LILIS ENERGY, INC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. The following discussion includes forward-looking statements, including, without limitation, statements relating to our plans, strategies, objectives, expectations, intentions and resources. Our actual results could differ materially from those discussed in these forward-looking statements as a result of many factors, including those discussed under "Risk Factors" and elsewhere in this Annual Report. Overview We are aPermian Basin focused company engaged in the exploration, production, development, and acquisition of oil, natural gas, and NGLs, with all of our properties and operations in theDelaware Basin . Our focus is on the production of "Liquids". In each of the past two years, over 90% of our revenues have been generated from the sale of Liquids. We have a largely contiguous acreage position with significant stacked-pay potential, which we believe includes at least five to seven productive zones and more than 1,000 future drilling locations. As ofDecember 31, 2019 , we were fully drawn against the borrowing base under our Revolving Credit Agreement (as defined in Note 11 - Long-Term Debt to our consolidated financial statements), with$115 million of indebtedness outstanding under our Revolving Credit Agreement. As provided for in the Seventh Amendment to our Revolving Credit Agreement and as a result of a decrease in commodity prices, onJanuary 17, 2020 , the borrowing base was decreased to$90.0 million . The reduction in the borrowing base resulted in a borrowing base deficiency of$25.0 million . We have made scheduled repayments of$17.3 million and pursuant to the Fourteenth Amendment to our Revolving Credit Agreement, the remaining$7.8 million is due onJune 5, 2020 . Refer to Note 11 - Long-Term Debt to our consolidated financial statements for additional information. Our next borrowing base redetermination is scheduled to occur on or aroundJune 5, 2020 . If the borrowing base is further reduced by the lenders in connection with this redetermination, we will be required to repay borrowings in excess of the borrowing base as we do not have sufficient additional oil and natural gas properties to eliminate the borrowing base deficiency by pledging additional oil and natural gas properties to secure our obligations under the Revolving Credit Agreement. Under the Revolving Credit Agreement, we have the option to affect such repayment either in full within 30 days after the redetermination or in monthly installments over a six-month period after the redetermination. Our liquidity and ability to comply with debt covenants under our Revolving Credit Agreement have been negatively impacted by the recent decrease in commodity prices, which have fallen approximately$43.00 a barrel based on WTI fromDecember 31, 2019 to the date of this Annual Report, due in part to failedOPEC negotiations as well as concerns about the COVID-19 pandemic, which has significantly decreased worldwide demand for oil and natural gas. Our Revolving Credit Agreement contains financial covenants requires the Company to maintain a ratio of Total Debt to EBITDAX (each as defined in the Revolving Credit Agreement) (the "Leverage Ratio") of not more than 4.00 to 1.00 and a ratio of Current Assets to Current Liabilities (each as defined in the Revolving Credit Agreement) (the "Current Ratio") of not less than 1.00 to 1.00 as of the last day of each fiscal quarter thereafter. See Note 11 - Long-term Debt to our consolidated financial statements for additional information regarding the financial covenants under our Revolving Credit Agreement. As ofDecember 31, 2019 , the Company was not in compliance with the Leverage Ratio and CurrentRatio covenants. Pursuant to the Twelfth Amendment (as defined in Note 11 - Long-Term Debt to our consolidated financial statements), the Company obtained a waiver from the requisite lenders of its compliance with the Leverage Ratio and Current Ratio covenants as ofDecember 31, 2019 . As ofMarch 31, 2020 , the Company was not in compliance with the Leverage Ratio and Current Ratio covenants. Pursuant to the Fourteenth Amendment (as defined in Note 11 - Long-Term Debt), the Company obtained a waiver from the requisite lenders of its compliance with the Leverage Ratio and Current Ratio covenants as ofMarch 31, 2020 . If we are not able to pay or defer the$7.8 million Borrowing Base Deficiency due onJune 5, 2020 or do not maintain compliance with our debt covenants, the obligations of the Company under the Revolving Credit Agreement may be accelerated, which would have a material adverse effect on our business. In order to improve our liquidity, leverage position and current ratio to meet the financial covenants under the Revolving Credit Agreement, we are currently pursuing or considering a number of actions, which in certain cases may require the consent of current lenders and stockholders. InNovember 2019 , our board of directors formed a Special Committee tasked with reviewing and evaluating strategic alternatives that may enhance the value of the Company, including alternatives that may be available to identify and access further sources of liquidity through financing alternatives or deleveraging transactions. The Special Committee hired financial and legal advisors to advise the Special Committee on these matters. 38 --------------------------------------------------------------------------------
The Special Committee continues to explore financing alternatives and deleveraging transactions. We are also addressing operational matters such as adjusting our capital budget and improving cash flows from operations by continuing to reduce costs, and intend to continue to pursue and consider other strategic alternatives. There can be no assurance that we will be able to implement any of these plans successfully, or that such plans, if executed, will result in the ability to pay borrowing base deficiencies, generate sufficient liquidity or comply with our Revolving Credit Agreement covenants. These factors raise substantial doubt about our ability to continue as a going concern within twelve-month period following the date of issuance of these consolidated financial statements.
2019 Operational and Financial Highlights
• Increased our net sales production by 3% to 5,102 BOE/d, for 2019 as compared
to 2018, despite planned well shut-ins and temporary suspensions of our
drilling and completions program throughout 2019. Net sales production for
2019 of 5,102 BOE/d was consistent with guidance for the year.
• Significantly reduced general and administrative expenses by completing the
closing of the
to a single location in
employees (corporate, operations and field personnel) by approximately 23%.
These efforts contributed to reductions of general and administrative
expenses by 15% for the year ended
year ended
• Reduced general and administrative expenses per BOE by 17% for 2019 as
compared to 2018
• Reduced our crude transportation costs per Bbl by 85% from
January and
year-end, resulting in a 2019 weighted average crude transportation cost of
savings of
• Reduced our saltwater disposal costs by 25% to approximately
of
• Increased saltwater disposal capacity through third party access by 380% to
46,600 bbl/d, compared to 2018.
• Added seasoned oil and gas professionals to our operations and land
departments.
• Significantly reduced our cycle times by reducing average drilling days for
longer lateral wells (> 1.5 miles) from approximately 45 days (spud to total
depth) to approximately 17 days.
• Successfully completed 7 gross wells (5.4 net) during 2019, despite temporary
suspensions in the Company's drilling and completions program.
• Reduced average drilling costs per well by 26% compared to wells drilled by
previous operations management in 2018.
• Secured necessary power commitments to begin full electrification of our
commitments for our
• Received 2-year extended flaring permits to mitigate the need for future
shut-ins associated with regulatory flaring compliance and have implemented
solutions for delivering all produced natural gas to sales by the end of the
second quarter of 2020.
• Received three drilling permits from the
of review.
• Completed two significant transactions that brought approximately
of capital into the Company
• Sold 513 net undeveloped acres inNew Mexico , noncontiguous to the Company's core operational area, for approximately$33,000 per net acre
• Completed an overriding royalty interest and working interest transaction
• Realized oil pricing of 91% of WTI for 2019 versus 82% of WTI as compared to
2018.
• Achieved commodity volume mix of 73% Liquids, including 61% crude oil,
resulting in 95% of revenue attributable to Liquids sales during 2019
39--------------------------------------------------------------------------------
2020 Updates
• Brought additional capital of
sale of certain undeveloped leasehold assets in New Mexico .
• Successfully installed gas treating system on certain well locations and
are now in the final stages of testing the treated gas that will flow to
sales. We anticipate all treated natural gas production to be flowing to
sales during the second quarter of 2020.
• In 2020, the Company has entered into the Seventh Amendment through the
Fourteenth Amendment to the Revolving Credit Agreement which, among other
things, amended the following (Refer to Note 11 - Long-Term Debt for
additional information):
• Reduced our borrowing base to $90.0 million , resulting in a
borrowing base deficiency of $25.0 million ,
• Extended the due date for the final borrowing basedeficiency
payment to June 5, 2020 , and
• Waived compliance with the Leverage Ratio and Current Ratio
covenants as of December 31, 2019 and March 31, 2020 .
In response to recent commodity prices and our efforts to strengthen our capital
through reducing operating costs, during April 2020 the Company elected to
shut-in 12 wells which were identified as uneconomic as a result of the
continued decline in commodity prices in 2020 and 19 additional wells have been
identified for short term shut-in through May and June. The 19 wells identified
for short term shut-in are naturally flowing wells and could be turned back to
sales quickly as market conditions dictate.
The Company has also implemented an employee furlough program to further reduce
general and administrative costs. The furloughed employees will not receive
compensation from the Company during the furlough period; however, subject to
local regulations, these employees will be eligible for unemployment
benefits. The furlough period is uncertain at this time and will be reassessed
as business conditions dictate.
Access to Infrastructure
We entered into an amendment to our previously negotiated water gathering and disposal agreement and entered into a new crude oil sales contract to support the sales of our production of Liquids and natural gas, including transportation and sales agreements and salt water gathering and disposal agreements. We believe these agreements secure us cost effective movement of our Liquids and natural gas production inTexas andMexico . Our agreements and relationships with SCM and ARM also provide the company with optionality in production storage capacity and down-stream transportation capacity. OnMarch 11, 2019 , the Company, SCM Water, andARM Energy Management, LLC ("ARM"), a related company to SCM Water, agreed to amend the terms of the previously negotiated water gathering and disposal agreement and entered into a new crude oil sales contract. Under the terms of such agreements, the Company agreed to an increase in salt water disposal rates in exchange for more favorable pricing differentials on the crude oil sales contract, modification on the minimum quantities of crude oil required under the crude oil sales contract, an upfront payment of$2.5 million and the elimination of the potential bonus for hitting a target of 40,000 barrels of produced water per day.
Market Conditions and Commodity Pricing
Our financial results depend on many factors, including the price of oil, natural gas and NGLs and our ability to market our production on economically attractive terms. We generate the majority of our revenues from sales of Liquids and, to a lesser extent, sales of natural gas. The price of these products are critical factors to our success and volatility in these prices could impact our results of operations. In addition, our business requires substantial capital to acquire properties and develop our non-producing properties. The price of oil, natural gas and NGLs have fallen significantly since the beginning of 2020, due in part to failedOPEC negotiations and to concerns about the COVID-19 pandemic, which has significantly decreased worldwide demand for oil and natural gas. This significant decline and any further declines in the price of oil, natural gas and NGLs have reduced our revenues and result in lower cash inflow which have made it more difficult for us to pursue our plans to acquire new properties and develop our existing properties. Such declines in oil, natural gas, and NGL prices also adversely affect our ability to obtain additional funding on favorable terms. Commodity prices continued to significantly decrease during first quarter 2020, through the date of filing. As ofMarch 31, 2020 , the Company was not in compliance with the Leverage Ratio and Current Ratio covenants and received a waiver from the requisite lenders of its compliance with the Leverage Ratio and Current Ratio covenants as ofMarch 31, 2020 . 40 --------------------------------------------------------------------------------
Results of Operations - For the Years Ended
Current Operations Update
During the year endedDecember 31, 2019 , seven horizontal wells were placed on production. As ofDecember 31, 2019 , we have 41 gross operated wells, of which 30 horizontal wells and 9 legacy vertical wells were producing and flowing to sales. We received three drilling permits from theBureau of Land Management inNew Mexico and are nearing completion on several additionalNew Mexico permits.
To enhance performance, the Company has installed artificial lift on select wells. Currently, eleven wells have been placed on artificial lift.
InJuly 2019 , we self-elected to temporarily shut-in four of our wells to remain withinTexas flaring regulations. By the end of the third quarter, we brought all four of those previously shut-in wells back online and flowing to sales, received extended flaring permits inTexas to mitigate the need for future shut-ins due to regulatory compliance, and continue to advance efforts with the implementation of field treating solutions. The treating systems involve chemical intervention, upgrades to the surface facilities at each tank battery and upgrades to natural gas handling facilities for specific wells that do not meet quality specifications. The facility upgrades necessary for the crude oil treating implementation has been completed and our third-party crude gathering system is currently capable of flowing treated crude to all receipt points. The natural gas treating solution continues to be advanced and began delivering treated natural gas, that was previously being flared, to sales in the first quarter of 2020. EffectiveMarch 1, 2019 , the Company began selling its crude oil under a single long-term contract with a term that extends to at leastDecember 31, 2024 . The purchaser's commitment has a quantity-based limit set forth in the contract, measured in barrels per day, with the maximum quantity commitment increasing at periodic intervals over the life of the contract to coincide with the Company's expected growth in production. Pursuant to the long-term contract, pricing is based on posted indexes for crude oil of similar quality, with a differential based on pipeline delivery toHouston . InMay 2018 , we engaged SCM to implement a gathering system to transport our crude oil production. Due to ongoing matters involving construction and use of the gathering system, we have not been able to use the system as expected, which has delayed our realization of efficiencies in getting our production to sales and has increased our transportation costs on sales.
Sales Volumes and Revenues
The following table sets forth selected revenue and sales volume data for the
years ended
Years Ended December 31,
2019 2018 Variance %
Net sales volume:
Oil (Bbl) 1,130,855 1,089,724 41,131 4 %
Natural gas (Mcf) 3,063,927 2,855,739 208,188 7 %
NGL (Bbl) 220,832 246,425 (25,593 ) (10 )%
Total (BOE) 1,862,342 1,812,106 50,236 3 %
Average daily sales volume (BOE/d) 5,102 4,965 137 3 %
Average realized sales price:
Oil ($/Bbl) $ 52.19 $ 53.26 $ (1.08 ) (2 )%
Natural gas ($/Mcf) 1.04 1.84 (0.80 ) (44 )%
NGL ($/Bbl) 17.52 28.11 (10.59 ) (38 )%
Total ($/BOE) $ 35.47 $ 38.75 $ (3.28 ) (8 )%
Oil, natural gas and NGL
revenues (in thousands):
Oil revenue $ 59,015 $ 58,042 $ 973 2 %
Natural gas revenue 3,180 5,246 (2,066 ) (39 )%
NGL revenue 3,868 6,928 (3,060 ) (44 )%
Total revenue $ 66,063 $ 70,216 $ (4,153 ) (6 )%
41--------------------------------------------------------------------------------
Total sales volume increased 3% to 1,862,342 BOE during the year endedDecember 31, 2019 , compared to 1,812,106 BOE during 2018, an increase of 50,236 BOE. The increase in total sales volume was primarily due to 7 gross (5.4 net) additional wells placed on production since the third quarter of 2018. Total revenue decreased$4.2 million to$66.1 million for the year endedDecember 31, 2019 , as compared to$70.2 million for the year endedDecember 31, 2018 , representing a 6% decrease. The decrease was primarily attributable to lower realized prices partially offset by increased volumes.
Operating Expenses
The following table shows a comparison of operating expenses for the years endedDecember 31, 2019 and 2018: Years Ended December 31, 2019 2018 Variance % Operating Expenses per BOE: Production costs $ 8.66$ 7.64 $ 1.02 13 % Gathering, processing and transportation 2.13 1.87 0.26 14 % Production taxes 1.77 2.05 (0.28 ) (14 )% General and administrative 15.23 18.35 (3.12 ) (17 )% Depreciation, depletion, amortization and accretion 17.85 14.00 3.85 28 % Impairment of oil and natural gas properties 122.60 -
122.60 100 %
Total operating expenses per BOE
Operating Expenses (in thousands): Production costs$ 16,127 $ 13,843 $ 2,284 16 % Gathering, processing and transportation 3,960 3,392 568 17 % Production taxes 3,302 3,709 (407 ) (11 )% General and administrative 28,371 33,251 (4,880 ) (15 )% Depreciation, depletion, amortization and accretion 33,252 25,367 7,885 31 % Impairment of oil and natural gas properties 228,324 - 228,324 100 % Total operating expenses$ 313,336 $ 79,562 $ 233,774 294 % Production Costs Production costs increased by$2.3 million , or 16%, to$16.1 million for the year endedDecember 31, 2019 , compared to$13.8 million for the year endedDecember 31, 2018 , due, in part, to the 7 gross (5.4 net) increase in producing wells during 2019. Our production costs on a per BOE basis increased by$1.02 , or 13%, to$8.66 for the year endedDecember 31, 2019 , as compared to$7.64 per BOE for the year endedDecember 31, 2018 . The increase in production costs per BOE was primarily the result of increased equipment rentals related to artificial lift and workover charges.
Gathering, Processing and Transportation
Gathering, processing and transportation costs increased by$0.6 million to$4.0 million for the year endedDecember 31, 2019 , compared to$3.4 million for the year endedDecember 31, 2018 . This cost increase was primarily the result of higher sales volumes of natural gas. The cost on a per BOE basis increased 14% from$1.87 for the year endedDecember 31, 2018 , to$2.13 for the year endedDecember 31, 2019 , primarily attributable to higher per BOE costs under our long-term natural gas purchase contract as compared to the short-term natural gas contract in the comparative period.
Production Taxes
Production taxes decreased$0.4 million to$3.3 million for the year endedDecember 31, 2019 , compared to$3.7 million for the same period in 2018. On a per BOE basis, production taxes decreased to$1.77 per BOE for the year endedDecember 31, 2019 , a 14% decrease from the$2.05 per BOE for the year endedDecember 31, 2018 , primarily due to lower revenue for 2019 as compared to 2018. 42 --------------------------------------------------------------------------------
General and Administrative Expenses ("G&A")
G&A decreased by$4.9 million to$28.4 million for the year endedDecember 31, 2019 , as compared to$33.3 million for the year endedDecember 31, 2018 . The decrease of$4.9 million in G&A was primarily attributable to a decrease in stock-based compensation of$2.5 million , a decrease in personnel costs of$1.0 million including severance costs and directors fees, and a$1.4 million decrease in professional services.
Depreciation, Depletion, Amortization and Accretion ("DD&A")
DD&A expense was$33.3 million for the year endedDecember 31, 2019 , compared to$25.4 million for the year endedDecember 31, 2018 ; resulting in an increase of$7.9 million , or 31%. Our DD&A rate increased by 28% to$17.85 per BOE during the year endedDecember 31, 2019 from$14.00 per BOE for the year endedDecember 31, 2018 . To a smaller degree, DD&A expense increased as a result of a 3% increase in sales volumes for the year endedDecember 31, 2019 as compared to the year endedDecember 31, 2018 . The increase was primarily due to a net increase of proved oil and natural gas net book value, prior to impairment, and a 71% decrease in total proved reserves volumes on a BOE basis.
Impairment of
The Company recorded charges for impairment of oil and natural gas properties of$228.3 million for the year endedDecember 31, 2019 . The net book value of the Company's oil and natural gas properties exceeded the ceiling limitation calculated as required under the full cost method of accounting atDecember 31, 2019 andSeptember 30, 2019 .December 31, 2019 discounted future net cash flows and proved reserves volumes decreased 63% and 71%, respectively, from ourDecember 31, 2018 proved reserves report. As a result of the uncertainty in our ability to fund future development costs associated with proved undeveloped reserves, all proved undeveloped reserves were reclassified to unproved. The reclassification represented nearly 23%, or$75.3 million , of the decrease in discounted future net cash flows and approximately 50% of the decrease in proved volumes, or 21,487 MBOE. Oil and natural gas pricing, calculated as required by theSEC , decreased approximately 16% fromDecember 31, 2018 as compared toDecember 31, 2019 . Proved reserve volumes reported in theDecember 31, 2019 proved reserves report were over 20%, or 8,699 MBOE, lower due to the decrease in pricing. Discounted future net cash flows decreased more than 40%, or$131.5 million , as a result of the decrease in pricing used in estimating proved reserves.
Other Income (Expenses)
The following table shows a comparison of other expenses for the years endedDecember 31, 2019 and 2018: Years Ended December 31, 2019 2018 Variance % (In Thousands) Other income (expense): Loss on early extinguishment of debt$ (1,299 ) $ (20,370 ) $ 19,071 (94 )% Gain (Loss) from commodity derivatives, net (8,985 ) 55 (9,040 ) (16,436 )% Change in fair value of financial instruments (3,573 ) 58,343 (61,916 ) (106 )% Interest expense (11,426 ) (32,827 ) 21,401 (65 )% Other income 435 2 433 21,650 % Total other income (expenses)$ (24,848 ) $ 5,203 $ (30,051 ) (578 )%
Loss on Early Extinguishment of Debt
In 2019, the Company repurchased certain overriding royalty interests in the acreage previously sold under the ORRI Agreement (as defined in Note 5 - Acquisitions and Divestitures to our consolidated financial statements), resulting in a$1.3 million loss on extinguishment of a portion of the financing arrangement. OnOctober 10, 2018 , we converted approximately$68.3 million of our Second Lien Credit Agreement into a combination of 39,254 shares of Series D Preferred Stock, stated value of$1,000 per share, and 5,952,763 shares of common stock. As a result, we recorded a loss of approximately$12.3 million on early extinguishment of debt. Concurrently, we executed the Revolving Credit Agreement, from which we received proceeds of$60.0 million that were used to pay off the outstanding balance of the Riverstone First Lien Credit Agreement totaling$57.0 million , including accrued interest and prepayment penalties. As a result 43 --------------------------------------------------------------------------------
of the prepayment of the Riverstone First Lien Credit Agreement, we recorded a
loss of approximately
Gain (Loss) from Commodity Derivatives, net
Loss on our commodity derivatives increased by$9.0 million during the year endedDecember 31, 2019 , resulting primarily from changes in underlying commodity prices as compared to the hedged prices within derivative instruments and the monthly settlement of those instruments. Additionally, during the year endedDecember 31, 2019 , our net loss from commodity derivatives consisted primarily of net losses of$3.4 million from settled positions and$5.6 million from mark-to-market adjustments on unsettled positions. During the year endedDecember 31, 2018 , our net loss from commodity derivatives consisted primarily of net losses of$1.9 million from settled positions and$2.0 million from mark-to-market adjustments on unsettled positions.
Change in Fair Value of Financial Instruments
The change in fair value of financial instruments is attributable to embedded derivatives associated with the conversion feature of the Second Lien Term Loan (as defined in Note 11 - Long-Term Debt to our consolidated financial statements). Changes in our stock price directly affect the fair value of the embedded derivative. During the period fromJanuary 1, 2019 toMarch 5, 2019 , we recognized a loss of$0.3 million on the embedded derivative. OnMarch 5, 2019 , the embedded derivative was extinguished as part of the 2019 Transaction Agreement (as defined in Note 11 - Long-Term Debt to our consolidated financial statements). As ofDecember 31, 2019 , we recognized an embedded derivative associated the ARM sales agreement as the agreement no longer meets the criteria for the "normal purchase normal sales" exception under ASC 815, "Derivatives and Hedging", due to the Company not meeting the minimum quantities deliverable under the contract and the net settlement criteria being met (see Note 21 - Commitments and Contingencies to our consolidated financial statements). Upon recognition, we recorded a loss of$3.2 million on the embedded derivative.
Interest Expense
Interest expense for the year endedDecember 31, 2019 was$11.4 million compared to$32.8 million for the year endedDecember 31, 2018 . For the year endedDecember 31, 2019 , interest expense included$6.5 million from the Revolving Credit Agreement,$1.6 million of PIK interest,$0.9 million from financing arrangements,$1.7 million related to amortization of the debt discount on our Second Lien Term Loan and$0.8 million for amortization debt issuance costs. For the year endedDecember 31, 2018 , we incurred interest expense of$32.8 million , which included$3.0 million for quarterly interest payments on notes payable and term loans,$12.2 million of PIK interest,$14.4 million related to amortization of debt discount on our Second Lien Term Loan and$3.2 million for amortization debt issuance costs. The Second Lien Term Loan was converted to common and preferred stock inMarch 2019 , and, as a result, there was less paid-in-kind interest and amortization of debt discount during the 2019 period.
Going Concern and Liquidity
Historically, our primary sources of capital have been cash flows from operations, borrowings from financial institutions and investors, the sale of equity and equity derivative securities and targeted asset dispositions. Our primary uses of capital have been for the acquisition, development, exploration and exploitation of oil and natural gas properties, in addition to refinancing of debt instruments. Our ability to fund planned capital expenditures and to make acquisitions depends upon commodity prices, our future operating performance, availability of borrowings under our Revolving Credit Agreement, and more broadly, on the availability of equity and debt financing, which is affected by prevailing economic conditions in our industry and financial, business and other factors, some of which are beyond our control. The Company has negative working capital, a history of net operating losses and cash flows used in operations. We cannot predict whether additional liquidity from equity or debt financings or borrowings under our Revolving Credit Agreement will be available on acceptable terms, or at all, in the foreseeable future. From time to time, we raise capital through the sale of oil and natural gas properties that are not in our current drilling plans. InAugust 2019 , we sold approximately 513 noncontiguous net acres inNew Mexico for net cash proceeds of$16.6 million . The Company repurchased certain overriding royalty interests in the acreage previously sold under the ORRI Agreement for$2.6 million , resulting in net proceeds of approximately$14 million that were used for general corporate purposes and to restart drilling and completion activity during the third quarter. We may continue to enter into such sales in the future. During the year endedDecember 31, 2019 , we exchanged and converted our outstanding Second Lien Term Loan with a face value of approximately$133.6 million for a combination of preferred stock and common stock, of which$60.0 million was converted into Series E Preferred Stock,$55.0 million was converted into Series F Preferred Stock, and$18.6 million was converted 44 --------------------------------------------------------------------------------
into common stock based on a$1.88 per share issuance price. Additionally, the conversion features and voting rights on the existing Series C Preferred Stock and Series D Preferred Stock were eliminated in exchange for the issuance of 7.8 million shares of our common stock. The net dilution to our common stockholders was decreased by approximately 12 million shares as the result of the conversion of the Second Lien Term Loan and the elimination of the conversion features on the Series C Preferred Stock and the Series D Preferred Stock. In 2019, we relied significantly on borrowings under our Revolving Credit Agreement to provide drilling and completion capital and for other general corporate purposes. Our ability to maintain or increase our borrowing base under our Revolving Credit Agreement is dependent on numerous factors, including our ability to add proved reserves and production, commodity prices and the lending policies of our lenders. We currently have four wells drilled and awaiting completion (referred to as "DUC" wells) that, when and if completed, would add to our current production cash flows in 2020. As ofDecember 31, 2019 , we were fully drawn against the borrowing base under our Revolving Credit Agreement (as defined in Note 11 - Long-Term Debt to our Consolidated Financial Statements), with$115 million of indebtedness outstanding under our Revolving Credit Agreement. As provided for in the Seventh Amendment to our Revolving Credit Agreement and as a result of a decrease in commodity prices, onJanuary 17, 2020 , the borrowing base was decreased to$90.0 million . As a result of theJanuary 17, 2020 redetermination of the borrowing base, a borrowing base deficiency in the amount of$25 million (the "Borrowing Base Deficiency") was created under the Revolving Credit Agreement. The Borrowing Base Deficiency constitutes the difference between the principal amount of borrowings currently outstanding under the Revolving Credit Agreement,$115 million , and the borrowing base as so redetermined,$90 million . OnFebruary 28, 2020 , we paid$17.25 million towards the Borrowing Base Deficiency. Pursuant to the Fourteenth Amendment to the Revolving Credit Agreement, the remaining payment of$7.8 million is dueJune 5, 2020 . The Company is seeking additional funding and considering certain strategic transactions to enable it to pay the remaining Borrowing Base Deficiency amount of$7.8 million . There is no assurance, however, that funding or additional transactions will be completed or that the bank group will agree to further deficiency payment extensions. If the Company is unable to repay the remaining borrowing base deficiency as and when required under the Revolving Credit Agreement, an event of default would occur under the Revolving Credit Agreement. Our next borrowing base redetermination is scheduled to occur on or aboutJune 5, 2020 . If the borrowing base is further reduced by the lenders in connection with this redetermination, we will be required to repay borrowings in excess of the borrowing base as we do not have sufficient additional oil and natural gas properties to eliminate the borrowing base deficiency by pledging additional oil and natural gas properties to secure our obligations under the Revolving Credit Agreement. Under the Revolving Credit Agreement, we have the option to affect such repayment either in full within 30 days after the redetermination or in monthly installments over a six-month period after the redetermination. Our liquidity and ability to comply with debt covenants under our Revolving Credit Agreement have been negatively impacted by the recent decrease in commodity prices, which have fallen significantly since the beginning of 2020, due in part to failedOPEC negotiations as well as concerns about the COVID-19 pandemic, which has significantly decreased worldwide demand for oil and natural gas. Our Revolving Credit Agreement contains financial covenants that require the Company to maintain a ratio of Total Debt to EBITDAX (each as defined in the Revolving Credit Agreement) (the "Leverage Ratio") of not more than 4.00 to 1.00 and a ratio of Current Assets to Current Liabilities (each as defined in the Revolving Credit Agreement) (the "Current Ratio") of not less than 1.00 to 1.00 as of the last day of each fiscal quarter thereafter. See Note 11-Long-term Debt to our consolidated financial statements for additional information regarding the financial covenants under our Revolving Credit Agreement. As ofDecember 31, 2019 , the Company was not in compliance with the Leverage Ratio and CurrentRatio covenants under the Revolving Credit Agreement. Pursuant to the Twelfth Amendment (as defined in Note 11 - Long-Term Debt to our consolidated financial statements), the Company obtained a waiver from the requisite lenders of its compliance with the Leverage Ratio and Current Ratio covenants as ofDecember 31, 2019 . As ofMarch 31, 2020 , the Company was not in compliance with the Leverage Ratio and Current Ratio covenants. Pursuant to the Fourteenth Amendment (as defined in Note 11 - Long-Term Debt), the Company obtained a waiver from the requisite lenders of its compliance with the Leverage Ratio and Current Ratio covenants as ofMarch 31, 2020 . If we are not able to pay or defer the$7.8 million Borrowing Base Deficiency due onJune 5, 2020 or do not maintain compliance with the covenants, the obligations of the Company under the Revolving Credit Agreement may be accelerated, which would have a material adverse effect on our business. Fluctuations in oil and natural gas prices have a material impact on our financial position, results of operations, cash flows and quantities of oil, natural gas and NGL reserves that may be economically produced. Historically, oil and natural gas 45 --------------------------------------------------------------------------------
prices have been volatile, and may be subject to wide fluctuations in the future. Furthermore, the Company has negative working capital, a history of net operating losses and cash flows use in operations. If continued depressed prices persist, the Company will continue to experience operating losses, negative cash flows from operating activities, and negative working capital. In order to improve our leverage position and current ratio to meet the financial covenants under the Revolving Credit Agreement, we are currently pursuing or considering a number of actions, which in certain cases may require the consent of current lenders and stockholders. InNovember 2019 , our board of directors formed a Special Committee tasked with reviewing and evaluating strategic alternatives that may enhance the value of the Company, including alternatives that may be available to identify and access further sources of liquidity. The Special Committee hired financial and legal advisors to advise the Special Committee on these matters. The Special Committee continues to explore financing alternatives and deleveraging transactions. We are also addressing operational matters such as adjusting our capital budget and improving cash flows from operations by continuing to reduce costs and intend to continue to pursue and consider other strategic alternatives. There can be no assurance that we will be able to implement any of these plans successfully, or that such plans, if executed, will result in the ability to pay borrowing base deficiencies, generate sufficient liquidity to continue as a going concern or comply with our Revolving Credit Agreement covenants. These factors raise substantial doubt about our ability to continue as a going concern within twelve-month period following the date of issuance of these consolidated financial statements. Our ability to fund our future operations, including drilling and completion capital expenditures, will largely be dependent upon our active management of our drilling and completion budget, and, if necessary, the continued suspension of our drilling plans until we are able to identify and access further sources of liquidity. We are currently considering alternative secured financing to replace the current revolving credit facility under our Revolving Credit Agreement. We are the operator of 100% of our 2020 operational capital program and we expect to operate a substantial majority of wells we may drill in the near future, and, as a result, we have had, and expect to continue to have, the discretion to control the amount and timing of a substantial portion of our capital expenditures. The Company has recently elected to temporarily suspend current drilling operations, until necessary funding is obtained, to focus on production and facilities optimization while the results and performance of the new wells are evaluated. In response to our efforts to strengthen our capital through reducing operating costs, duringApril 2020 the Company elected to shut-in 12 wells which were identified as uneconomic as a result of the continued decline in commodity prices in 2020 and 19 additional wells have been identified for short term shut-in through May and June. The 19 wells identified for short term shut-in are naturally flowing wells and could be turned back to sales quickly as market conditions dictate. We may in the future, however, determine it prudent to extend the current suspension or temporarily suspend further drilling and completion operations due to capital constraints, shortage of liquidity, or reduced returns on investment as a result of commodity price weakness.
Information about our cash flows for the years ended
Years Ended December 31,
2019 2018
Cash provided by (used in):
Operating activities $ (25,824 ) $ 92,132
Investing activities (65,527 ) (242,935 )
Financing activities 73,967 154,478
Net change in cash and cash equivalents
Operating Activities
For the year endedDecember 31, 2019 , net cash used in operating activities was$25.8 million , compared to net cash provided by operating activities of$92.1 million for the year endedDecember 31, 2018 . The$25.8 million used in operating activities was primarily made up of net loss of$272.1 million , non cash adjustments to net income of$282.5 million , and cash used by change in working capital of$36.2 million , primarily the result of payments of accounts payable outstanding atDecember 31, 2018 . 46 --------------------------------------------------------------------------------
Investing Activities For the year endedDecember 31, 2019 , net cash used in investing activities was$65.5 million , compared to$242.9 million for the same period in 2018. The$65.5 million in cash used for investing activities during the year endedDecember 31, 2019 , was primarily attributable to the following:
• cash payments of approximately
oil and gas properties; partially offset by
• approximately
Capital Expenditure Breakdown
During the year endedDecember 31, 2019 , drilling and completion capital cost incurred was$93.1 million , comprised of$36.7 million on 2018 DUC wells and$40.3 million related to the 2019 drilling program, plus an additional$3.7 million related to the 2018 drilling program and$10.8 million for facility and water supply and disposal projects. Of the capital cost incurred on 2018 DUC wells, adjustments to Lilis' working interests due to non-consent elections increased capital costs by$7.5 million while reducing accounts receivable from other working interest partners by that amount. AtDecember 31, 2019 , we had four DUC wells compared to six DUC wells atDecember 31, 2018 . Although additional costs were incurred on all six DUC wells during 2019, four wells were placed on production during 2019. Those four wells included the Oso #1H, Haley #1H, Haley #2H, and NE Axis #2H. In addition, three wells were drilled, completed and placed on production during the fourth quarter of 2019, those being the Kudu A#2H, Kudu B#2H and Grizzly A#2H. During the second half of 2019, under the direction of the Company's new operations team, significant reductions in drilling days and drilling costs have been achieved. Reduced drilling cycle times were realized by incorporating oil-based drilling mud, utilizing a higher quality rig and better down hole tools/configurations. This has reduced the number of bit trips by 44% and increased the rate of penetration by 110% over prior wells drilled in early 2019. The identification of optimal drilling zones within drilling targets has also reduced time spent slide drilling by 5%. The Company has also improved in-zone precision from approximately 89% in 2018 to approximately 100% in recent wells. In addition to these changes, continuous drilling optimization is being evaluated and implemented with different hole sizes and configurations to further reduce cycle times. If and when the Company obtains the capital required to do so, the Company expects to incorporate these improved techniques on all future wells with the goal of achieving similar cost savings. Year Ended December 31, 2019 2018 Leasehold Acquisitions Proved $ -$ 20,040 Unproved 1,643 98,193 2017 Drilling & Completion Program - 12,440
2018 Drilling & Completion Program 3,658 119,350 2018 Drilling & Completion Program-DUCs 36,738 24,887 2018 Working Interest Acquisitions
- 1,293
2019 Drilling & Completion Program 40,263 -
Facilities & Other Projects 10,824 9,484
Total Capital Spending $ 93,126 $ 285,687
Financing Activities
For the year ended December 31, 2019 , net cash provided by financing activities
was $74.0 million compared to cash provided by financing activities of $154.5
million during the same period in 2018. The $74.0 million in net cash provided
by financing activities included $56.9 million in net proceeds from drawdowns on
the Revolving Credit Agreement and $38.2 million in net proceeds from the ORRI
Agreement and WI Agreement (as defined in Note 5 - Acquisitions and Divestitures
to our consolidated financial statements), offset by repayment of $18.0 million
on the Revolving Credit Agreement.
47
--------------------------------------------------------------------------------Capital Structure Revolving Credit Agreement OnOctober 10, 2018 , we entered into a five-year,$500 million senior secured revolving credit agreement (the "Revolving Credit Agreement") by and among the Company, as borrower, certain subsidiaries of the Company, as guarantors (the "Guarantors"),BMO Harris Bank, N.A ., as administrative agent, and the lenders party thereto. The Revolving Credit Agreement provides for a senior secured reserves based revolving credit facility with an initial borrowing base of$95 million and also provides for issuance of letters of credit in an aggregate amount up to$5 million . The borrowing base is subject to semiannual redetermination in May and November of each year. Borrowings under the Revolving Credit Agreement bear interest at a floating rate of either LIBOR or a specified base rate plus a margin determined based upon the usage of the borrowing base. The Company is required to pay a commitment fee of 0.5% per annum on any unused portion of the borrowing base. The Company's obligations under the Revolving Credit Agreement are secured by first priority liens on substantially all of the Company's and the Guarantors' assets and are unconditionally guaranteed by each of the Guarantors. The Revolving Credit Agreement matures on the earlier of the fifth anniversary of the closing date and the date that is 180 days prior to the maturity date of the Second Lien Credit Agreement (as defined below). Borrowings under the Revolving Credit Agreement are subject to mandatory repayment with the net proceeds of certain asset sales and debt incurrences or if a borrowing base deficiency occurs. The Company also may voluntarily repay borrowings from time to time and, subject to the borrowing base limitation and other customary conditions, may re-borrow amounts that are voluntarily repaid. The Revolving Credit Agreement contains certain customary representations and warranties and affirmative and negative covenants, including covenants relating to: maintenance of books and records, financial reporting and notification, compliance with laws, maintenance of properties and insurance; and limitations on incurrence of indebtedness, liens, fundamental changes, international operations, asset sales, certain debt payments and amendments, restrictive agreements, investments, dividends and other restricted payments and hedging. It also requires the Company to maintain a ratio of Total Debt to EBITDAX of not more than 4.00 to 1.00 and a ratio of current assets to current liabilities of not less than 1.00 to 1.00 (each as defined in the Revolving Credit Agreement). As ofDecember 31, 2019 , the Company was not in compliance with the CurrentRatio covenant or Leverage Ratio covenant under the Revolving Credit Agreement (as defined and described in Note 11 - Long-Term Debt to our consolidated financial statements). Pursuant to the Twelfth Amendment (as defined in Note 11 - Long-Term Debt to our consolidated financial statements), the Company obtained a waiver from the requisite lenders of its compliance with the Current Ratio and Leverage Ratio covenant, among other waivers, as ofDecember 31, 2019 .
Seventh Amendment to Revolving Credit Agreement
OnJanuary 17, 2020 , the Company entered into a Seventh Amendment (the "Seventh Amendment") to the Revolving Credit Agreement. The Seventh Amendment provided for theJanuary 14, 2020 redetermination of the borrowing base under the Revolving Credit Agreement (the "Scheduled Redetermination"). As so redetermined, the borrowing base was set at$90 million . As a result of the Scheduled Redetermination, a borrowing base deficiency in the amount of$25 million existed under the Revolving Credit Agreement (the "Borrowing Base Deficiency"). The Seventh Amendment required repayment of the Borrowing Base Deficiency in four equal monthly installments, with the first payment of$6.25 million scheduled to occur onJanuary 24, 2020 .
Eighth Amendment to Revolving Credit Agreement
OnJanuary 23, 2020 , the Company entered into an Eighth Amendment (the "Eighth Amendment") to the Revolving Credit Agreement. The Eighth Amendment, among other things, amended the Revolving Credit Agreement to provide that the due date for the first Installment Payment was extended fromJanuary 24, 2020 toFebruary 7, 2020 and that the due dates for the subsequent Installment Payments wereFebruary 14, 2020 ,March 16, 2020 andApril 14, 2020 . 48 --------------------------------------------------------------------------------
Ninth Amendment to Revolving Credit Agreement
OnFebruary 6, 2020 , the Company entered into an Ninth Amendment (the "Ninth Amendment") to the Revolving Credit Agreement. The Ninth Amendment amended the Revolving Credit Agreement to provide that the due date for the first Installment Payment was extended fromFebruary 7, 2020 toFebruary 18, 2020 and the due date for the second Installment Payment was extended fromFebruary 14, 2020 toFebruary 18, 2020 . The due dates for the two subsequent Installment Payments remainedMarch 16, 2020 andApril 14, 2020 .
Tenth Amendment to Revolving Credit Agreement
OnFebruary 14, 2020 , the Company entered into an Tenth Amendment (the "Tenth Amendment") to the Revolving Credit Agreement. The Tenth Amendment amended the Revolving Credit Agreement to provide that the due date for the first two Installment Payments was extended fromFebruary 18, 2020 toFebruary 28, 2020 and the due dates for the two subsequent Installment Payments remainedMarch 16, 2020 andApril 14, 2020 .
Eleventh Amendment to Revolving Credit Agreement
OnMarch 13, 2020 , the Company entered into an Eleventh Amendment (the "Eleventh Amendment") to the Revolving Credit Agreement. The Eleventh Amendment amended the Revolving Credit Agreement to extend the due date for the$1.50 million installment of the Borrowing Base Deficiency fromMarch 16, 2020 toMarch 30, 2020 . The due date for the final installment of the Borrowing Base Deficiency remainedApril 14, 2020 .
Twelfth Amendment to Revolving Credit Agreement
OnMarch 30, 2020 , the Company entered into an Twelfth Amendment (the "Twelfth Amendment") to the Revolving Credit Agreement. The Twelfth Amendment amended the Revolving Credit Agreement to, among other things extend the due date for the$1.50 million installment of the Borrowing Base Deficiency fromMarch 30, 2020 toApril 14, 2020 . The due date for the final installment of the Borrowing Base Deficiency remainsApril 14, 2020 . The lenders under the Revolving Credit Agreement also waived the requirement under the Revolving Credit Agreement that the Company comply with a leverage ratio and a current ratio, in each case, as ofDecember 31, 2019 , and granted certain other waivers, including the requirement to comply with certain hedging obligations set forth in the Revolving Credit Agreement untilJune 30, 2020 . Additionally, the lenders consented to an extension of an additional 45 days for the Company to provide its audited annual financial statements for the fiscal year endedDecember 31, 2019 , and waived the requirement that such financial statements be delivered without a "going concern" or like qualification or exception.
Thirteenth Amendment to Revolving Credit Agreement
OnApril 14, 2020 , the Company entered into a Thirteenth Amendment (the "Thirteenth Amendment") to the Revolving Credit Agreement. The Thirteenth Amendment amended the Revolving Credit Agreement to extend the due date for the final$7.75 million installment of the Borrowing Base Deficiency fromApril 14, 2020 toApril 21, 2020 .
Fourteenth Amendment to Revolving Credit Agreement
OnApril 21, 2020 , the Company entered into a Fourteenth Amendment (the "Fourteenth Amendment") to the Revolving Credit Agreement. The Fourteenth Amendment, among other things, amended the Revolving Credit Agreement to extend the due date for the final$7.75 million installment of the Borrowing Base Deficiency fromApril 21, 2020 toJune 5, 2020 . The lenders under the Revolving Credit Agreement also waived the requirement under the Revolving Credit Agreement that the Company comply with a leverage ratio and a current ratio, in each case, as ofMarch 31, 2020 . Additionally, the lenders consented to defer the timing of the scheduled spring redetermination of the borrowing base under the Revolving Credit Agreement from on or aboutMay 1, 2020 to on or aboutJune 5, 2020 . Second Lien Credit Agreement OnApril 26, 2017 , the Company entered into a second lien credit agreement, dated as ofApril 26, 2017 , by and among the Company, certain subsidiaries of the Company, as guarantors (the "Guarantors"),Wilmington Trust, National Association , as administrative agent (the "Agent"), and the lenders party thereto (the "Lenders"), including Värde, as amended (the "SecondLien Credit Agreement") comprised of convertible loans in an aggregate initial principal amount of up to$125 million in two tranches. The first tranche consisted of an$80 million term loan (the "Second Lien Term Loan"), which was fully drawn and funded onApril 26, 2017 . The second tranche consisted of up to$45 million in delayed-draw term loans (the "Delayed Draw Term Loan" 49 --------------------------------------------------------------------------------
and, together with the Second Lien Term Loan, the "Second Lien Loans"). The Second Lien Term Loan was subsequently converted into common stock and preferred stock in two separate transactions onOctober 2018 andMarch 2019 as described below.
Exchange and Conversion of Second Lien Term Loan and Issuance of Preferred Stock
OnOctober 10, 2018 , as consideration for the reduction by approximately$56.3 million of the outstanding principal amount of the Second Lien Term Loan under the Second Lien Credit Agreement, together with accrued and unpaid interest and the make-whole amount thereon totaling approximately$11.9 million , the Company entered into a transaction by and among the Company and certain private funds affiliated with the Värde Parties, pursuant to which the Company agreed to issue to the Värde Parties an aggregate of 5,952,763 shares of the Company's common stock, par value$0.0001 per share, which includes 5,802,763 shares of common stock at an exchange price of$5.00 per share of common stock plus an additional 150,000 shares of common stock, and 39,254 shares of a newly created series of preferred stock of the Company, designated as "Series D 8.25% Convertible Participating Preferred Stock" (the "Series D Preferred Stock"); OnMarch 5, 2019 , in exchange for satisfaction of the outstanding principal amount of the Second Lien Term Loan, accrued and unpaid interest thereon and the make-whole premium totaling approximately$133.6 million , the Company issued to the Värde Parties an aggregate of 60,000 shares of a newly created series of preferred stock of the Company, designated as "Series E 8.25% Convertible Participating Preferred Stock", corresponding to$60 million of the Second Lien Exchange Amount based on the aggregate initial Stated Value of the shares of Series E Preferred Stock; 55,000 shares of a newly created series of preferred stock of the Company, designated as "Series F 9.00% Participating Preferred Stock", corresponding to$55 million of the Second Lien Exchange Amount based on the aggregate initial Stated Value of the shares of Series F Preferred Stock; and 9,891,638 shares of common stock, corresponding to approximately$18.6 million of the Second Lien Exchange Amount, based on the$1.88 closing price of the common stock on the NYSE American onMarch 4, 2019 . In connection with the transaction, the Company also issued to the Värde Parties an aggregate of 7,750,000 shares of common stock as consideration for the Värde Parties' consent to the amendment of the terms of the Series C Preferred Stock and the Series D Preferred Stock to, among other things, eliminate the convertibility of the Series C Preferred Stock and Series D Preferred Stock into shares of common stock and the voting rights of the Series C Preferred Stock and the Series D Preferred Stock. See Note 13 - Related Party Transactions and Note 15 - Preferred Stock to our consolidated financial statements for additional information aboutRelated Party Transactions and the Company's Preferred Stock.
Related Party Transactions
OnMarch 5, 2019 , pursuant to the 2019 Transaction Agreement and the related payoff letter, the Company agreed to issue to the Värde Parties shares of two new series of its preferred stock and shares of its common stock, as consideration for the termination of the Second Lien Credit Agreement with the Värde Parties and the satisfaction in full, in lieu of repayment in cash, of the Second Lien Term Loan under the Second Lien Credit Agreement. See Note 11 - Long-Term Debt and Note 15 - Preferred Stock to our consolidated financial statements for additional information. OnJuly 31, 2019 , the Company entered into two agreements with affiliates of Värde for the sale of an overriding royalty interest and a non-operated working interest in undeveloped assets. WLR's (as defined in Note 5 - Acquisitions and Divestitures to our consolidated financial statements) proportionate share of revenue of$0.4 million for the year endedDecember 31, 2019 is included in interest expense on the Company's consolidated statements of operations. Three of the properties included in the WI Agreement were producing as ofDecember 31, 2019 and net revenue (revenue less production costs) of$0.5 million is included in interest expense on the Company's consolidated statements of operations. See Note 5 - Acquisitions and Divestitures to our consolidated financial statements for additional information. OnAugust 16, 2019 , the Company entered into an agreement with an affiliate of Värde to repurchase the overriding royalty interest for theNew Mexico acreage sold. See Note 5 - Acquisitions and Divestitures to our consolidated financial statements for additional information. OnApril 21, 2020 , VärdeInvestment Partners, L.P. , an affiliate of VärdePartners, Inc. , became a lender under our Revolving Credit Agreement by acquiring, from a prior lender, loans and commitments under the Revolving Credit Agreement in the principal amount of approximately$25.7 million . The loans and commitments acquired by VärdeInvestment Partners, L.P. are subject to certain subordination provisions set forth in the Revolving Credit Agreement, as amended by the Fourteenth Amendment thereto datedApril 21, 2020 . For additional information regarding our Revolving Credit Agreement, as amended, see Note 11 - Long-Term Debt to our consolidated financial statements included in this Annual Report and "Item 7 - Management's 50 --------------------------------------------------------------------------------
Discussion and Analysis of Financial Condition and Results of Operations - Revolving Credit Agreement" in Part II of this Annual Report.
Subsequent Events
Sale of Certain Undeveloped Acreage in
On
COVID-19
OnJanuary 30, 2020 , theWorld Health Organization ("WHO") announced a global health emergency due to the COVID-19 outbreak, which originated inWuhan, China , and the risks to the international community as the virus spreads globally beyond its point of origin. InMarch 2020 , the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. In addition, inMarch 2020 , members ofOPEC failed to agree on production levels which has caused an increased supply and has led to a substantial decrease in oil prices and an increasingly volatile market. The oil price war ended with a deal to cut global petroleum output but did not go far enough to offset the impact of COVID-19 on demand. There has been an increase in supply which has pushed prices down further since March. If the depressed pricing continues for an extended period it will lead to i) further reductions in the borrowing base under our credit facility which would require us to make additional borrowing base deficiency payments, ii) reductions in reserves, and iii) additional impairment of proved and unproved oil and gas properties. We also expect disclosures of supplemental oil and gas information to be impacted by price declines. In response to recent commodity prices and our efforts to strengthen our capital through reducing operating costs,duringApril 2020 the Company elected to shut-in 12 wells which were identified as uneconomic as a result of the continued decline in commodity prices in 2020 and 19 additional wells have been identified for short term shut-in through May and June. The 19 wells identified for short term shut-in are naturally flowing wells and could be turned back to sales quickly as market conditions dictate. The Company has also implemented an employee furlough program to further reduce general and administrative costs. The furloughed employees will not receive compensation from the Company during the furlough period; however, subject to local regulations, these employees will be eligible for unemployment benefits. The furlough period is uncertain at this time and will be reassessed as business conditions dictate. The full impact of the COVID-19 outbreak and the decline in oil prices continues to evolve as of the date of this Annual Report. As such, it is uncertain as to the full magnitude that these events will have on the Company's financial condition, liquidity, and future results of operations. Management is actively monitoring the global situation on its financial condition, liquidity, operations, suppliers, industry, and workforce. Given the daily evolution of the COVID-19 outbreak and the global responses to curb its spread, the Company is not able to estimate the effects of the COVID-19 outbreak on its results of operations, financial condition, or liquidity for fiscal year 2020. These matters could have a continued material adverse impact on economic and market conditions and trigger a period of global economic slowdown, which may impair the Company's asset values, including reserve estimates. Further, consumer demand has decreased since the spread of the outbreak and new travel restrictions placed by governments in an effort to curtail the spread of the coronavirus. Although the Company cannot estimate the length or gravity of the impacts of these events at this time, if the pandemic and/or decreased oil prices continue, they will have a material adverse effect on the Company's results of future operations, financial position, and liquidity in fiscal year 2020.
Coronavirus Aid, Relief, and Economic Security Act
OnMarch 27, 2020 ,President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act"). The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations, increased limitations on qualified charitable contributions, and technical corrections to tax depreciation methods for qualified improvement property. 51 --------------------------------------------------------------------------------
It also appropriated funds for the SBA Paycheck Protection Program loans that are forgivable in certain situations to promote continued employment, as well as Economic Injury Disaster Loans to provide liquidity to small businesses harmed by COVID-19. There is no assurance we are eligible for these funds or will be able to obtain them. We continue to examine the impact that the CARES Act may have on our business. Currently, we are unable to determine the impact that the CARES Act will have on our financial condition, results of operations, or liquidity.
Effects of Inflation and Pricing
The oil and gas industry is very cyclical and the demand for goods and services of oil field companies, suppliers and others associated with the industry puts pressure on the economic stability and pricing structure within the industry. Typically, as prices for oil and natural gas increase, so do all associated costs. Material changes in prices impact the current revenue stream, estimates of future reserves, borrowing base calculations of bank loans and the value of properties in purchase and sale transactions. Material changes in prices, such as those experienced to date in 2020, can impact the value of oil and natural gas companies and their ability to raise capital, borrow money and retain personnel. We anticipate business costs will vary in accordance with commodity prices for oil and natural gas, and the associated increase or decrease in demand for services related to production and exploration.
Off-Balance Sheet Arrangements
We do not have any material off-balance sheet arrangements.
Commitments and Contractual Obligations
OnAugust 2, 2018 , the Company executed a five-year agreement withSCM Crude, LLC , an affiliate of SCM, to secure firm takeaway pipeline capacity and pricing on a long-haul pipeline to theGulf Coast region commencingJuly 1, 2019 . OnMarch 11, 2019 , the agreement was replaced with a five-year agreement between the Company and ARM, a related company to SCM. The new agreement accelerated the start date toMarch 2019 and guarantees firm takeaway capacity on a long-haul pipeline toCorpus Christi, Texas , once completed, at a specified price. Under the terms of the new contract, the Company received pricing differentials on the crude oil sales contract subject to minimum quantities of crude oil to be delivered as follows: Date Quantity (Barrels per Day)March 2019 -June 2019 5,000July 2019 -December 2019 4,000January 2020 -June 2020 5,000July 2020 -June 2021 6,000July 2021 -December 2024 (1) 7,500
(1) Extending to the later of
Further, ARM has agreed to purchase crude from the Company based upon MagellanEast Houston pricing with a fixed "differential basis". As ofDecember 31, 2019 , the agreement no longer meets the criteria for the "normal purchase normal sales" exception under ASC 815, "Derivatives and Hedging", due to the Company not meeting the minimum quantities deliverable under the contract and the net settlement criteria being met. See Note 9 - Derivatives to our consolidated financial statements for information regarding the recognition of the net settlement mechanism as an embedded derivative over the remainder of the contract.
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements in conformity with generally accepted accounting principles inthe United States ("GAAP") requires our management to make assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the significant accounting policies and related estimates that affect our financial disclosures.
Critical accounting policies are defined as those significant accounting policies that are most critical to an understanding of a company's financial condition and results of operation. We consider an accounting estimate or judgment to be critical if (i) it
52
--------------------------------------------------------------------------------requires assumptions to be made that were uncertain at the time the estimate was made, and (ii) changes in the estimate or different estimates that could have been selected could have a material impact on our results of operations or financial condition.
Use of Estimates
The accompanying consolidated financial statements are prepared in conformity
with GAAP which requires the Company to make a number of estimates and
assumptions relating to the reported amounts of assets and liabilities;
disclosure of contingent assets and liabilities at the date of the financial
statements; the reported amounts of revenues and expenses during the reporting
period; and the quantities and values of proved oil, natural gas and natural gas
liquid ("NGL") reserves used in calculating depletion and assessing impairment
of its oil and natural gas properties. The most significant estimates pertain to
the evaluation of unproved properties for impairment, proved oil and natural gas
reserves and related cash flow estimates used in the depletion and impairment of
oil and natural gas properties; the timing and amount of transfers of our
unevaluated properties into our amortizable full cost pool; the fair value of
embedded derivatives and commodity derivative contracts, accrued oil and natural
gas revenues and expenses, valuation of options and warrants, and common stock;
and the allocation of general and administrative expenses. Actual results could
differ significantly from these estimates.
Oil and Natural Gas Reserves
We follow the full cost method of accounting. All of our oil and natural gas properties are located withinthe United States and, therefore, all costs related to the acquisition and development of oil and natural gas properties are capitalized into a single cost center referred to as a full cost pool. Depletion of exploration and development costs and depreciation of production equipment is computed using the units-of-production method based upon estimated proved oil and natural gas reserves. Under the full cost method of accounting, capitalized oil and natural gas property costs less accumulated depletion and net of deferred income taxes may not exceed an amount equal to the present value, discounted at 10%, of estimated future net revenues from proved oil and natural gas reserves less the future cash outflows associated with the asset retirement obligations that have been accrued on the balance sheet plus the cost, or estimated fair value if lower, of unproved properties. Should capitalized costs exceed this ceiling, impairment would be recognized. Under the applicableSEC rules, we prepared our oil and natural gas reserves estimates as ofDecember 31, 2019 , using the average, first-day-of-the-month price during the 12-month period endedDecember 31, 2019 . Estimating accumulations of oil and natural gas is complex and is not exact because of the numerous uncertainties inherent in the process. The process relies on interpretations of available geological, geophysical, engineering and production data. The extent, quality and reliability of this technical data can vary. The process also requires certain economic assumptions, some of which are mandated by theSEC , such as oil and natural gas prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The accuracy of a reserves estimate is a function of the quality and quantity of available data; the interpretation of that data; the accuracy of various mandated economic assumptions; and the judgment of the persons preparing the estimate. We believe estimated reserves quantities and the related estimates of future net cash flows are among the most important estimates made by an exploration and production company such as ours because they affect the perceived value of our Company, are used in comparative financial analysis ratios, and are used as the basis for the most significant accounting estimates in our financial statements, including the quarterly calculation of depletion, depreciation and impairment of our proved oil and natural gas properties. Proved oil and natural gas reserves are the estimated quantities of crude oil, natural gas, and NGLs that geological and engineering data demonstrate with reasonable certainty to be recoverable in future periods from known reservoirs under existing economic and operating conditions. We determine anticipated future cash inflows and future production and development costs by applying benchmark prices and costs, including transportation, quality and basis differentials, in effect at the end of each quarter to the estimated quantities of oil and natural gas remaining to be produced as of the end of that quarter. We reduce expected cash flows to present value using a discount rate that depends upon the purpose for which the reserves estimates will be used. For example, the standardized measure calculation requires us to apply a 10% discount rate. Although reserves estimates are inherently imprecise and estimates of new discoveries and undeveloped locations are more imprecise than those of established proved producing oil and natural gas properties, we make considerable effort to estimate our reserves, including through the use of independent reserves engineering consultants. We expect that quarterly reserves estimates will change in the future as additional information becomes available or as oil and natural gas prices and operating and capital costs change. We evaluate and estimate our oil and natural gas reserves as ofDecember 31 , and quarterly throughout the year. For purposes of depletion, depreciation, and impairment, we adjust reserves quantities at all quarterly periods for the estimated impact of acquisitions and dispositions. Changes in depletion, depreciation or impairment calculations caused by changes in reserves quantities or net cash flows are recorded in the period in which the reserves or net cash flow estimate changes.
Oil and Natural Gas Properties-Full Cost Method of Accounting
53
--------------------------------------------------------------------------------We use the full cost method of accounting whereby all costs related to the acquisition and development of oil and natural gas properties are capitalized into a single cost center referred to as a full cost pool. These costs include land acquisition costs, geological and geophysical expenses, carrying charges on non-producing properties, costs of drilling, and overhead charges directly related to acquisition and exploration activities.
Capitalized costs, together with the costs of production equipment, are depleted and amortized on the unit-of-production method based on the estimated gross proved reserves as determined by independent petroleum engineers. For this purpose, we convert our petroleum products and reserves to a common unit of measurement.
Costs of acquiring and evaluating unproved properties are initially excluded from depletion calculations. This undeveloped acreage is assessed quarterly to ascertain whether impairment has occurred. When proved reserves are assigned or the property is considered to be impaired, the cost of the property or the amount of the impairment is added to the amortization base and becomes subject to the depletion calculation. Proceeds from the sale of oil and natural gas properties are applied against capitalized costs, with no gain or loss recognized, unless the sale would alter the rate of depletion by more than 25%. Royalties paid, net of any tax credits received, are netted against oil and natural gas sales. Under the full cost method of accounting, capitalized oil and natural gas property costs, less accumulated depletion and net of deferred income taxes, may not exceed an amount equal to the present value using the preceding 12-months' average price based on closing prices on the first day of each month, adjusted for price differentials, discounted at 10%, of estimated future net revenues from proved oil and natural gas reserves, plus the cost, or estimated fair value if lower, of unproved properties. Should capitalized costs exceed this ceiling, we would recognize impairment. Subsequent toDecember 31, 2019 , commodity prices declined significantly, which we expect to significantly reduce the undiscounted expected cash flows from our proved reserves. Declines in commodity prices used for our full cost ceiling test will result in additional impairments of our proved properties during 2020. If there are significant delays in the completion of our drilling program due to capital constraints resulting from current market conditions, we will lose a portion of our acreage through lease expirations that will result in impairments recorded throughout 2020 related to those expirations.
Derivative Instruments
All derivative instruments are recorded on the consolidated balance sheet at fair value as either an asset or a liability with changes in fair value recognized currently in earnings. Although commodity based derivative instruments are used by the Company to manage the price risk attributable to its expected oil and natural gas production, those derivative instruments have not been designated as accounting hedges under the accounting guidance. All of our derivatives are accounted for as mark-to-market activities. Under ASC Topic 815, "Derivatives and Hedging," these instruments are recorded on the consolidated balance sheets at fair value as either short term or long-term assets or liabilities based on their anticipated settlement date. The Company nets derivative assets and liabilities by commodity for counterparties where a legal right to such offset exists. Changes in the derivatives' fair values are recognized in current earnings since the Company has elected not to designate its current derivative contracts as cash flow hedges for accounting purposes. The Company has recognized certain conversion features within its Second Lien Term Loan as embedded derivatives that have been bifurcated from the Second Lien Term Loan, as defined in Note 11 - Long-Term Debt to our consolidated financial statements in Item 16 of this Annual Report on Form 10-K and accounted for separately from the debt. The Company has recognized our crude oil sales agreement with ARM no longer meets the criteria for the "normal purchase normal sales" exception under ASC 815, "Derivatives and Hedging", due to the Company not meeting the minimum quantities deliverable under the contract and the net settlement criteria being met. As a result, an embedded derivative exists as it is no longer probable the contract will only result in physical deliveries of crude oil and may not settle. See Note 9 - Derivatives to our consolidated financial statements in Item 16 of this Annual Report on Form 10-K.
Revenue Recognition
Revenue is recognized when control passes to the purchaser which generally
occurs when production is transferred to the purchaser. The Company measures
revenue as the amount of consideration it expects to receive in exchange for the
commodities transferred. All of the Company's revenues from contracts with
customers represent products transferred at a point in time as control is
transferred to the customer.
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--------------------------------------------------------------------------------The Company records revenue based on consideration specified in its contracts with its customers. The amounts collected on behalf of third parties are recorded in revenue payable. The Company recognizes revenue in the amount that reflects the consideration it expects to receive in exchange for transferring control of those goods to the customer. The contract consideration in the Company's variable price contracts is typically allocated to specific performance obligations in the contract according to the price stated in the contract. Payment is generally received one or two months after the sale has occurred. Income Taxes The Company uses the asset and liability method in accounting for income taxes. Deferred tax assets and liabilities are recognized for temporary differences between financial statement carrying amounts and the tax bases of assets and liabilities and are measured using the tax rates expected to be in effect when the differences reverse. Deferred tax assets are also recognized for operating loss and tax credit carry forwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is used to reduce deferred tax assets when uncertainty exists regarding their realization. The Company recognizes its tax benefits only for tax positions that are more likely than not to be sustained upon examination by tax authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely to be realized upon settlement. A liability for "unrecognized tax benefits" is recorded for any tax benefits claimed that do not meet these recognition and measurement standards. As ofDecember 31, 2019 and 2018, the Company has determined that no liability is required to be recognized. The Company's policy is to recognize any interest and penalties related to unrecognized tax benefits in income tax expense. No interest or penalties were required to be accrued atDecember 31, 2019 and 2018. Further, the Company does not expect that the total amount of unrecognized tax benefits will significantly increase or decrease during the next 12 months.
Recently Issued Accounting Pronouncements
For a discussion of recently adopted accounting standards and recent accounting standards not yet adopted, see "Note 3 - Basis of Presentation and Summary of Significant Accounting Policies" to our Consolidated Financial Statements in Item 16 of this Annual Report.
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