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ESTE > SEC Filings for ESTE > Form 10-Q on 13-Nov-2012All Recent SEC Filings

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Form 10-Q for EARTHSTONE ENERGY INC


13-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Company's Annual Report on Form 10-K for the year ended March 31, 2012, as well as the unaudited condensed consolidated financial statements and related notes and other information appearing in Item 1 of this report.

The preparation of the Company's unaudited condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires us to make estimates and assumptions that affect the reported amounts in the unaudited condensed consolidated financial statements and the accompanying notes including matters arising during the normal course of business. We apply our best judgment, our knowledge of existing facts and circumstances and our knowledge of actions that we may undertake in the future in determining the estimates that will affect our unaudited condensed consolidated financial statements. We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change. As future events and their effects cannot be determined with precision, actual results may differ from these estimates.

As used in this report, unless the context otherwise indicates, references to "we," "our," and "us" refer to Earthstone Energy, Inc. and its subsidiary collectively.

As an oil and natural gas producer, our revenue, cash flow from operations, other income and profitability, reserve values, access to capital and future rate of growth are influenced by the prevailing prices of crude oil and natural gas. Changes in commodity prices affect, both positively and negatively, our financial condition, liquidity, ability to obtain financing and operating results. Changes in commodity prices may influence, both positively and negatively, the amount of crude oil and natural gas that we choose to produce. Prevailing prices for such commodities fluctuate in response to changes in supply and demand and a variety of additional factors beyond our control, such as global, political and economic conditions. Inherently, the prices received for crude oil and natural gas production are unpredictable, and such volatility is expected. Most of our production is sold at market prices. Obviously, if the commodity indexes fluctuate, the price that we receive for our production will fluctuate. Therefore, the amount of revenue that we realize, as well as our estimates of future revenues, is to a large extent determined by factors beyond our control.

Liquidity and Capital Resources

Liquidity Outlook. Our primary source of funding is the net cash flow from the sale of our oil and natural gas production. The profitability and cash flow generated by our operations in any particular accounting period will be directly related to: (a) the volume of oil and gas produced and sold, (b) the average realized prices for oil and gas sold, and (c) lifting costs. At the current price of oil, we believe the cash generated from operations, along with existing cash balances, should enable us to meet our existing and normal recurring obligations during the next year and beyond.

Overview of our Capital Structure. We recognize the importance of developing our capital resource base in order to pursue our objectives. However, subsequent to our last public offering in 1980, debt financing has been the sole source of external funding. In addition to our routine production-related costs, general and administrative expenses and, when necessary, debt repayment requirements, we require capital to fund our exploratory and development drilling efforts and the acquisition of additional properties as well as the enhancement of held and newly acquired properties.

We have received numerous inquiries regarding the possibility of funding our efforts through equity contributions or debt instruments. Given strong cash flows, we have thus far declined these overtures. Our primary concern in this area is the dilution of our existing shareholders. However, going forward, given that one of the key components of our growth strategy is to expand our oil and natural gas reserve base through drilling and/or acquisitions, if we were presented with a significant opportunity and available cash and bank debt financing were insufficient, it is possible we would consider alternative forms of additional financing.


Hedging. During the three months ended September 30, 2012 and 2011, we did not participate in any hedging activities, nor did we have any open futures or option contracts.

Working Capital. At September 30, 2012, we had a working capital surplus of $1,824,000 (a current ratio of 1.42:1) compared to a working capital surplus at March 31, 2012 of $6,572,000 (a current ratio of 2.91:1). The decrease in current ratio is primarily a result of the use of cash for the acquisition, development and exploration of oil and gas properties.

Cash Flow. Cash provided by operating activities was $518,000 for the six months ended September 30, 2012, compared to $2,195,000 for the six months ended September 30, 2011. Changes in operating cash relate primarily to the decline in net income adjusted for non-cash expenses for the six months ended September 30, 2012 compared to the same period ended September 30, 2011. The fluctuation in deferred income tax expense, the timing and payment of accounts payable and accrued liabilities, especially pertaining to capital expenditure outlays, in addition to the timing and collection of accounts receivable and the application of prepaid balances were also factors in deriving net cash flows from operations.

Overall, net cash used in investing activities increased for the six months ended September 30, 2012, to $4,720,000, from $3,025,000 for the six months ended September 30, 2011. This was the result of an increase in the number of wells drilled and completed during the current period compared to the same period in the prior year, in addition to spending on the acquisitions of oil and gas property, as explained in "Capital Expenditures" below.

Net cash used for financing activities was $0 for the six months ended September 30, 2012 and $84,000 for the six months ended September 30, 2011 for the purchase of treasury shares.

Capital Expenditures

The amounts presented herein are presented on an accrual basis, and as such may not be consistent with the amounts presented on the condensed consolidated statements of cash flows under investing activities for expenditures on oil and gas property, which are presented on a cash basis.

During the six months ended September 30, 2012, we spent $6,396,000 on various projects. This compares to $3,516,000 for the six months ended September 30, 2011. During the six months ended September 30, 2012, capital expenditures were comprised of the drilling and completion of six wells (approximately 0.17 net) producing as of period end (7%), the drilling of thirty-seven wells (approximately 1.27 net) to be completed as of calendar year end (87%), and leasehold expenditures (2%). The remaining costs (4%) were primarily related to recompleting existing wells. The majority (89%) of capital expenditures were spent in the Williston basin. These projects were funded entirely with internally generated cash flow and cash on hand.

We are continually evaluating drilling and acquisition opportunities for possible participation. Typically, at any one time, several opportunities are in various stages of evaluation. Our policy is to not disclose the specifics of a project or prospect, nor to speculate on such ventures, until such time as those various opportunities are finalized and undertaken. We caution that the absence of news and/or press releases should not be interpreted as a lack of development or activity.

Divestitures/Abandonments

We neither sold nor plugged any wells during the six months ended September 30, 2012.


Impact of Inflation and Pricing

We deal primarily in U.S. dollars. Inflation has not had a material impact on the Company in recent years because of the relatively low rates of inflation in the United States. However, the oil and natural gas industry can be cyclical and the demand for production places pressure on the economic stability and pricing within the industry. Typically, as prices for oil and natural gas increase, associated costs rise. Conversely, cost declines are likely to lag and may not adjust downward in proportion to declining prices. Changes in prices impact our revenues, estimates of reserves, assessments of any impairment of oil and natural gas properties, as well as values of properties being acquired or sold. Price changes have the potential to affect our ability to raise capital, borrow money, and retain personnel. While we do not presently expect business costs to materially rise, higher prices for oil and natural gas could result in increases in the costs of materials, services and personnel.

Reserves

During the six months ended September 30, 2012, proved reserves in barrels of oil equivalent ("BOE") increased 22% from March 31, 2012, from 1,335,000 to 1,625,000 at September 30, 2012. The reserve balance reflects the favorable impact of newly developed reserves offset by the natural decline curve for existing wells.

Other Commitments

We do not have any other commitments beyond our office lease and software maintenance contracts. See further detail contained in the notes to the unaudited condensed consolidated financial statements.


Results of Operations

The following provides selected financial information and averages for the three
and six months ended September 30, 2012 and 2011.

                                               Three Months Ended September 30,            Six Months Ended September 30,
                                                 2012                    2011                  2012                 2011
Revenue
   Oil                                     $       2,546,000       $       2,185,000     $      4,674,000       $  4,372,000
   Gas                                               154,000                 320,000              246,000            613,000
Total revenue 1                                    2,700,000               2,505,000            4,920,000          4,985,000

Total production expense 2                         1,085,000               1,026,000            2,115,000          1,959,000

Gross profit                               $       1,615,000       $       1,479,000     $      2,805,000       $  3,026,000

Depletion expense                          $         446,000       $         217,000     $        725,000       $    402,000

Sales volume
   Oil (Bbls)                                         31,169                  25,056               58,168             47,618
   Gas (Mcfs) 3                                       30,818                  46,259               45,384             77,662

Average sales price 4
   Oil (per Bbl)                           $           81.68       $           87.20     $          80.35       $      91.81
   Gas (per Mcf)                           $            5.00       $            6.92     $           5.42       $       7.89

Average per BOE 5
   Production expense 3, 4                 $           29.89       $           31.31     $          32.18       $      32.35
   Gross profit 4                          $           44.48       $           45.14     $          42.67       $      49.97
   Depletion expense 4                     $           12.28       $            6.62     $          11.03       $       6.64

1 Amount does not include water service and disposal revenue. For the three and six months ended September 30, 2011, this revenue amount is net of $109,000 and $236,000, respectively, in well service and water disposal revenue, which would otherwise total $2,809,000 and $5,156,000, respectively, in revenue, compared to $40,000 and $85,000 in the respective periods ended September 30, 2011, to total $2,545,000 and $5,070,000 for the comparable three and six month periods ended September 30, 2011.

2 Overall lifting cost (oil and gas production costs, including production taxes and the cost of workovers)

3 Estimates of volumes are inherent in reported volumes to coincide with revenue accruals as a result of the timing of sales information reporting by third party operators.

4 Averages calculated based upon non-rounded figures

5 Per equivalent barrel (6 thousand cubic feet, "Mcf", of gas is equivalent to 1 barrel, "Bbl", of oil)

Three months ended September 30, 2012 compared to three months ended September 30, 2011

Overview. Net income for the three months ended September 30, 2012, was $486,000 compared to net income of $728,000 for the three months ended September 30, 2011. The decrease in net income resulted from the decline in oil prices coupled with a decrease in gas sales revenue as described in "Revenues" and "Volumes and Prices" below and an increase in expenses for the current three month period.

Revenues. Oil sales revenue increased 17% for the three months ended September 30, 2012, from $2,185,000 for the three months ended September 30, 2011 compared to $2,546,000 for the current period, due to the increase in reported production, partially offset by a lower realized price per barrel as described in "Volumes and Prices" below.


Gas sales revenue decreased $166,000 (52%) for the three months ended September 30, 2012, compared to the three months ended September 30, 2011, as a result of having divested the Company's working and/or override interests in 38 gas wells in Weld County, Colorado in January of this year.

Volumes and Prices. Oil sales volumes rose by 24% for the three months ended September 30, 2012, compared to the three months ended September 30, 2011. The average price per barrel declined by 6% for the three months ended September 30, 2012, compared to the three months ended September 30, 2011. The rise in oil sales volumes for the three months ended September 30, 2012 was the result of a significant contribution from 19 new producing oil wells (approximately 0.67 net) in North Dakota since the comparable period in the prior year.

The divestiture of the Company's working and/or override interests in 38 wells in Weld County, Colorado since the comparable prior year period ended September 30, 2011, resulted in the decline in our reported natural gas production. As of September 30, 2012, we hold interests in 3 gas wells. The 28% drop in average price per Mcf for the three months ended September 30, 2012, compared to the respective period in the prior year had only a minor impact relative to the divestiture of the aforementioned properties.

Production Expense. Production expense is comprised of the following items:

                                      Three Months Ended
                                        September 30,
                                      2012            2011

Lease operating costs            $    591,000     $   551,000
Workover costs                        216,000         161,000
Production taxes                      262,000         200,000
Transportation and other costs         16,000         114,000

Total production expense         $  1,085,000     $ 1,026,000

Oil and gas production expense increased $59,000 (6%) for the three months ended September 30, 2012, over the expenses for the three months ended September 30, 2011, primarily due to the increase in number of producing wells.

Routine lease operating expense ("LOE"), consisting of field personnel, fuel/power, chemicals, disposal and other costs, per BOE was $16.72 for the three months ended September 30, 2012, compared to $20.30 for the three months ended September 30, 2011, due primarily to the reduction in transportation costs associated with the gas properties which were divested in January of 2012.

As a percent of oil and gas sales revenue, routine LOE was 22% for the three months ended September 30, 2012, compared to 27% for the three months ended September 30, 2011. This favorable movement in cost in proportion to revenue was primarily due to the reduction in transportation costs associated with the gas properties which were divested in January of 2012.

Workover operations, which generally consist of downhole repairs on a producing well, are conducted to restore or increase production and are generally random in nature. Therefore, workovers account for unpredictable fluctuations in oil and gas expense from period to period. The number of wells on which workover costs are expended varies as does the extent of workover operations. Workover expenses increased $55,000 (34%) for the three months ended September 30, 2012, compared to the respective period ended September 30, 2011. Consequently, workover costs in the second quarter of fiscal year 2013 increased from $4.91 per BOE in the second quarter of fiscal 2012 to $5.95 per BOE in the current quarter.


Production taxes for the three months ended September 30, 2012, increased 31% over the three months ended September 30, 2011, primarily due to a reduction in production in jurisdictions with lower tax rates (Colorado and Texas) and the upsurge in production in jurisdictions with higher production tax rates (North Dakota). The increase in production volumes also contributed to the increase in production tax expense. As a percent of oil and gas sales revenue, production taxes rose to 10% from 8% for the respective prior year three month period. Production taxes are primarily based on the wellhead values of production, though normal fluctuations occur in the percentage between periods based upon the timing of approval of incentive tax credits in Texas, changes in tax rates, and changes in the proportion of our production between states. Because production tax rates vary from state to state our average production tax rate will vary depending on the quantities produced from each area and the production tax rates in effect for those jurisdictions.

While overall lifting costs (oil and gas production costs, including production taxes as well as workovers) increased slightly during the current quarter, those costs are spread over greater reported volumes, per BOE, for the three months ended September 30, 2012, compared to the three months ended September 30, 2011, causing the costs per BOE to decline from $31.31 to $29.89.

Other Expenses.
Depletion and depreciation increased $232,000 (101%) for the three months ended September 30, 2012, compared to the three months ended September 30, 2011. The increase in expense was a result of an increase in BOE production for the quarter and the addition of capital costs for newly drilled wells transferred into the pool of depletable property costs.

General & Administrative ("G&A") expense increased $120,000 (24%) for the three months ended September 30, 2012, over the expense for the three months ended September 30, 2011. This rise in costs is comprised primarily of compensation-related expenses for additional employees, contract labor and consultants, which account for $100,000 of the increase. State franchise taxes increased $20,000 for the three month period.

The escalation in G&A costs resulted in a 12% increase in expense per BOE from $15.47 for the three months ended September 30, 2011, to $17.27 for the three months ended September 30, 2012.

Income Tax. For the three months ended September 30, 2012, we recorded income tax expense of $92,000, as compared to $74,000 for the three months ended September 30, 2011. Our effective income tax rate was 15.9% for the three months ended September 30, 2012. The overall effective tax rate expressed as a percentage of book income before income tax for the three months ended September 30, 2012, as compared to the same period in 2011, was higher due to nonrecurring adjustments in the three months ended September 30, 2011. These adjustments were not necessary during the three months ended September 30, 2012.

Six months ended September 30, 2012 compared to six months ended September 30, 2011

Overview. Net income for the six months ended September 30, 2012, was $756,000 compared to net income of $1,393,000 for the six months ended September 30, 2011. The decrease in net income resulted from the decline in oil prices coupled with a decrease in gas sales revenue as described in "Revenues" and "Volumes and Prices" below and an increase in expenses for the three month period.

Revenues. Oil sales revenue increased 7% for the six months ended September 30, 2012, from $4,372,000 for the six months ended September 30, 2011 to $4,674,000 for the current period, due to an increase in production volumes, partially offset by a lower realized price per barrel offset by the increase in reported production as described in "Volumes and Prices" below.

Gas sales revenue decreased $367,000 (60%) for the six months ended September 30, 2012, compared to the six months ended September 30, 2011, as a result of having divested the Company's working and/or override interests in 38 gas wells in Weld County, Colorado in January of 2012.


Volumes and Prices. Oil sales volumes rose by 22% for the six months ended September 30, 2012, compared to the six months ended September 30, 2011. The average price per barrel declined by 13% for the six months ended September 30, 2012, compared to the six months ended September 30, 2011. The rise in oil sales volumes for the six months ended September 30, 2012 was the result of a significant contribution from 19 new producing oil wells (approximately 0.67 net) in North Dakota since the comparable period in the prior year.

The divestiture of the Company's working and/or override interests in 38 wells in Weld County, Colorado since the comparable prior year period ended September 30, 2011, resulted in the decline in our reported natural gas production. As of September 30, 2012, we hold interests in 3 gas wells. The 31% drop in average price per Mcf for the six months ended September 30, 2012, compared to the respective period in the prior year had only a minor impact relative to the divestiture of the aforementioned properties.

Production Expense. Production expense is comprised of the following items:

                                       Six Months Ended
                                        September 30,
                                      2012            2011

Lease operating costs            $  1,249,000     $ 1,077,000
Workover costs                        387,000         361,000
Production taxes                      458,000         338,000
Transportation and other costs         21,000         183,000

Total production expense         $  2,115,000     $ 1,959,000

Oil and gas production expense increased $156,000 (8%) for the six months ended September 30, 2012, over the expenses for the six months ended September 30, 2011, largely due to the increase in number of producing wells.

Routine lease operating expense ("LOE"), consisting of field personnel, fuel/power, chemicals, disposal and other costs, per BOE was $19.32 for the six months ended September 30, 2012, compared to $20.81 for the six months ended September 30, 2011. Increases in lease operating costs were partially offset by reductions in transportation costs and total production expense in the six months ended September 30, 2012 and was allocated over a larger production volume than in the six months ended September 30, 2011.

As a percent of oil and gas sales revenue, routine LOE was 26% for the six months ended September 30, 2012 and 25% for the six months ended September 30, 2011.

Workover operations, which generally consist of downhole repairs on a producing well, are conducted to restore or increase production and are generally random in nature. Therefore, workovers account for unpredictable fluctuations in oil and gas expense from period to period. The number of wells on which workover costs are expended varies as does the extent of workover operations. Workover expenses increased $26,000 (7%) for the six months ended September 30, 2012, compared to the respective period ended September 30, 2011. While workover costs increased, the costs were spread over increased production volumes resulting in a decrease in workover costs per BOE in the six months ended September 30, 2012 to $5.89 from $5.96 per BOE in the six months ended September 30, 2011.

Production taxes for the six months ended September 30, 2012, increased 36% over the six months ended September 30, 2011, primarily due to a reduction in production in jurisdictions with lower tax rates (Colorado and Texas) and the upsurge in production in jurisdictions with higher production tax rates (North Dakota). The increase in production volumes also contributed to the increase in production tax expense. As a percent of oil and gas sales revenue, production taxes rose to 9% from 7% for the respective prior year six month period. Production taxes are primarily based on the wellhead values of production, though normal fluctuations occur in the percentage between periods based upon the timing of approval of incentive tax credits in Texas, changes in tax rates, and changes in the proportion of our production between states. Because production tax rates vary from state to state our average production tax rate will vary depending on the quantities produced from each area and the production tax rates in effect for those jurisdictions.


While overall lifting costs (oil and gas production costs, including production taxes as well as workovers) increased slightly during the current period, those costs are spread over greater reported volumes per BOE, for the six months ended September 30, 2012, compared to the six months ended September 30, 2011, causing the cost per BOE to decline from $32.35 to $32.18.

Other Expenses.
Depletion and depreciation increased $330,000 (78%) for the six months ended September 30, 2012, compared to the six months ended September 30, 2011. The increase in expense was a result of an increase in BOE production for the quarter and the addition of capital costs for newly drilled wells into the pool of depletable property costs.

General & Administrative ("G&A") expense increased $359,000 (38%) for the six months ended September 30, 2012, over the expense for the six months ended September 30, 2011. This rise in costs is comprised primarily of compensation-related expenses for additional employees, contact labor and consultants, which account for $291,000 of the increase. Public company expenses and state franchise taxes were up $15,000 and $40,000, respectively, for the six month period.

The escalation in G&A costs resulted in the 27% increase in expense per BOE from $15.67 for the six months ended September 30, 2011, to $19.90 for the six months ended September 30, 2012.

Income Tax. For the six months ended September 30, 2012, we recorded income tax expense of $100,000, as compared to $320,000 for the six months ended September 30, 2011. Our effective income tax rate was 12.1% for the six months ended September 30, 2012. The overall effective tax rate expressed as a percentage of . . .

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