Carrizo Oil & Gas, Inc. is an independent energy company which, together with its subsidiaries (collectively referred to herein as the “Company”), is engaged in the exploration, development, production and transportation of natural gas and oil, principally in the United States. The Company’s current operations are principally focused in proven, producing natural gas plays known as “shale plays” or “resource plays.” The Company’s primary core area is the Barnett Shale area, with a focus in Southeast Tarrant County, Texas. The Company has also established a significant position in the Marcellus Shale area in Pennsylvania, New York and West Virginia. In addition to the Barnett and the Marcellus plays, the Company’s current focus areas include the Eagle Ford Shale in South Texas, th e Niobrara formation in Colorado and the Huntington Field located in the U.K. North Sea.
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany transactions and balances and are presented in accordance with U.S. generally accepted accounting principles. The consolidated financial statements reflect necessary adjustments, all of which were of a recurring nature and are in the opinion of management necessary for a fair presentation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). The Company believes that the disclosures presented are adequate to al low the information presented not to be misleading. The consolidated financial statements included herein should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
The Company accounts for its investment in Pinnacle Gas Resources, Inc. as available-for-sale and adjusts the book value to fair value through other comprehensive income (loss), net of taxes. This fair value is assessed quarterly for other than temporary impairment based on publicly available information. If the impairment is deemed other than temporary, it is recognized in earnings. Subsequent recoveries in fair value are reflected as increases to investments and other comprehensive income (loss), net of taxes.
The Company accounts for its investment in Oxane Materials, Inc. using the cost method of accounting and adjusts the carrying amount of its investment for contributions to and distributions from the entity.
Certain reclassifications have been made to prior period amounts to conform to the current period presentation. These reclassifications had no effect on total assets, total liabilities, shareholders’ equity, net income (loss), comprehensive income (loss) or net cash provided by/used in operating, investing or financing activities.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods reported. Actual results could differ from these estimates.
Significant estimates include volumes of oil and gas reserves used in calculating depletion of proved oil and gas properties, future net revenues and abandonment obligations, impairment of unproved properties, future taxable income and related income tax assets and liabilities, the collectability of outstanding accounts receivable, fair values of derivative instruments, stock-based compensation, contingencies and the results of current and future litigation. Oil and gas reserve estimates, which are the basis for unit-of-production depletion and the ceiling test, have numerous inherent uncertainties. The accuracy of any reserve estimate is a function of the quality and quantity of available data and the application of engineering and geological interpretation and judgment to available data. Subsequent dr illing results, testing and production may justify revisions of such estimates. Accordingly, reserve estimates are often
different from the quantities of oil and gas that are ultimately recovered. In addition, reserve estimates are vulnerable to changes in prices of oil and gas. Such prices have been volatile in the past and can be expected to be volatile in the future.
The significant estimates are based on current assumptions that may be materially affected by changes to future economic conditions such as the market prices received for sales of oil and gas, the credit worthiness of counterparties, interest rates, the market value and volatility of the Company’s common stock and the Company’s ability to generate future taxable income. Future changes in these assumptions may affect these significant estimates materially in the near term. The Company has evaluated subsequent events for recording and disclosures, including assumptions used in its estimates.
Investments in oil and gas properties are accounted for using the full-cost method of accounting. All costs directly associated with the acquisition, exploration and development of oil and gas properties are capitalized. Such costs include lease acquisitions, seismic surveys, and drilling and completion equipment. The Company proportionately consolidates its interests in unincorporated joint ventures and oil and gas properties. The Company capitalized employee-related costs for employees working directly on acquisition, exploration and development activities of $1.4 million and $1.1 million for the three months ended September 30, 2010 and 2009, respectively, and $4.2 million and $4.1 million for the nine months ended September 30, 2010 and 2009, respectively. Maintenance and repai rs are expensed as incurred.
Depreciation, depletion and amortization (“DD&A”) of proved oil and gas properties is based on the unit-of-production method using estimates of proved reserve quantities. The depletable base includes estimated future development costs and dismantlement, restoration and abandonment costs, net of estimated salvage values. The depletion rate per Mcfe for the three months ended September 30, 2010 and 2009 was $1.17 and $1.50, respectively, and for the nine months ended September 30, 2010 and 2009 was $1.16 and $1.62, respectively. Under the full-cost method of accounting, the depletion rate is the current period production as a percentage of the total proved oil and gas reserves. Total proved reserves include both proved developed and proved undeveloped reserves. The depletion rate is applied to the net book value of the oi l and gas properties (excluding unproved properties, capitalized interest and exploratory wells in progress) and estimated future development costs less salvage value to calculate the depletion expense.
Costs not subject to amortization include costs of unproved properties (which consists of unevaluated leaseholds and seismic costs associated with specific unevaluated properties), capitalized interest and exploratory wells in progress. These costs are evaluated periodically for impairment on a property-by-property basis. If the results of an assessment indicate that the properties have been impaired, the amount of such impairment is added to the proved oil and gas property costs subject to DD&A and the full-cost ceiling test. Factors considered by management in its impairment assessment include drilling results by the Company and other operators, the terms of oil and gas leases not held by production, production response to secondary activities, drilling plans and available funds for exploration and development. The Company expect s it will complete its evaluation of the properties representing the majority of its unproved property costs within the next two to five years. The Company capitalized interest costs associated with its unproved properties of $5.6 million and $5.0 million for the three months ended September 30, 2010 and 2009, respectively, and $15.1 million for the nine months ended September 30, 2010 and 2009.
Dispositions of oil and gas properties are accounted for as adjustments to capitalized costs with no gain or loss recognized, unless such adjustments significantly alter the relationship between capitalized costs and proved reserves. The Company has not had any transactions that significantly alter that relationship.
Capitalized costs, less accumulated amortization and related deferred income taxes, are limited to a “ceiling-test” based on the estimated future net revenues based on average market prices for sales of oil and gas on the first calendar day of each month during the preceding 12-month period, discounted at 10% per annum, from proved oil and gas reserves, less estimated future expenditures to be incurred in developing and producing the proved reserves, less any related income tax effects. If net capitalized costs exceed this limit, the excess is charged to earnings. Prices used in the ceiling test computation do not include the impact of derivative instruments as the Company does not designate its derivative instruments as a cash flow hedge.
Depreciation of other property and equipment is provided using the straight-line method based on estimated useful lives ranging from five to ten years.
The Company owns a profit interest (“B Units”) in ACP II Marcellus, LLC (“ACP II”), the Company’s existing joint venture partner in the Marcellus Shale and an affiliate of Avista Capital Partners, LP, a private equity fund (together with its affiliates, “Avista”). The B Units, which were issued to the Company in connection with the formation of the joint venture with Avista in 2008, entitle the
Company to receive increasing percentages of the cash distributions to Avista that exceed certain internal rates-of-return and return–on-investment thresholds. The B Units provide consent rights only in limited, specified circumstances and generally do not entitle the Company to vote or participate in the management of ACP II, which is controlled by Avista. Steven A. Webster, Chairman of the Company’s Board of Directors, also serves as Co-Managing Partner and President of Avista. Cash distributions received on the Company’s B Units are treated as distributions on the Company’s investment in ACP II and are recognized as Distribution Income-Related Party when ACP II declares and pays cash distributions to Avista.
The Company grants stock options, stock appreciation rights (“SARs”) and restricted stock to directors, employees and independent contractors.
For stock options, including SARs that the Company expects to settle in common stock (“Stock SARs”), compensation expense is based on the grant-date fair value and expensed over the vesting period (generally three years) using the straight-line method, except for awards with performance conditions, in which case the Company uses the graded vesting method. Stock options typically expire ten years after the date of grant. SARs expire seven years after the date of grant. Stock SARs allow the Company to elect whether to settle the Stock SARs in cash or common stock. For SARs that settle in cash (“Cash SARs”) and Stock SARs that the Company expects to settle in cash, the liability is adjusted to fair value at each reporting period date and amortized to expense over the vesting period and is classified as other accrued liabilities for the portion of the awards that are vested or are expected to vest within the next 12 months, with the remainder classified as other long-term liabilities.
For restricted stock, the Company measures deferred compensation based on the average of the high and low price of the Company’s stock on the grant date. The deferred compensation is amortized to expense over the vesting period of the restricted stock (generally one to three years), using the straight-line method, except for awards with performance conditions, in which case the Company uses the graded vesting method. Restricted stock issued to independent contractors is adjusted to fair value at each reporting period date and amortized to expense over the vesting period.
The Company recognized the following stock-based compensation expense for the periods indicated, which are reflected as general and administrative expense in the accompanying consolidated statements of operations:
Prior to July 2010, the Company expected the Stock SARs granted in June 2009 to settle in common stock. In July 2010, the Company elected to settle those Stock SARs in cash upon exercise. As a result, the Company recognized a fair value liability for those awards at September 30, 2010, along with related compensation expense.
The Company’s Board of Directors sets all risk management policies and reviews the status and results of derivative activities, including volumes, types of instruments and counterparties on a quarterly basis. These policies require that derivative instruments be executed only by the President or Chief Financial Officer after consultation and concurrence by the President, Chief Financial Officer and Chairman of the Board. The master contracts with approved counterparties identify the President and Chief Financial Officer as
the only Company representatives authorized to execute trades. See Note 9., “Derivative Instruments” for further discussion of the Company’s derivative instruments.
At September 30, 2010 and December 31, 2009, the Company had related party receivables of $0.5 million and $0.4 million, respectively, with ACP II.
The Company establishes provisions for losses on accounts receivable when it determines that it will not collect all or a part of the outstanding balance. The Company reviews collectability quarterly and adjusts the allowance as necessary using the specific identification method. At September 30, 2010 and December 31, 2009, the Company’s allowance for doubtful accounts was $2.4 million and $2.0 million, respectively.
| | | Three Months | | | Nine Months | |
| | | Ended September 30, | | | Ended September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | (In thousands, except | |
| | | per share amounts) | |
| Net income (loss) | | $ | 24,355 | | | $ | (4,795 | ) | | $ | 45,876 | | | $ | (136,357 | ) |
| | | | | | | | | | | | | | | | | |
| Average common shares outstanding | | | | | | | | | | | | | | | | |
| Weighted average common shares outstanding | | | 34,730 | | | | 31,053 | | | | 33,301 | | | | 30,980 | |
| Restricted stock, stock options and SARs | | | 371 | | | | - | | | | 423 | | | | - | |
| Diluted weighted average common shares outstanding | | | 35,101 | | | | 31,053 | | | | 33,724 | | | | 30,980 | |
| | | | | | | | | | | | | | | | | |
| Net income (loss) per common share | | | | | | | | | | | | | | | | |
| Basic | | $ | 0.70 | | | $ | (0.15 | ) | | $ | 1.38 | | | $ | (4.40 | ) |
| Diluted | | $ | 0.69 | | | $ | (0.15 | ) | | $ | 1.36 | | | $ | (4.40 | ) |
| | | | | | | | | | | | | | | | | |
Basic earnings per common share is based on the weighted average number of shares of common stock outstanding during the periods. Diluted earnings per common share is based on the weighted average number of common shares outstanding and all dilutive potential common shares outstanding during the periods. The Company excluded 67,562 and 74,738 shares related to restricted stock, stock options and SARs from the calculation of dilutive shares for the three months and nine months ended September 30, 2010, respectively, because the grant prices were greater than the average market prices of the common shares for the periods and would be antidilutive to the computations. The Company excluded 893,837 shares related to stock options and SARs from the calculation of dilutive shares for the three months and nine months ended September 30, 2009 due to the net loss reported in the periods. Shares of common stock subject to issuance pursuant to the conversion features of the 4.375% convertible senior notes due 2028 did not have an effect on the calculation of dilutive shares for the three months and nine months ended September 30, 2010 and 2009.
Income Taxes
Deferred income taxes are recognized at each reporting period for the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts based on tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. The Company routinely assesses the realizability of its deferred tax assets and considers future taxable income based upon the Company’s estimated production of proved reserves at estimated future pricing in making such assessments. If the Company concludes that it is more likely than not that some portion or all of the deferred tax assets will not be realized, the deferred tax assets are reduced by a valuation allowance.
Recently Adopted Accounting Pronouncements
A standard to improve disclosures about fair value measurements was issued by the Financial Accounting Standards Board (the “FASB”) in January 2010. The additional disclosures required include: (1) the different classes of assets and liabilities measured at fair value, (2) the significant inputs and techniques used to measure Level 2 and Level 3 assets and liabilities for both recurring and nonrecurring fair value measurements, (3) the gross presentation of purchases, sales, issuances and settlements for the rollforward of
Level 3 activity and (4) the transfers in and out of Levels 1 and 2. The Company adopted the new disclosures in the first quarter of 2010.
Investments consisted of the following at September 30, 2010 and December 31, 2009:
| | | September 30, | | | December 31, | |
| | | 2010 | | | 2009 | |
| | | (In thousands) | |
| Pinnacle Gas Resources, Inc. | | $ | 818 | | | $ | 835 | |
| Oxane Materials, Inc. | | | 2,523 | | | | 2,523 | |
| | | $ | 3,341 | | | $ | 3,358 | |
| | | | | | | | | |
Pinnacle Gas Resources, Inc.
In 2003, the Company and its wholly-owned subsidiary CCBM, Inc. contributed their interests in certain oil and gas leases in Wyoming and Montana in areas prospective for coalbed methane to a newly formed entity, Pinnacle Gas Resources, Inc. (“Pinnacle”).
At March 31, 2009, the market value of the Company’s investment in Pinnacle had consistently remained below its original book basis since October 2008. The Company determined that the impairment was other than temporary and, accordingly, recorded an impairment of $2.1 million at March 31, 2009. At September 30, 2010, the Company owned 2,555,825 shares of Pinnacle common stock and reported the fair value of the stock at $0.8 million (based on $0.33 per share, the closing price of Pinnacle’s common stock on September 30, 2010).
On February 23, 2010, Pinnacle entered into an Agreement and Plan of Merger (the “Merger Agreement”) with affiliates of Scotia Waterous (USA), Inc. At the closing of the transactions contemplated by the Merger Agreement, Pinnacle is expected to be owned by an investor group led by Scotia Waterous (USA), Inc., which includes DLJ Merchant Banking Partners III, L.P. and affiliated investment funds and certain members of Pinnacle’s management team. Subject to the terms and conditions of the Merger Agreement, at the effective time and as a result of the Merger, each outstanding share of Pinnacle common stock, (other than dissenting shares and those owned by the buyers and affiliates) will be converted into the right to receive a cash amount of $0.34 per share. The merger is expected to be c ompleted during the fourth quarter of 2010.
Oxane Materials, Inc.
In May 2008, the Company entered into a strategic alliance agreement with Oxane Materials, Inc. (“Oxane”) in connection with the development of a proppant product to be used in the Company’s exploration and production program. The Company contributed approximately $2.0 million to Oxane in exchange for warrants to purchase Oxane common stock and for certain exclusive use and preferential purchase rights with respect to the proppant. The Company simultaneously invested an additional $500,000 in a convertible promissory note from Oxane. The convertible promissory note accrued interest at a rate of 6% per annum. During the fourth quarter of 2008, the Company converted the promissory note into 630,371 shares of Oxane preferred stock.
| 3. | PROPERTY AND EQUIPMENT, NET |
At September 30, 2010 and December 31, 2009, property and equipment, net consisted of the following:
| | | September 30, | | | December 31, | |
| | | 2010 | | | 2009 | |
| | | (In thousands) | |
| Proved oil and gas properties | | $ | 801,685 | | | $ | 667,907 | |
| Costs not subject to amortization: | | | | | | | | |
| Unevaluated leaseholds and seismic costs | | | 325,086 | | | | 258,300 | |
| Capitalized interest | | | 43,166 | | | | 34,563 | |
| Exploratory wells in progress | | | 74,650 | | | | 37,744 | |
| Land, building and other equipment | | | 7,332 | | | | 6,475 | |
| Total property and equipment | | | 1,251,919 | | | | 1,004,989 | |
| Accumulated depreciation, depletion and amortization | | | (302,351 | ) | | | (271,289 | ) |
| Total property and equipment, net | | $ | 949,568 | | | $ | 733,700 | |
| | | | | | | | | |
In June 2010, the Company concluded that it was uneconomical to pursue development on the license covering the Monterey field in the U.K. North Sea and terminated further development efforts resulting in a full-cost ceiling test impairment of $2.7 million ($1.8 million after-tax) for the nine months ended September 30, 2010 with respect to the U.K. cost center. For the nine months ended September 30, 2009, the Company incurred a full cost-ceiling test impairment of $216.4 million ($140.6 million net of tax) with respect to the U.S. cost center. To measure the full-cost ceiling test impairment for the first quarter of 2009, the Company elected to use a pricing date subsequent to the balance sheet date, as allowed by SEC guidelines in effect at the time. Using prices as of May 6, 2009, the Company incurred a full-co st ceiling test impairment of $216.4 million ($140.6 million net of tax). Had the Company used prices in effect as of March 31, 2009, a full cost ceiling test impairment of $323.2 million ($210.1 million net of tax) would have been recorded for the first quarter of 2009. The option to use a pricing date subsequent to the balance sheet date is no longer available to the Company due to the adoption of the new oil and gas reporting requirements effective December 31, 2009.
The Company computes quarterly income taxes under the effective tax rate method based on applying an anticipated annual effective income tax rate to the year-to-date income (loss), except for discrete items. Income taxes for discrete items are computed and recorded in the period that the specific transaction occurs. Actual income tax (expense) benefit differs from income tax (expense) benefit computed by applying the U.S. federal statutory corporate rate of 35% to pretax income (loss) as follows:
| | | Three Months Ended | | | Nine Months Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | (In thousands) | |
| (Expense) benefit at the statutory rate | | $ | (13,704 | ) | | $ | 3,076 | | | $ | (25,791 | ) | | $ | 73,894 | |
| State and local income tax expense, | | | | | | | | | | | | | |
| net of federal benefit | | | (1,115 | ) | | | 109 | | | | (2,463 | ) | | | 2,618 | |
| Other | | | 18 | | | | 809 | | | | 441 | | | | (1,743 | ) |
| Total income tax (expense) benefit | | $ | (14,801 | ) | | $ | 3,994 | | | $ | (27,813 | ) | | $ | 74,769 | |
| | | | | | | | | | | | | | | | | |
At September 30, 2010, the Company had a net deferred tax asset of $43.0 million. The Company has determined it is more likely than not that its deferred tax assets are fully realizable based on projections of future taxable income which included estimated production of proved reserves at estimated future pricing. No valuation allowance for the net deferred tax asset is currently needed.
The Company classifies interest and penalties associated with income taxes as interest expense. At September 30, 2010, the Company had no material uncertain tax positions and the tax years since 1999 remain open to review by federal and various state tax jurisdictions.
Debt consisted of the following at September 30, 2010 and December 31, 2009:
| | | September 30, | | | December 31, | |
| | | 2010 | | | 2009 | |
| | | (In thousands) | |
| Convertible Senior Notes | | $ | 373,750 | | | $ | 373,750 | |
| Unamortized discount for Convertible Senior Notes | | | (35,681 | ) | | | (45,122 | ) |
| Senior Secured Revolving Credit Facility | | | 246,000 | | | | 191,400 | |
| Other | | | 160 | | | | 308 | |
| | | | 584,229 | | | | 520,336 | |
| Less: Current maturities | | | (160 | ) | | | (148 | ) |
| | | $ | 584,069 | | | $ | 520,188 | |
| | | | | | | | | |
Convertible Senior Notes
In May 2008, the Company issued $373.8 million aggregate principal amount of 4.375% convertible senior notes due 2028 (the “Convertible Senior Notes”). Interest is payable on June 1 and December 1 each year. The notes are convertible, using a net share settlement process, into a combination of cash and Company common stock that entitles holders of the Convertible Senior Notes to receive cash up to the principal amount ($1,000 per note) and common stock in respect of the remainder, if any, of the Company’s conversion obligation in excess of such principal amount.
The notes are convertible into the Company’s common stock at a ratio of 9.9936 shares per $1,000 principal amount of notes, equivalent to a conversion price of approximately $100.06. This conversion rate is subject to adjustment upon certain corporate events. In addition, if certain fundamental changes occur on or before June 1, 2013, the Company will in some cases increase the conversion rate for a holder electing to convert notes in connection with such fundamental change; provided, that in no event will the total number of shares issuable upon conversion of a note exceed 14.7406 per $1,000 principal amount of notes (subject to adjustment in the same manner as the conversion rate).
Holders may convert the notes only under the following conditions: (a) during any calendar quarter if the last reported sale price of the Company’s common stock exceeds 130 percent of the conversion price for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter, (b) during the five business days after any five consecutive trading day period in which the trading price per $1,000 principal amount of the notes is equal to or less than 97% of the conversion value of such notes, (c) during specified periods if specified distributions to holders of the Company’s common stock are made or specified corporate transactions occur, (d) prior to the close of business on the business day preceding the redemption date if the notes are called for re demption or (e) on or after March 31, 2028 and prior to the close of business on the business day prior to the maturity date of June 1, 2028.
The holders of the Convertible Senior Notes may require the Company to repurchase the notes on June 1, 2013, 2018 and 2023, or upon a fundamental corporate change at a repurchase price in cash equal to 100 percent of the principal amount of the notes to be repurchased plus accrued and unpaid interest, if any. The Company may redeem notes at any time on or after June 1, 2013 at a redemption price equal to 100 percent of the principal amount of the notes to be redeemed plus accrued and unpaid interest, if any.
The Convertible Senior Notes are subject to customary non-financial covenants and events of default, including a cross default under the Senior Credit Facility (defined below), the occurrence and continuation of which could result in the acceleration of amounts due under the Convertible Senior Notes.
The Convertible Senior Notes are unsecured obligations of the Company and rank equal to all future senior unsecured debt but rank second in priority to the Senior Credit Facility.
The Company valued the Convertible Senior Notes at May 21, 2008, as $309.6 million of debt and $64.2 million of equity representing the fair value of the conversion premium. The resulting debt discount is being amortized to interest expense through June 1, 2013, the first date on which the holders may require the Company to repurchase the Convertible Senior Notes, resulting in an effective interest rate of approximately 8% for the Convertible Senior Notes. Amortization of the debt discount amounted to $3.2 million and $3.1 million for the three months ended September 30, 2010 and 2009, respectively, and $9.4 million and $9.1 million for the nine months ended September 30, 2010 and 2009, respectively.
Subsequent to September 30, 2010, the Company commenced a tender offer for up to $300 million of the Convertible Senior Notes, as discussed in Note 13., “Subsequent Events.”
Senior Secured Revolving Credit Facility
The Company has a senior secured revolving credit facility (the “Senior Credit Facility”) with Wells Fargo Bank, N.A., as administrative agent. The Senior Credit Facility provides for a revolving credit facility up to the lesser of the borrowing base or $375.0 million. It is secured by substantially all of the Company’s proved oil and gas assets and is currently guaranteed by certain of the Company’s subsidiaries: CCBM, Inc.; CLLR, Inc.; Carrizo (Marcellus) LLC; Carrizo (Marcellus) WV LLC, Carrizo Marcellus Holding, Inc.; Hondo Pipeline, Inc.; Bandelier Pipeline Holding, LLC, Chama Pipeline Holding LLC, and Mescalero Pipeline, LLC. The Senior Credit Facility matures on October 29, 2012, and is subject to semi-annual borrowing base redeterminations as of March 31 and September 30.
In April 2009, the Company amended the Senior Credit Facility to, among other things, (1) adjust the maximum ratio of total net debt to Consolidated EBITDA (as defined in the Senior Credit Facility); (2) modify the calculation of total net debt for purposes of determining the ratio of total net debt to Consolidated EBITDA to exclude the following amounts, which represent a portion of the Convertible Senior Notes deemed to be an equity component that may be settled in cash (including partial cash settlement) upon conversion: $51.3 million during 2009, $38.9 million during 2010, $26.0 million during 2011 and $12.7 million during 2012 until the maturity date; (3) add a new senior leverage ratio; (4) modify the interest rate margins applicable to Eurodollar loans; (5) modify the interest rate margins applicable to base rate loans; and (6) establish new procedures governing the modification of swap agreements.
In May 2009, the Company amended the Senior Credit Facility to, among other things, (1) provide that the aggregate notional volume of oil and gas subject to swap agreements may not exceed 80% of “forecasted production from proved producing reserves,” (as that term is defined in the Senior Credit Facility), for any month, (2) remove a provision that limited the maximum duration of swap agreements permitted under the Senior Credit Facility to five years, and (3) provide that the aggregate notional amount under interest rate swap agreements may not exceed the amount of borrowings then outstanding under the Senior Credit Facility.
In May 2010, the Company amended the Senior Credit Facility to increase the borrowing base to $375 million from $350 million.
If the outstanding principal balance of the revolving loans under the Senior Credit Facility exceeds the borrowing base at any time, the Company has the option within 30 days to take any of the following actions, either individually or in combination: make a lump sum payment curing the deficiency, pledge additional collateral sufficient in the lenders’ opinion to increase the borrowing base and cure the deficiency or begin making equal monthly principal payments that will cure the deficiency within the ensuing six-month period. Those payments would be in addition to any payments that may come due as a result of the quarterly borrowing base reductions. Otherwise, any unpaid principal or interest will be due at maturity.
The annual interest rate on each base rate borrowing is (a) the greatest of the agent’s Prime Rate, the Base CD Rate plus 1.0% and the Federal Funds Effective Rate plus 0.5%, plus (b) a margin between 1.00% and 2.00% (depending on the then-current level of borrowing base usage), but such interest rate can never be lower than the adjusted Daily LIBO rate on such day plus a margin between 2.25% to 3.25% (depending on the current level of borrowing base usage). The interest rate on each Eurodollar loan will be the adjusted daily LIBO rate plus a margin between 2.25% to 3.25% (depending on the then-current level of borrowing base usage). At September 30, 2010, the average interest rate for amounts outstanding under the Senior Credit Facility was 3.1%.
Subsequent to September 30, 2010, the Company amended its Senior Credit Facility, as discussed in Note 13., “Subsequent Events” and the following description does not reflect such amendment. The Company is subject to certain covenants under the amended terms of the Senior Credit Facility which include, but are not limited to, the maintenance of the following financial ratios: (1) a minimum current ratio of 1.00 to 1.00 (as defined in the Senior Credit Facility); and (2) a maximum total net debt (which excludes certain amounts attributable to the Convertible Senior Notes) to Consolidated EBITDA (as defined in the Senior Credit Facility) of (a) 4.75 to 1.00 for each quarter ending on or after December 31, 2009 and on or before September 30, 2010, (b) 4.25 to 1.00 for the quarter ending December 31, 2010, and (c) 4. 00 to 1.00 for each quarter ending on or after March 31, 2011; and (3) a maximum ratio of senior debt (which excludes certain amounts attributable to the Convertible Senior Notes) to Consolidated EBITDA of 2.25 to 1.00. As defined in the Senior Credit Facility, the current ratio was 1.56 to 1, the total net debt to Consolidated EBITDA ratio was 4.01 to 1 and the ratio of senior debt to Consolidated EBITDA ratio was 1.71 to 1 as of September 30, 2010. Because the calculation of the financial ratios are made as of a certain date, the financial ratios can fluctuate significantly period to period as the amounts outstanding under the Senior Credit Facility are dependent on the timing of cash flows related to operations, capital expenditures, sales of oil and gas properties and securities offerings.
The Senior Credit Facility also places restrictions on indebtedness, dividends to shareholders, liens, investments, mergers, acquisitions, asset dispositions, repurchase or redemption of our common stock, swap agreements, transactions with affiliates and other matters.
The Senior Credit Facility is subject to customary events of default, the occurrence and continuation of which could result in the acceleration of amounts due under the facility by the agent or the lenders.
At September 30, 2010, the Company had $246.0 million of borrowings outstanding under the Senior Credit Facility. We have also issued $4.1 million of letters of credit which reduce the amounts available under the Senior Credit Facility. Future availability under our $375.0 million borrowing base is subject to the terms and covenants of the Senior Credit Facility. The Senior Credit Facility is used to fund ongoing working capital needs and the remainder of the Company’s capital expenditure plan only to the extent such amounts exceed the cash flow from operations, proceeds from the sale of oil and gas properties and securities offerings.
| 6. | ASSET RETIREMENT OBLIGATION |
The following is a rollforward of the asset retirement obligation:
| | | Nine Months Ended | | | Year Ended | |
| | | September 30, | | | December 31, | |
| | | 2010 | | | 2009 | |
| | | (In thousands) | |
| Asset retirement obligation at beginning of period | | $ | 5,410 | | | $ | 6,503 | |
| Liabilities incurred | | | 125 | | | | 444 | |
| Liabilities settled | | | (80 | ) | | | (36 | ) |
| Accretion expense | | | 160 | | | | 308 | |
| Revisions of previous estimates | | | (1,200 | ) | | | (1,809 | ) |
| Asset retirement obligation at end of period | | $ | 4,415 | | | $ | 5,410 | |
| | | | | | | | | |
The revisions of previous estimates relate primarily to increases in the estimated life of wells in the Barnett Shale and the reduction of estimated obligations in the U.K. North Sea.
| 7. | COMMITMENTS AND CONTINGENCIES |
From time to time, the Company is party to certain legal actions and claims arising in the ordinary course of business. While the outcome of these events cannot be predicted with certainty, management does not currently expect these matters to have a material adverse effect on the financial position or results of operations of the Company.
The financial position and results of operations of the Company continue to be affected from time to time in varying degrees by domestic and foreign political developments as well as legislation and regulations pertaining to restrictions on oil and gas production, imports and exports, natural gas regulation, tax increases, environmental regulations and cancellation of contract rights. Both the likelihood and overall effect of such occurrences on the Company vary greatly and are not predictable.
The following is a rollforward of the Company’s shares outstanding:
| | | Nine Months | |
| | | Ended September 30, | |
| | | 2010 | | | 2009 | |
| | | (In thousands) | |
| Shares outstanding at January 1 | | | 31,100 | | | | 30,860 | |
| Common stock offering | | | 3,220 | | | | - | |
| Restricted stock awards, net of forfeitures | | | 303 | | | | 179 | |
| Stock options exercised for cash | | | 262 | | | | 5 | |
| Other | | | - | | | | 10 | |
| Shares outstanding at September 30 | | | 34,885 | | | | 31,054 | |
| | | | | | | | | |
In April 2010, the Company sold 3.22 million shares of its common stock in an underwritten public offering at a price of $23.00 per share. The Company received proceeds of approximately $73.8 million, which were used to repay a portion of the outstanding borrowings under the Senior Credit Facility.
On November 24, 2009, the Company entered into a Land Agreement, as amended (the “Land Agreement”), with an unrelated third party and its affiliate. Under this arrangement, the Company may until May 31, 2011 acquire up to $20 million of oil, gas and mineral interests/leases in certain specified areas in the Barnett Shale from the third party. In consideration of the Company’s receipt of an option to purchase the leases acquired by the third party, each time the third party purchases a lease group under the Land Agreement, if any, the Company will issue to the third party’s affiliate warrants to purchase a number of shares of the Company’s common stock equal to the quotient of (rounded up to the nearest whole number) (1) 20% of the purchase price of such lease group divided by (2) $13.00, with an exercise p rice of $22.09 and an expiration date of August 21, 2017. In addition, under certain circumstances where the Company reaches surface casing point on an initial well in one of the areas covered by the Land Agreement but has not achieved a specified lease up threshold for acreage in such area, the Company will issue additional warrants, on the same terms, to purchase a number of shares of the Company’s stock equal to the quotient (rounded up to the nearest whole number) of (1) 20% of the product of (A) the number of acres below the specified lease up threshold multiplied by (B) $5,000, divided by (2) $13.00. The warrants are subject to antidilution adjustments and may be exercised on a “cashless” basis.
On September 13, 2010, the Company issued warrants to purchase 48,385 shares of the Company’s common stock to the third party’s affiliate in connection with purchases of leases by the third party under the Land Agreement.
| 9. | DERIVATIVE INSTRUMENTS |
The Company relies on various types of derivative instruments to manage its exposure to commodity price risk and to provide a level of certainty in its forward cash flows supporting its capital investment program. The commodity derivative instruments typically used are fixed-rate swaps, costless collars, puts, calls and basis swaps. The Company’s current long-term strategy is to manage exposure for a substantial, but varying, portion of forecasted production up to 36 months. The derivative instruments are carried at fair value in the consolidated balance sheets, with the changes in fair value included in the consolidated statements of operations for the period in which the changes occur.
Under these derivative instruments, payments are received or made based on the differential between a fixed and a variable product price. These agreements are settled in cash at termination, expiration or exchanged for physical delivery contracts. The Company enters into the majority of its derivative transactions with three counterparties and netting agreements are in place with those counterparties. The Company does not obtain collateral to support the agreements but monitors the financial viability of counterparties and believes its credit risk is minimal on these transactions. In the event of nonperformance, the Company would be exposed to price and credit risk. The Company had not required its counterparties to post collateral at September 30, 2010 and December 31, 2009.
The following sets forth a summary of our natural gas derivative positions at average delivery location (Waha and Houston Ship Channel) prices as of September 30, 2010. Our crude oil derivative positions at September 30, 2010, were not significant.
| | | | | | Weighted | | | Weighted | |
| | | | | | Average | | | Average | |
| | | Volume | | | Floor Price | | Ceiling Price | |
| Period | | (in MMbtu) | | | ($/MMbtu) | | | ($/MMbtu) | |
| 2010 | | | 6,716,000 | | | $ | 5.76 | | | $ | 6.32 | |
| 2011 | | | 21,340,000 | | | $ | 6.12 | | | $ | 6.49 | |
| 2012 | | | 7,963,000 | | | $ | 6.53 | | | $ | 7.03 | |
| | | | | | | | | | | | | |
In connection with the derivative instruments above, the Company has entered into protective put spreads. When the market price declines below the short put price as reflected below, the Company will effectively receive the market price plus a put spread. For example, for the remainder of 2010, if market prices fall below the short put price of $4.11, the floor price becomes the market price plus the put spread of $1.65 on 5,209,000 of the 6,716,000 MMBtus and the remaining 1,507,000 MMBtus have a floor price of $5.76.
| | | | | | Weighted | | | Weighted | |
| | | | | | Average | | | Average | |
| | | Volume | | | Short Put Price | | Put Spread | |
| Period | | (in MMbtu) | | | ($/MMbtu) | | | ($/MMbtu) | |
| 2010 | | | 5,209,000 | | | $ | 4.11 | | | $ | 1.65 | |
| 2011 | | | 16,799,000 | | | $ | 4.29 | | | $ | 1.83 | |
| 2012 | | | 6,404,000 | | | $ | 4.47 | | | $ | 2.06 | |
| | | | | | | | | | | | | |
For the three months and nine months ended September 30, 2010 and 2009, the Company recorded the following related to its derivative instruments:
| | | Three Months | | | Nine Months | |
| | | Ended September 30, | | | Ended September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | (In thousands) | |
| Realized gain | | $ | 9,111 | | | $ | 16,038 | | | $ | 22,859 | | | $ | 62,064 | |
| Unrealized gain (loss) | | | 12,409 | | | | (18,024 | ) | | | 24,677 | | | | (36,262 | ) |
| Gain (loss) on derivative instruments, net | | $ | 21,520 | | | $ | (1,986 | ) | | $ | 47,536 | | | $ | 25,802 | |
| | | | | | | | | | | | | | | | | |
The Company deferred the payment of premiums associated with certain of its derivative instruments totaling $5.4 million and $4.8 million at September 30, 2010 and December 31, 2009, respectively. The Company classified $4.3 million and $1.8 million as other current liabilities at September 30, 2010 and December 31, 2009, respectively, and $1.1 million and $3.0 million as other non-current liabilities at September 30, 2010 and December 31, 2009, respectively. These deferred premiums will be paid to the counterparty with each monthly settlement (October 2010 – December 2011) and recognized as a reduction of realized gain on derivative instruments.
The fair value of derivative instruments at September 30, 2010 and December 31, 2009 was a net asset of $35.8 million and $12.1 million, respectively. At September 30, 2010, approximately 81% of the fair value of the Company’s derivative instruments were with Credit Suisse, 15% were with Shell Energy North America (US) LP, and the remaining 4% were with Credit Agricole.
| 10. | FAIR VALUE MEASUREMENTS |
Accounting guidelines for measuring fair value establish a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy categorizes assets and liabilities measured at fair value into one of three different levels depending on the observability of the inputs employed in the measurement. The three levels are defined as follows:
Level 1 – Observable inputs such as quoted prices in active markets at the measurement date for identical, unrestricted assets or liabilities.
Level 2 – Other inputs that are observable directly or indirectly such as quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability.
Level 3 – Unobservable inputs for which there is little or no market data and which the Company makes its own assumptions about how market participants would price the assets and liabilities.
The following presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2010 and December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
| | | September 30, 2010 | | | December 31, 2009 | |
| | | Level 1 | | | Level 2 | | | Level 3 | | | Total | | | Level 1 | | | Level 2 | | | Level 3 | | | Total | |
| | | (in thousands) | |
| Assets: | | | | | | | | | | | | | | | | | | | | | | | | |
| Investment in Pinnacle | | | | | | | | | | | | | | | | | | | | | | | | |
| Gas Resources, Inc. | | $ | 818 | | | $ | - | | | $ | - | | | $ | 818 | | | $ | 835 | | | $ | - | | | $ | - | | | $ | 835 | |
| Derivative instruments | | | - | | | | 65,213 | | | | - | | | | 65,213 | | | | - | | | | 48,192 | | | | - | | | | 48,192 | |
| Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Derivative instruments | | | - | | | | 29,446 | | | | - | | | | 29,446 | | | | - | | | | 36,129 | | | | - | | | | 36,129 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total | | $ | 818 | | | $ | 35,767 | | | $ | - | | | $ | 36,585 | | | $ | 835 | | | $ | 12,063 | | | $ | - | | | $ | 12,898 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
The derivative assets and liabilities above are presented as gross assets and liabilities, without regard to master netting arrangements, which are considered in the presentation of derivative assets and liabilities in our consolidated balance sheets.
Derivatives instruments are valued by industry-standard valuation models that consider various inputs including: (a) quoted forward prices for commodities, (b) time value, (c) volatility factors and (d) current market and contractual prices for the underlying instruments, as well as other relevant economic measures. We had no transfers in or out of Levels 1 or 2 for the nine months ended September 30, 2010.
Fair Value of Other Financial Instruments
The Company’s other financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and debt. The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to the highly liquid nature or short-term nature of these instruments. The fair values of the borrowings under the Senior Credit Facility approximate the carrying amounts as of September 30, 2010 and December 31, 2009, and were determined based upon interest rates currently available to the Company for borrowings with similar terms. The fair value of the Convertible Senior Notes at September 30, 2010 and December 31, 2009 was estimated at approximately $345.7 million and $321.7 million, respectively, based on a quote provided by an investment bank.
| 11. | MARCELLUS SHALE JOINT VENTURE |
On September 10, 2010, the Company completed the sale of 20% of its interests in oil and gas properties in parts of Pennsylvania in the Marcellus Shale to Reliance Marcellus II, LLC (“Reliance”), a wholly-owned subsidiary of Reliance Holding USA, Inc. and an affiliate of Reliance Industries Limited for $13.1 million in cash and a commitment to pay 75% of certain of our future development costs of up to approximately $52 million. The Company received $11.9 million during the third quarter and expects to receive the remaining $1.2 million pending completion of land and title matters. The proceeds were recognized as a reduction to proved oil and gas properties, net and 20% of the unevaluated leaseholds and seismic costs associated with these properties (approximately $13.3 million) were transferred to pro ved oil and gas properties, net. A portion of the proceeds received by the Company in this transaction was used to repay borrowings under the Senior Credit Facility.
Simultaneous with this transaction, the Company and Reliance also entered into agreements to form a new joint venture with respect to the interests being purchased by Reliance from the Company and Avista as described below. The new Carrizo/Reliance joint venture agreement covers approximately 104,400 net acres in northern and central Pennsylvania. Under the terms of the agreement, the Company generally retained a 40% working interest in the acreage and Reliance generally acquired a 60% working interest. In addition to funding its own share of future development obligations, Reliance agreed to fund 75% of the Company’s portion of these costs until September 2012 or until the earlier full utilization of the up to $52 million development carry, subject to certain conditions and extensions.
| 12. | RELATED PARTY TRANSACTIONS |
Simultaneous with the closing of the Marcellus shale joint venture transactions discussed above, the Company’s existing joint venture partner in the Marcellus Shale, ACP II closed the sale of its entire interest in the same oil and gas properties to Reliance for a purchase price of approximately $327 million. The Company and Avista amended the participation agreement that governs the joint venture to provide that the proceeds from the sales of the Company��s and Avista’s properties to Reliance would be allocated separately from other properties subject to the joint venture. The parties also agreed that profit interest distributions to the Company with respect to Avista’s sale of properties to Reliance would be principally based upon the return on investment and internal rates of return associated with such proper ties. In connection with the closing of the transactions with Reliance, on September 10, 2010, the Company and Avista further amended the participation agreement and other joint venture agreements with Avista to provide that the properties that the Company and Avista sold to Reliance, as well as the properties the Company commits to the new joint venture with Reliance, are not subject to the terms of the Avista joint venture, and that the Avista joint venture’s area of mutual interest will generally not include Pennsylvania, in which those properties are located. Our Marcellus joint venture with Avista continues and now covers approximately 147,000 net acres, primarily in West Virginia and New York.
During the third quarter, the Company received cash distributions of $20.8 million on its B Unit investment in ACP II as a result of ACP II’s distribution of Reliance sale proceeds to Avista. These cash distributions were recognized as Distribution Income-Related Party in the accompanying consolidated statements of operations. A portion of the proceeds received by the Company in this transaction was used to repay borrowings under our Senior Credit Facility.
Steven A. Webster, Chairman of the Company’s Board of Directors, also serves as Co-Managing Partner and President of Avista. As previously disclosed, the Company has been a party to prior arrangements with affiliates of Avista Capital Holdings, LP in respect of the Company’s investment in Pinnacle Gas Resources, Inc.
On October 13, 2010, the Company received an additional $0.3 million from Reliance pursuant to the purchase and sale agreement and an additional $1.4 million in cash distributions from ACP II.
On October 21, 2010, the Company amended the Senior Credit Facility to permit the offering and issuance of the senior notes described below and the tender offer of the Convertible Senior Notes described below. The amendment also added restrictions on the Company’s ability to repurchase any senior notes issued in the senior notes offering and to make certain amendments to the terms of any senior notes issued in the senior notes offering, and added further restrictions on the Company’s ability to purchase the Convertible Senior Notes (other than pursuant to the tender offer described below).
In addition, the amendment to the Senior Credit Facility amended certain financial covenants in the credit agreement for the Senior Credit Facility. Specifically, from and after the date on which the senior notes offering closed, the Company is required to maintain: (1) a minimum current ratio of 1.00 to 1.00 (as defined in the Senior Credit Facility); and (2) a maximum total net debt (which excludes certain amounts attributable to the Convertible Senior Notes) to Consolidated EBITDA (as defined in the Senior Credit Facility) of (a) 4.75 to 1.00 for the fiscal quarter ending on September 30, 2010, (b) 4.25 to 1.00 for the fiscal quarters ending on or after December 31, 2010 and on or before June 30, 2011, (c) 4.50 to 1.00 for the fiscal quarters ending on or after September 30, 2011 and on or before December 31, 2011, and (d) 4.00 to 1 .00 for each fiscal quarter ending on or after March 31, 2012; and (3) a maximum ratio of senior debt (which excludes the aggregate principal amount of the senior notes and the Convertible Senior Notes) to Consolidated EBITDA of (a) 2.25 to 1.00 for the fiscal quarters ending on or after September 30, 2010 and on or before June 30, 2011, (b) 2.50 to 1.00 for the fiscal quarters ending on or after September 30, 2011 and on or before December 31, 2011 and (c) 2.25 to 1.00 for each fiscal quarter ending on or after March 31, 2012. Because the calculation of the financial ratios are made as of a certain date, the financial ratios can fluctuate significantly period to period as the amounts outstanding under the Senior Credit Facility are dependent on the timing of cash flows related to operations, capital expenditures, sales of oil and gas properties and securities offerings.
The amendment also provided that, upon the issuance of senior notes pursuant to the senior notes offering, the Company must repay all outstanding amounts under the Senior Credit Facility. Furthermore, the amendment provided that, on the date that the Company purchases any Convertible Senior Notes pursuant to the tender offer, the borrowing base under the Senior Credit Facility will be reduced by an amount equal to 25% of the difference between the aggregate principal amount of the senior notes issued in the senior notes offering and the aggregate principal amount of Convertible Senior Notes purchased pursuant to the tender offer.
On November 2, 2010, the Company completed its private placement of 8.625% $400 million aggregate principal amount of its senior notes due 2018 at an offering price equal to 99.302% (the “Senior Notes”). The Senior Notes are guaranteed by certain of the
Company’s subsidiaries: CCBM, Inc.; CLLR, Inc.; Carrizo (Marcellus) LLC; Carrizo (Marcellus) WV LLC; Carrizo Marcellus Holding, Inc.; Hondo Pipeline, Inc.; Bandelier Pipeline Holding, LLC; Chama Pipeline Holding, LLC; and Mescalero Pipeline, LLC. The net proceeds of $387.7 million (after deducting initial purchasers’ discounts and the Company’s estimated expenses) were used to repay in full borrowings outstanding under the Senior Credit Facility with the remaining net proceeds initially being held in short-term investments. Upon closing of the tender offer for up to $300 million of its Convertible Senior Notes discussed below, the Company intends to use the net proceeds that are being held in short-term investments, together with borrowings under the Senior Credit Facility, to fund the tender off er. If the tender offer is not consummated, the Company intends to use the net proceeds from the Senior Notes offering that were held in short-term investments to fund in part its recently expanded capital expenditure program, including exploration in the Eagle Ford Shale and Niobrara formation, and for general corporate purposes.
On November 2, 2010, the Company and the guarantors of the Senior Notes entered into a supplement to the indenture pursuant to which such guarantors also guaranteed the Convertible Senior Notes. The guarantee of the Convertible Senior Notes by the guarantors was required under the indenture for the Convertible Senior Notes as a result of the issuance of their guarantees of the Senior Notes.
On October 25, 2010, the Company commenced a tender offer for up to $300 million aggregate principal amount outstanding of the Convertible Senior Notes. Each holder will receive $1,000 for each $1,000 principal amount of Convertible Senior Notes purchased in the tender offer, plus accrued and unpaid interest. The tender offer is subject to conditions, including that at least $200 million aggregate principal amount are tendered and not withdrawn. The Company may amend, extend or waive conditions to, or terminate, the tender offer. The tender offer will expire on November 23, 2010 unless extended by the Company. The Company expects to recognize a non-cash, pre-tax loss on extinguishment of debt as a result of the purchase of the Convertible Senior Notes in the tender offer currently estimated to be approx imately $30 million, assuming the purchase of the full $300 million principal amount sought in the tender offer.
