oil and Gas, LLC; (ii) its direct and indirect wholly-owned subsidiaries: Alta Mesa Services, LP, Aransas Resources, LP (and its wholly-owned subsidiary ARI Development, LLC), Brayton Management GP II, LLC, Brayton Resources II, LP, Buckeye Production Company, LP, Cairn Energy USA, LLC, FBB Anadarko, LLC, Galveston Bay Resources, LP, Louisiana Exploration & Acquisitions, LP (and its wholly-owned subsidiary Louisiana Exploration & Acquisition Partnership, LLC), Louisiana Onshore Properties LLC, Navasota Resources, Ltd., LLP, New Exploration Technologies Company, LLC, Nueces Resources, LP, Oklahoma Energy Acquisitions, LP, Petro Acquisitions, LP, Petro Operating Company, LP, Sundance Acquisition, LLC, TE TMR, LLC, Texas Energy Acquisitions, LP, The Meridian Production LLC, The Meridian Resource & Exploration LLC, The Meridian Resource LLC, TMR Drilling, LLC, TMR Equipment, LLC; and (iii) its partially-owned subsidiaries: Brayton Management GP, LLC, Brayton Resources, LP, LEADS Resources, L.L.C., and Orion Operating Company, LP.
Nature of Operations. We are engaged primarily in the acquisition, exploration, development, and production of oil and natural gas properties. Our core properties are located in Texas, Louisiana, and Oklahoma.
We use accounting policies which reflect industry practices and conform to accounting principles generally accepted in the U.S. (“GAAP”). As used herein, the following acronyms have the following meanings: “FASB” means the Financial Accounting Standards Board; the “Codification” refers to the Accounting Standards Codification, the collected accounting and reporting guidance maintained by the FASB; “ASC” means Accounting Standards Codification and is generally followed by a number indicating a particular section of the Codification; and “ASU” means Accounting Standards Update, followed by an identification number, which are the periodic updates made to the Codification by the FASB. “SEC” means the Securities and Exchange Commission.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, after eliminating all significant intercompany transactions. The Company’s interest in oil and natural gas exploration and production ventures and partnerships are proportionately consolidated.
Use of Estimates. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.
Reserve estimates significantly impact depreciation, depletion and amortization expense and potential impairments of oil and natural gas properties and are subject to change based on changes in oil and natural gas prices and trends and changes in estimated reserve quantities. We analyze estimates, including those related to oil and natural gas reserves, the value of oil and natural gas properties, oil and natural gas revenues, bad debts, asset retirement obligations, derivative contracts, income taxes and contingencies and litigation. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
Cash and Cash Equivalents. We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. The Company maintains cash balances at financial institutions in the United States of America, which at times exceed federally insured amounts. The Federal Deposit Insurance provides insurance up to $250,000 per depositor. We monitor the financial condition of the financial institutions and have experienced no losses associated with these accounts. Restricted cash includes a balance on deposit related to deferred payment of certain royalties.
Accounts Receivable. The Company’s receivables arise from the sale of oil and natural gas to third parties and joint interest owner receivables for properties in which we serve as the operator. This concentration of customers may impact our overall credit risk, either positively or negatively, in that these entities may be similarly affected by changes in economic or other conditions affecting the oil and natural gas industry. Accounts receivable are generally not collateralized.
Allowance for Doubtful Accounts. We routinely assess the recoverability of all material trade and other receivables to determine their collectability. We accrue a reserve when, based on the judgment of management, it is probable that a receivable will not be collected and the amount of the reserve can be reasonably estimated. Accounts receivable are shown net of allowance for doubtful accounts of $784,000 and $557,000 as of December 31, 2012 and 2011, respectively.
Index to Financial Statements Deferred Financing Costs. Deferred financing costs and the amount of discount at which notes payable have been issued (debt discount) are amortized using the straight-line method, which approximates the interest method, over the term of the related debt. For the years ended December 31, 2012, 2011, and 2010, amortization of deferred financing costs included in interest expense amounted to $2.4 million, $2.8 million, and $4.2 million, respectively. Deferred financing costs are listed among our long-term assets, net of accumulated amortization of $9.9 million and $7.5 million at December 31, 2012 and 2011, respectively.
Property and Equipment. Oil and natural gas producing activities are accounted for using the successful efforts method of accounting. Under the successful efforts method, lease acquisition costs and all development costs, including unsuccessful development wells, are capitalized.
Unproved Properties - Acquisition costs associated with the acquisition of leases are recorded as unproved properties and capitalized as incurred. These consist of costs incurred in obtaining a mineral interest or right in a property, such as a lease in addition to options to lease, broker fees, recording fees and other similar costs related to activities in acquiring properties. Unproved properties are classified as unproved until proved reserves are discovered, at which time related costs are transferred to proved oil and natural gas properties.
Exploration Expense - Exploration expenses, other than exploration drilling costs, are charged to expense as incurred. These expenses include seismic expenditures and other geological and geophysical costs, expired leases, and lease rentals. The costs of drilling exploratory wells and exploratory-type stratigraphic wells are initially capitalized pending determination of whether the well has discovered proved commercial reserves. If the exploratory well is determined to be unsuccessful, the cost of the well is transferred to expense. Exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Assessments of such capitalized costs are made quarterly.
Proved Oil and Natural Gas Properties - Costs incurred to obtain access to proved reserves and to provide facilities for extracting, treating, gathering, and storing oil and natural gas are capitalized. All costs incurred to drill and equip successful exploratory wells, development wells, development-type stratigraphic test wells, and service wells, including unsuccessful development wells, are capitalized.
Impairment - The capitalized costs of proved oil and natural gas properties are reviewed quarterly for impairment following the guidance provided in ASC 360-10-35, “Property, Plant and Equipment, Subsequent Measurement,” or whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset or asset group exceeds its fair market value and is not recoverable. The determination of recoverability is based on comparing the estimated undiscounted future net cash flows at a producing field level to the carrying value of the assets. If the future undiscounted cash flows, based on estimates of anticipated production from proved reserves and future crude oil and natural gas prices and operating costs, are lower than the carrying cost, the carrying cost of the asset or group of assets is reduced to fair value. For our proved oil and natural gas properties, we estimate fair value by discounting the projected future cash flows at an appropriate risk-adjusted discount rate.
Our evaluation of the Company’s proved properties resulted in impairment expense of $90.3 million, $16.9 million, and $6.4 million for the years ended December 31, 2012, 2011, and 2010, respectively.
In addition, the Company recorded other write-downs and impairment expense of casing and tubing to lower of cost or market, of zero, $162,000 and $18,000 for the years ended December 31, 2012, 2011 and 2010, respectively.
Unproved properties are assessed at least annually to determine whether they have been impaired. Individually significant properties are assessed for impairment on a property-by-property basis, while individually insignificant unproved properties may be assessed in the aggregate. If unproved properties are found to be impaired, an impairment allowance is provided and a loss is recognized in the consolidated statement of operations. For the years ended December 31, 2012, 2011 and 2010, impairment expense of unproved properties was $5.9 million, $1.8 million, and $2.0 million, respectively.
Management evaluates whether the carrying value of all other long-lived assets has been impaired when circumstances indicate the carrying value of those assets may not be recoverable. This evaluation is based on undiscounted cash flow projections. The carrying amount is not recoverable if it exceeds the undiscounted sum of cash flows expected to result from the use and eventual disposition of the assets. Management considers various factors when determining if these assets should be evaluated for impairment.
If the carrying value is not recoverable on an undiscounted basis, the impairment loss is measured as the excess of the asset’s carrying value over its fair value. Management assesses the fair value of long-lived assets using commonly accepted techniques, and may use more than one method, including, but not limited to, recent third party comparable sales, internally developed discounted cash flow analysis and analysis from outside advisors. Significant changes in market conditions resulting from events such as the condition of an asset or a change in management’s intent to utilize the asset would generally require management to reassess the cash flows related to the long-lived assets. For the years ended December 31, 2012, 2011, and 2010, respectively, the Company did not record any impairment expense related to other long-lived assets.
Index to Financial Statements Depreciation, Depletion and Amortization - Depreciation, depletion, and amortization (“DD&A”) of capitalized costs of proved oil and natural gas properties is computed using the unit-of-production method based upon estimated proved reserves. Assets are grouped for DD&A on the basis of reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. The reserve base used to calculate DD&A for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. The reserve base used to calculate DD&A for lease and well equipment costs, which include development costs and successful exploration drilling costs, includes only proved developed reserves.
DD&A expense for the years ended December 31, 2012, 2011, and 2010 related to oil and natural gas properties was $106.6 million, $92.3 million, and $58.2 million, respectively.
The Company’s drilling rig is depreciated using the straight-line method of depreciation over a period of approximately fifteen years. Depreciation expense of the rig for the years ended December 31, 2012, 2011, and 2010 was $700,000, $693,000, and $444,000, respectively.
Leasehold improvements to offices are depreciated using the straight-line method over the life of the lease.
Other property and equipment is depreciated using the straight-line method over periods ranging from three to seven years. Depreciation expense for other property and equipment for the years ended December 31, 2012, 2011, and 2010 was $2.0 million, $1.2 million, and $494,000 respectively.
Investment. The Company’s investment consists of a 10% ownership interest in a drilling company, Orion Drilling Company, LP (“Orion”). The investment is accounted for under the cost method. Under this method, the Company’s share of earnings or losses of the investment are not included in the statements of operations. Distributions from Orion are recognized in current period earnings as declared. For the years ended December 31, 2012, 2011, and 2010, distributions of zero, zero, and $735,000 respectively, were included in “Other revenues” in the consolidated statements of operations.
Asset Retirement Obligations. The Company estimates the present value of future costs of dismantlement and abandonment of its wells, facilities, and other tangible long-lived assets, recording them as liabilities in the period incurred. Asset retirement obligations are calculated using an expected present value technique. Salvage values are excluded from the estimation. We follow ASC 410, “Asset Retirement and Environmental Obligations.” ASC 410 requires that an asset retirement obligation (“ARO”) associated with the retirement of a tangible long-lived asset be recognized as a liability in the period in which it is incurred or becomes determinable (as defined by the ASC), with an associated increase in the carrying amount of the related long-lived asset. The cost of the tangible asset, including the initially recognized asset retirement cost, is depreciated over the useful life of the asset and accretion expense is recognized over time as the discounted liability is accreted to its expected settlement value. The fair value of new ARO’s are measured using expected future cash outflows for abandonment discounted generally at our cost of capital at the time of recognition.
Derivative Financial Instruments. We use derivative contracts to hedge the effects of fluctuations in the prices of oil, natural gas and interest rates. We account for such derivative instruments in accordance with ASC 815, “Derivatives and Hedging,” which establishes accounting and disclosure requirements for derivative instruments and requires them to be measured at fair value and recorded as assets or liabilities in the consolidated balance sheets (see Note 5 for information on fair value).
Under ASC 815, hedge accounting is used to defer recognition of unrealized changes in the fair value of such financial instruments, for those contracts which qualify as fair value or cash flow hedges, as defined in the guidance. Historically, we have not designated any of our derivative contracts as fair value or cash flow hedges. Accordingly, the unrealized changes in fair value of the contracts are included in earnings in the period of the change as “Unrealized gain (loss) - oil and natural gas derivative contracts” for oil and natural gas contracts, and in interest expense for interest derivative contracts. Realized gains and losses are recorded in income in the period of settlement, and included in the related revenue account or in interest expense. Cash flows from settlements of derivative contracts are classified with the income or expense item to which such settlements directly relate.
Income Taxes. The Company has elected under the Internal Revenue Code provisions to be treated as individual partnerships for tax purposes. Accordingly, items of income, expense, gains and losses flow through to the partners and are taxed at the partner level. Accordingly, no tax provision for federal income taxes is included in the consolidated financial statements.
The Company is subject to the Texas margin tax, which is considered a state income tax, and is included in “Benefit from (provision for) state income tax” on the consolidated statements of operations. The Company records state income tax (current and deferred) based on taxable income, as defined under the rules for the margin tax.
Index to Financial Statements We follow guidance issued by the FASB in accounting for uncertainty in income taxes. This guidance clarifies the accounting for income taxes by prescribing the minimum recognition threshold an income tax position is required to meet before being recognized in the consolidated financial statements and applies to all income tax positions. Each income tax position is assessed using a two step process. A determination is first made as to whether it is more likely than not that the income tax position will be sustained, based upon technical merits, upon examination by the taxing authorities. If the income tax position is expected to meet the more likely than not criteria, the benefit recorded in the consolidated financial statements equals the largest amount that is greater than 50% likely to be realized upon its ultimate settlement.
Management has considered the Company’s exposure under the standard at both the federal and state tax levels. We did not have any uncertain tax positions as of December 31, 2012 and 2011. We record income tax, related interest, and penalties, if any, as a component of income tax expense. We did not incur any interest or penalties for the years ended December 31, 2012, 2011, or 2010.
The Company’s tax returns for the years ended December 31, 2008 forward remain open for examination. None of the Company’s federal or state tax returns are currently under examination by the relevant authorities.
Revenue Recognition. We recognize oil, natural gas and natural gas liquids revenues when products are delivered at a fixed or determinable price, title has transferred and collectability is reasonably assured. We use the sales method of accounting for recognition of natural gas imbalances. Revenue from drilling rigs has been recorded when services were performed.
Fair Value of Financial Instruments. The fair value of cash, accounts receivable and current liabilities approximate book value due to their short-term nature. The estimate of fair value of long-term debt under our credit facility is not considered to be materially different from carrying value due to market rates of interest. The fair value of the debt to our founder is not practicable to determine. We have estimated the fair value of our senior notes payable at $463.5 million on December 31, 2012. Derivative financial instruments are carried at fair value. See Note 5 for further information on fair values of financial instruments. See Note 9 for information on long-term debt.
Acquisitions. Acquisitions are accounted for as purchases using the acquisition method of accounting. Accordingly, the results of operations are included in our consolidated statements of operations from the closing date of the acquisitions. Purchase prices are allocated to acquired assets and assumed liabilities based on their estimated fair value at the time of the acquisition.
Reclassifications. Certain amounts in the 2011 and 2010 consolidated financial statements have been reclassified to conform to the 2012 presentation. The reclassifications had no impact on net income or partners’ capital.
Recent Accounting Pronouncements
In December 2011, the FASB issued ASU No. 2011-11, which was clarified as to scope in January 2013 by ASU 2013-01. The two ASU’s address increases to disclosures about offsetting assets and liabilities. New disclosures are required to enable users of financial statements to understand significant quantitative differences in balance sheets prepared under GAAP and International Financial Reporting Standards (IFRS) related to the offsetting of financial instruments. The existing GAAP guidance allowing balance sheet offsetting, including industry-specific guidance, remains unchanged. The guidance in ASU Nos. 2011-11 and 2013-01 is effective for annual and interim reporting periods beginning on or after January 1, 2013. The disclosures should be applied retrospectively for all prior periods presented. We do not expect the adoption of these pronouncements to have a material impact on our consolidated financial statements.
We adopted ASU No. 2011-04 to Topic 820, Fair Value Measurements, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS” on January 1, 2012. The ASU changes certain definitions of terms used in its guidance regarding fair value measurements, as well as modifying certain disclosure requirements and other aspects of the guidance. The additional disclosure is included in Note 5.
In February 2013 the FASB issued ASU 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income,” which updates a 2011 standard regarding disclosures about this component of capital accounts. ASU 2013-02 gives companies the flexibility to present information regarding significant amounts reclassified from Other Comprehensive Income either on the face of the financial statements or parenthetically in the notes thereto, provided that all of the required information is presented in a single location. The guidance is effective for annual and interim periods beginning after December 31, 2012. We do not expect the adoption of this pronouncement to have a material impact on our consolidated financial statements.
NOTE 3 - SIGNIFICANT ACQUISITIONS
Meridian Acquisition
In 2010 we acquired The Meridian Resource Corporation (“Meridian”), a public exploration and production company, at a cost of $158 million. Results of the acquisition are included in our consolidated statements of operations from the acquisition date of May 13, 2010.
Index to Financial Statements Sydson and TODD Acquisitions
In 2011, we purchased certain oil and natural gas assets from Sydson Energy and certain of its related parties (“Sydson”) for a total of $28.4 million. We also purchased certain properties from Texas Oil Distribution & Development, Inc. and Matrix Petroleum LLC and certain other parties (“TODD”) for a total of $23.4 million. Funding for both acquisitions was provided through our credit facility. Results of the acquisitions are included in our consolidated statements of operations from the respective acquisition dates for Sydson and TODD of April 21, 2011 and June 17, 2011.
NOTE 4 - PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
Suspended Well Costs
We have capitalized $4.6 million and zero, respectively, in exploratory well costs pending determination of proved reserves for periods less than one year at December 31, 2012 and 2011. We have not capitalized exploratory well costs for periods greater than one year at December 31, 2012 and 2011.
NOTE 5 - FAIR VALUE DISCLOSURES
The Company follows ASC 820, “Fair Value Measurements and Disclosure.” ASC 820 provides a hierarchy of fair value measurements, based on the inputs to the fair value estimation process. It requires disclosure of fair values classified according to defined “levels,” which are based on the reliability of the evidence used to determine fair value, with Level 1 being the most reliable and Level 3 the least. Level 1 evidence consists of observable inputs, such as quoted prices in an active market. Level 2 inputs typically correlate the fair value of the asset or liability to a similar, but not identical item which is actively traded. Level 3 inputs include at least some unobservable inputs, such as valuation models developed using the best information available in the circumstances.
We utilize the modified Black-Scholes option pricing model to estimate the fair value of oil and natural gas derivative contracts. Inputs to this model include observable inputs from the New York Mercantile Exchange (NYMEX) and other exchanges for futures contracts, and inputs derived from NYMEX observable inputs, such as implied volatility of oil and natural gas prices. We have classified the fair values of all our oil and natural gas derivative contracts as Level 2.
Index to Financial Statements The fair value of our interest rate derivative contracts, which expired in 2012, was calculated using the Black-Scholes option pricing model and is also considered a Level 2 fair value.
Our senior notes are carried at historical cost, net of amortized discount; we estimate the fair value of the senior notes for disclosure purposes (see Note 2). This estimation is based on the most recent trading values of the notes at or near the reporting date.
Oil and natural gas properties are subject to impairment testing and potential impairment write down as described in Note 2. Oil and natural gas properties with a carrying amount of $363.7 million were written down to their fair value of $267.5 million, resulting in an impairment charge of $96.2 million for the year ended December 31, 2012. Oil and natural gas properties with a carrying amount of $35.2 million were written down to their fair value of $16.5 million, resulting in an impairment charge of $18.7 million for the year ended December 31, 2011. Oil and natural gas properties with a carrying amount of $19.1 million were written down to their fair value of $10.7 million, resulting in an impairment charge of $8.4 million for the year ended December 31, 2010. The impairment analysis is based on the estimated discounted future cash flows for those properties. Significant Level 3 assumptions used in the calculation of estimated discounted cash flows included our estimate of future oil and natural gas prices, production costs, development expenditures, estimated quantities and timing of production of proved reserves, appropriate risk-adjusted discount rates, and other relevant data.
In addition, other equipment, included in oil and gas properties, was impaired zero, $162,000, and $18,000 for the years ended December 31, 2012, 2011 and 2010, respectively, based on market information for similar products, which is a Level 3 value.
In connection with the Meridian acquisition in 2010, we recorded oil and natural gas properties with a fair value of $147 million. In connection with the Sydson and TODD acquisitions in 2011, we recorded oil and natural gas properties with a fair value of $28 million and $23 million, respectively. Significant Level 3 inputs used were the same as those used in determining impairments based on estimated discounted cash flows for the acquired properties.
New additions to asset retirement obligations result from estimations for new properties, and fair values for them are categorized as Level 3. Such estimations are based on present value techniques which utilize company-specific information for such inputs as cost and timing of plug and abandonment of wells and facilities. We recorded a total of $2.3 million in additions to asset retirement obligations measured at fair value for the year ended December 31, 2012. We recorded a total of $3.4 million in additions to asset retirement obligations measured at fair value for the year ended December 31, 2011.
The following table presents information about our financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and 2011, and indicates the fair value hierarchy of the valuation techniques we utilized to determine such fair value:
The amounts above are presented on a gross basis; presentation on our consolidated balance sheets utilizes netting of assets and liabilities with the same counterparty where master netting agreements are in place.
For additional information on derivative contracts, see Note 6.
NOTE 6 - DERIVATIVE FINANCIAL INSTRUMENTS
We account for our derivative contracts under the provisions of ASC 815, “Derivatives and Hedging.” We have entered into forward-swap contracts and collar contracts to reduce our exposure to price risk in the spot market for oil and natural gas. We also utilize financial basis swap contracts, which address the price differential between market-wide benchmark prices and other benchmark pricing referenced in certain of our crude oil and natural gas sales contracts. Substantially all of our hedging agreements are executed by affiliates of the lenders under our credit facility described in Note 9 below, and are collateralized by the security interests of the respective affiliated lenders in certain of our assets under the credit facility. The contracts settle monthly and are scheduled to coincide
Index to Financial Statements
with either oil production equivalent to barrels (Bbl) per month or gas production equivalent to volumes in millions of British thermal units (MMbtu) per month. The contracts represent agreements between us and the counter-parties to exchange cash based on a designated price, or in the case of financial basis hedging contracts, based on a designated price differential between various benchmark prices. Cash settlement occurs monthly based on the specified price benchmark. We have not designated any of our derivative contracts as fair value or cash flow hedges; accordingly we use mark-to-market accounting, recognizing unrealized gains and losses in the consolidated statement of operations at each reporting date. Realized gains and losses on commodities hedging contracts are included in oil and natural gas revenues.
From time to time, the Company enters into interest rate swap agreements with financial institutions to mitigate the risk of loss due to changes in interest rates. The interest rate swaps are not designated as cash flow hedges in accordance with ASC 815. Both realized gains and losses from settlement and unrealized gains and losses from changes in the fair market value of the interest rate swaps are included in interest expense.
No derivative contracts have been entered into for trading purposes, and the Company typically holds each instrument to maturity.
The second table below provides information on the location and amounts of realized and unrealized gains and losses on derivatives included in the consolidated statement of operations for each of the years ended December 31, 2012 and 2011.
The following table summarizes the fair value (see Note 5 for further discussion of fair value) and classification of the Company’s derivative instruments, none of which have been designated as hedging instruments under ASC 815:
Commodity contracts are subject to master netting arrangements and are presented on a net basis in the consolidated balance sheets. This netting can cause derivative assets to be ultimately presented in a (liability) account on the consolidated balance sheets. Likewise, derivative (liabilities) could be presented in an asset account.
Index to Financial Statements The following table summarizes the effect of our derivative instruments in the consolidated statements of operations:
Although the Company’s counterparties provide no collateral, the master derivative agreements with each counterparty effectively allow the Company, so long as it is not a defaulting party, after a default or the occurrence of a termination event, to set-off an unpaid hedging agreement receivable against the interest of the counterparty in any outstanding balance under the Credit Facility. If a counterparty were to default in payment of an obligation under the master derivative agreements, the Company could be exposed to commodity price fluctuations, and the protection intended by the hedge could be lost. The value of our derivative financial instruments would be impacted.
In the tables below for natural gas and crude oil derivative positions open as of December 31, 2012, the notional amount is equal to the total net volumetric hedge position of the Company during the periods presented. We have hedged approximately 81% of our forecasted production from proved developed producing reserves through 2017.
Index to Financial Statements We had the following open derivative contracts for natural gas at December 31, 2012:
NATURAL GAS DERIVATIVE CONTRACTS
Index to Financial Statements We had the following open derivative contracts for crude oil at December 31, 2012:
OIL DERIVATIVE CONTRACTS
In those instances where contracts are identical as to time period, volume and strike price, but opposite as to direction (long and short), the volumes and average prices have been netted in the two tables above. In some instances our counterparties in the offsetting contracts are not the same, and may have different credit ratings. Prices stated in the table above for oil may settle against either NYMEX or Brent ICE indices or may reflect a mix of positions settling on these two indices.
We had the following open financial basis swap contracts for natural gas at December 31, 2012:
(1) The spread in these trades limits the differential of the settlement quotation prices for NYMEX Henry Hub over the Houston Ship Channel index published in Inside FERC.
Index to Financial Statements We had the following open financial basis swap contracts for crude oil at December 31, 2012:
(2) The spread in these trades limits the differential of the settlement quotation prices for Brent IPE over Argus Louisiana Light Sweet crude.
NOTE 7 - ASSET RETIREMENT OBLIGATIONS
As discussed in Note 2, the Company follows ASC 410 in accounting for asset retirement obligations. A summary of the changes in asset retirement obligations is included in the table below:
NOTE 8 - RELATED PARTY TRANSACTIONS
The Company has notes payable to our founder which bear interest at 10% with a balance of $22.1 million and $20.9 million at December 31, 2012 and 2011, respectively. See further information at Note 9.
Alta Mesa Services, LP (“Alta Mesa Services”), one of our wholly owned subsidiaries, conducts our business and operations and, in addition to the board of directors of our general partner, makes decisions on our behalf. Prior to the consummation of the offering of our senior notes in October 2010, Alta Mesa Services was owned by Michael E. Ellis, the founder of the Company, as well as Chief Operating Officer and Chairman of the Board and Mickey Ellis, his spouse. The consolidated results of operations include the financial activity of Alta Mesa Services for the years ended December 31, 2012, 2011, and 2010, respectively.
During 2012, 2011, and 2010 Michael E. Ellis received capital distributions from the Company of $165,000, $165,000 and $235,000, respectively.
NOTE 9 - LONG TERM DEBT
Long-term debt consists of the following:
Credit Facility. On May 13, 2010, we entered into a Sixth Amended and Restated Credit Agreement (as amended, the “credit facility”). The credit facility matures on May 23, 2016 and is secured by substantially all of our oil and gas properties. The credit facility borrowing base is redetermined periodically and, as of December 31, 2012, the borrowing base under the facility was $313.7 million. The credit facility bears interest at LIBOR plus applicable margins between 2.00% and 2.75% or a “Reference Rate,” which is based on the prime rate of Wells Fargo Bank, N. A., plus a margin ranging from 1.00% to 1.75%, depending on the utilization of our borrowing base. The rate was 2.33% as of December 31, 2012 and 2.774% as of December 31, 2011.
Index to Financial Statements Senior Notes. On October 13, 2010, we issued senior notes due October 15, 2018 with a face value of $300 million, at a discount of $2.1 million. The senior notes carry a face interest rate of 9.625%, with an effective rate of 9.75%; interest is payable semi-annually each April 15th and October 15th. On October 15, 2012 we issued an additional $150 million of senior notes (“additional senior notes”) governed by the same indenture as the original issue of senior notes, and carrying the same face interest rate, maturity and interest payment dates. The additional senior notes were issued at a discount of $1.5 million, and proceeds were used to reduce outstanding borrowings under the credit facility. All of the senior notes, including the additional senior notes (together, “senior notes”) are secured by general corporate credit, and effectively rank junior to any of our existing or future secured indebtedness, which includes the credit facility. The senior notes are unconditionally guaranteed on a senior unsecured basis by each of our material subsidiaries. The balance is presented net of unamortized discount of $2.9 million and $1.8 million at December 31, 2012 and December 31, 2011, respectively.
The senior notes contain an optional redemption provision available prior to October 2013 allowing us to retire up to 35% of the principal outstanding under the senior notes at 109.625% with the proceeds of an equity offering. Additional optional redemption provisions allow for retirement at 104.813%, 102.406%, and 100.0% beginning on each of October 15, 2014, 2015, and 2016, respectively.
The original $300 million senior notes were exchanged for substantially identical registered senior notes in 2011. The additional $150 million senior notes were exchanged for substantially identical registered senior notes in February 2013.
Notes Payable to Founder. We also have notes payable to our founder which bear simple interest at 10% with a balance of $22.1 million and $20.9 million at December 31, 2012 and December 31, 2011, respectively. The notes mature December 31, 2018. Interest and principal are payable at maturity. These founder notes are subordinate to all debt. Interest on the notes payable to our founder amounted to $1.2 million during 2012, $1.2 million during 2011, and $1.4 million during 2010, respectively. Such amounts have been added to the balance of the founder notes.
Future maturities of long-term debt, including the notes payable to our founder, at December 31, 2012 are as follows (dollars in thousands):
The credit facility and senior notes include covenants requiring that the Company maintain certain financial covenants including a current ratio, leverage ratio, and interest coverage ratio. At December 31, 2012, the Company was in compliance with the covenants. The terms of the credit facility also restrict the Company’s ability to make distributions and investments.
Index to Financial Statements NOTE 10 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
The following provides the detail of accounts payable and accrued liabilities:
NOTE 11 - COMMITMENTS AND CONTINGENCIES
Contingencies
Hilltop Field Litigation: On July 23, 2009, we made a payment of $25.5 million and took assignment of substantially all working interests that Chesapeake Energy Corporation (“Chesapeake”) had acquired from Gastar Exploration Ltd. (“Gastar”) in an approximate 50,000 acre area of Leon and Robertson Counties, Texas known as the Hilltop field, in which the Deep Bossier formation was the principal focus for development. We exercised our preferential right to purchase these interests from Gastar in late 2005, but Gastar and Chesapeake had opposed this and Chesapeake took record title at that time. We finally and conclusively prevailed when, in 2008, a Texas court of appeals directed that specific performance take place. In early 2009, the Texas Supreme Court denied the defendants’ request to review the appeal. As a result, we were able to take assignment of working interests in over 30 producing wells and participate in further development of the area, primarily with EnCana, but also with Gastar. A subsequent payment to EnCana of $15.2 million plus purchase accounting adjustments of $3.8 million brought the total cost of the acquisition to $44.5 million. While the ownership of these interests has been decided by the courts, we pursued other claims against Chesapeake and Gastar; Chesapeake claimed an additional $36.3 million of past expenses. We entered into settlements with both the Chesapeake-related defendants and Gastar in 2012. The effects of these settlements, recorded in the second quarter of 2012, were not material to our financial position or results of operations.
Environmental claims: Management has established a liability for soil contamination in Florida of $1.0 million at December 31, 2012 and December 31, 2011, based on our undiscounted engineering estimates. The obligations are included in other long-term liabilities in the accompanying consolidated balance sheets.
Various landowners have sued our wholly owned subsidiary The Meridian Resource Corporation and its subsidiaries (“Meridian”), which we acquired in 2010, in lawsuits concerning several fields in which Meridian has had operations. The lawsuits seek injunctive relief and other relief, including unspecified amounts in both actual and punitive damages for alleged breaches of mineral leases and alleged failure to restore the plaintiffs’ lands from alleged contamination and otherwise from Meridian’s oil and natural gas operations. We are unable to express an opinion with respect to the likelihood of an unfavorable outcome of the various environmental claims or to estimate the amount or range of potential loss should the outcome be unfavorable. Therefore, we have not provided any amount for these claims in our financial statements at December 31, 2012.
Due to the nature of our business, some contamination of the real estate property owned or leased by us is possible. Environmental site assessments of the property would be necessary to adequately determine remediation costs, if any. No accrual has been made other than the balance noted above.
Title/lease disputes: Title and lease disputes may arise in the normal course of our operations. These disputes are usually small but could result in an increase or decrease in reserves once a final resolution to the title dispute is made.
Other contingencies: We are subject to legal proceedings, claims and liabilities arising in the ordinary course of business. The outcome cannot be reasonably estimated; however, in the opinion of management, such litigation and claims will be resolved without material adverse effect on our financial position, results of operations or cash flows. Accruals for losses associated with litigation are made when losses are deemed probable and can be reasonably estimated.
We have a contingent commitment to pay an amount up to a maximum of approximately $2.7 million for properties acquired in 2008. The additional purchase consideration will be paid if certain product price conditions are met.
Index to Financial Statements Commitments
Office and Equipment Leases: The Company leases office space, as well as certain field equipment such as compressors, under long-term operating lease agreements. The lease for our main office will expire in 2022. Any initial rent-free months are amortized over the life of the lease. Equipment leases are generally for four years or less. Rent expense, including office space and compressors, for the years ended December 31, 2012, 2011, and 2010 amounted to approximately $4.5 million, $4.3 million, and $2.9 million, respectively.
At December 31, 2012, future base rentals for non-cancelable leases are as follows (dollars in thousands):
Additionally, at December 31, 2012, the Company had posted bonds in the aggregate amount of $12.6 million, primarily to cover future abandonment costs.
NOTE 12 - MAJOR CUSTOMERS
The Company markets production on a competitive basis. Natural gas is sold under short-term contracts generally with month-to-month pricing based on published regional indices (typically the market index for delivery at the Houston Ship Channel for gas produced in Texas and the Henry Hub for gas produced in Louisiana), with differentials for transportation taken into account. Our oil is primarily sold under short-term contracts, based on regional prices, adjusted for transportation, location, and quality.
For the year ended December 31, 2012, based on revenues excluding hedging activities, three major customers accounted for 10% or more of those revenues individually, with contributions of $63.3 million, $50.1 million, and $44.8 million. On the same basis, for the year ended December 31, 2011, two major customers accounted for 10% or more of those revenues individually, with contributions of $67.7 million and $40.8 million. On the same basis, for the year ended December 31, 2010, one major customer accounted for 10% or more of those revenues individually, with contributions of $38.4 million. We believe that the loss of such customers would not have a material adverse effect on us because alternative purchasers are readily available.
NOTE 13 - 401(k) SAVINGS PLAN
Employees of Alta Mesa Services and Petro Operating Company, LP (“POC”) may participate in a 401(k) savings plan, whereby the employees may elect to make contributions pursuant to a salary reduction agreement. Alta Mesa Services and POC make a matching contribution equal to fifty-percent (50%) of an employee’s salary deferral contribution up to a maximum of eight percent (8%) of an employee’s salary. Matching contributions to the plan were approximately $422,000, $404,000, and $393,000 for the years ended December 31, 2012, 2011, and 2010, respectively.
NOTE 14 - SIGNIFICANT RISKS AND UNCERTAINTIES
The Company’s business makes it vulnerable to changes in wellhead prices of crude oil and natural gas. Such prices have been volatile in the past and can be expected to be volatile in the future. By definition, proved reserves are based on analysis of current oil and natural gas prices. Price declines reduce the estimated value of proved reserves and increase annual amortization expense (which is based on proved reserves). We mitigate some of this vulnerability by entering into oil and natural gas price derivative contracts. See Note 6.
NOTE 15 - PARTNERS’ CAPITAL
In September 2006, our limited partnership agreement was amended such that the affiliates of Alta Mesa Holdings, LP and certain other parties became Class A limited partners (“Class A Partners”) and our capital partner, Alta Mesa Investment Holdings, Inc. (“AMIH”), was admitted to the partnership as the sole Class B limited partner (“Class B Partner”). AMIH is an affiliate of Denham Commodity Partners Fund IV LP (“DCPF IV”). DCPF IV is advised by Denham Capital Management LP, a private equity firm focused on energy and commodities.
Index to Financial Statements Management and Control: Our business and affairs are managed by Alta Mesa Holdings GP, LLC, our general partner (“General Partner”). With certain exceptions, the General Partner may not be removed except for the reasons of “cause,” which are defined in the Alta Mesa Holdings, LP Partnership Agreement (“Partnership Agreement”). The Class B limited partner has certain approval rights, generally over capital plans and significant transactions in the areas of finance, acquisition, and divestiture.
Distribution and Income Allocation: Net cash flow from operations may be distributed to the Class A and Class B Partners based on a variable formula as defined in the Partnership Agreement.
The Class B Partner may require the General Partner to make distributions; however, any distribution must be permitted under the terms of our credit facility and our senior notes.
Distribution of net cash flow from a Liquidity Event (as defined below) is distributed to the Class A and Class B Partners according to a variable formula as defined in the Partnership Agreement. A “Liquidity Event” is any event in which we receive cash proceeds outside the ordinary course of our business. The Class B Partner can, without consent of any other partners, request that the General Partner take action to cause us, or our assets, to be sold to one or more third parties.
NOTE 16 - SUBSEQUENT EVENTS
Management has evaluated all events subsequent to the balance sheet date of December 31, 2012 and has determined that no subsequent events require disclosure.
NOTE 17 - SUBSIDIARY GUARANTORS
All of our material wholly-owned subsidiaries are guarantors under the terms of both our senior notes and our credit facility.
Our consolidated financial statements reflect the combined financial position of these subsidiary guarantors. Our parent company, Alta Mesa Holdings, LP, has no independent operations, assets, or liabilities. The guarantees are full and unconditional and joint and several. Those subsidiaries which are not wholly owned and are not guarantors are minor. There are no restrictions on dividends, distributions, loans, or other transfers of funds from the subsidiary guarantors to our parent company.
NOTE 18 - SUPPLEMENTAL QUARTERLY INFORMATION (Unaudited)
Results of operations by quarter for the year ended December 31, 2012 were:
Results of operations by quarter for the year ended December 31, 2011 were:
(1) Results of operations from exploration and production activities, which approximate gross profit, are computed as revenues, exclusive of unrealized gain/loss on oil and natural gas derivative contracts, less expenses for lease operating, severance and ad valorem taxes, workovers, exploration, depletion and depreciation, impairment, and accretion.
NOTE 19 - SUPPLEMENTAL OIL AND NATURAL GAS DISCLOSURES (UNAUDITED)
The unaudited reserve and other information presented below is provided as supplemental information in accordance with the provisions of ASC Topic 932-235.
Our proved reserves and associated cash flows are based on our internally produced reserve report as of December 31, 2012, which was audited by Netherland, Sewell & Associates, Inc. (“NSAI”).
Index to Financial Statements For further information on the methods and controls used in the process of estimating reserves, as well as the qualifications of our preparers and of NSAI, see “Our Oil and Natural Gas Reserves - Internal Control and Qualifications” included herein.
Oil and natural gas producing activities are conducted onshore within the continental United States and all of our proved reserves are located within the United States.
Estimated Quantities of Proved Reserves
The following table sets forth our net proved reserves as of December 31, 2012, 2011, and 2010, and the changes therein during the years then ended. Proved oil and natural gas reserves are the estimated quantities of crude oil, natural gas, and natural gas liquids that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made.
(1) Natural gas liquids were not tracked in our reserve reports prior to 2010.
(2) Purchase of Meridian in 2010.
(3) Primarily the purchases of Sydson and TODD in 2011.
Proved Undeveloped Reserves
At December 31, 2012 we had proved undeveloped reserves (“PUDs”) of 111 Bcfe, or approximately 36% of total proved reserves. The PUDs are primarily in our Eagleville field in the Eagle Ford play in South Texas, in South Louisiana, and in Florida. Total PUDs at December 31, 2011 were 96 Bcfe, or 28% of our total reserves.
In 2012, we converted 13.2 Bcfe, or 14% of total year end 2011 PUDs, to proved developed reserves. Costs relating to the development of PUDs were approximately $ 49.8 million in 2012. Costs of PUD development in 2012 do not represent the total costs of these conversions, as additional costs may have been recorded in previous years. Estimated future development costs relating to the development of 2012 year-end PUDs are $238 million. All PUDs but two are scheduled to be drilled by 2017; those two are sidetrack developments in producing wells which will be drilled after the current zones are depleted.
Index to Financial Statements We dropped, revised, or reclassified to unproved categories, approximately 28.2 Bcfe from our 2011 PUD balance due to decreased gas prices. These were primarily in our Hilltop field and in one other field in South Texas. We added approximately 45.3 Bcfe in PUDs during 2012, primarily in our Eagle Ford shale properties (28.8 Bcfe), in our Weeks Island field in South Louisiana (9.6 Bcfe net increase), and from an acquisition (6.9 Bcfe). Total PUDs also increased approximately 11.3 Bcfe for various reasons, primarily revisions based on performance and/or reinterpretation of data.
None of our PUDs at December 31, 2012 originated more than five years ago.
Capitalized Costs Relating to Oil and Natural Gas Producing Activities
Costs Incurred in Oil and Natural Gas Acquisition, Exploration and Development Activities
Acquisition costs in the table below include costs incurred to purchase, lease, or otherwise acquire property. Exploration expenses include additions to exploratory wells, including those in progress, and other exploration expenses, such as geological and geophysical costs. Development costs include additions to production facilities and equipment and additions to development wells, including those in progress.
(1) Property acquisition costs for proved properties in 2011 include primarily the purchase of Sydson ($28.4 million) and TODD ($23.4 million). Property acquisition costs for proved properties in 2010 include the purchase of Meridian for $147.4 million and an adjustment to the purchase price of the Hilltop properties of $1.0 million.
(2) Includes asset retirement costs of $1.7 million, $587,000, and $609,000, for the years ended December 31, 2012, 2011, and 2010, respectively.
Index to Financial Statements Results of Operations from Oil and Natural Gas Producing Activities
(1) Excludes depreciation of non-oil and gas assets of $2.7 million, $1.9 million, and $0.9 million in 2012, 2011, and 2010, respectively.
Standardized Measure of Discounted Future Net Cash Flows
The information that follows has been developed pursuant to ASC 932-235 and utilizes reserve and production data prepared by our independent petroleum consultants. Reserve estimates are inherently imprecise and estimates of new discoveries are less precise than those of producing oil and natural gas properties. Accordingly, these estimates are expected to change as future information becomes available.
Future cash inflows as of December 31, 2012 and 2011 were calculated using an un-weighted arithmetic average of oil and natural gas prices in effect on the first day of each month in the respective year, except where prices are defined by contractual arrangements. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation.
Actual future prices and costs may be materially higher or lower. Actual future net revenues also will be affected by factors such as actual production, supply and demand for oil and natural gas, curtailments or increases in consumption by natural gas purchasers, changes in governmental regulations or taxation and the impact of inflation on costs.
Index to Financial Statements The following table sets forth the components of the standardized measure of discounted future net cash flows for the years ended December 31, 2012, 2011, and 2010:
No consideration was given to the Company’s hedged transactions.
Changes in Standardized Measure of Discounted Future Net Cash Flows
The following table sets forth the changes in standardized measure of discounted future net cash flows: